Epsilon Energy 10Q 2020 Q3 Quarterly report

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

⌧ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2020

◻ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 001-38770

EPSILON ENERGY LTD.

(Exact name of registrant as specified in its charter)


Alberta, Canada		98-1476367
(State or other jurisdiction of incorporation or organization)		(I.R.S Employer Identification No.)

16945 Northchase Drive, Suite 1610

Houston, Texas 77060

(281) 670-0002

(Address of principal executive offices including zip code and

telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:


Title of each class	Trading Symbol	Name of each exchange on which registered
Common Shares, no par value	“EPSN”	NASDAQ Global Market

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ⌧ No ◻

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes⌧ No ◻

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ◻	Accelerated filer ◻	Non-accelerated filer ⌧
Smaller reporting company ⌧	Emerging growth company ⌧

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. Yes ◻ No ⌧

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ◻ No ⌧

As of November 10, 2020, there were 23,859,136 Common Shares outstanding.

Table of Contents


Contents

FORWARD-LOOKING STATEMENTS		4
PART I-FINANCIAL INFORMATION		5
ITEM 1. FINANCIAL STATEMENTS		5
Unaudited Condensed Consolidated Balance Sheets		5
Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income		6
Unaudited Condensed Consolidated Statements of Changes in Shareholders’ Equity		7
Unaudited Condensed Consolidated Statements of Cash Flows		9
Notes to the Unaudited Condensed Consolidated Financial Statements		10
1.	Description of Business	10
2.	Basis of Preparation	11
	Interim Financial Statements	11
	Principles of Consolidation	11
	Use of Estimates	11
	Recently Issued Accounting Standards	11
3.	Cash, Cash Equivalents, and Restricted Cash	12
4.	Property and Equipment	13
	Property Additions and Acquisitions	13
	Property Impairment	13
5.	Revolving Line of Credit	13
6.	Shareholders’ Equity	15
7.	Revenue Recognition	18
8.	Accumulated Other Comprehensive Income (Loss)	20
9.	Income Taxes	20
10.	Commitments and Contingencies	21
	Litigation	21
11.	Net Income Per Share	21
12.	Operating Segments	22
13.	Risk Management Activities	25
	Commodity Price Risks	25
	Commodity Derivative Contracts	26
14.	Asset Retirement Obligations	27
15.	Fair Value Measurements	27
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		28
	Overview	28
	Business Strategy	28
	Operational Highlights	31
	Non-GAAP Financial Measures-Adjusted EBITDA	31
	Net Operating Revenues	32
	Operating Costs	33
	Depletion, Depreciation, Amortization and Accretion (“DD&A”)	34
	General and Administrative	35
	Interest Expense	35
	Net Gain (Loss) on Commodity Contracts	35

Table of Contents

	Miscellaneous Income (Expense)	36
	Capital Resources and Liquidity	36
	Cash Flow	36
	Credit Agreement	37
	Derivative Transactions	38
	Contractual Obligations	38
	Off-Balance Sheet Arrangements	39
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		39
	Gathering System Revenue Risk	39
	Interest Rate Risk	39
	Commodity Contracts	39
ITEM 4. CONTROLS AND PROCEDURES		39
	Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures	39
	Changes in Internal Control Over Financial Reporting	40
PART II OTHER INFORMATION		40
ITEM 1. LEGAL PROCEEDINGS		40
ITEM 1A. RISK FACTORS		40
ITEM 2. UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS		41
ITEM 3. DEFAULTS UPON SENIOR SECURITIES		42
ITEM 4. MINE SAFETY DISCLOSURES		42
ITEM 5. OTHER INFORMATION		42
ITEM 6. EXHIBITS		43
SIGNATURES		43

Table of Contents

FORWARD-LOOKING STATEMENTS

Certain statements contained in this report constitute forward-looking statements. The use of any of the words ‘‘anticipate,’’ ‘‘continue,’’ ‘‘estimate,’’ ‘‘expect,’’ ‘‘may,’’ ‘‘will,’’ ‘‘project,’’ ‘‘should,’’ ‘‘believe,’’ and similar expressions and statements relating to matters that are not historical facts constitute ‘‘forward looking information’’ within the meaning of applicable securities laws. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results or events to differ materially from those anticipated. Such forward-looking statements are based on reasonable assumptions, but no assurance can be given that these expectations will prove to be correct and the forward-looking statements included in this report should not be unduly relied upon. These statements are made only as of the date of this report. All statements that address operating performance, events or developments that we expect or anticipate will occur in the future — including statements relating to natural gas and oil production rates, commodity prices for crude oil or natural gas, supply and demand for natural gas and oil; the estimated quantity of natural gas and oil reserves, including reserve life; future development and production costs, and statements expressing general views about future operating results — are forward-looking statements. Management believes that these forward-looking statements are reasonable as and when made. However, caution should be taken not to place undue reliance on any such forward-looking statements because such statements speak only as of the date when made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In addition, forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our present expectations or projections. These risks and uncertainties include, but are not limited to, those described in our Annual Report on Form 10-K for the year ended December 31, 2019, and those described from time to time in our future reports filed with the Securities and Exchange Commission. You should consider carefully the statements under Item 1A. Risk Factors included in our Annual Report on Form 10-K for the year ended December 31, 2019 and in the quarterly reports on Form 10-Q for the quarters ended June 30, 2020 and March 31, 2020, which describe factors that could cause our actual results to differ from those set forth in the forward-looking statements. Our Annual Report on Form 10-K for the year ended December 31, 2019 and quarterly reports on Form 10-Q for the quarters ended June 30, 2020 and March 31, 2020 are available on our website at www.epsilonenergyltd.com.

Table of Contents

PART I-FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Balance Sheets


	September 30,		December 31,
	2020		2019
ASSETS
Current assets
Cash and cash equivalents	$	11,580,278	$	14,052,417
Accounts receivable, net of allowance for doubtful accounts of $819,000 at September 30, 2020 and nil at December 31, 2019		3,652,036		4,296,917
Fair value of derivatives		20,258		1,999,802
Prepaid income taxes		2,091,399		1,641,501
Other current assets		511,483		433,687
Total current assets		17,855,454		22,424,324
Non-current assets
Property and equipment:
Oil and gas properties, successful efforts method
Proved properties		133,138,412		130,819,256
Unproved properties		21,448,546		21,047,512
Accumulated depletion, depreciation, amortization and impairment		(96,864,983)		(89,255,035)
Total oil and gas properties, net		57,721,975		62,611,733
Gathering system		41,912,242		41,445,225
Accumulated depletion, depreciation, amortization and impairment		(31,697,749)		(29,961,690)
Total gathering system, net		10,214,493		11,483,535
Land		637,464		375,314
Buildings and other property and equipment, net		343,677		211,879
Total property and equipment, net		68,917,609		74,682,461
Other assets:
Restricted cash		565,049		561,294
Prepaid drilling costs		1,341		1,124
Total non-current assets		69,483,999		75,244,879
Total assets	$	87,339,453	$	97,669,203

LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities
Accounts payable trade	$	1,638,763	$	2,828,495
Royalties payable		1,046,899		1,306,922
Accrued capital expenditures		95,237		627,356
Accrued gathering fees		529,722		373,929
Other accrued liabilities		1,427,489		858,188
Asset retirement obligation		1,581,561		1,503,978
Total current liabilities		6,319,671		7,498,868
Non-current liabilities
Asset retirement obligation		1,489,386		1,405,877
Deferred income taxes		12,201,046		12,401,464
Total non-current liabilities		13,690,432		13,807,341
Total liabilities		20,010,103		21,306,209
Commitments and contingencies (Note 10)
Shareholders' equity
Common shares, no par value, unlimited shares authorized and 23,817,470 issued and outstanding at September 30, 2020 and 26,790,985 shares issued and outstanding at December 31, 2019.		131,730,401		140,808,923
Additional paid-in capital		7,614,593		7,029,488
Accumulated deficit		(81,834,413)		(81,285,895)
Accumulated other comprehensive income		9,818,769		9,810,478
Total shareholders' equity		67,329,350		76,362,994
Total liabilities and shareholders' equity	$	87,339,453	$	97,669,203

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

Table of Contents

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income


	Three months ended September 30,				Nine months ended September 30,
	2020		2019		2020		2019
Revenues from contracts with customers:
Gas, oil, NGLs and condensate revenue	$	3,590,706	$	2,999,581	$	11,716,897	$	13,005,722
Gas gathering and compression revenue		2,219,905		2,219,613		6,800,347		6,923,058
Total revenue		5,810,611		5,219,194		18,517,244		19,928,780

Operating costs and expenses:
Lease operating expenses		2,147,795		1,548,902		6,229,682		4,851,090
Gathering system operating expenses		43,711		461,036		221,191		1,012,709
Development geological and geophysical expenses		2,693		—		7,595		83,748
Depletion, depreciation, amortization, and accretion		2,769,193		1,851,466		7,761,339		5,630,368
Impairment of proved properties		—		—		1,760,000		—
Gain on sale of property		—		(445,173)		—		(1,375,000)
Bad debt expense		—		—		819,000		—
General and administrative expenses:
Stock based compensation expense		239,134		133,720		585,105		401,161
Other general and administrative expenses		1,330,604		952,503		3,575,445		3,213,371
Total operating costs and expenses		6,533,130		4,502,454		20,959,357		13,817,447
Operating income (loss)		(722,519)		716,740		(2,442,113)		6,111,333

Other income (expense):
Interest income		4,724		38,618		39,294		127,906
Interest expense		(28,629)		(29,416)		(84,952)		(86,035)
Gain on derivative contracts		419,879		1,270,494		2,055,548		3,494,727
Other income (expense)		—		1		(2,228)		456
Other income, net		395,974		1,279,697		2,007,662		3,537,054

Income (loss) before income tax expense		(326,545)		1,996,437		(434,451)		9,648,387
Income tax expense (benefit)		(33,762)		543,139		114,067		2,983,555
NET INCOME (LOSS)	$	(292,783)	$	1,453,298	$	(548,518)	$	6,664,832
Currency translation adjustments		2,273		(900)		8,291		10,944
NET COMPREHENSIVE INCOME (LOSS)	$	(290,510)	$	1,452,398	$	(540,227)	$	6,675,776

Net income (loss) per share, basic	$	(0.01)	$	0.05	$	(0.02)	$	0.24
Net income (loss) per share, diluted	$	(0.01)	$	0.05	$	(0.02)	$	0.24
Weighted average number of shares outstanding, basic		23,955,619		27,060,387		25,550,194		27,218,162
Weighted average number of shares outstanding, diluted		23,955,619		27,094,391		25,550,194		27,240,117

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

Table of Contents

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Changes in Shareholders’ Equity


									Accumulated
									Other				Total
	Common Shares Issued			Treasury Shares			Additional		Comprehensive		Accumulated		Shareholders'
	Shares	Amount		Shares	Amount		paid-in Capital		Income		Deficit		Equity
Balance at January 1, 2020	26,790,985	$	140,808,923	—	$	—	$	7,029,488	$	9,810,478	$	(81,285,895)	$	76,362,994
Net income	—		—	—		—		—		—		310,299		310,299
Stock-based compensation expenses	—		—	—		—		173,919		—		—		173,919
Buyback of common shares	—		—	(488,029)		(1,499,586)		—		—		—		(1,499,586)
Other comprehensive loss	—		—	—		—		—		(114)		—		(114)
Balance at March 31, 2020	26,790,985	$	140,808,923	(488,029)	$	(1,499,586)	$	7,203,407	$	9,810,364	$	(80,975,596)	$	75,347,512
Net loss	—		—	—		—		—		—		(566,034)		(566,034)
Stock-based compensation expenses	—		—	—		—		172,052		—		—		172,052
Buyback of common shares	—		—	(169,285)		(427,612)		—		—		—		(427,612)
Other comprehensive income	—		—	—		—		—		6,132		—		6,132
Balance at June 30, 2020	26,790,985	$	140,808,923	(657,314)	$	(1,927,198)	$	7,375,459	$	9,816,496	$	(81,541,630)	$	74,532,050
Net income	—		—	—		—		—		—		(292,783)		(292,783)
Stock-based compensation expenses	—		—	—		—		239,134		—		—		239,134
Retirement of treasury shares	(657,314)		(1,927,198)	657,314		1,927,198		—		—		—		—
Shares retired through tender offer	(2,337,034)		(7,151,324)	—		—		—		—		—		(7,151,324)
Vesting of shares of stock	20,833		—	—		—		—		—		—		—
Other comprehensive income	—		—	—		—		—		2,273		—		2,273
Balance at September 30, 2020	23,817,470	$	131,730,401	—	$	—	$	7,614,593	$	9,818,769	$	(81,834,413)	$	67,329,350

