Epsilon Energy 10Q 2021 Q1 Quarterly report

Epsilon Energy (EPSN) 10-Q2021 Q1 Quarterly report

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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 March 31, 2021

◻ 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 May 5, 2021, there were 23,798,884 Common Shares outstanding.

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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		8
Notes to the Unaudited Condensed Consolidated Financial Statements		9
1.	Description of Business	9
2.	Basis of Preparation	9
	Interim Financial Statements	9
	Principles of Consolidation	9
	Use of Estimates	9
	Recently Issued Accounting Standards	10
3.	Cash, Cash Equivalents, and Restricted Cash	10
4.	Property and Equipment	11
	Property Impairment	11
5.	Revolving Line of Credit	11
6.	Shareholders’ Equity	12
7.	Revenue Recognition	16
8.	Income Taxes	18
9.	Commitments and Contingencies	18
	Litigation	18
10.	Net Income Per Share	19
11.	Operating Segments	19
12.	Risk Management Activities	21
	Commodity Price Risks	21
	Commodity Derivative Contracts	21
13.	Asset Retirement Obligations	22
14.	Fair Value Measurements	23
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		24
	Overview	24
	Business Strategy	24
	Operational Highlights	25
	Non-GAAP Financial Measures-Adjusted EBITDA	26
	Net Operating Revenues	26
	Operating Costs	28
	Depletion, Depreciation, Amortization and Accretion (“DD&A”)	28
	General and Administrative	29
	Interest Expense	30
	Net Gain (Loss) on Commodity Contracts	30
	Miscellaneous Income (Expense)	30
	Capital Resources and Liquidity	30

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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, 2020, 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, 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, 2020 are available on our website at www.epsilonenergyltd.com.

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PART I-FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Balance Sheets


	March 31,		December 31,
	2021		2020
ASSETS
Current assets
Cash and cash equivalents	$	17,851,587	$	13,270,913
Accounts receivable		3,462,548		3,917,288
Fair value of derivatives		401,141		—
Prepaid income taxes		—		89,285
Other current assets		339,209		500,583
Total current assets		22,054,485		17,778,069
Non-current assets
Property and equipment:
Oil and gas properties, successful efforts method
Proved properties		134,831,162		133,902,723
Unproved properties		21,510,765		21,552,063
Accumulated depletion, depreciation, amortization and impairment		(99,469,225)		(98,200,111)
Total oil and gas properties, net		56,872,702		57,254,675
Gathering system		42,215,928		42,202,644
Accumulated depletion, depreciation, amortization and impairment		(32,480,738)		(32,101,624)
Total gathering system, net		9,735,190		10,101,020
Land		637,764		637,764
Buildings and other property and equipment, net		335,455		338,419
Total property and equipment, net		67,581,111		68,331,878
Other assets:
Restricted cash		566,540		565,858
Prepaid drilling costs		223		379
Total non-current assets		68,147,874		68,898,115
Total assets	$	90,202,359	$	86,676,184

LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities
Accounts payable trade	$	725,168	$	1,195,479
Gathering fees payable		780,096		909,768
Royalties payable		1,414,126		1,155,698
Income taxes payable		247,513		—
Accrued capital expenditures		724,714		139,766
Other accrued liabilities		786,130		1,002,935
Asset retirement obligations		108,258		106,734
Total current liabilities		4,786,005		4,510,380
Non-current liabilities
Asset retirement obligations		3,042,871		3,043,509
Deferred income taxes		10,908,211		10,102,852
Total non-current liabilities		13,951,082		13,146,361
Total liabilities		18,737,087		17,656,741
Commitments and contingencies (Note 9)
Shareholders' equity
Common shares, no par value, unlimited shares authorized and 23,985,799 issued and 23,862,599 outstanding at March 31, 2021 and 23,985,799 shares issued and outstanding at December 31, 2020.		131,730,401		131,730,401
Treasury shares, 123,200 at March 31, 2021		(492,479)		—
Additional paid-in capital		8,081,618		7,879,119
Accumulated deficit		(77,675,157)		(80,410,724)
Accumulated other comprehensive income		9,820,889		9,820,647
Total shareholders' equity		71,465,272		69,019,443
Total liabilities and shareholders' equity	$	90,202,359	$	86,676,184

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

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EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income


	Three months ended March 31,
	2021		2020
Revenues from contracts with customers:
Gas, oil, NGLs and condensate revenue	$	6,439,155	$	4,111,144
Gas gathering and compression revenue		2,002,157		2,316,702
Total revenue		8,441,312		6,427,846

Operating costs and expenses:
Lease operating expenses		1,594,188		2,047,767
Gathering system operating expenses		190,947		97,778
Development geological and geophysical expenses		11,539		2,629
Depletion, depreciation, amortization, and accretion		1,682,860		2,414,376
Impairment of proved properties		—		1,760,000
General and administrative expenses:
Stock based compensation expense		202,499		173,919
Other general and administrative expenses		1,327,161		1,008,113
Total operating costs and expenses		5,009,194		7,504,582
Operating income (loss)		3,432,118		(1,076,736)

Other income (expense):
Interest income		7,813		21,529
Interest expense		(27,073)		(28,006)
Gain on derivative contracts		465,341		1,721,018
Other income (expense)		1,941		(2,225)
Other income, net		448,022		1,712,316

Net income before income tax expense		3,880,140		635,580
Income tax expense		1,144,573		325,281
NET INCOME	$	2,735,567	$	310,299
Currency translation adjustments		242		(114)
NET COMPREHENSIVE INCOME	$	2,735,809	$	310,185

