BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Executive Summary
We are engaged in three lines of business: (i) ownership of crude oil and condensate processing assets, (ii) pipeline transportation services to producer/shippers and (iii) oil and gas exploration and production.
Crude Oil and Condensate Processing Assets. Crude oil and condensate processing operations are conducted through our crude oil processing facility, located in Nixon, Texas (the “Nixon Facility”). The Nixon Facility, which has an operating capacity of approximately 15,000 barrels per day (“bpd”), consists of tankage, a distillation unit, naphtha stabilizer, depropanizer, recovery facilities and the necessary utility systems. The typical refining process for most U.S. Gulf Coast refineries is complex and involves numerous stages to create final products. By contrast, the Nixon Facility is only involved in the first stage of the refining process. As a “topping unit,” the Nixon Facility separates crude oil and condensate into Non-Road, Locomotive, and Marine Diesel Fuels (“NRLM”) for sale into nearby markets, as well as naphtha and atmospheric gas oil for sale to nearby refineries for further processing. Crude oil and condensate is currently purchased under an exclusive supply agreement with GEL Tex Marketing, LLC, an affiliate of Genesis Energy, LLC (“GEL and “Genesis,” respectively) and delivered by truck. The Nixon Facility also has the potential ability to receive crude oil and condensate via pipeline. Refined products, constituting naphtha, NRLM and atmospheric gas oil, are currently sold and delivered by truck and barge. All of our crude oil and condensate processing assets are owned by our wholly-owned subsidiary, Lazarus Energy, LLC (“LE”). On average during this period, the Facility operated at approximately 8,900 bpd, or 59% of operating capacity.
Pipeline Operations. We gather and transport oil and natural gas for producers/shippers operating offshore in the vicinity of our pipelines in the U.S. Gulf of Mexico and charge a fee based on anticipated throughput volumes. For oil, onshore transportation, facilities services, such as storage, and sale are handled by a third-party. We handle the sale of gas through a chemical plant complex and intrastate pipeline system tie-in. All of our pipeline assets are held by and the business conducted by our wholly-owned subsidiary, Blue Dolphin Pipeline Company. Unless otherwise stated herein, all gas liquid volumes transported are attributable to production from third-party producers/shippers.
The following provides a summary of our pipeline assets:
Pipeline Segment | | Market | | Undivided Ownership Interest | | | Miles of Pipeline | | | Capacity (MMcf/d) | |
| | | | | | | | | | | | |
| BDPS | | Gulf of Mexico | | | 83⅓ | % | | | 38 | | | | 180 | |
| GA 350 | | Gulf of Mexico | | | 83⅓ | % | | | 13 | | | | 65 | |
| Omega | | Gulf of Mexico | | | 83⅓ | % | | | 18 | | | | 110 | |
| ● | Blue Dolphin Pipeline System (“BDPS”) – The BDPS spans approximately 38 miles and runs from Galveston Area Block 288 offshore to our onshore facilities and the Dow Chemical Plant Complex in Freeport, Texas. The BDPS has an aggregate capacity of approximately 180 MMcf of gas and 7,000 Bbls of crude oil and condensate per day. The BDPS is currently transporting an aggregate of approximately 2.2 MMcf of gas per day, which represents approximately 1% of throughput capacity. |
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
| | The BDPS includes: (i) approximately 188 acres of land in Brazoria County, Texas where the Blue Dolphin Pipeline comes ashore and where the BDPS’ onshore facilities, pipeline easements and rights-of-way are located, (ii) an offshore platform and (iii) the Blue Dolphin Pipeline. The BDPS gathers and transports oil and gas from various offshore fields in the Galveston Area of the U.S. Gulf of Mexico to our onshore facilities located in Freeport, Texas. The oil is processed, stored and sold by a third-party. The gas is transported to the Dow Chemical Plant Complex and a major intrastate pipeline system with further downstream tie-ins to other intrastate and interstate pipeline systems and end users. |
| ● | Galveston Area Block 350 Pipeline (the “GA 350”) – The GA 350 is an 8-inch, 13 mile offshore pipeline extending from Galveston Area Block 350 to an interconnect with a transmission pipeline in Galveston Area Block 391 located approximately 14 miles south of the Blue Dolphin Pipeline. Current system capacity on the GA 350 is 65 MMcf of gas per day. The GA 350 is currently transporting an aggregate of approximately 14.0 MMcf of gas per day, which represents approximately 22% of throughput capacity. |
| ● | Omega Pipeline (the “Omega”) – The Omega originates in the High Island Area, East Addition Block A-173 and extends to West Cameron Block 342, where it was previously connected to the High Island Offshore System. The Omega is currently inactive. Reactivation of the Omega is dependent upon future drilling activity in the vicinity and successfully attracting producer/shippers to the system. |
Exploration and Production. Our oil and gas exploration and production activities include leasehold interests in properties located in the U.S. Gulf of Mexico and the North Sumatra Basin offshore Indonesia. Our leasehold interests, which are held by and the business conducted by our wholly-owned subsidiary, Blue Dolphin Petroleum Company, are subject to royalty and overriding royalty interests. We evaluate and manage oil and gas properties by considering geology, reserve life and hydrocarbon mix based on seismic and other data.