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

Table of Contents


									Accumulated
									Other				Total
	Common Shares Issued			Treasury Shares			Additional		Comprehensive		Accumulated		Shareholders'
	Shares	Amount		Shares	Amount		paid-in Capital		Income		Deficit		Equity
Balance at January 1, 2019	27,439,300	$	143,705,441	(26,953)	$	(94,418)	$	6,519,028	$	9,797,930	$	(89,983,894)	$	69,944,087
Net income	—		—	—		—		—		—		1,373,676		1,373,676
Stock-based compensation expenses	—		—	—		—		133,720		—		—		133,720
Retirement of treasury shares	(26,953)		(94,418)	26,953		94,418		—		—		—		—
Buyback and retirement of common shares	(57,100)		(248,381)	—		—		—		—		—		(248,381)
Other comprehensive income	—		—	—		—		—		10,792		—		10,792
Balance at March 31, 2019	27,355,247	$	143,362,642	—	$	—	$	6,652,748	$	9,808,722	$	(88,610,218)	$	71,213,894
Net income	—		—	—		—		—		—		3,837,858		3,837,858
Stock-based compensation expenses	—		—	—		—		133,721		—		—		133,721
Buyback of common shares	—		—	(237,189)		(985,264)		—		—		—		(985,264)
Other comprehensive income	—		—	—		—		—		1,052		—		1,052
Balance at June 30, 2019	27,355,247	$	143,362,642	(237,189)	$	(985,264)	$	6,786,469	$	9,809,774	$	(84,772,360)	$	74,201,261
Net income	—		—	—		—		—		—		1,453,298		1,453,298
Stock-based compensation expenses	—		—	—		—		133,720		—		—		133,720
Exercise of stock options	25,000		54,250	—		—		—		—		—		54,250
Buyback of common shares	—		—	(126,341)		(480,646)		—		—		—		(480,646)
Other comprehensive loss	—		—	—		—		—		(900)		—		(900)
Balance at September 30, 2019	27,380,247	$	143,416,892	(363,530)	$	(1,465,910)	$	6,920,189	$	9,808,874	$	(83,319,062)	$	75,360,983

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

Table of Contents

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Cash Flows


	Nine months ended September 30,
	2020		2019
Cash flows from operating activities:
Net income (loss)	$	(548,518)	$	6,664,832
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depletion, depreciation, amortization, and accretion		7,761,339		5,630,368
Impairment of proved properties		1,760,000		—
Bad debt expense		819,000		—
Gain on sale/disposal of properties		—		(1,375,000)
Gain on derivative contracts		(2,055,548)		(3,494,727)
Cash received from settlements of derivative contracts		4,035,092		1,344,690
Stock-based compensation expense		585,105		401,161
Deferred income tax expense (benefit)		(200,418)		853,116
Changes in assets and liabilities:
Accounts receivable		(174,119)		1,869,411
Prepaid income taxes and other current assets		(527,694)		19,321
Accounts payable, royalties payable and other accrued liabilities		639,224		(1,422,238)
Income taxes payable		—		1,338,225
Net cash provided by operating activities		12,093,463		11,829,159
Cash flows from investing activities:
Acquisition of unproved oil and gas properties		—		(596,500)
Additions to unproved oil and gas properties		(401,034)		(919,873)
Additions to proved oil and gas properties		(4,238,580)		(5,452,166)
Additions to gathering system properties		(436,111)		(238,823)
Additions to land, buildings and property and equipment		(415,674)		—
Prepaid drilling costs		(217)		(1,739)
Proceeds from sale of leases		—		1,375,000
Net cash used in investing activities		(5,491,616)		(5,834,101)
Cash flows from financing activities:
Buyback of common shares		(9,078,522)		(1,714,291)
Exercise of stock options		—		54,250
Net cash used in financing activities		(9,078,522)		(1,660,041)
Effect of currency rates on cash, cash equivalents and restricted cash		8,291		10,944
Increase (decrease) in cash, cash equivalents and restricted cash		(2,468,384)		4,345,961
Cash, cash equivalents and restricted cash, beginning of period		14,613,711		14,959,518
Cash, cash equivalents and restricted cash, end of period	$	12,145,327	$	19,305,479

Supplemental cash flow disclosures:
Income taxes paid	$	760,000	$	733,200
Interest paid	$	84,952	$	89,817

Non-cash investing activities:
Change in proved properties accrued in accounts payable and accrued liabilities	$	(1,926,910)	$	1,129,972
Change in gathering system accrued in accounts payable and accrued liabilities	$	30,906	$	(1,142)
Asset retirement obligation asset additions and adjustments	$	7,487	$	9,997

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

1. Description of Business

Epsilon Energy Ltd. (the “Company” or “Epsilon” or “we”) was incorporated under the laws of the Province of Alberta, Canada on March 14, 2005. On October 24, 2007, the Company became a publicly traded entity trading on the Toronto Stock Exchange (“TSX”) in Canada. On February 14, 2019, Epsilon’s registration statement on Form 10 was declared effective by the United States Securities and Exchange Commission and on February 19, 2019, the Company began trading in the United States on the NASDAQ Global Market under the trading symbol “EPSN.” The Company is engaged in the acquisition, development, gathering and production of primarily natural gas reserves in the United States.

Recent Developments

The significant demand declines caused by the global response to the coronavirus 2019 pandemic (“COVID-19”) as well as the actions taken by a number of global oil producers has contributed to steep declines in the demand and pricing for oil, natural gas and NGLs, negatively impacting U.S. producers. The commodity price environment is expected to remain depressed based on over-supply, decreased demand and a drastic global economic downturn. While Epsilon did not incur significant disruptions to operations during the nine months ended September 30, 2020 as a result of the COVID-19 pandemic, the Company did need to recognize an impairment on its legacy Oklahoma producing assets due to the historically low commodity prices. The full impact of the COVID-19 pandemic continues to evolve as of the date of this report. As such, the full magnitude that the pandemic will have on the Company’s financial condition, liquidity, and future results of operations is uncertain. Management is actively monitoring the impact of the COVID-19 pandemic on the Company's financial condition, liquidity, operations, suppliers, industry and ability to obtain financing in future reporting periods. Given the daily evolution of the COVID-19 pandemic and the global responses to curb its spread, the Company is currently not able to estimate the effects of the COVID-19 pandemic on its results of operations, financial condition, or liquidity for the future. However, if the pandemic and the low oil and gas price environment continue, it may have a material adverse effect on the Company’s operating cash flows, liquidity, and future development plans.

The federal government has passed a series of relief and stimulus packages, including the CARES Act, for the country, but Epsilon has not and does not anticipate that it will apply for assistance under such programs. Accordingly, these programs have no effect on Epsilon’s financial statements.

On June 28, 2020, Chesapeake Energy Corporation (“CHK”) filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code (“Petition”). Chesapeake Energy Marketing, Inc. is one of the Anchor Shippers under the Anchor Ship Gas Gathering Agreement (“ASGGA”) for the Auburn GGS with a 43.8750% voting percentage. The Williams Companies Inc. (“Williams”), including its subsidiary Appalachia Midstream Services, L.L.C. (“AMS”), is listed in the petition as a top 30 creditor of CHK, with an amount due by CHK under the ASGGA. On June 28, 2020 unpaid fees attributable to CHK for the ASGGA for May and June 2020 gathering fees were $1.1 million and $1.3 million respectively. As of September 30, 2020, Epsilon has recorded an allowance for doubtful accounts for the Company’s 35% share of these payments for a total bad debt expense of $0.8 million. Epsilon is a 35% owner in the ASGGA. Whether and when these pre-petition amounts are paid depends on how the bankruptcy proceeding unfolds related to the ASGGA. Pre-petition amounts are handled differently than post-petition amounts (amounts for services related to CHK’s production after June 28, 2020). The general rule post-petition is that, if CHK wants to receive the continued provision of services under the ASGGA, Williams is required to continue to perform under the ASGGA provided that Williams is paid for such performance. Currently, CHK continues to produce into the gathering system, and drill and complete wells in the areas covered by the ASGGA, as such, no further provision for amounts post-petition was required. In addition, one well that we have interest in began production in October 2020, and another is scheduled to begin in November.

Accordingly, the Company is unable to predict the impact that the COVID-19 pandemic and the CHK bankruptcy will have on it, including our financial position, operating results, liquidity and ability to obtain financing in future reporting periods, due to numerous uncertainties.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

2. Basis of Preparation

Interim Financial Statements

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the appropriate rules and regulations of the SEC. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. All adjustments which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the interim periods presented have been included. The interim financial information and notes hereto should be read in conjunction with the Company’s consolidated financial statements as of and for the years ended December 31, 2019 and 2018. The results of operations for interim periods are not necessarily indicative of results to be expected for a full fiscal year.

Principles of Consolidation

The Company’s unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Epsilon Energy USA, Inc. and its wholly owned subsidiaries, Epsilon Midstream, LLC, Dewey Energy GP, LLC, Dewey Energy Holdings, LLC, Epsilon Operating, LLC, and Altolisa Holdings, LLC. With regard to the gathering system, in which Epsilon owns an undivided interest in the asset, proportionate consolidation accounting is used. All inter-company transactions have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates pertain to proved natural gas and oil reserves and related cash flow estimates used in impairment tests of natural gas and oil, and gathering system properties, asset retirement obligations, accrued natural gas and oil revenues and operating expenses, accrued gathering system revenues and operating expenses, as well as the valuation of commodity derivative instruments. Actual results could differ from those estimates.

Recently Issued Accounting Standards

The Company, an emerging growth company (“EGC”), has elected to take advantage of the benefits of the extended transition period provided for in Section 7(a)(2)(B) of the Securities Act, for complying with new or revised accounting standards which allows the Company to defer adoption of certain accounting standards until those standards would otherwise apply to private companies.

In March 2020, the FASB issued ASU No. 2020-04 - Reference Rate Reform (Topic 848), codified as ASC 848 (“ASC 848”). The purpose of ASC 848 is to provide optional guidance to ease the potential effects on financial reporting of the market-wide migration away from Interbank Offered Rates (“IBORs”) to alternative reference rates. ASC 848 applies only to contracts, hedging relationships, and other transactions that reference a reference rate expected to be discontinued because of reference rate reform. The guidance may be applied upon issuance of ASC 848 through December 31, 2022. The Company is currently assessing the impact of adopting this new guidance.

In December 2019, the Financial Accounting Standards Board (“FASB”) issued ASU 2019-12, “Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes,” which simplifies the accounting for income taxes by removing certain exceptions to the general principles in Topic 740, Income Taxes. The guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. Early adoption is permitted. The Company is currently assessing the impact of adopting this new guidance.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

In June 2016 the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which removes the thresholds that companies apply to measure credit losses on financial instruments measured at amortized cost, such as loans, receivables, and held-to-maturity debt securities. Under current U.S. GAAP, companies generally recognize credit losses when it is probable that the loss has been incurred. The revised guidance will remove all recognition thresholds and will require companies to recognize an allowance for credit losses for the difference between the amortized cost basis of a financial instrument and the amount of amortized cost that the company expects to collect over the instrument’s contractual life. ASU 2016-13 is effective for fiscal years beginning after December 15, 2022, and interim periods within those fiscal years, and must be applied retrospectively. Early adoption is permitted. Epsilon will adopt ASU 2016-13 as of January 1, 2023.

In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842)” (ASU 2016-02), which significantly changes accounting for leases by requiring that lessees recognize a right of use asset and a related lease liability representing the obligation to make lease payments, for all lease transactions with terms greater than one year. Additional disclosures about an entity’s lease transactions will also be required. ASU 2016-02 defines a lease as “a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.” ASU 2016-02 is effective for the Company for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. In July, the FASB voted to extend the adoption date by one year for private and non-profit companies, and thus emerging growth companies as well. As an emerging growth company, Epsilon plans to defer adoption of ASU 2016-02 until the fiscal year beginning after December 15, 2021. Lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented in the financial statements using a modified retrospective approach. Epsilon is reviewing the provisions of ASU 2016-02 and anticipates the addition of an insignificant asset and related liability associated with our office lease beginning in January 2022.

3. Cash, Cash Equivalents, and Restricted Cash

Cash and cash equivalents include cash on hand and short term, highly liquid investments with original maturities of three months or less that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

Restricted cash consists of amounts deposited to back bonds or letters of credit for potential well liabilities. The Company presents restricted cash with cash and cash equivalents in the Consolidated Statements of Cash Flows. The following table provides a reconciliation of cash, cash equivalents and restricted cash reported in the Consolidated Balance Sheets to the total of the amounts in the Consolidated Statements of Cash Flows as of September 30, 2020 and 2019:


	September 30,		September 30,
	2020		2019
Cash and cash equivalents	$	11,580,278	$	18,746,426
Restricted cash included in other assets		565,049		559,053
Cash, cash equivalents and restricted cash in the statement of cash flows	$	12,145,327	$	19,305,479

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

4. Property and Equipment

The following table summarizes the Company’s property and equipment as at September 30, 2020 and December 31, 2019:


	September 30,		December 31,
	2020		2019
Property and equipment:
Oil and gas properties, successful efforts method
Proved properties	$	133,138,412	$	130,819,256
Unproved properties		21,448,546		21,047,512
Accumulated depletion, depreciation, amortization and impairment		(96,864,983)		(89,255,035)
Total oil and gas properties, net		57,721,975		62,611,733
Gathering system		41,912,242		41,445,225
Accumulated depletion, depreciation, amortization and impairment		(31,697,749)		(29,961,690)
Total gathering system, net		10,214,493		11,483,535
Land		637,464		375,314
Buildings and other property and equipment, net		343,677		211,879
Total property and equipment, net	$	68,917,609	$	74,682,461

Property Additions and Acquisitions

No acquisitions were made during the nine months ended September 30, 2020. During the year ended December 31, 2019, the Company acquired additional acres in the Anadarko Basin for $596,500.