Net income per share, basic	$	0.11	$	0.01
Net income per share, diluted	$	0.11	$	0.01
Weighted average number of shares outstanding, basic		23,947,222		26,565,084
Weighted average number of shares outstanding, diluted		24,030,104		26,565,084

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

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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, 2021	23,985,799	$	131,730,401	—	$	—	$	7,879,119	$	9,820,647	$	(80,410,724)	$	69,019,443
Net income	—		—	—		—		—		—		2,735,567		2,735,567
Stock-based compensation expenses	—		—	—		—		202,499		—		—		202,499
Buyback of common shares	—		—	(123,200)		(492,479)		—		—		—		(492,479)
Other comprehensive income	—		—	—		—		—		242		—		242
Balance at March 31, 2021	23,985,799	$	131,730,401	(123,200)	$	(492,479)	$	8,081,618	$	9,820,889	$	(77,675,157)	$	71,465,272


									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

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

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EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Cash Flows


	Three months ended March 31,
	2021		2020
Cash flows from operating activities:
Net income	$	2,735,567	$	310,299
Adjustments to reconcile net income to net cash provided by operating activities:
Depletion, depreciation, amortization, and accretion		1,682,860		2,414,376
Impairment of proved properties		—		1,760,000
Gain on derivative contracts		(465,341)		(1,721,018)
Cash received from settlements of derivative contracts		64,200		1,345,942
Settlement of asset retirement obligation		(3,483)		—
Stock-based compensation expense		202,499		173,919
Deferred income tax expense (benefit)		805,359		(69,478)
Changes in assets and liabilities:
Accounts receivable		454,740		530,156
Prepaid income taxes and other current assets		161,374		478,540
Accounts payable, royalties payable and other accrued liabilities		(349,705)		(9,215)
Income taxes payable		336,798		—
Net cash provided by operating activities		5,624,868		5,213,521
Cash flows from investing activities:
Additions to unproved oil and gas properties		(23,702)		(61,978)
Additions to proved oil and gas properties		(481,021)		(2,045,439)
Additions to gathering system properties		(40,963)		(101,473)
Additions to land, buildings and property and equipment		(5,745)		(145,640)
Prepaid drilling costs		156		244
Net cash used in investing activities		(551,275)		(2,354,286)
Cash flows from financing activities:
Buyback of common shares		(492,479)		(1,499,586)
Net cash used in financing activities		(492,479)		(1,499,586)
Effect of currency rates on cash, cash equivalents and restricted cash		242		(114)
Increase in cash, cash equivalents and restricted cash		4,581,356		1,359,535
Cash, cash equivalents and restricted cash, beginning of period		13,836,771		14,613,711
Cash, cash equivalents and restricted cash, end of period	$	18,418,127	$	15,973,246

Supplemental cash flow disclosures:
Income taxes paid	$	—	$	—
Interest paid	$	29,562	$	28,006

Non-cash investing activities:
Change in unproved properties accrued in accounts payable and accrued liabilities	$	(65,000)	$	—
Change in proved properties accrued in accounts payable and accrued liabilities	$	468,972	$	(903,544)
Change in gathering system accrued in accounts payable and accrued liabilities	$	(27,679)	$	(21,026)
Asset retirement obligation asset additions and adjustments	$	(21,554)	$	3,937

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

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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.” Effective as of the close of trading on March 15, 2019 Epsilon voluntarily delisted its common shares from the TSX. The Company is engaged in the acquisition, development, gathering and production of primarily natural gas reserves in the United States.

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 year ended December 31, 2020. 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.

COVID-19

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.

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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”). This was followed by ASU No. 2021-01, Reference Rate Reform (Topic 848): Scope (“ASU 2021-01”), issued in January 2021. 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. We do not expect a material impact from the adoption of this ASU.

In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740). The ASU simplifies the accounting for income taxes by removing certain exceptions to the general principles in Topic 740 and modifies other areas of the topic to clarify the application of GAAP. Certain amendments within the standard are required to be applied on a retrospective basis and others on a prospective basis. Effective January 1, 2021, we adopted this ASU with no material impact on the Company’s consolidated financial position or results of operations.

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 currently assessing the expected impact on our consolidated financial statements and will adopt for the year beginning in 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.

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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 March 31, 2021 and 2020:


	March 31,		March 31,
	2021		2020
Cash and cash equivalents	$	17,851,587	$	15,410,599
Restricted cash included in other assets		566,540		562,647
Cash, cash equivalents and restricted cash in the statement of cash flows	$	18,418,127	$	15,973,246

4. Property and Equipment

The following table summarizes the Company’s property and equipment as of March 31, 2021 and December 31, 2020:


	March 31,		December 31,
	2021		2020
Property and equipment:
Oil and gas properties, successful efforts method
Proved properties	$	134,831,162	$	133,902,723
Unproved properties		21,510,765		21,552,063
Accumulated depletion, depreciation, amortization and impairment		(99,469,225)		(98,200,111)
Total oil and gas properties, net		56,872,702		57,254,675
Gathering system		42,215,928		42,202,644
Accumulated depletion, depreciation, amortization and impairment		(32,480,738)		(32,101,624)
Total gathering system, net		9,735,190		10,101,020
Land		637,764		637,764
Buildings and other property and equipment, net		335,455		338,419
Total property and equipment, net	$	67,581,111	$	68,331,878

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, GAAP requires that the Company first compares 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, which 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, 2021, no impairment was required. 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 recorded on the Company’s Oklahoma assets during the three months ended March 31, 2020.

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.