The following provides a summary of our oil and gas assets:
| Field | | Operator | | Interest |
| | | | | |
| Indonesia: | | | | |
| North Sumatra Basin-Langsa Field | | Blue Sky Langsa, Ltd. | | 7% WI, 5.20625% NRI (+ reversion) |
| U.S. Gulf of Mexico: | | | | |
| High Island Block 115 | | Rooster Petroleum, LLC | | 2.5% WI, 2.008% NRI |
| Galveston Area Block 321 | | Black Elk Energy Offshore Operations LLC | | 0.5% ORRI |
| High Island Block 37 | | Hilcorp Energy Company | | 2.88% WI, 2.246% NRI |
| ● | North Sumatra Basin-Langsa Field – Located offshore Indonesia, the North Sumatra Basin-Langsa Field covers approximately 77 square kilometers and contains two oil fields – the “L” Field and the “H” Field. Four wells have been completed in each field. All four wells in the “L” Field were shut-in following unsuccessful attempts to raise capital for well remedial program. In the “H” Field, two of the wells were plugged and abandoned, one was suspended due to formation pressure and one (the H-4 Well) is currently producing. The wells are completed subsea in 325 feet of water and productive via flexible pipelines to a Floating Production Storage and Offloading barge. The H-4 Well is currently producing approximately 359 barrels of oil per day. |
Although our fully impaired U.S. Gulf of Mexico oil and gas properties may continue to operate over the next twelve to eighteen months, we expect the operating costs of the properties to exceed gross revenues based on current reserves and net cash flow estimates making these properties uneconomical.
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
Relationship with Genesis
We are highly dependent on our relationship with Genesis and its affiliates. Our relationship with Genesis is governed primarily by three agreements:
| ● | the Crude Oil Supply and Throughput Services Agreement by and between GEL and LE dated August 12, 2011 (the “Crude Supply Agreement”); |
| ● | the Construction and Funding Contract by and between LE and Milam Services, Inc., an affiliate of Genesis (“Milam”), dated August 12, 2011 (the “Construction and Funding Agreement”); and |
| ● | the Joint Marketing Agreement by and between GEL and LE dated August 12, 2011 (as subsequently amended, the “Joint Marketing Agreement”). |
Below is a discussion of the material terms and conditions of each of our agreements with Genesis.
Supply Agreement
Crude Oil Supplies: Pursuant to the Crude Supply Agreement, GEL is the exclusive supplier of crude oil to the Nixon Facility; we are not permitted to buy crude oil from any other source without GEL’s express written consent. GEL supplies crude oil to LE at cost plus freight expense and costs associated with hedging. All crude oil supplied to LE pursuant to the Crude Supply Agreement is paid for pursuant to the terms of the Joint Marketing Agreement described below. As security for all obligations owed to GEL and its affiliates under the Joint Marketing Agreement, LE has granted GEL a security interest in the refined products produced by the Nixon Facility until such time as LE has fulfilled its obligations under the Joint Marketing Agreement. LE is not entitled to use the crude oil received from GEL for any purpose other than the operation of the Nixon Facility. Title to the crude oil stored, transferred or handled pursuant to the Crude Supply Agreement remains with GEL until the time it passes the flange connection between the storage tanks at the Nixon Facility to the delivery line, into the Nixon Facility, at which time we take title.