Property Sale

In June 2019, the Company completed the first part of a sale of undeveloped, stranded leases in Pennsylvania. At that time, the Company received $1.0 million. The sale was completed in July 2019 with a final payment of $0.4 million for a total of $1.4 million received for the stranded leases. No subsequent sales have occurred.

Property Impairment

Epsilon performs a quantitative impairment test quarterly or whenever events or changes in circumstances indicate that an asset group's carrying amount may not be recoverable, over proved properties using the published NYMEX forward prices, timing, methods and other assumptions consistent with historical periods. When indicators of impairment are present, tests require that the Company first compare expected future undiscounted cash flows by asset group to their respective carrying values. If the carrying amount exceeds the estimated undiscounted future cash flows, a reduction of the carrying amount of the natural gas properties to their estimated fair values is required. This is determined based on discounted cash flow techniques using significant assumptions including projected revenues, future commodity prices, and a market-specific weighted average cost of capital which are affected by expectations about future market and economic conditions.

During the three months ended March 31, 2020, Epsilon recognized certain indicators of impairments specific to our Oklahoma assets related to historically low oil and NGL prices and determined that the carrying value of those assets was not recoverable. As a result of this assessment, a $1.76 million impairment was assessed on the Company’s Oklahoma assets at March 31, 2020. No further impairment was required at September 30, 2020 and no impairment was required as of December 31, 2019.

5. Revolving Line of Credit

Effective July 30, 2013, Epsilon Energy USA Inc., a wholly owned subsidiary of the Company, executed a three-year senior secured revolving credit facility with a bank (‘‘Credit Facility’’) for a total commitment of up to $100 million.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Upon each advance, interest is charged at the rate of LIBOR plus an ‘‘applicable margin’’. The applicable margin ranges from 2.75 - 3.75% and is based on the percent of the line of credit utilized.

The terms “Borrowing Base” and “Mortgaged Properties” include the Company’s gathering system assets in addition to the natural gas and oil properties. The “Required Reserve Value” is the lesser of 90% of the recognized value of all proved natural gas and oil properties or 150% of the then current borrowing base.

On January 7, 2019, the maturity date of the Credit Facility was extended to March 1, 2022 and the borrowing base was increased from $13.5 million to $23 million. The borrowing base is subject to twice per annum redetermination by the lenders based on, among other things, their evaluation of the Company’s natural gas reserves. Additionally, the Company is required to maintain acceptable commodity hedging agreements covering at least 25% of projected production of natural gas for the succeeding calendar year, along with 50% for the current calendar year.

On August 14, 2019 the commodity hedging requirements were updated. Currently, when the Company’s utilization exceeds 25%, the Company must have in place acceptable commodity hedging agreements covering at least 75% of projected production for the first full twelve months after such occurrence and 50% of projected production of natural gas for the succeeding nine months.

On February 11, 2020 the borrowing base was reaffirmed at $23 million and hedging requirements remained unchanged.

The lender under the Credit Facility has a first priority security interest in the tangible and intangible assets, including the gathering system, of Epsilon Energy USA, Inc. to secure any outstanding amounts under the agreement. Under the terms of the agreement, the Company must maintain the following covenants:

● Interest coverage ratio greater than 3 based on income adjusted for interest, taxes and non-cash amounts.

● Current ratio, adjusted for line of credit amounts used and available and non-cash amounts, greater than 1.

● Leverage ratio less than 3.5 based on income adjusted for interest, taxes and non-cash amounts.

The Company was in compliance with the financial covenants of the Credit Facility as of September 30, 2020 and December 31, 2019 and expects to be in compliance with the financial covenants for the next 12 months.

A commitment fee of 0.50% is assessed quarterly on the daily average unused borrowing base on the Credit Facility.

Balance at

September 30,

December 31,

Current

Interest Rate

2020

2019

Borrowing Base

3 mo.

Revolving line of credit

—

23,000,000

LIBOR + 2.75%⁽¹⁾

(1)	At September 30, 2020, the weighted average interest rate was 2.98%.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

6. Shareholders’ Equity

(a)Authorized shares

The Company is authorized to issue an unlimited number of Common Shares with no par value and an unlimited number of Preferred Shares with no par value.

(b)Purchases of Equity Shares

Normal Course Issuer Bid

Prior to moving the Company listing from the TSX to the NASDAQ, and prior to the purchase of the equity shares on the NASDAQ shown below, the Company purchased shares through a normal-course issuer bid (“NCIB”) program with the TSX, which expired February 28, 2019. On the TSX the Company repurchased and retired 57,100 shares of common stock through the year ended December 31, 2019. The repurchased stock had an average price of $4.26 per share. The average share price (converted to US$ using a rate of Cdn$1.33 to US$1) on the TSX from January 1, 2019 through the last day of trading on the TSX, March 15, 2019, was $4.22.

Repurchases were made at management’s discretion from time to time through the facilities of the NASDAQ Global Market. The price paid for the common shares was, subject to applicable securities laws, the prevailing market price of such common shares on the NASDAQ Global Market at the time of such purchase. The Company funded the purchases out of available cash and did not incur debt to fund the share repurchase program.

Substantial Issuer Bid/Issuer Tender Offer

On May 14, 2020, the Company’s Board of Directors announced its intention to commence a substantial issuer bid/issuer tender offer to purchase for cash up to an aggregate of approximately $6.2 million of its common shares. In May 2020, upon the terms and subject to the conditions described in the Offer to Purchase dated May 19, 2020, as amended, the Company offered to repurchase up to 2,000,000 of its common shares for $3.06 per share, excluding taxes and interest, for a total cost of approximately $6.1 million, excluding expenses of the tender offer. As permitted under Rule 13e-4(f) and Rule 14e-1(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and as stated in its Offer to Purchase, Epsilon was permitted to take up and pay for 2,000,000 Common Shares plus 2% of its issued and outstanding Common Shares, or an aggregate total of up to 2,522,673 Common Shares. The tender offer expired on June 30, 2020, and on July 6, 2020 the Company announced that it accepted 2,337,034 shares for repurchase under the terms of the Offer to Purchase for an aggregate consideration of $7,151,324, or $3.06 per share, excluding fees and expenses. The Company canceled all common shares taken up and paid for under the tender offer. The Company funded the repurchases under the tender offer with cash on hand. As of November 10, 2020, the Company has 23,859,136 shares issued and outstanding.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table contains activity relating to our acquisition of equity securities during the nine months ended September 30, 2020:


				Total number		Maximum number
				of shares		of shares that
				purchased as		may yet be
	Total number	Average price		part of publicly		purchased under
	of shares	paid per		announced plans		the plans or
	purchased	share		or programs⁽⁴⁾		programs⁽⁵⁾
Beginning of normal-course issuer bid, May 20, 2019							1,367,762
Shares purchased through December 31, 2019 ^{(1) (2)}	696,096	$	3.72
January 2020⁽²⁾	102,051	$	2.95
February 2020⁽²⁾	261,519	$	3.11
March 2020⁽²⁾	124,459	$	2.98
April 2020⁽²⁾	156,585	$	2.48
May 2020⁽²⁾	12,700	$	2.91
July 2020⁽³⁾	2,337,034	$	3.06		2,337,034
Total as of September 30, 2020	3,690,444	$	3.16		2,337,034		—

(1)

Shares purchased through December 31, 2019 were cancelled prior to the year ended December 31, 2019.

(2)

Epsilon repurchased these shares under its share repurchase program that commenced on May 20, 2019, as described above.

(3)

Epsilon repurchased these shares under its substantial issuer bid/issuer tender offer dated May 19, 2020, as described above.

(4)

The Company announced its intention to commence a substantial issuer bid/issuer tender offer on May 14, 2020, and the substantial issuer bid/issuer tender offer commenced May 19, 2020, as described above.

(5)

The normal-course issuer bid expired on May 19, 2020, and the substantial issuer bid/issuer tender offer expired on June 30, 2020.

(c)Equity Incentive Plan

Epsilon’s board of directors (the “Board”) adopted the 2020 Equity Incentive Plan (the “2020 Plan”) on July 22, subject to approval by Epsilon’s shareholders at Epsilon’s 2020 Annual General and Special Meeting of shareholders, which occurred on September 1, 2020 (the “Meeting”). Shareholders approved the 2020 Plan at the Meeting. Following Epsilon’s listing on the NASDAQ Global Market, the Board determined that it is in the best interest of the shareholders to approve a new incentive plan that is compliant with U.S. public company equity plan rules and practices that would replace Epsilon’s Amended and Restated 2017 Stock Option Plan (including its predecessors) and the Share Compensation Plan (collectively referred to as the “Predecessor Plans”). No further awards will be granted under the Predecessor Plans.

The 2020 Plan provides for incentive compensation in the form of stock options, stock appreciation rights, restricted stock and stock units, performance shares and units, other stock-based awards and cash-based awards. Under the 2020 Plan, Epsilon will be authorized to issue up to 2,000,000 Common Shares. As of September 30, 2020, the Company granted, after the Compensation Committee approved the terms, target formulas, and peer group applicable to the performance incentive awards, and the shareholders approved the 2020 Plan at the Meeting on September 1, 2020, 125,000 awards to Mr. Raleigh, leaving 1,875,000 shares available to be granted under the 2020 Plan. No shares subject to awards currently outstanding under the Predecessor Plans that expire or are forfeited will become available for issuance under the 2020 Plan.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Restricted and Performance Stock Units

For the nine months ended September 30, 2020, 20,833 performance-based, restricted shares were awarded to Michael Raleigh, the Company’s chief executive officer, based on the approval by the Company’s independent compensation committee. Additionally, Mr. Raleigh was granted 104,167 Performance Stock Units (“PSU”) that will potentially vest over the next 3 years, with the potential to add another 125,000 bonus shares. These shares are based on certain terms, target formulas, and relative peer group performance, and Mr. Raleigh’s continued employment. Compensation related to these PSUs was immaterial for the three months ended September 30, 2020, and therefore was not recognized..

For the year ended December 31, 2019, 184,500 common shares of Restricted Stock were awarded to the Company’s officers, employees, and board of directors. These shares vest over a three-year period, with one-third of the shares being issued per period on the anniversary of the award resolution. The vesting of the shares is contingent on the individuals’ continued employment or service. The Company determined the fair value of the granted Restricted Stock based on the market price of the common shares of the Company on the date of grant.

Stock compensation expense for the granted Restricted Stock is recognized over the vesting period. Stock compensation expense recognized during the three and nine months ended September 30, 2020 was $239,134 and $583,238, respectively (for the three and nine months ended September 30, 2019, $127,419 and $382,258, respectively).

At September 30, 2020, the Company had unrecognized stock based compensation related to these shares of $793,439 to be recognized over a weighted average period of 1.02 years (at December 31, 2019: $1,309,594 over 1.34 years).

The following table summarizes Restricted Stock activity for the nine months ended September 30, 2020, and the year ended December 31, 2019:


	Nine months ended		Year ended
	September 30, 2020		December 31, 2019
		Weighted		Weighted
	Number of	Average	Number of	Average
	Shares	Remaining Life	Shares	Remaining Life
	Outstanding	(years)	Outstanding	(years)
Balance non-vested Restricted Stock at beginning of period	346,499	1.67	282,833	2.56
Granted	20,833	—	184,500	3.00
Vested	(20,833)	—	(106,834)	—
Forfeited	—	—	(14,000)	2.64
Balance non-vested Restricted Stock at end of period	346,499	0.92	346,499	1.67

Stock Options

Through September 30, 2020, the Company had outstanding stock options covering 245,000 Common Shares at an overall average exercise price of $5.27 per Common Share to directors, officers, and employees of the Company and its subsidiaries. These 245,000 options have a weighted average expected remaining term of approximately 2.5 years.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table summarizes stock option activity for the nine months ended September 30, 2020 and the year ended December 31, 2019:


	Nine months ended			Year ended
	September 30, 2020			December 31, 2019
		Weighted				Weighted
	Number of	Average		Number of		Average
	Options	Exercise		Options		Exercise
Exercise price in US$	Outstanding	Price⁽¹⁾		Outstanding		Price⁽¹⁾
Balance at beginning of period	245,000	$	5.27		290,750	$	5.02
Exercised	—				(25,000)		2.17
Expired/Forfeited	—				(20,750)		5.37
Balance at period-end	245,000	$	5.27		245,000	$	5.27

Exercisable at period-end	245,000	$	5.27		206,670	$	5.32

(1)

Exercise price has been converted to US$ using the rate of Cdn$1.33 to US$1, the rate on March 15, 2019, the date Epsilon Energy, Ltd was delisted from the TSX.

At September 30, 2020, using the Black Scholes model, the Company had unrecognized stock based compensation, related to these options, of nil (at December 31, 2019: $1,867 over 0.08 years). The aggregate intrinsic value at September 30, 2020 was nil (at December 31, 2019: nil). For the three and nine months ended September 30, 2020, nil and $1,867, respectively, of stock compensation expense, related to these options, was recognized (for the three and nine months ended September 30, 2019, $6,301 and $18,903, respectively).

During the nine months ended September 30, 2020 and the year ended December 31, 2019, the Company awarded no stock options.