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

On April 6, 2021 the agreement was amended to extend the maturity date to March 1, 2024 and the borrowing base was decreased from $23 million to $18 million. In addition, the “applicable margin” rates were adjusted from 2.75%-3.75% to 3.25%-4.25%, a LIBOR minimum rate of 0.25% was added, and the leverage ratio compliance threshold was decreased from less than 3.5 to less than 3.0. The amendment also includes a “Benchmark Replacement” definition and transition plan to be used at such time when the LIBOR rate is discontinued. This rate also has a minimum of 0.25%.

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 3.0 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 March 31, 2021 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

March 31,

December 31,

Current

Interest Rate

2021

2020

Borrowing Base

3 mo.

Revolving line of credit

—

18,000,000

LIBOR + 3.25%⁽¹⁾

(1)	At March 31, 2021, the weighted average interest rate was 3.50%.

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.

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Notes to the Unaudited Condensed Consolidated Financial Statements

(b)Purchases of Equity Shares

Normal Course Issuer Bid

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, and the shares were subsequently cancelled.

Commencing on January 1, 2021, 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 is authorized to repurchase up to 1,193,000 of its outstanding common shares, representing 5% of the outstanding common shares of Epsilon as of January 1, 2021. The program will end on December 31, 2021 unless the maximum amount of common shares is purchased before then or Epsilon provides earlier notice of termination.

Repurchases may be made at management’s discretion from time to time through the facilities of the NASDAQ Global Market. The price paid for the common shares will be, 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 intends to fund the purchase out of available cash and does not expect to incur debt to fund the share repurchase program. The shares are accounted for as treasury shares until such a time as they are cancelled.

The following table contains activity relating to our acquisition of equity securities during the three months ended March 31, 2021:


				Maximum number
				of shares that
				may yet be
	Total number	Average price		purchased under
	of shares	paid per		the plans or
	purchased	share		programs
Beginning of normal-course issuer bid, January 1, 2021					1,193,000
January 2021⁽¹⁾	—	$	—
February 2021⁽¹⁾	62,400	$	4.07
March 2021⁽¹⁾	60,800	$	3.92
Total as of March 31, 2021	123,200	$	4.00		1,069,800

(1)

Epsilon repurchased these shares under its share repurchase program that commenced on January 1, 2021, as described above.

(c)Equity Incentive Plan

Epsilon’s board of directors (the “Board”) adopted the 2020 Equity Incentive Plan (the “2020 Plan”) on July 22, 2020 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 December 31, 2020, the Company

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Notes to the Unaudited Condensed Consolidated Financial Statements

granted, after the Compensation Committee approved the terms, target formulas, and peer group applicable to the performance incentive awards, 214,000 performance stock units (“PSUs”), and 111,900 time-based restricted shares to employees, leaving 1,674,100 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.

Restricted and Performance Stock Units

For the three months ended March 31, 2021, no shares of Restricted Stock were awarded. For the year ended December 31, 2020, 111,900 common shares of Restricted Stock with a weighted average market price at the grant date of $3.71 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.

The following table summarizes Restricted Stock activity for the three months ended March 31, 2021, and the year ended December 31, 2020:


	Three months ended		Year ended
	March 31, 2021		December 31, 2020
		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	290,070	1.60	346,499	1.67
Granted	—	—	111,900	3.00
Vested	—	—	(168,329)	—
Forfeited	(22,000)	1.68	—	—
Balance non-vested Restricted Stock at end of period	268,070	1.34	290,070	1.60

Stock compensation expense for the granted Restricted Stock is recognized over the vesting period. Stock compensation expense recognized during the three months ended March 31, 2021 and 2020 related to these awards was $137,206 and $172,052, respectively.

At March 31, 2021, the Company had unrecognized stock-based compensation related to these shares of $850,929 to be recognized over a weighted average period of 1.10 years (at December 31, 2020: $1,068,819 over 1.2 years).

Performance Share Unit Awards (“PSU”)

The Company grants PSUs, which are paid in stock to certain key employees. For the three months ended March 31, 2021, no PSUs were awarded. For the year ended December 31, 2020, 214,000 PSUs. PSUs are based on a three-year performance period with performance being measured each year at December 31. The PSUs will vest on the last day of the performance period. The number of PSUs that will ultimately vest is based on two performance targets as follows:

●

The targets for the PSUs are based on (i) the relative total stockholder return (“TSR”) percentile ranking and (ii) the relative cash flow per debt adjusted share – growth (“CFDAS Growth”) percentile ranking of the Company, each as compared to the Company’s Performance Peer Group during the applicable one-year performance period ending on December 31.

●

Cash Flow per Debt Adjusted Share (“CFDAS”) is defined as EBITDA (earnings before interest, taxes, depreciation and amortization) divided by the sum of the 1) the total debt plus the value of preferred stock minus cash and the amount of dividends paid for the year divided by the share price at the end of the year; and 2) the actual share count at year end.

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Notes to the Unaudited Condensed Consolidated Financial Statements

●

The vesting of each PSU Award will be based 50% on TSR performance and 50% based on CFDAS Growth performance.

●

The recipient of the award must be employed with the Company at the time of vesting.

The number of shares ultimately issued under these awards can range from zero to 200% of target award amounts.

The PSUs are accounted for as equity awards. The fair value of the 50% for performance based on CFDAS Growth was determined as the market price of the common shares of the Company on the date of grant. Weighted average fair value of CFDAS PSUs granted during the year ended December 31, 2020 was $3.41 per unit. The fair value of the 50% for performance based on TSR was determined on the grant date by the application of a Monte Carlo simulation model. Weighted average fair value of TSR PSUs granted during the year ended December 31, 2020 was $4.10 per share.

The Monte Carlo simulation model calculated grant date fair value for awards issued during the period using the following assumptions:


	March 31,		December 31,
	2021		2020
Expected life (in years)		—		0.33 - 3
Expected volatility		—		42.1% - 53.6%
Risk-free rate of return		—		0.10% - 0.17%
Weighted average grant-date fair value per PSU	$	—	$	4.10

The Monte Carlo simulation model utilizes multiple input variables that determine the probability of satisfying the market condition stipulated in the performance stock awards, to calculate the fair value of the awards. Expected volatilities in the model were estimated using a historical period consistent with the expected term for each annual performance period of the awards. The risk-free interest rate was based on the United States Treasury rate measured over a term commensurate with the expected term for each annual performance period of the awards. The expected term is based on the time between the valuation date and the end of each annual performance period of the awards. The valuation model assumes dividends are immediately reinvested.

The following table summarizes PSUs for the three months ended March 31, 2021 and the year ended December 31, 2020:


	Three months ended		Year ended
	March 31, 2021		December 31, 2020
		Weighted		Weighted
	Number of	Average	Number of	Average
	Shares	Remaining Life	Shares	Remaining Life
	Outstanding	(years)	Outstanding	(years)
Balance non-vested PSUs at beginning of period	193,167	1.60	—	—
Granted	—	—	214,000	1.61
Vested	—	—	(20,833)	—
Balance non-vested PSUs at end of period	193,167	1.35	193,167	1.60

Stock compensation expense for the granted PSUs is recognized over the vesting period. Stock compensation expense recognized during the three months ended March 31, 2021 related to PSUs was $65,293 (for the three months ended March 31, 2020, nil).

At March 31, 2021, the Company had unrecognized stock-based compensation related to these shares of $503,293 to be recognized over a weighted average period of 1.27 years (at March 31, 2020: nil over nil years).

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Notes to the Unaudited Condensed Consolidated Financial Statements

Stock Options

Through March 31, 2021, 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 2.2 years.

The following table summarizes stock option activity for the three months ended March 31, 2021 and the year ended December 31, 2020:


	Three months ended			Year ended
	March 31, 2021			December 31, 2020
		Weighted				Weighted
	Number of	Average		Number of		Average
	Options	Exercise		Options		Exercise
Exercise price in US$	Outstanding	Price⁽¹⁾		Outstanding		Price⁽¹⁾
Balance at period-end	245,000	$	5.27		245,000	$	5.27

Exercisable at period-end	245,000	$	5.27		245,000	$	5.27

(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 March 31, 2021, using the Black Scholes model, the Company had unrecognized stock-based compensation, related to these options, of nil (at December 31, 2020: nil). The aggregate intrinsic value at March 31, 2021 was nil (at December 31, 2020: nil). For the three months ended March 31, 2021, nil of stock compensation expense, related to these options, was recognized (for the three months ended March 31, 2020, $1,867).

During the three months ended March 31, 2021 and the year ended December 31, 2020, 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 months ended March 31, 2021 and 2020.


	Three Months Ended March 31,
	2021		2020
Operating revenue
Natural gas	$	6,332,099	$	4,019,764
Natural gas liquids		45,621		31,658
Oil and condensate		61,435		59,722
Gathering and compression fees		2,002,157		2,316,702
Total operating revenue	$	8,441,312	$	6,427,846

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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. As of March 31, 2021 and 2020, there were no accounts for which collection was not probable.

The following table details accounts receivable as of March 31, 2021 and December 31, 2020.


	March 31,		December 31,
	2021		2020
Accounts receivable
Natural gas and oil sales	$	1,860,300	$	2,107,910
Joint interest billing		87,713		69,495
Gathering and compression fees		1,446,478		1,736,043
Other		68,057		3,840
Total accounts receivable	$	3,462,548	$	3,917,288

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Notes to the Unaudited Condensed Consolidated Financial Statements

8. Income Taxes

Income tax provisions for the three months ended March 31, 2021 and 2020 are as follows:


	Three months ended March 31,
	2021		2020
Current:
Federal	$	155,370	$	297,863
State		183,844		96,896
Total current income tax expense		339,214		394,759
Deferred:
Federal		663,202		(131,081)
State		142,157		61,603
Total deferred tax expense (benefit)		805,359		(69,478)
Income tax expense	$	1,144,573	$	325,281

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, 2017 through December 31, 2020. 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 three months ended March 31, 2021 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.

9. Commitments and Contingencies

The Company’s future minimum lease commitments as of March 31, 2021 are summarized in the following table:


Year ended
December 31,	Payments
2021	$	77,925
2022		106,797
2023		36,013
	$	220,735

The Company enters into commitments for capital expenditures in advance of the expenditures being made. As of March 31, 2021, the Company had commitments of $1.49 million for capital expenditures.

Litigation

On March 10, 2021, Epsilon filed a complaint against Chesapeake Appalachia, LLC (“Chesapeake”) in the United States District Court for the Middle District of Pennsylvania, Scranton, Pennsylvania. Epsilon claims that Chesapeake has breached a settlement agreement and several operating agreements (“JOAs”) to which Epsilon and Chesapeake are parties. Epsilon asserts that Chesapeake has failed to cooperate with Epsilon’s efforts to develop resources in the Auburn Development, located in North-Central Pennsylvania, as required under both the settlement agreement and JOAs.

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Notes to the Unaudited Condensed Consolidated Financial Statements

Epsilon has requested a preliminary injunction, among other requests for relief. Accordingly, a hearing on that request is expected to be heard during the summer of 2021.