7. Revenue Recognition

Revenues are comprised primarily of sales of natural gas along with the revenue generated from the Company’s ownership interest in the gas gathering system in the Auburn field in Northeastern Pennsylvania. Also included to a much lesser degree is natural gas, crude oil and NGLs from Oklahoma.

Overall, product sales revenue generally is recorded in the month when contractual delivery obligations are satisfied, which occurs when control is transferred to the Company’s customers at delivery based on contractual terms and conditions. In addition, gathering and compression revenue generally is recorded in the month when contractual service obligations are satisfied, which occurs as control of those services is transferred to the Company’s customers.

The following table details revenue for the three and nine months ended September 30, 2020 and 2019.


	Three months ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
Operating revenue
Natural gas	$	3,573,908	$	2,933,695	$	11,470,012	$	12,698,643
Natural gas liquids		14,843		23,905		56,705		88,256
Oil and condensate		1,955		41,981		190,180		218,823
Gathering and compression fees		2,219,905		2,219,613		6,800,347		6,923,058
Total operating revenue	$	5,810,611	$	5,219,194	$	18,517,244	$	19,928,780

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Product Sales Revenue

The Company enters into contracts with third party purchasers to sell its natural gas, oil, NGLs and condensate production. Under these product sales arrangements, the sale of each unit of product represents a distinct performance obligation. Product sales revenue is recognized at the point in time that control of the product transfers to the purchaser based on contractual terms which reflect prevailing commodity market prices. To the extent that marketing costs are incurred by the Company prior to the transfer of control of the product, those costs are included in lease operating expenses on the Company’s consolidated statements of operations.

Settlement statements for product sales, and the related cash consideration, are received from the purchaser within 30 days. As a result, the Company must estimate the amount of production delivered to the customer and the consideration that will ultimately be received for sale of the natural gas, oil, NGLs, or condensate. Estimated revenue due to the Company is recorded within the receivables line item on the accompanying consolidated balance sheets until payment is received.

Gas Gathering and Compression Revenue

The Company also provides natural gas gathering and compression services through its ownership interest in the gas gathering system in the Auburn field. For the provision of gas gathering and compression services, the Company collects its share of the gathering and compression fees per unit of gas serviced and recognizes gathering revenue over time using an output method based on units of gas gathered.

The settlement statement from the operator of the Auburn Gas Gathering System is received two months after transmission and compression has occurred. As a result, the Company must estimate the amount of production that was transmitted and compressed within the system. Estimated revenue due to the Company is recorded within the receivables line item on the accompanying consolidated balance sheets until payment is received.

Allowance for Doubtful Accounts

The Company records an allowance for doubtful accounts on a case by case basis once there is evidence that collection is not probable. Due to the bankruptcy filed by Chesapeake Energy Corporation (“CHK”) on June 28, 2020, the Company recorded an allowance for possible uncollectable fees. Unpaid fees attributable to CHK for May and June 2020 gathering system services were $1.1 million and $1.3 million respectively. As of September 30, 2020, Epsilon has recorded an allowance for doubtful accounts for the Company’s 35% share of these payments for a total bad debt expense of $0.8 million. Additional amounts of bad debt expense are not needed as CHK is currently paying all post-petition amounts.

The following table details accounts receivable net of allowance for doubtful accounts as at September 30, 2020 and December 31, 2019.


	September 30,		December 31,
	2020		2019
Accounts receivable
Natural gas and oil sales	$	1,792,828	$	2,293,044
Joint interest billing		61,556		59,127
Gathering and compression fees		2,612,753		1,940,308
Other		3,899		4,438
Total accounts receivable		4,471,036		4,296,917
Less: allowance for doubtful accounts		(819,000)		—
Total accounts receivable, net of allowance for doubtful accounts	$	3,652,036	$	4,296,917

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

8. Accumulated Other Comprehensive Income

Accumulated other comprehensive income (loss) includes certain transactions that have generally been reported in the condensed consolidated statements of changes in shareholders’ equity, including translation gains (losses) related to the convertible debentures that will remain frozen in accumulated other comprehensive income until such time Epsilon Energy Ltd. is liquidated. Activity within Accumulated other comprehensive income for the three and nine months ended September 30, 2020 and 2019 consisted of the following:


	Three months ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
Balance at beginning of period	$	9,816,496	$	9,809,774	$	9,810,478	$	9,797,930
Translation gain other		2,273		(900)		8,291		10,944
Balance at end of period	$	9,818,769	$	9,808,874	$	9,818,769	$	9,808,874

9. Income Taxes

Income tax provisions for the three and nine months ended September 30, 2020 and 2019 are as follows:


	Three months ended September 30,				Nine months ended September 30,
	2020		2019		2020		2019
Current:
Federal	$	159,626	$	1,622,486	$	272,016	$	1,622,486
State		4,829		460,765		42,469		507,953
Total current income tax expense		164,455		2,083,251		314,485		2,130,439
Deferred:
Federal		(185,265)		(1,256,553)		(251,979)		509,308
State		(12,952)		(283,559)		51,561		343,808
Total deferred tax expense (benefit)		(198,217)		(1,540,112)		(200,418)		853,116
Income tax expense (benefit)	$	(33,762)	$	543,139	$	114,067	$	2,983,555

The Company files federal income tax returns in the United States and Canada, and various returns in state and local jurisdictions.

The Company believes it has appropriate support for the income tax positions taken and to be taken on our tax returns and that the accruals for tax liabilities are adequate for all open years based on our assessment of various factors including past experience and interpretations of tax law applied to the facts of each matter. The Company's tax returns are open to audit under the statute of limitations for the years ending December 31, 2016 through December 31, 2019. To the extent we utilize net operating losses generated in earlier years, such earlier years may also be subject to audit.

Our effective tax rate will typically differ from the statutory federal rate primarily as a result of state income taxes and the valuation allowance against the Canadian net operating loss. The effective tax rate for the nine months ended September 30, 2020 was higher than the statutory federal rate as a result of the state income taxes and the valuation allowance against the Canadian net operating loss.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

10. Commitments and Contingencies

The Company’s future minimum lease commitments as of September 30, 2020 are summarized in the following table:


Year ended
December 31,	Payments
2020		25,147
2021		103,073
2022		106,797
2023		36,013
	$	271,030

The Company enters into commitments for capital expenditures in advance of the expenditures being made. As of September 30, 2020, the Company had commitments of $2.63 million for capital expenditures.

Litigation

The Company is not currently involved in any litigation. Management is of the opinion that the potential for litigation is remote.

11. Net Income (Loss) Per Share

Basic net income (loss) per share is computed on the basis of the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per share is computed based upon the weighted-average number of common shares outstanding during the period plus the assumed issuance of common shares for all potentially dilutive securities.

The net income (loss) used in the calculation of basic and diluted net income (loss) per share is as follows:

		��
	Three months ended September 30,				Nine months ended September 30,
	2020		2019		2020		2019
Net income (loss) available to shareholders	$	(292,783)	$	1,453,298	$	(548,518)	$	6,664,832

In calculating the net income (loss) per share, basic and diluted, the following weighted-average shares were used:


	Three months ended September 30,		Nine months ended September 30,
	2020	2019	2020	2019
Basic weighted-average number of shares outstanding	23,955,619	27,060,387	25,550,194	27,218,162
Dilutive stock options	—	—	—	—
Unvested restricted shares granted	—	34,004	—	21,955
Diluted weighted average shares outstanding	23,955,619	27,094,391	25,550,194	27,240,117

The Company excluded the following shares from the diluted EPS because their inclusion would have been anti-dilutive.


	Three months ended September 30,		Nine months ended September 30,
	2020	2019	2020	2019
Anti-dilutive options	245,000	255,000	245,000	255,000
Anti-dilutive unvested restricted shares	346,499	248,829	346,499	260,878
Total Anti-dilutive shares	591,499	503,829	591,499	515,878

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

12. Operating Segments

Operating segments are reported in a manner consistent with the internal reporting provided to the chief operating decision-maker. The chief operating decision-maker, who is responsible for allocating resources and assessing performance of the operating segments, has been identified as executive management. Segment performance is evaluated based on operating profit or loss as shown in the table below. Interest income and expense, and income taxes are managed separately on a group basis.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The Company’s reportable segments are as follows:

The Upstream segment activities include acquisition, development and production of oil, natural gas, and other liquid reserves on properties within the United States;

The Gas Gathering segment partners with two other companies to operate a natural gas gathering system; and

The Corporate segment activities include corporate listing and governance functions of the Company.

Segment activity as of, and for the nine months ended September 30, 2020 and 2019 is as follows:


	Upstream			Gas Gathering		Corporate			Elimination		Consolidated
As of and for the nine months ended September 30, 2020
Operating revenue
Natural gas	$	11,470,012		$	—	$	—		$	—	$	11,470,012
Natural gas liquids		56,705			—		—			—		56,705
Oil and condensate		190,180			—		—			—		190,180
Gathering and compression fees		—			8,210,255		—			(1,409,908)		6,800,347
Total operating revenue	$	11,716,897	⁽¹⁾	$	8,210,255	$	—		$	(1,409,908)	$	18,517,244

Net earnings (loss) for the period	$	(2,301,433)		$	4,019,870	$	(2,266,955)	⁽³⁾	$	—	$	(548,518)
Operating costs		6,229,682			1,631,099		—			(1,409,908)		6,450,873
Development geological and geophysical expenses		7,595			—		—			—		7,595
Depletion, deprec., amortization and accretion		6,021,053			1,740,286		—			—		7,761,339
Impairment		1,760,000			—		—			—		1,760,000
Bad debt expense		—			819,000		—			—		819,000

Segment assets	$	70,549,241		$	16,698,193	$	92,019		$	—	$	87,339,453
Capital expenditures⁽²⁾		3,128,378			467,017		—			—		3,595,395
Proved properties		36,273,429			—		—			—		36,273,429
Unproved properties		21,448,546			—		—			—		21,448,546
Gathering system		—			10,214,493		—			—		10,214,493
Other property and equipment		981,141			—		—			—		981,141

As of and for the nine months ended September 30, 2019
Operating revenue
Natural gas	$	12,698,643		$	—	$	—		$	—	$	12,698,643
Natural gas liquids		88,256			—		—			—		88,256
Oil and condensate		218,823			—		—			—		218,823
Gathering and compression fees		—			7,779,107		—			(856,049)		6,923,058
Total operating revenue	$	13,005,722	⁽¹⁾	$	7,779,107	$	—		$	(856,049)	$	19,928,780

Net earnings for the period	$	5,259,959		$	4,465,906	$	(3,061,033)	⁽³⁾	$	—	$	6,664,832
Operating costs		4,851,090			1,868,758		—			(856,049)		5,863,799
Development geological and geophysical expenses		83,748			—		—			—		83,748
Depletion, deprec., amortization and accretion		4,185,925			1,444,443		—			—		5,630,368
Gain on sale of property		(1,375,000)			—		—			—		(1,375,000)

Segment assets	$	78,581,513		$	16,340,875	$	87,991		$	—	$	95,010,379
Capital expenditures⁽²⁾		8,098,511			237,681		—			—		8,336,192
Proved properties		37,535,119			—		—			—		37,535,119
Unproved properties		21,015,039			—		—			—		21,015,039
Gathering system		—			11,696,643		—			—		11,696,643

(1)

Segment operating revenue represents revenues generated from the operations of the segment. Inter-segment sales during the nine months ended September 30, 2020 and 2019 have been eliminated upon consolidation. For the nine months ended September 30, 2020, Epsilon sold natural gas to 23 unique customers. The four customers over 10% comprised 27%, 22%, 16% and 13% of total revenue. For the nine months ended September 30, 2019, Epsilon sold natural gas to 26 unique customers. The three customers over 10% comprised 36%, 35% and 11% of total revenue.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

(2)

Capital expenditures for Upstream segment consist primarily of the acquisition of properties, and the drilling and completing of wells while Gas Gathering consists of expenditures relating to the expansion and completion of the gathering and compression facility.

(3)

Segment reporting for net earnings for the period does not include non-monetary compensation, general and administrative expense, interest income, interest expense, both gains and (losses) on derivative contracts, or income tax amounts as they are managed on a group basis and are instead included in the corporate column for reconciliation purposes.

Segment activity for the three months ended September 30, 2020 and 2019 is as follows:


		Upstream			Gas Gathering		Corporate			Elimination		Consolidated
For the three months ended September 30, 2020
Operating revenue
Natural gas		$	3,573,908		$	—	$	—		$	—	$	3,573,908
Natural gas liquids			14,843			—		—			—		14,843
Oil and condensate			1,955			—		—			—		1,955
Gathering and compression fees			—			2,740,186		—			(520,281)		2,219,905
Total operating revenue		$	3,590,706	⁽¹⁾	$	2,740,186	$	—		$	(520,281)		5,810,611

Net earnings for the period		$	(694,490)		$	1,541,709	$	(1,140,002)	⁽³⁾		—	$	(292,783)
Operating costs			2,147,795			563,992		—			(520,281)		2,191,506
Development geological and geophysical expenses			2,693			—		—			—		2,693
Depletion, deprec., amortization and accretion			2,134,708			634,485		—			—		2,769,193
Bad debt expense			—			—		—			—		—

Capital expenditures⁽²⁾			673,716			325,071		—			—		998,787

For the three months ended September 30, 2019
Operating revenue	��
Natural gas		$	2,933,695		$	—	$	—		$	—	$	2,933,695
Natural gas liquids			23,905			—		—			—		23,905
Oil and condensate			41,981			—		—			—		41,981
Gathering and compression fees			—			2,498,232		—			(278,619)		2,219,613
Total operating revenue		$	2,999,581	⁽¹⁾	$	2,498,232	$	—		$	(278,619)		5,219,194

Net earnings for the period		$	516,408		$	1,286,555	$	(349,665)	⁽³⁾	$	—	$	1,453,298
Operating costs			1,548,902			739,655		—			(278,619)		2,009,938
Development geological and geophysical expenses			—			—		—			—		—
Depletion, deprec., amortization and accretion			1,379,444			472,022		—			—		1,851,466
Gain on sale of property			(445,173)			—		—			—		(445,173)

Capital expenditures⁽²⁾			4,821,766			(7,944)		—			—		4,813,822

(1)

Segment operating revenue represents revenues generated from the operations of the segment. Inter-segment sales during the three months ended September 30, 2020 and 2019 have been eliminated upon consolidation. For the three months ended September 30, 2020, Epsilon sold natural gas to 20 unique customers. The three customers over 10% comprised 25%, 22% and 21% of total revenue. For the three months ended September 30, 2019, Epsilon sold natural gas to 21 unique customers. The two customers over 10% comprised 60% and 11% of total revenue.

(2)

(3)

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

13. Commodity Risk Management Activities

Commodity Price Risks

Epsilon engages in price risk management activities from time to time. These activities are intended to manage Epsilon’s exposure to fluctuations in commodity prices for natural gas by securing fixed price contracts for a portion of expected sales volumes.

Inherent in the Company’s fixed price contracts, are certain business risks, including market risk and credit risk. Market risk is the risk that the price of natural gas and oil will change, either favorably or unfavorably, in response to changing market conditions. Credit risk is the risk of loss from nonperformance by the Company’s counterparty to a contract. The Company does not currently require collateral from any of its counterparties nor does its counterparties require collateral from the Company.

The Company enters into certain commodity derivative instruments to mitigate commodity price risk associated with a portion of its future natural gas production and related cash flows. The natural gas revenues and cash flows are affected by changes in commodity product prices, which are volatile and cannot be accurately predicted. The objective for holding these commodity derivatives is to protect the operating revenues and cash flows related to a portion of the future natural gas sales from the risk of significant declines in commodity prices, which helps ensure the Company’s ability to fund the capital budget.

In January 2020, the World Health Organization (“WHO”) announced a global health emergency because of a new strain of coronavirus (“COVID-19”) and the significant risks to the international community and economies as the virus spreads globally beyond its point of origin. In March 2020, the WHO classified COVID-19 as a pandemic, based on the rapid increase in exposure globally, and throughout the second quarter of 2020 and thereafter, COVID-19 continued to spread throughout the U.S. In addition, after the Organization of the Petroleum Exporting Countries (“OPEC”) and a group of oil producing nations led by Russia failed in March 2020 to agree on oil production cuts, Saudi Arabia announced that it would cut oil prices and increase production, leading to a sharp further decline in oil and natural gas prices. While OPEC, Russia and other oil producing countries reached an agreement in April 2020 to reduce production levels, U.S. production has declined, and a significant crude oil price recovery is not expected until global supply matches current lower levels of demand caused by a number of factors, including the uncertainty around the extent and timing of an economic recovery due to the COVID-19 pandemic. The effects of COVID-19 and concerns regarding its domestic and global spread, as well as the recent actions by Russia and Saudi Arabia, could continue to negatively impact the domestic and international supply and demand for oil and natural gas, to sustain continued price volatility and impact the price paid for oil and natural gas and to materially and adversely affect the demand for and marketability of oil and natural gas production.

Epsilon has historically elected not to designate any of its financial commodity derivative contracts as accounting hedges and, accordingly, accounts for these financial commodity derivative contracts using the mark-to-market accounting method. Under this accounting method, changes in the fair value of outstanding financial instruments are recognized as gains or losses in the period of change and are recorded as gain (loss) on derivative contracts on the condensed consolidated statements of operations and comprehensive income. The related cash flow impact is reflected in cash flows from operating activities. During the three and nine months ended September 30, 2020, Epsilon recognized gains on commodity derivative contracts of $419,879 and $2,055,548, respectively. This amount included cash received on settlements of these contracts of $1,657,323 during the three months ended September 30, 2020 and $4,035,092 during the nine months ended September 30, 2020. For the three and nine months ended September 30, 2019, Epsilon recognized gains on commodity derivative contracts of $1,270,494 and $3,494,727 respectively. This amount included cash received on settlements of these contracts of $1,157,271 during the three months ended September 30, 2019 and $1,344,690 during the nine months ended September 30, 2019.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Commodity Derivative Contracts

Presented below is a summary of Epsilon’s natural gas price and basis swap contracts as of September 30, 2020.


		Weighted Average Price ($/MMbtu)					Fair Value
	Volume				Basis		September 30,
Derivative Type	(MMbtu)		Swaps		Differential		2020
2020
Fixed price swap	762,500		$	2.73	$	—		(73,029)
Basis swap	762,500		$	—	$	(0.44)		93,287
							$	20,258

As of September 30, 2020 and 2019, all of the Company’s economic derivative hedge positions were with large financial institutions, which are not known to the Company to be in default on their derivative positions. The Company is exposed to credit risk to the extent of non-performance by the counterparties in the derivative contracts discussed above; however, the Company does not anticipate non-performance by such counterparties. None of the Company’s derivative instruments contains credit-risk related contingent features. Derivatives are net on the balance sheet as they are subject to the right to offset the liabilities with the assets.

The following tables summarize the gross fair values of our derivative instruments, presenting the impact of offsetting the derivative assets and liabilities on our condensed consolidated balance sheets as of the dates indicated below:


	Fair Value of Derivative Assets
	September 30,		December 31,
	2020		2019
Current
Basis swap	$	97,899	$	162,844
Fixed price swap		76,522		2,001,496
	$	174,421	$	2,164,340


	Fair Value of Derivative Liabilities
	September 30,		December 31,
	2020		2019
Current
Basis swap	$	(4,611)	$	(164,538)
Fixed price swap		(149,552)		—
	$	(154,163)	$	(164,538)


Net Fair Value of Derivatives	$	20,258	$	1,999,802

The following table presents the changes in the fair value of Epsilon’s commodity derivatives for the periods indicated:


	Three months ended September 30,				Nine months ended September 30,
	2020		2019		2020		2019
Fair value of asset (liability), beginning of the period	$	1,257,702	$	1,739,791	$	1,999,802	$	(297,023)
Gains (losses) on derivative contracts included in earnings		419,879		1,270,494		2,055,548		3,494,727
Settlement of commodity derivative contracts		(1,657,323)		(1,157,271)		(4,035,092)		(1,344,690)
Fair value of asset, end of the period	$	20,258	$	1,853,014	$	20,258	$	1,853,014

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

14. Asset Retirement Obligations

Asset retirement obligations were estimated by management based on Epsilon’s net ownership interest in all wells and the gathering system, estimated costs to reclaim and abandon such assets and the estimated timing of the costs to be incurred in future periods.

The following tables summarize the changes in asset retirement obligations for the periods indicated:


	Nine Months Ended		Year ended
		September 30,		December 31,
	2020		2019
Balance beginning of period	$	2,909,855	$	1,625,154
Liabilities from drilling of new wells		5,306		16,163
Change in estimates		2,181		1,153,740
Accretion		153,605		114,798
Balance end of period	$	3,070,947	$	2,909,855

15. Fair Value Measurements

The methodologies used to determine the fair value of our financial assets and liabilities at September 30, 2020 were the same as those used at December 31, 2019.

Cash, cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities are carried at cost, which approximates their fair value because of the short-term maturity of these instruments. The Company’s revolving line of credit has a recorded value that approximates its fair value since its variable interest rate is tied to current market rates and the applicable margins represent market rates.

Commodity derivative instruments consist of fixed-price swaps and basis swap contracts for natural gas. The Company’s derivative contracts are valued based on an income approach. The model considers various assumptions, such as quoted forward prices for commodities, time value and volatility factors. These assumptions are observable in the marketplace throughout the full term of the contract, can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace, and are therefore designated as Level 2 within the valuation hierarchy. The Company utilizes its counterparties’ valuations to assess the reasonableness of its own valuations.

Table of Contents

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

The following discussion is intended to assist in the understanding of trends and significant changes in or results of operations and the financial condition of Epsilon Energy Ltd. and its subsidiaries for the periods presented. The following discussion and analysis should be read in conjunction with our unaudited consolidated financial statements and notes thereto presented in this report, including the unaudited condensed consolidated financial statements as of September 30, 2020 and 2019 and for the nine months then ended together with accompanying notes, as well as our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2019. The following discussion contains “forward-looking statements” that reflect our future plans, estimates, beliefs, and expected performance. Actual results and the timing of events may differ materially from those contained in these forward- looking statements due to a number of factors. See “Part II. Item 1A. Risk Factors” and “Forward-Looking Statements.”

Overview

Epsilon Energy Ltd. (the “Company”) is a North American onshore focused independent natural gas and oil company engaged in the acquisition, development, gathering and production of natural gas and oil reserves. Our primary area of operation is Pennsylvania. Our assets are concentrated in areas with known hydrocarbon resources, which are conducive to multi well, repeatable drilling programs.

Substantially all of the production from our Pennsylvania acreage (4,130 net) is dedicated to the Auburn Gas Gathering System, or the Auburn GGS, located in Susquehanna County, Pennsylvania for a 15 year term expiring in 2026 under an operating agreement whereby the Auburn GGS owners receive a fixed percentage rate of return on the total capital invested in the construction of the system. Epsilon owns a 35% interest in the system which is operated by a subsidiary of Williams Partners, LP. In the three and nine months ended September 30, 2020, Epsilon paid $0.52 million and $1.41 million, respectively to the Auburn GGS to gather and treat our 3.0 Bcf and 8.4 Bcf of natural gas production in Pennsylvania ($0.28 million and $0.86 million to the Auburn GGS to gather and treat our 1.8 Bcf and 5.4 Bcf of natural gas in the three and nine months ended September 30, 2019, respectively).

Epsilon realized a net loss of $0.3 million and $0.6 million for the three and nine months ended September 30, 2020, respectively, as compared to net income of $1.5 million and $6.7 million for the three and nine months ended September 30, 2019, respectively.

Our common shares trade on the NASDAQ Global Market under the ticker symbol “EPSN.”

Business Strategy

Our business strategy is to manage the cash flow generated from our producing leasehold and midstream assets in a manner where the risked capital allocation provides attractive rates of return. Our remaining inventory of drillable locations within existing leasehold is sufficient to maintain this cash flow for several years at capital expenditure levels well within the yearly free cash flow generated from these assets. In addition, the Company seeks to identify attractive onshore natural gas and oil properties in the United States, to acquire a leasehold interest and to develop the leasehold interest with the goal of deploying capital at attractive rates.

The core Marcellus Shale is one of the most attractive dry gas resources in the lower United States and has attracted significant development capital. Well productivity has improved dramatically for many years resulting in increasing initial production rates and gas recoveries. The resulting supply of natural gas has at times stressed the transportation infrastructure of the Northeast U.S. and exacerbated the local price discount to Henry Hub. In many other basins throughout the U.S., the increase in natural gas production has outpaced demand. This market condition has resulted in historically weaker natural gas prices for the benchmark index Henry Hub.

In the Marcellus, the Company continues to critically evaluate the value of our core assets. As part of this process we analyze existing well spacing and completion productivity data for both the Lower and Upper Marcellus. In addition, we contract third party experts in the technical modelling aspects of integrating rock mechanics, fluid pumping and proppant placement variables associated with best completion practices. Epsilon continually meets with our well operators

Table of Contents

to seek increased operating efficiencies. In addition, Epsilon works closely with our gathering system partners in order to enhance operational safety and to preserve and grow the long-term value of our gathering system assets.

The major producers in the Appalachian region are under tremendous pressure from capital markets to demonstrate capital discipline and control costs. Several major producers have announced reduced capital programs to balance the supply-demand for the commodity. Accordingly, the Company expects local production to remain flat or decline modestly throughout the remainder of 2020. The Company cannot, however, predict the duration of the current global market conditions that resulted in a drastic global economic downturn and its impact on oil and gas demand and commodity prices. Our target is to maintain our current production level or grow modestly, but only if natural gas prices improve and the capital deployed can achieve our internal rate of return.

In the longer term, Epsilon believes natural gas prices will become more constructive due to a moderating of supply and incremental demand from LNG exports, exports to Mexico and further coal to gas switching for domestic electrical power generation. Specifically, LNG export capacity is expected to grow more than 70% from the current ~ 10.0 Bcf/d to 17 Bcf/d by 2024 based only on facilities currently commissioning or under construction.

In the Northwest STACK, the Company chooses to not deploy capital due to depressed natural gas liquids and natural gas pricing. However, the leases are held by production which provides a long-term right to develop additional sales when commodity prices appear attractive. In the interim, the Company intends to closely monitor development activities from offset operators in our area in an effort to further appraise our leasehold interest without risking capital.