10. Net Income Per Share

Basic net income per share is computed on the basis of the weighted-average number of common shares outstanding during the period. Diluted net income 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 used in the calculation of basic and diluted net income per share is as follows:

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


	Three months ended March 31,
	2021	2020
Basic weighted-average number of shares outstanding	23,947,222	26,565,084
Unvested time-based restricted shares	29,034	—
Unvested performance-based restricted shares	53,848	—
Basic and diluted weighted average shares outstanding	24,030,104	26,565,084

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


	Three months ended March 31,
	2021	2020
Anti-dilutive options	245,000	245,000
Anti-dilutive unvested time-based restricted shares	239,036	346,499
Anti-dilutive unvested performance-based restricted shares	139,319	—
Total Anti-dilutive shares	623,355	591,499

11. 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.

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.

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Notes to the Unaudited Condensed Consolidated Financial Statements

Segment activity as of, and for the three months ended March 31, 2021 and 2020 is as follows:


	Upstream		Gas Gathering		Corporate			Elimination		Consolidated
As of and for the three months ended March 31, 2021
Operating revenue
Natural gas	$	6,332,099	$	—	$	—		$	—	$	6,332,099
Natural gas liquids		45,621		—		—			—		45,621
Oil and condensate		61,435		—		—			—		61,435
Gathering and compression fees		—		2,386,588		—			(384,431)		2,002,157
Total operating revenue ⁽¹⁾	$	6,439,155	$	2,386,588	$	—		$	(384,431)	$	8,441,312

Net earnings (loss) for the period	$	3,531,142	$	1,430,636	$	(2,226,211)	⁽³⁾	$	—	$	2,735,567
Operating costs		1,594,188		575,378		—			(384,431)		1,785,135
Development geological and geophysical expenses		11,539		—		—			—		11,539
Depletion, deprec., amortization and accretion		1,302,286		380,574		—			—		1,682,860
Impairment		—		—		—			—		—

Segment assets	$	76,473,690	$	13,674,102	$	54,567		$	—	$	90,202,359
Capital expenditures ⁽²⁾		914,440		13,284		—			—		927,724
Proved properties (net)		35,361,937		—		—			—		35,361,937
Unproved properties (net)		21,510,765		—		—			—		21,510,765
Gathering system (net)		—		9,735,190		—			—		9,735,190
Other property and equipment (net)		973,219		—		—			—		973,219

As of and for the three months ended March 31, 2020
Operating revenue
Natural gas	$	4,019,764	$	—	$	—		$	—	$	4,019,764
Natural gas liquids		31,658		—		—			—		31,658
Oil and condensate		59,722		—		—			—		59,722
Gathering and compression fees		—		2,736,138		—			(419,436)		2,316,702
Total operating revenue⁽¹⁾	$	4,111,144	$	2,736,138	$	—		$	(419,436)	$	6,427,846

Net earnings for the period	$	(1,580,897)	$	1,686,193	$	205,003	⁽³⁾	$	—	$	310,299
Operating costs		2,047,767		517,214		—			(419,436)		2,145,545
Development geological and geophysical expenses		2,629		—		—			—		2,629
Depletion, deprec., amortization and accretion		1,881,645		532,731		—			—		2,414,376
Gain on sale of property		1,760,000		—		—			—		1,760,000

Segment assets	$	80,725,283	$	14,907,581	$	71,626		$	—	$	95,704,490
Capital expenditures ⁽²⁾		1,349,514		80,446		—			—		1,429,960
Proved properties (net)		39,122,341		—		—			—		39,122,341
Unproved properties (net)		21,109,490		—		—			—		21,109,490
Gathering system (net)		—		11,032,630		—			—		11,032,630
Other property and equipment (net)		727,616		—		—			—		727,616

(1)

Segment operating revenue represents revenues generated from the operations of the segment. Inter-segment sales during the three months ended March 31, 2021 and 2020 have been eliminated upon consolidation. For the three months ended March 31, 2021, Epsilon sold natural gas to 18 unique customers. The one customer over 10% comprised 54% of total revenue. For the three months ended March 31, 2020, Epsilon sold natural gas to 23 unique customers. The four customers over 10% comprised 27%, 22%, 16% and 13% of total revenue.

(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.

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Notes to the Unaudited Condensed Consolidated Financial Statements

12. 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.

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 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 months ended March 31, 2021, Epsilon recognized gains on commodity derivative contracts of $465,341. This amount included cash received on settlements of these contracts of $64,200. For the three months ended March 31, 2020, Epsilon recognized gains on commodity derivative contracts of $1,721,018. This amount included cash received on settlements of these contracts of $1,345,942.

Commodity Derivative Contracts

Presented below is a summary of Epsilon’s natural gas price and basis swap contracts as of March 31, 2021.


								Fair Value
	Volume	Ceiling		Floor		Basis		March 31,
Derivative Type	(MMbtu)	Price		Price		Differential		2021
2021
Basis swap	305,000					$	(1.10)		(27,181)
Two-way costless collar	2,755,000	$	3.27	$	2.78				411,801
2022
Two-way costless collar	900,000	$	3.34	$	2.80				16,521
								$	401,141

As of March 31, 2021 and 2020, 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

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Notes to the Unaudited Condensed Consolidated Financial Statements

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
	March 31,		December 31,
	2021		2020
Current
Basis swap	$	—	$	—
Two-way costless collar		894,240		—
	$	894,240	$	—


	Fair Value of Derivative Liabilities
	March 31,		December 31,
	2021		2020
Current
Basis swap	$	(27,181)	$	—
Two-way costless collar		(465,918)		—
	$	(493,099)	$	—


Net Fair Value of Derivatives	$	401,141	$	—

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


	Three months ended March 31,
	2021		2020
Fair value of asset (liability), beginning of the period	$	—	$	1,999,802
Gains (losses) on derivative contracts included in earnings		465,341		1,721,018
Settlement of commodity derivative contracts		(64,200)		(1,345,942)
Fair value of asset, end of the period	$	401,141	$	2,374,878

13. 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.

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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


	Three Months Ended		Year ended
		March 31,		December 31,
	2021		2020
Balance beginning of period	$	3,150,243	$	2,909,855
Liabilities from drilling of new wells		6,908		5,826
Wells plugged and abandoned		(31,945)		(850)
Change in estimates		—		32,668
Accretion		25,923		202,744
Balance end of period	$	3,151,129	$	3,150,243

14. Fair Value Measurements

The methodologies used to determine the fair value of our financial assets and liabilities at March 31, 2021 were the same as those used at December 31, 2020.

Cash and 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.

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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 March 31, 2021 and 2020 and for the three 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, 2020. 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 (3,979 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 months ended March 31, 2021, Epsilon paid $0.38 million to the Auburn GGS to gather and treat our 2.4 Bcf of natural gas production in Pennsylvania ($0.42 million to the Auburn GGS to gather and treat our 2.7 Bcf of natural gas in the three months ended March 31, 2020).

Epsilon realized net income of $2.7 million for the three months ended March 31, 2021, as compared to net income of $0.3 million for the three months ended March 31, 2020.

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, we seek to identify attractive onshore natural gas and oil properties in the United States, to acquire leasehold interests and to develop our leasehold interests with the goal of deploying capital to earn attractive rates of return.

The core Marcellus Shale is one of the most attractive dry gas resources in the United States and has attracted significant development capital. Well productivity has improved dramatically for many years due to improving techniques in drilling and completing wells, resulting in increasing initial production rates and gas recoveries. The resulting supply of natural gas at times stresses the transportation infrastructure of the Northeast US and exacerbates the local price discount to Henry Hub. In many other basins throughout the US, 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.

The operating environment remains challenging in Northeast Pennsylvania. We implemented a number of initiatives to enhance the value of our core assets in the Marcellus including a comprehensive review of well spacing and completion productivity for both the Lower and Upper Marcellus, and we are working with our well operators to increase operating efficiency. In addition, we continue to work closely with our gathering system partners in order to optimize the operating conditions, enhance operational safety, and to preserve and grow the long-term value of our gathering system assets.

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The major producers in the Appalachian region are under 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, we expect local production during 2021 to be flat compared to 2020. We cannot, however, predict the beginning of and duration of a global recession 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 price levels are sufficient and the capital deployed can achieve our internal hurdle rate of return.

In the longer term, we believe natural gas prices will become more constructive due to moderating supply from both dry gas regions and associated gas from oil prone basins, 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 more than double from the current ~ 10.5 Bcf/d to 17 Bcf/d by 2024 based only on facilities currently commissioning or under construction.

In the Northwest STACK, the Company is evaluating options for deploying capital due to the increase in prices for oil, natural gas liquids and natural gas. The leases are held by production which provides a long-term right to develop these assets when prospective rates of return are attractive. In the interim, Company continues to monitor the development activities from offset operators in our area in an effort to further appraise our leasehold.

Recent Developments

Three months ended March 31, 2021 Highlights

Operational Highlights

Marcellus Shale – Pennsylvania

● During the three months ended March 31, 2021, Epsilon’s realized natural gas price was $2.56 per Mcf, an 75% increase over the three months ended March 31, 2020.

● During the three months ended March 31, 2021, Epsilon’s natural gas production was 2.4 Bcf, as compared to 2.7 Bcf during the same period in 2020.

● Marcellus working interest (WI) gas averaged 30.9 MMcf/d for the three months ended March 31, 2021.

● Gathered and delivered 17.5 Bcf gross (6.1 Bcf net to Epsilon’s interest) during the three months ended March 31, 2021 through the Auburn GGS which represents approximately 87% of maximum throughput as currently configured. Gathering volumes decreased 25% for the three months ended March 31, 2021, as compared to the three months ended March 31, 2020. The decrease is attributable to reduced crossflow volumes due to the expansion of a compression facility in an adjacent midstream system and reduced capacity at Auburn compression facility due to the reduction of the target suction pressure to 550 psig.

Anadarko, NW Stack Trend – Oklahoma

● During the three months ended March 31, 2021, Epsilon’s realized price for all Oklahoma production was $3.56 per Mcfe, a 29% increase over the three months ended March 31, 2020.

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● Total production for the three months ended March 31, 2021 included natural gas, oil, and other liquids and was 0.07 Bcfe, 2.8% increase over the same period in 2020.

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 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 months ended March 31, 2021 and 2020, which is the most directly comparable measure of financial performance calculated under U.S. GAAP and should be reviewed carefully.


	Three months ended March 31,
	2021		2020
Net income	$	2,735,567	$	310,299
Add Back:
Net interest expense		19,260		6,477
Income tax expense		1,144,573		325,281
Depreciation, depletion, amortization, and accretion		1,682,860		2,414,376
Impairment expense		—		1,760,000
Stock based compensation expense		202,499		173,919
Gain on derivative contracts net of cash received or paid on settlement		(401,141)		(375,076)
Foreign currency translation loss		332		2,225
Adjusted EBITDA	$	5,383,950	$	4,617,501

Results of Operations

Net Operating Revenues

For the three months ended March 31, 2021 revenues increased $2.0 million to $8.4 million from $6.4 million during the same period of 2020.