Recent Developments

On May 14, 2020, the Company’s Board of Directors announced its intention to commence a substantial issuer bid/issuer tender offer to purchase for cash up to an aggregate of approximately $6.2 million of its common shares. In May 2020, upon the terms and subject to the conditions described in the Offer to Purchase dated May 19, 2020, as amended, the Company offered to repurchase up to 2,000,000 of its common shares for $3.06 per share, excluding taxes and interest, for a total cost of approximately $6.1 million, excluding expenses of the tender offer. As permitted under Rule 13e-4(f) and Rule 14e-1(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and as stated in its Offer to Purchase, Epsilon was permitted to take up and pay for 2,000,000 Common Shares plus 2% of its issued and outstanding Common Shares, or an aggregate total of up to 2,522,673 Common Shares. The tender offer expired on June 30, 2020, and on July 6, 2020 the Company announced that it accepted 2,337,034 shares for repurchase under the terms of the Offer to Purchase for an aggregate consideration of $7,151,324, or $3.06 per share, excluding fees and expenses. The Company canceled all common shares taken up and paid for under the tender offer. The Company funded the repurchases under the tender offer with cash on hand. After giving effect to the cancellation of the common shares purchased under the tender offer, 23,796,637 common shares were issued and outstanding. As of November 9, 2020, the Company has 23,859,136 shares issued and outstanding.

On March 11, 2020, the World Health Organization characterized the global outbreak of the novel strain of coronavirus, COVID-19, as a “pandemic.” To limit the spread of COVID-19, governments have taken various actions including the issuance of stay-at-home orders and social distancing guidelines, causing some businesses to suspend operations and a reduction in demand for many products from direct or ultimate customers. Such actions have resulted in a swift and unprecedented reduction in international and U.S. economic activity which, in turn, has adversely affected the demand and prices for oil and natural gas and caused significant volatility and disruption of the financial markets.

Epsilon is closely monitoring the current and potential impacts of COVID-19 on all aspects of our business and geographies, including how it has impacted, and may in the future impact our operations, financial results, liquidity, contractors, customers, employees and vendors. The Company continues to monitor a number of factors that may cause actual results of operations to differ from our historical results or current expectations. These factors include but are not limited to: the impact of the COVID-19 pandemic and the related economic downturn, the historically low natural gas liquids prices, and ramifications of the crude oil price war between the Organization of Petroleum Exporting Countries ("OPEC") /Saudi Arabia and Russia that occurred in March. While OPEC agreed in April to cut production, production of oil in the United States has declined, and oil prices remain low and may remain so for the foreseeable future, particularly given concerns over available storage capacity for refined products such as crude, and refinery inputs including condensate and NGL’s. These and other factors, such as those described in this paragraph, could negatively affect the Company’s oil and gas properties, operations, earnings and cash flows for some time and could cause our financial condition and results

Table of Contents

from operations to not be comparable to those of the same period in previous years. Commodity prices are expected to continue to be volatile as a result of the changes in oil and natural gas production, inventories and demand, as well as national and international economic pressure. The Company cannot predict when prices will improve and stabilize. The results presented in this Form 10-Q are not necessarily indicative of future operating results.

Epsilon did not incur significant disruptions to operations during the nine months ended September 30, 2020 as a result of the COVID-19 pandemic. However, during the three months ended March 31, 2020, Epsilon recognized certain indicators of impairment specific to its Oklahoma assets due to historically low oil and NGL prices. Epsilon determined that the carrying value of those assets was not recoverable, based on the current indicators. As a result of this assessment, a $1.76 million impairment was assessed on the Company’s Oklahoma assets at March 31, 2020, but no further impairment was required at September 30, 2020 and no impairment was required as of December 31, 2019.

Additionally, the Company is unable to predict the impact that the COVID-19 pandemic will have on us, including our financial position, operating results, liquidity and ability to obtain financing in future reporting periods, due to numerous uncertainties. These uncertainties include the severity of the virus, the duration of the outbreak, governmental or other actions taken to combat the virus (which could include limitations on our operations or the operations of our customers and vendors), and the effect that the COVID-19 pandemic and the current oil price war have on the demand for natural gas and natural gas liquids. The situation surrounding COVID-19 remains fluid and unpredictable, and Epsilon is actively managing our response and assessing potential impacts to our financial position and operating results, as well as any adverse developments that could impact our business. However, at this point, Epsilon does not anticipate any prolonged negative financial consequences to our financial position. At September 30, 2020, Epsilon has no debt and after accounting for the payment of approximately $7.15 million under the substantial issuer bid, excluding fees and expenses, has approximately $12 million of cash on hand to fund planned operating activities and to potentially weather a prolonged depressed economic environment.

The federal government has passed a series of relief and stimulus packages, including the CARES Act, for the country but Epsilon has not and does not believe it will need to avail itself of them and as such, these programs have no effect on Epsilon’s financial statements at this time.

Epsilon has also taken, and is continuing to take, proactive steps to keep our employees safe and manage any disruption in our business caused by COVID-19. For instance, the Company was an early adopter in employing a work-from-home system, even before any government mandate on non-essential businesses was enacted. Epsilon increased its technology platform, infrastructure and security to allow for a work-from-home environment prior to COVID-19. Epsilon has also deployed additional layered safety protocols at our office in order to keep our operations running without material disruptions.

Table of Contents

Three and Nine months ended September 30, 2020 Highlights

Operational Highlights

Marcellus Shale – Pennsylvania

● During the three months ended September 30, 2020, Epsilon’s realized natural gas price was $1.18 per Mcf, a 28% decrease over the three months ended September 30, 2019. During the nine months ended September 30, 2020, Epsilon’s realized natural gas price was $1.32 per Mcf, a 42% decrease over the nine months ended September 30, 2019.

● During the three months ended September 30, 2020, Epsilon’s natural gas production was 3.0 Bcf, as compared to 1.8 Bcf during the same period in 2019. Total nine months ended September 30, 2020 natural gas production was 8.5 Bcf, as compared to 5.4 Bcf during the same period in 2019.

● Marcellus working interest (WI) gas averaged 37.4 MMcf/d and 35.4 MMcf/d for the three and nine months ended September 30, 2020, respectively.

● Gathered and delivered 15.3 Bcf gross (5.4 Bcf net to Epsilon’s interest) during the three months ended September 30, 2020 through the Auburn GGS which represents approximately 83% of maximum throughput as currently configured. Gathered and delivered 54.2 Bcf gross (19.0 Bcf net to Epsilon’s interest) during the nine months ended September 30, 2020. Gathering volumes decreased 3% and 17% for the three and nine months ended September 30, 2020, respectively, as compared to the three and nine months ended September 30, 2019. The decrease is almost entirely attributable to the expansion of a compression facility in an adjacent midstream system which reduced the crossflow volumes received by the Auburn GGS.

Anadarko, NW Stack Trend – Oklahoma

● During the three months ended September 30, 2020, Epsilon’s realized price for all Oklahoma production was $1.01 per Mcfe, a 54% decrease over the three months ended September 30, 2019. During the nine months ended September 30, 2020, Epsilon’s realized price for all Oklahoma production was $2.17 per Mcfe, a 32% decrease over the nine months ended September 30, 2019.

● Total production for the three months ended September 30, 2020 included natural gas, oil, and other liquids and was 0.07 Bcfe, 18.5% increase over the same period in 2019. Total production for the nine months ended September 30, 2020 included natural gas, oil, and associated liquids was 0.24 Bcfe, a 13.3% increase over the same period in 2019.

Non-GAAP Financial Measures-Adjusted EBITDA

Epsilon defines Adjusted EBITDA as earnings before (1) net interest expense, (2) taxes, (3) depreciation, depletion, amortization and accretion expense, (4) impairments of natural gas and oil properties, (5) non-cash stock compensation expense, (6) gain or loss on derivative contracts net of cash received or paid on settlement, and (7) other income. Adjusted EBITDA is not a measure of financial performance as determined under U.S. GAAP and should not be considered in isolation from or as a substitute for net income or cash flow measures prepared in accordance with U.S. GAAP or as a measure of profitability or liquidity.

Additionally, Adjusted EBITDA may not be comparable to other similarly titled measures of other companies. Epsilon has included Adjusted EBITDA as a supplemental disclosure because its management believes that EBITDA provides useful information regarding its ability to service debt and to fund capital expenditures. It further provides investors a helpful measure for comparing operating performance on a normalized or recurring basis with the performance of other companies, without giving effect to certain non-cash expenses and other items. This provides management, investors and analysts with comparative information for evaluating the Company in relation to other natural gas and oil companies providing corresponding non-U.S. GAAP financial measures or that have different financing and capital

Table of Contents

structures or tax rates. These non-U.S. GAAP financial measures should be considered in addition to, but not as a substitute for, measures for financial performance prepared in accordance with U.S. GAAP.

The table below sets forth a reconciliation of net income to Adjusted EBITDA for the three and nine months ended September 30, 2020 and 2019, which is the most directly comparable measure of financial performance calculated under U.S. GAAP and should be reviewed carefully.


	Three months ended September 30,				Nine months ended September 30,
	2020		2019		2020		2019
Net income (loss)	$	(292,783)	$	1,453,298	$	(548,518)	$	6,664,832
Add Back:
Net interest (income) expense		23,905		(9,202)		45,658		(41,871)
Income tax expense (benefit)		(33,762)		543,139		114,067		2,983,555
Depreciation, depletion, amortization, and accretion		2,769,193		1,851,466		7,761,339		5,630,368
Impairment expense		—		—		1,760,000		—
Stock based compensation expense		239,134		133,720		585,105		401,161
(Gain) loss on derivative contracts net of cash received or paid on settlement		1,237,444		(113,223)		1,979,544		(2,150,037)
Foreign currency translation (gain) loss		—		(1)		2,228		(456)
Adjusted EBITDA	$	3,943,131	$	3,859,197	$	11,699,423	$	13,487,552

Results of Operations

Net Operating Revenues

For the three months ended September 30, 2020 revenues increased $0.6 million to $5.8 million from $5.2 million during the same period of 2019. During the nine months ended September 30, 2020 revenues decreased $1.4 million, or 7.1%, to $18.5 million from $19.9 million during the same period of 2019.

Revenue and volume statistics for the three and nine months ended September 30, 2020 and 2019 were as follows:


	Three months ended				Nine months ended
	September 30,				September 30,
	2020		2019		2020		2019
Revenues
Natural gas revenue	$	3,573,908	$	2,933,695	$	11,470,012	$	12,698,643
Volume (MMcf)		3,037		1,790		8,622		5,533
Avg. Price ($/Mcf)	$	1.18	$	1.64	$	1.33	$	2.29
PA Exit Rate (MMcfpd)		29.9		16.7		29.9		16.7
Oil and other liquids revenue	$	16,798	$	65,886	$	246,885	$	307,079
Volume (MBO)		3.4		2.8		11.3		10.6
Avg. Price ($/Bbl)	$	4.99	$	23.69	$	21.93	$	28.99
Gathering system revenue	$	2,219,905	$	2,219,613	$	6,800,347	$	6,923,058
Total Revenues	$	5,810,611	$	5,219,194	$	18,517,244	$	19,928,780

We earn gathering system revenue as a 35% owner of the Auburn Gas Gathering system. This revenue consists of fees paid by Anchor Shippers (parties listed in Anchor Shipper Gas Gathering Agreement for Northern Pennsylvania, including Epsilon Midstream, LLC) and third-party customers of the system to transport gas from the wellhead to the compression facility, and then to the delivery meter at the Tennessee Gas Pipeline. For the nine months ended September 30, 2020, approximately 82% of the Auburn GGS revenues earned were gathering fees, while 18% were compression fees. Gathering revenues from third-party customers represented approximately 5% of total gathering revenues and third-party compression revenues represented 12% of total compression revenues. For the three months ended September 30, 2020, approximately 82% of the Auburn GGS revenues earned were gathering fees, while 18% were compression fees. Third-

Table of Contents

party customers represented approximately 0.7% of gathering revenues and 3% of compression revenues. For the nine months ended September 30, 2019, approximately 87% of the Auburn GGS revenues earned were gathering fees, while 13% were compression fees. Gathering revenues from third-party customers represented approximately 11% of revenues and third-party compression revenues represented 5% of revenues. For the three months ended September 30, 2019, approximately 86% of the Auburn GGS revenues earned were gathering fees, while 14% were compression fees. Third party customers represented approximately 15% of gathering revenues and 7% of compression revenues. Revenues derived from Epsilon’s production which have been eliminated from gathering system revenues amounted to $0.52 and $1.41 million for the three and nine months ended September 30, 2020, respectively and $0.28 and $0.86 million for the three and nine months ended September 30, 2019, respectively.

Upstream natural gas revenue for the nine months ended September 30, 2020 decreased by $1.4 million, or 7%, over the same period in 2019. This was a result of lower natural gas prices; however, this was offset by higher volumes being produced. For the three months ended September 30, 2020, upstream natural gas revenue increased $0.6 million or 11.3% over the same period in 2019.This was a result of higher volumes, but was offset by lower natural gas prices.