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Revenue and volume statistics for the three months ended March 31, 2021 and 2020 were as follows:


	Three months ended
	March 31,
	2021		2020
Revenues
Natural gas revenue	$	6,332,099	$	4,019,764
Volume (MMcf)		2,466		2,727
Avg. Price ($/Mcf)	$	2.57	$	1.47
PA Exit Rate (MMcfpd)		32.8		33.1
Oil and other liquids revenue	$	107,056	$	91,380
Volume (MBO)		3.7		3.1
Avg. Price ($/Bbl)	$	28.58	$	29.22
Gathering system revenue	$	2,002,157	$	2,316,702
Total Revenues	$	8,441,312	$	6,427,846

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 three months ended March 31, 2021, approximately 81% of the Auburn GGS revenues earned were gathering fees, while 19% were compression fees. Gathering revenues from third-party customers represented approximately 8% of total gathering revenues and third-party compression revenues represented 3% of total compression revenues. For the three months ended March 31, 2020, 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. Revenues derived from Epsilon’s production which have been eliminated from gathering system revenues amounted to $0.38 million and $0.42 million for the three months ended March 31, 2021 and 2020, respectively.

Upstream natural gas revenue for the three months ended March 31, 2021 increased by $2.3 million, or 58%, over the same period in 2020. This was primarily a result of higher natural gas prices; however, this was partially offset by lower volumes being produced.

The Company’s share of gathering system revenue decreased by $0.3 million during the three months ended March 31, 2021, decreasing by 14% over the same period in 2020. 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.

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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 months ended March 31, 2021 and 2020:


	Three months ended March 31,
	2021		2020
Lease operating costs	$	1,594,188	$	2,047,767
Gathering system operating costs		190,947		97,778
	$	1,785,135	$	2,145,545

Upstream operating costs—Total $/Mcfe		0.65		0.75
Gathering system operating costs $ / Mcf		0.10		0.04

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 March 31, 2021 decreased $0.5 million, or 22.2%, over the same period in 2020. The decrease in total cost was due to a reduction in the annual assessment of the PA impact fee (an assessment of an annual fee by the State of PA to mitigate the impacts of the activities associated with unconventional gas wells on the communities in which the wells are located), a reduction in discretionary maintenance spending by the operator, and the decrease in volumes produced.

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.

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 $0.38 million and $0.42 million for the three months ended March 31, 2021 and 2020, respectively, (see Note 11, ‘‘Operating Segments,’’ of the Notes to Unaudited Condensed Consolidated Financial Statements).

Gathering system costs (net of intercompany elimination) for the three months ended March 31, 2021 increased $0.1 million over the same period in 2020. The Company’s share of total gathering system costs increased only $0.06 million, or 11%, for the three months ended March 31, 2021 over 2020; however, the decreased production from Epsilon resulting in a decrease in the elimination entry costs subtracted from the consolidated operating statements resulted in a larger increase in gathering system operating costs reported. These higher reported costs along with decreased throughput in the gathering system resulted in a higher cost per Mcf.

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

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, due to the historically low commodity prices, the December 31, 2019 reserves report volumes were updated based on relevant prices

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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.

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 decreased $0.7 million, or 30% for the three months ended March 31, 2021 compared to the same period in 2020. This was mainly due to the increase in reserves reported and the decrease in production volumes. The lower volumes spread over the increased reserves resulted in lower DD&A. Also minimally affecting the decrease was the impairment of the Oklahoma assets.

Impairment

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 recorded on the Company’s Oklahoma assets during the three months ended March 31, 2020. No impairment was required during the three months ended March 31, 2021.

General and Administrative

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 March 31, 2021 increased $0.3 million or 29.4%. This was mainly due to the increased legal fees related to the complaint filed against Chesapeake, the addition of the salary and benefits for the CEO and increased stock-based compensation resulting from the 2020 stock grants.

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Interest Expense

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

Interest expense remained consistent during the three months ended March 31, 2021 as compared to the three months ended March 31, 2020. 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

For the three months ended March 31, 2021 and 2020, Epsilon entered into NYMEX Henry Hub Natural Gas Futures swap, Dominion basis swap, and two-way costless collar derivative contracts for the purpose of hedging its physical natural gas sales revenue. During the three months ended March 31, 2021 we received net cash settlements of $64,200. For the three months ended March 31, 2020, Epsilon received $1,345,942 on the settlement of contracts.

For the three months ended March 31, 2021 gains decreased due to having fewer open contracts at March 31, 2021 and also fewer settled contracts during the three months ended March 31, 2021. All contracts open at March 31, 2020 were settled by November 30, 2020. The Company did not enter into any new contracts until February 2021.

Other Income (Expense)

For the three months ended March 31, 2021 and 2020 other income consisted primarily of interest income.

Interest income decreased for the three months ended March 31, 2021 due to lower interest rates.

Capital Resources and Liquidity

Cash Flow

The primary source of cash for Epsilon during the three months ended March 31, 2021 was funds generated from operations. For the three months ended March 31, 2020, the primary source of funds was from operations in addition to cash received on the settlement of derivative contracts. In addition to operations, the primary uses of cash for the three months ended March 31, 2021 and 2020 were development of natural gas properties and the repurchase of shares of common stock.

At March 31, 2021, we had a working capital surplus of $17.3 million, an increase of $4.0 million over the $13.3 million surplus at December 31, 2020. The surplus increased from December 31, 2020 due mainly to the cash that is continually being generated by operations. The Company anticipates its current cash balance, cash flows from operations, and available sources of liquidity to be sufficient to meet its cash requirements.

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Three months ended March 31, 2021 compared to 2020

During the three months ended March 31, 2021, $5.6 million was provided by the Company’s operating activities, compared to $5.2 million provided during the same period in 2020, a $0.4 million, and 7.9% increase. The increase was mainly due to increased cash received as revenues during the normal course of business.

The Company used $0.6 million and $2.4 million of cash for investing activities during the three months ended March 31, 2021 and 2020, respectively. This was spent primarily on leasehold and development costs targeting increasing production in Pennsylvania.

The $0.5 million for the three months ended March 31, 2021, and the $1.5 million for the three months ended March 31, 2020, 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 $18 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 (3.25%-4.25% based on the percent of the line of credit utilized) with the minimum being 0.25%, b) the Prime Rate, or c) the sum of the Federal Funds Rate plus 0.5%.

Effective April 6, 2021 the agreement was amended to extend the maturity date to March 1, 2024. In addition, the agreement was amended to include a Benchmark Replacement definition and transition plan to be used at such time when the LIBOR rate is discontinued.

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 3.0 based on income adjusted for interest, taxes and non-cash amounts.

Epsilon was in compliance with the financial covenants of the agreement as of March 31, 2021 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 2020 and all operations through March 31, 2021 out of operating cash flow and cash on hand and expect to continue to do so through 2021.

Balance at

March 31,

December 31,

Borrowing Base

Interest

2021

2020

March 31, 2021

Rate

Revolving line of credit

—

18,000,000

3 mo. LIBOR + 3.25%

Available borrowing capacity under the credit agreement decreased from $23 million to $18 million on April 6, 2021.

Repurchase Transactions

Commencing on January 1, 2021, 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

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share. The NCIB continues through December 31, 2021. Since the commencement of the NCIB on January 1, 2021, Epsilon has strengthened its financial position and overhead costs. With sufficient cash flow from operations, it used discretionary cash to fund these repurchases. Since January 1, 2021, Epsilon has repurchased 123,200 common shares of the authorized 1,193,000 purchase amount. During the three months ended March 31, 2021, the Company spent $492,479 under the NCIB.

Commencing on May 20, 2019, Epsilon conducted a normal course issuer bid (“NCIB”) to repurchase our issued and outstanding common shares. The NCIB ended on May 19, 2020. Epsilon was authorized to purchase 1,367,762 shares. During the three months ended March 31, 2020, the Company spent $1,499,586 under the NCIB to purchase 488,029 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 March 31, 2021, Epsilon’s outstanding natural gas commodity swap contracts consisted of the following:



	Volume	Ceiling		Floor		Basis		Fair Value of Asset
Derivative Type	(MMbtu)	Differential		Price		Differential		March 31, 2021
2021
Basis swap	305,000	$	—	$	—	$	(1.10)		(27,181)
Two-way costless collar	2,755,000	$	(3.27)	$	2.78	$	—		411,801
2022
Two-way costless collar	900,000	$	(3.34)	$	2.80	$	—		16,521
	3,960,000							$	401,141

Contractual Obligations

The following table summarizes Epsilon’s contractual obligations at March 31, 2021:


	Payments Due by Period
			Less than		1 – 3		Greater than
	Total		1 Year		Years		3 Years
Derivative liabilities⁽¹⁾		493,099		493,099		—		—
Asset retirement obligations, undiscounted	$	8,660,131	$	108,549	$	—	$	8,551,582
Capital expenditure commitments		1,485,070		1,485,070		—		—
Operating leases		220,735		104,003		116,732		—
Total future commitments	$	10,859,035	$	2,190,721	$	116,732	$	8,551,582

________________________

(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.

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.

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Off-Balance Sheet Arrangements

As of March 31, 2021, 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 three 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 March 31, 2021 and 2020, 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 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. Our principal executive officer and principal financial officer have concluded that our current disclosure controls and procedures were effective as of March 31, 2021 at the reasonable assurance level.

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Changes in Internal Control over Financial Reporting

No changes in our internal control over financial reporting occurred during the quarter ended March 31, 2021 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

Epsilon has requested a preliminary injunction, among other requests for relief. Accordingly, a hearing on that request is expected to be heard during the summer of 2021.

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, 2020.

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

The following table contains information about our acquisition of equity securities during the three months ended March 31, 2021:


				Maximum number
				of shares that
				may yet be
	Total number	Average price		purchased under
	of shares	paid per		the plans or
	purchased	share		programs
Beginning of normal-course issuer bid, January 1, 2021					1,193,000
January 2021⁽¹⁾	—	$	—
February 2021⁽¹⁾	62,400	$	4.07
March 2021⁽¹⁾	60,800	$	3.92
Total as of March 31, 2021	123,200	$	4.00		1,069,800

(1)

Commencing on January 1, 2021, 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

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Company is authorized to repurchase up to 1,193,000 of its outstanding common shares, representing 5% of the outstanding common shares of Epsilon as of January 1, 2021. The program will end on December 31, 2021 unless the maximum number of common shares is purchased before then or Epsilon provides earlier notice of termination. 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.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

Not applicable.

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ITEM 6. —EXHIBITS




Exhibit No.		Description of Exhibit

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: May 6, 2021	By:	/s/ B. Lane Bond
		B. Lane Bond
		Chief Financial Officer (Principal Financial Officer and Duly Authorized Officer)

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Litigous
Readability	H.S. freshman Avg

Three months ended March 31,

Net income available to shareholders