The Company’s share of gathering system revenue remained generally consistent during the three and nine months ended September 30, 2020, increasing by less than 1% and decreasing by 1.8%, respectively, over the same periods in 2019. However, total upstream gathering fees increased due to increased production from Epsilon, which resulted in an increase in the amount of revenues eliminated from the consolidated operating statements. This increased elimination entry resulted in a net decrease in gathering system revenue to Epsilon. The Auburn GGS is subject to a cost of service model, whereby the Anchor Shippers dedicate acreage and reserves to the Auburn GGS. In exchange for this dedication, the owners of the Auburn system agree to a fixed rate of return on capital invested which cannot be exceeded. Therefore, rather than being subject to a fixed gathering rate, the Shippers are subject to a fluctuating gathering rate which is redetermined annually in order to produce the contractual return on capital to the Auburn GGS owners. The term of the model is fixed from 2012 to 2026. Each year, actual throughput, revenue, operating expenses and capital are captured in the model, and the remaining years are forecasted. The model then resolves a gathering rate that yields the contractual rate of return. All else being equal, to the extent that throughput is higher or capital is lower than the preceding year’s forecast, the gathering rate will decline.

Operating Costs

The following table presents total cost and cost per unit of production (Mcfe), including ad valorem, severance, and production taxes for the three and nine months ended September 30, 2020 and 2019:


	Three months ended September 30,				Nine months ended September 30,
	2020		2019		2020		2019
Lease operating costs	$	2,147,795	$	1,548,902	$	6,229,682	$	4,851,090
Gathering system operating costs		43,711		461,036		221,191		1,012,709
	$	2,191,506	$	2,009,938	$	6,450,873	$	5,863,799

Upstream operating costs—Total $/Mcfe		0.71		0.86		0.72		0.88
Gathering system operating costs $ / Mcf		0.02		0.16		0.03		0.11

Upstream operating costs consist of lease operating expenses necessary to extract natural gas and oil, including gathering and treating the natural gas and oil to ready it for sale.

Upstream operating costs for three months ended September 30, 2020 increased $0.6 million, or 38.7%, over the same period in 2019. For the nine months ended September 30, 2020, upstream operating costs increased $1.4 million, or 28.4%, from the same period in 2019 The increase in total cost was primarily due to the increase in volumes produced and the cost of operating four new wells that went online in October of 2019, in addition to four new wells that went online in May of 2020.

Gathering system operating costs consist primarily of rental payments for the natural gas fueled compression units. Other significant gathering system operating costs include chemicals (to prevent corrosion and to reduce water vapor in the gas stream), saltwater disposal, measurement equipment / calibration and general project management.

Table of Contents

The gathering system total per unit operating costs reported include the effects of elimination entries to remove the gas gathering fees billed by the gas gathering system operator to Epsilon’s upstream operations, and the volume associated with those fees. The elimination entries amounted to $1.41 million and $0.86 million for the nine months ended September 30, 2020 and 2019, respectively, and $0.52 million and $0.28 million for the three months ended September 30, 2020 and 2019, respectively, (see Note 12, ‘‘Operating Segments,’’ of the Notes to Unaudited Condensed Consolidated Financial Statements).

Gathering system costs (net of intercompany elimination) for the nine months ended September 30, 2020 decreased $0.8 million over the same period in 2019 and $0.4 million for the three months ended September 30, 2020 over the same period in 2019. The Company’s share of total gathering system costs decreased only $0.2 million and $0.2 million for the three and nine months ended September 30, 2020 over 2019; however, due to increased production from Epsilon and the resulting increase in the elimination of entry costs subtracted from the consolidated operating statements resulted in the large decrease in gathering system operating costs reported, and a very low cost per Mcf.

Depletion, Depreciation, Amortization and Accretion (“DD&A”)

Three months ended September 30,

Nine months ended September 30,

2020

2019

2020

2019

Depletion, depreciation, amortization and accretion

2,769,193

1,851,466

7,761,339

5,630,368

Natural gas and oil and gathering system assets are depleted and depreciated using the units of production method aggregating properties on a field basis. For leasehold acquisition costs and the cost to acquire proved and unproved properties, the reserve base used to calculate depreciation and depletion is total proved reserves. At this time, the Company has only minimal leasehold acquisition costs, and only in Oklahoma. For natural gas and oil development and gathering system costs, the reserve base used to calculate depletion and depreciation is proved developed reserves. A reserve report is prepared as of December 31, each year. The depletion for the first three quarters of the next year is normally based on the reserve report prepared at the end of the previous year, taking into consideration the limited development of the reserves over these time periods. The fourth quarter depletion is calculated using the reserve volumes from the reserve report prepared as of December 31 of the current year. However, for the three months ended March 31, 2020 and the three months ended June 30, 2020, due to the historically low commodity prices, the December 31, 2019 reserves report volumes were updated based on relevant prices and the depletion and depreciation were calculated using the lower volumes that resulted from the economics of the properties due to the lower prices because of the COVID-19 pandemic. For the three months ended September 30, 2020, volumes remained consistent with the June 30, 2020 volumes.

Depreciation expense includes primarily amounts pertaining to our office furniture and fixtures, leasehold improvements, and computer hardware. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, ranging from 3 to 7 years. Also included in depreciation expense is an amount pertaining to buildings owned by the Company. Depreciation for the buildings is calculated using the straight-line method over an estimated useful life of 30 years.

Accretion expense is related to the asset retirement obligations.

DD&A expense increased $2.1 million, or 38% for the nine months ended September 30, 2020 compared to the same period in 2019, and $0.9 million, or 50% for the three months ended September 30, 2020 compared to the same period in 2019. This was mainly due to the reduction of the line pressure of the gathering system, and the addition of four new wells that went online in October 2019, and four new wells that went online in May 2020 which resulted in increased production volumes.

Impairment

Three months ended September 30,

Nine months ended September 30,

2020

2019

2020

2019

Impairment

—

1,760,000

—

Table of Contents

During the three months ended March 31, 2020, the Company recognized certain indicators of impairments specific to our Oklahoma assets and determined that carrying value of those assets was not recoverable based on the current indicators. As a result of this assessment, a $1.76 million impairment was assessed on the Company’s Oklahoma assets at March 31, 2020. No impairment was required as of September 30, 2020 or September 30, 2019.

General and Administrative

Three months ended September 30,

Nine months ended September 30,

2020

2019

2020

2019

General and administrative

1,569,738

1,086,223

4,160,550

3,614,532

G&A expenses consist of general corporate expenses such as compensation, legal, accounting and professional fees, consulting services, travel and other related corporate costs such as stock options and restricted stock granted and the related non-cash compensation.

G&A expenses for the three months ended September 30, 2020 increased $0.5 million or 44.5%. For the nine months ended September 30, 2020, G&A expenses increased $0.5 million, or 15.1%, compared to the same period in 2019. This was due to legal and administrative fees related to the tender offer in June 2020, which closed in July 2020, legal fees related to executive compensation, and increased stock based compensation associated with the 2019 and 2020 stock grants.

Interest Expense

Three months ended September 30,

Nine months ended September 30,

2020

2019

2020

2019

Interest expense

28,629

29,416

84,952

86,035

Interest expense relates to the commitment fees paid on the revolving line of credit.

Interest expense remained consistent during the three and nine months ended September 30, 2020 as compared to the three and nine months ended September 30, 2019. Interest expense for the periods consists primarily of commitment fees as Epsilon did not access our line of credit during this time.

Gain (Loss) on Derivative Contracts

Three months ended September 30,

Nine months ended September 30,

2020

2019

2020

2019

Gain on derivative contracts

419,879

1,270,494

2,055,548

3,494,727

For the nine months ended September 30, 2020 and 2019, Epsilon entered into NYMEX Henry Hub Natural Gas Futures swap and Dominion basis swap derivative contracts for the purpose of hedging its physical natural gas sales revenue. During the three and nine months ended September 30, 2020 we received net cash settlements of $1,657,323 and $4,035,092 respectively. For the three and nine months ended September 30, 2019, Epsilon received $1,157,271, and $1,344,690, respectively on the settlement of contracts.

Table of Contents

For the three months ended September 30, 2020, an $840,285 decrease in the value of Henry Hub swaps, due to an increase in Henry Hub prices, was offset by a $1,272,589 increase in the value of Dominion basis swaps, due to widening regional basis, and $12,425 in transaction costs. For the three months ended September 30, 2019, the value of the Henry Hub swaps and Dominion basis swaps increased $680,918 and $601,651, respectively, due to lower Henry Hub prices and widening regional basis, partially offset by $12,075 of transaction costs.

For the nine months ended September 30, 2020, the value of the Henry Hub swaps and Dominion basis swaps increased $997,303 and $1,099,776, respectively, due to lower Henry Hub prices and widening regional basis, partially offset by $41,531 of transaction costs. For the nine months ended September 30, 2019, the value of the Henry Hub swaps and Dominion basis swaps increased $3,371,735 and $160,143, respectively, due to lower Henry Hub prices and widening regional basis, partially offset by $37,150 of transaction costs.

Other Income (Expense)

Three months ended September 30,

Nine months ended September 30,

2020

2019

2020

2019

Interest income and other income (expense)

4,721

38,619

37,064

128,362

For the three and nine months ended September 30, 2020 and 2019 other income consisted primarily of interest income.

Capital Resources and Liquidity

Cash Flow

The primary source of cash for Epsilon during the three and nine months ended September 30, 2020 was funds generated from operations, and cash received on the settlement of derivative contracts. For the three and nine months ended September 30, 2019, the primary source of funds was from operations. In addition to operations, the primary uses of cash for the three and nine months ended September 30, 2020 were development of natural gas properties, and the repurchase of shares of common stock under Epsilon’s substantial issuer bid/issuer tender offer dated May 19, 2020, as amended. Under its substantial issuer bid/tender offer, Epsilon utilized cash on hand to pay for the 2,337,034 properly tendered and not withdrawn common shares at a cost of approximately $7.15 million, excluding fees and expenses. For the three and nine months ended September 30, 2019 cash was used for income tax pre-payments, repurchase of shares of common stock, and acquisitions and development of oil and gas properties.

At September 30, 2020, we had a working capital surplus of $11.5 million, a decrease of $3.4 million over the $14.9 million surplus at December 31, 2019. The surplus decreased from December 31, 2019 due to the $7.15 million of cash spent on the repurchase of stock under the substantial bid/issuer tender offer. This decrease in cash was offset by the cash that is continually being generated by operations and cash received from the settlement of derivative contracts. The Company anticipates its current cash balance, cash flows from operations, and available sources of liquidity to be sufficient to meet its cash requirements. However, as the impact of recent declines in worldwide crude oil and natural gas prices and the impact of COVID-19 on the economy evolves, Epsilon will continue to assess its liquidity needs. In the event of a sustained market deterioration, the Company may need additional liquidity, which would require it to evaluate available alternatives and take appropriate actions.

Three and nine months ended September 30, 2020 compared to 2019

During the nine months ended September 30, 2020, $12.1 million was provided by the Company’s operating activities, compared to $11.8 million provided during the same period in 2019, a $0.3 million, and 2.2% increase. The increase was mainly due to increased cash received on the settlement of derivative contracts, but was offset by a decrease in revenues received as discussed previously. During the three months ended September 30, 2020, $3.8 million was provided by the Company’s operating activities compared to a consistent $3.8 million also provided during the same period in 2019.

Table of Contents

The Company used $1.4 million and $5.5 million of cash for investing activities during the three and nine months ended September 30, 2020, respectively. This was spent primarily on leasehold and development costs targeting increasing production in Pennsylvania. For the three and nine months ended September 30, 2019, the Company used $1.2 million and $5.8 million, respectively mainly on cash calls for wells to be developed in Oklahoma and leasehold development costs in Pennsylvania.

The $7.2 million and $9.1 million for the three and nine months ended September 30, 2020, respectively, and the $0.4 million and $1.7 million for the three and nine months ended September 30, 2019, respectively, of cash used for financing activity was related to the repurchase of common shares of the Company.

Credit Agreement

In addition, the Company has a senior secured credit facility which includes a total commitment of up to $100 million. The current effective borrowing base is $23 million, which is subject to semi-annual redetermination. There are currently no borrowings under the facility. If Epsilon decided to access the facility, depending on the level of borrowing, the Company might need to increase its hedging activity. Borrowings from the Facility may be used for the acquisition and development of oil and gas properties, investments in cash flow generating assets complimentary to the production of oil and gas, and for letters of credit and other general corporate purposes. Upon each advance, interest is charged at the highest of a) rate of LIBOR plus an applicable margin (2.75%-3.75% based on the percent of the line of credit utilized), b) the Prime Rate, or c) the sum of the Federal Funds Rate plus 0.5%. Effective January 7, 2019 the agreement was amended to extend the maturity date to March 1, 2022.

The bank has a first priority security interest in the tangible and intangible assets of Epsilon Energy USA, Inc. to secure any outstanding amounts under the agreement. Under the terms of the agreement, the Company must maintain the following covenants:

● Interest coverage ratio greater than 3 based on income adjusted for interest, taxes and non-cash amounts.

● Current ratio, adjusted for line of credit amounts used and available and non-cash amounts, greater than 1.

● Leverage ratio less than 3.5 based on income adjusted for interest, taxes and non-cash amounts.

Epsilon was in compliance with the financial covenants of the agreement as of September 30, 2020 and December 31, 2019 and expect to be in compliance for the next 12 months. We expect to remain in compliance as we currently have no borrowings under the facility and funded all operations for 2019 and all operations through September 30, 2020 out of operating cash flow and cash on hand and expect to continue to do so through 2020.

Balance at

September 30,

December 31,

Borrowing Base

Interest

2020

2019

September 30, 2020

Rate

Revolving line of credit

—

23,000,000

3 mo. LIBOR + 2.75%

Available borrowing capacity under the credit agreement is $23 million was reaffirmed on February 11, 2020.

Repurchase Transactions

Since May 20, 2019, Epsilon has conducted a normal course issuer bid (“NCIB”) to repurchase our issued and outstanding common shares, when doing so has been accretive to management's estimates of intrinsic value per share. The NCIB ended on May 19, 2020. Since the commencement of the NCIB on May 20, 2019, Epsilon has strengthened its financial position and overhead costs. With sufficient cash flow from operations, it used discretionary cash to fund these repurchases. Since May 20, 2019, Epsilon has repurchased 1,353,410 common shares of the authorized 1,367,762 purchase amount. During the nine months ended September 30, 2020, the Company spent $1,910,765, excluding fees and expenses,

Table of Contents

under the NCIB. For the nine months ended September 30, 2019, Epsilon spent $1,456,417, excluding fees and expenses, to repurchase common shares.

On May 14, 2020, the Company’s Board of Directors announced its intention to commence a substantial issuer bid/issuer tender offer to purchase for cash up to an aggregate of approximately $6.2 million of its common shares. In May 2020, upon the terms and subject to the conditions described in the Offer to Purchase dated May 19, 2020, as amended, the Company offered to repurchase up to 2,000,000 of its common shares for $3.06 per share, excluding taxes and interest, for a total cost of approximately $6.1 million, excluding expenses of the tender offer. As permitted under Rule 13e-4(f) and Rule 14e-1(b) of the Exchange Act and as stated in its Offer to Purchase, Epsilon was permitted to take up and pay for 2,000,000 common shares plus 2% of its issued and outstanding common shares, or an aggregate total of up to 2,522,673 common shares. The tender offer expired on June 30, 2020, and on July 6, 2020 the Company announced that it accepted 2,337,034 shares for repurchase under the terms of the Offer to Purchase for an aggregate consideration of $7,151,324, or $3.06 per share, excluding fees and expenses. The Company canceled all common shares taken up and paid for under the tender offer. The Company funded the repurchases under the tender offer with cash on hand.

Accordingly, during the nine months ended September 30, 2020, the Company has spent $9,062,089, excluding fees and expenses, to repurchase common shares.

Derivative Transactions

The Company has entered into hedging arrangements to reduce the impact of natural gas price volatility on operations. By removing the price volatility from a significant portion of natural gas production, the potential effects of changing prices on operating cash flows have been mitigated, but not eliminated. While mitigating the negative effects of falling commodity prices, these derivative contracts also limit the benefits we might otherwise receive from increases in commodity prices.

At September 30, 2020, Epsilon’s outstanding natural gas commodity swap contracts consisted of the following:


		Weighted Average Price ($/MMbtu)
	Volume			Basis		Fair Value of Asset
Derivative Type	(MMbtu)	Swaps		Differential		September 30, 2020
2020
Fixed price swap	762,500	$	2.73	$	—		(73,029)
Basis swap	762,500	$	—	$	(0.44)		93,287
	1,525,000					$	20,258

Contractual Obligations

The following table summarizes Epsilon’s contractual obligations at September 30, 2020:


	Payments Due by Period
			Less than		1 – 3		Greater than
	Total		1 Year		Years		3 Years
Derivative liabilities⁽¹⁾		154,163		154,163		—		—
Asset retirement obligation, undiscounted		8,948,964		1,608,499		—		7,340,465
Capital expenditure commitments		2,627,774		655,398		1,972,376		—
Operating leases		271,030		25,147		209,870		36,013
Total future commitments	$	12,001,931	$	2,443,207	$	2,182,246	$	7,376,478

________________________

(1)

The liability balance shown represents the gross mark-to-market liability balance of derivative contracts before being offset by contracts in an asset position.

We enter into commitments for capital expenditures in advance of the expenditures being made. At a given point in time, it is estimated that we have committed to capital expenditures equal to approximately one quarter of our capital budget by means of giving the necessary authorizations to the asset operator to incur the expenditures in a future period. Current commitments have been included in the contractual obligations table above.

Table of Contents

Based on current natural gas prices and anticipated levels of production, we believe that the estimated net cash generated from operations, together with cash on hand and amounts available under our credit agreement, will be adequate to meet liquidity needs for the next 12 months and beyond, including satisfying our financial obligations and funding our operating and development activities.

Off-Balance Sheet Arrangements

As of September 30, 2020, the Company had no off-balance sheet arrangements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our earnings and cash flow are significantly affected by changes in the market price of commodities. The prices of natural gas and oil can fluctuate widely and are influenced by numerous factors such as demand, production levels, world political and economic events, and the strength of the US dollar relative to other currencies. Should the price of natural gas and oil decline substantially, the value of our assets could fall dramatically, impacting our future operations and exploration and development activities, along with our gas gathering system revenues. In addition, our operations are exposed to market risks in the ordinary course of our business, including interest rate and certain exposure as well as risks relating to changes in the general economic conditions in the United States.

Gathering System Revenue Risk

The Auburn Gas Gathering System lies within the Marcellus Basin with historically high levels of recoverable reserves and low cost of production. We believe that a short-term low commodity price environment will not significantly impact the reserves produced and thus the revenue of our gas gathering system.

Interest Rate Risk

Market risk is estimated as the change in fair value resulting from a hypothetical 100 basis point change in the interest rate on the outstanding balance under our credit agreement. The credit agreement allows us to fix the interest rate for all or a portion of the principal balance for a period up to nine months. To the extent that the interest rate is fixed, interest rate changes affect the instrument’s fair market value but do not affect results of operations or cash flows. Conversely, for the portion of the credit agreement that has a floating interest rate, interest rate changes will not affect the fair market value but will affect future results of operations and cash flows.

At September 30, 2020 and 2019, the outstanding principal balance under the credit agreement was nil.

Derivative Contracts

The Company’s financial results and condition depend on the prices received for natural gas production. Natural gas prices have fluctuated widely and are determined by economic and political factors. Supply and demand factors, including weather, general economic conditions, the ability to transport the gas to other regions, as well as conditions in other natural gas regions, impact prices. Epsilon has established a hedging strategy and may manage the risk associated with changes in commodity prices by entering into various derivative financial instrument agreements and physical contracts. Although these commodity price risk management activities could expose Epsilon to losses or gains, entering into these contracts helps to stabilize cash flows and support the Company’s capital spending program.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

As required by Rule 13a-15(b) under the Exchange Act, we have evaluated, under the supervision and with the participation of our management, including our principal executive officer and our principal financial officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this 10-Q. Our disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed by us in reports that we file

Table of Contents

under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure and is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC.

Based upon such evaluation, we have concluded that as of September 30, 2020 our disclosure controls and procedures were effective. However, as of March 31, 2020 and June 30, 2020 our disclosure controls and procedures were not effective as of such date as a result of a material weakness in our internal control over financial reporting related to the preparation of our oil and gas properties impairment calculation in accordance with the relevant accounting literature and the related review control as of March 31, 2020.

The effect of the error that resulted from the material weakness discussed above was corrected as part of the 10-Q reporting process, and management has concluded that the consolidated financial statements included in both our report at March 31, 2020, and this report fairly present, in all material respects, our financial condition, results of operations and cash flows for the periods presented in conformity with accounting principles generally accepted in the United States.

Management’s Remediation Plan

Our management has implemented a remediation plan to address the operating effectiveness control deficiencies that led to the material weakness described above. Management’s plan of remediation included a review of Epsilon’s internal controls by a third-party consultant. The review of impairment and related processes has been completed and Epsilon has put into effect their recommendations regarding implementing new controls and processes over the calculation and evaluation of impairment. Additionally, Epsilon added a research subscription to the Company’s accounting resources, which management believes will improve the Company’s ability to research accounting rules and procedures. We believe the remediation to be complete, subject to testing.

Changes in Internal Control over Financial Reporting

Subject to these remediation efforts, that we implemented after March 31, 2020, there have been no significant changes in the Company’s internal control over financial reporting during the period covered by this Quarterly Report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Inherent Limitations on Effectiveness of Controls

Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that of limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, the risk.

PART II OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The Company is not currently involved in any litigation.

ITEM 1A. RISK FACTORS

There have been no material changes from the risk factors disclosed in Item 1A. Risk Factors of our Annual Report on Form 10-K for the year ended December 31, 2019 and Part II, Item 1A in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2020 and June 30, 2020.

Table of Contents

ITEM 2. UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS

The following table contains information about our acquisition of equity securities during the nine months ended September 30, 2020:


				Total number		Maximum number
				of shares		of shares that
				purchased as		may yet be
	Total number	Average price		part of publicly		purchased under
	of shares	paid per		announced plans		the plans or
	purchased	share		or programs⁽⁴⁾		programs⁽⁵⁾
Beginning of normal-course issuer bid, May 20, 2019							1,367,762
Shares purchased through December 31, 2019 ^{(1) (2)}	696,096	$	3.72
January 2020⁽²⁾	102,051	$	2.95
February 2020⁽²⁾	261,519	$	3.11
March 2020⁽²⁾	124,459	$	2.98
April 2020⁽²⁾	156,585	$	2.48
May 2020⁽²⁾	12,700	$	2.91
July 2020⁽³⁾	2,337,034	$	3.06		2,337,034
Total as of September 30, 2020	3,690,444	$	3.16		2,337,034		—

(1)

Shares purchased through December 31, 2019 were cancelled prior to the year ended December 31, 2019.

(2)

Commencing on May 20, 2019, the Company entered into a share repurchase program on the NASDAQ conducted in accordance with Rule 10b-18 promulgated under the Securities Exchange Act of 1934. The Company was authorized to repurchase up to 1,367,762 of its outstanding common shares, representing 5% of the outstanding common shares of Epsilon as of May 20, 2019, for an aggregate purchase price of not more than $5.0 million. The program ended on May 19, 2020, but Epsilon’s final repurchase under this program occurred on May 8, 2020. Repurchases were made at management’s discretion from time to time through the facilities of the NASDAQ Global Market. The price paid for the common shares was, subject to applicable securities laws, the prevailing market price of such common shares on the NASDAQ Global Market at the time of such purchase. The Company funded the purchase out of available cash and did not incur debt to fund the share repurchase program.

(3)

On May 14, 2020, the Company’s Board of Directors announced its intention to commence a substantial issuer bid/issuer tender offer to purchase for cash up to an aggregate of approximately $6.2 million of its common shares. In May 2020, upon the terms and subject to the conditions described in the Offer to Purchase dated May 19, 2020, as amended, the Company offered to repurchase up to 2,000,000 of its common shares for $3.06 per share, excluding taxes and interest, for a total cost of approximately $6.1 million, excluding expenses of the tender offer. As permitted under Rule 13e-4(f) and Rule 14e-1(b) of the Exchange Act and as stated in its Offer to Purchase, Epsilon was permitted to take up and pay for 2,000,000 common shares plus 2% of its issued and outstanding common shares, or an aggregate total of up to 2,522,673 common shares. The tender offer expired on June 30, 2020, and on July 6, 2020 the Company announced that it accepted 2,337,034 shares for repurchase under the terms of the Offer to Purchase for an aggregate consideration of $7,151,324, or $3.06 per share, excluding fees and expenses. The Company canceled all common shares taken up and paid for under the tender offer. The Company funded the repurchases under the tender offer with cash on hand. After giving effect to the cancellation of the common shares purchased under the tender offer, 23,796,637 common shares were issued and outstanding.

(4)

Although disclosed in the Company’s Form 10-Q filed August 26, 2019, the Company did not publicly announce the share repurchase program under which it purchased the shares described in the column “Total number of shares Purchased” for January through May 2020. The Company publicly announced its intention to commence a substantial issuer bid/issuer tender offer on May 14, 2020, and the issuer tender offer commenced May 19, 2020.

Table of Contents

(5)

The normal-course issuer bid expired on May 19, 2020, and the substantial issuer bid/issuer tender offer expired on June 30, 2020^.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

Not applicable.

Table of Contents

ITEM 6. —EXHIBITS




Exhibit No.		Description of Exhibit

3.1		Bylaws, as amended (effective September 1, 2020) (filed herewith)

31.1		Sarbanes-Oxley Section 302 certification of Principal Executive Officer.

31.2		Sarbanes-Oxley Section 302 certification of Principal Financial Officer.

32.1		Sarbanes-Oxley Section 906 certification of Principal Executive Officer.

32.2		Sarbanes-Oxley Section 906 certification of Principal Financial Officer.

101.INS		XBRL Instance Document.

101.SCH		XBRL Schema Document.

101.CAL		XBRL Calculation Linkbase Document.

101.DEF		XBRL Definition Linkbase Document.

101.LAB		XBRL Labels Linkbase Document.

101.PRE		XBRL Presentation Linkbase Document.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


Epsilon Energy Ltd.
(Registrant)

Date: November 10, 2020	By:	/s/ B. Lane Bond
		B. Lane Bond
		Chief Financial Officer (Principal Financial Officer and Duly Authorized Officer)

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. sophomore Avg

Epsilon Energy (EPSN) 10-Q2020 Q3 Quarterly report

Content analysis