Tank Storage: GEL has a first right of refusal to use three storage tanks at the Nixon Facility during the term of the Crude Supply Agreement. If GEL terminates the Construction and Funding Agreement, and such termination, directly or indirectly, results in the termination of the Crude Supply Agreement, then GEL shall have the option to lease the storage tanks at the Nixon Facility pursuant to the agreed upon terms. The fees paid by GEL previously to LE under the tank storage agreement (the “Tank Storage Fees”), which were approximately $314,000, will be repaid to GEL by LE pursuant to the Joint Marketing Agreement as described below. The Crude Supply Agreement also grants to GEL the exclusive option to build additional tank storage facilities at the Nixon Facility. If, at any time after the Nixon Facility becomes operational, LE receives an offer from a third-party to build additional tank storage facilities at the Nixon Facility, GEL has a right of first refusal whereby, within 30 days after receiving notice of the third-party offer from LE, GEL can give notice of its intent to exercise its option. After giving such notice, GEL and LE will have a period of 180 days in which to negotiate an agreement covering the post-construction operation of such additional facilities and begin construction of the additional facilities. If GEL has not begun construction by the end of the 180 day term, then GEL will be deemed to have waived its option and LE will be free to engage any third-party to construct the additional facilities.
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
Term and Termination: The Crude Supply Agreement has an initial term of three years, expiring on August 12, 2014. After the expiration of its initial term, the Crude Supply Agreement automatically renews for successive one year terms unless either party notifies the other party of its election to terminate the Crude Supply Agreement within 90 days of the expiration of the then current term. The Crude Supply Agreement may be terminated before the expiration of its then current term if: (a) either party fails to carry out its duties under the Crude Supply Agreement for a period of 45 days after written notice of such failure has been given by the other party, then the non-defaulting party may immediately terminate the Crude Supply Agreement, (b) LE’s equipment and facilities for storage and/or handling of crude oil are restrained or enjoined by judicial process or terminated by any governmental authority, then GEL may terminate the Crude Supply Agreement upon 30 days written notice to LE, (c) the Joint Marketing Agreement is terminated, then the Crude Supply Agreement will terminate on that date unless otherwise agreed to by the parties and (d) LE is in breach of the Construction and Funding Agreement and GEL elects to terminate the Construction and Funding Agreement or GEL elects to terminate the Construction and Funding Agreement pursuant to the elective termination provisions thereof, then GEL may terminate the Crude Supply Agreement in its sole discretion.
Construction and Funding Agreement
Construction Services: Pursuant to the Construction and Funding Agreement, LE engaged Milam to provide construction services on a turnkey basis in connection with the construction, installation and refurbishment of certain equipment at the Nixon Facility (the “Project”). Milam is performing this work as an independent contractor of LE. As compensation for its work on the Project, LE agreed to pay Milam a fee of $100,000.
Construction Funding: The Construction and Funding Agreement also sets forth the terms upon which Milam is financing the costs and expenses incurred in connection with the Project. Milam has provided LE with $3.7 million for capital expenditures and $400,000 for startup operating expenses related to the Nixon Facility (collectively, the “Funding Amount Limit”). Milam has continued to make advances in excess of these amounts, in their discretion, for certain construction and operating costs at the Nixon Facility. All amounts advanced to LE pursuant to the terms of the Construction and Funding Agreement bear interest at 6% per annum.
Repayment of Milam: In March 2012 (the month after initial operation of the Nixon Facility occurred), LE began paying Milam, in accordance with the provisions of the Joint Marketing Agreement, a minimum monthly payment of $150,000 as repayment of interest and amounts advanced to LE under the Construction and Funding Agreement. If, however, the Gross Profits of LE (as defined below) in any given month (calculated as the revenue from the sale of products from the Nixon Facility minus the cost of crude oil) are insufficient to make this payment, then there is a deficiency amount, which shall accrue interest (the “Deficiency Amount”). If there is a Deficiency Amount, then 100% of the gross profits in subsequent calendar months will be paid to Milam until the Deficiency Amount has been satisfied in full and all previous $150,000 monthly payments have been made. LE is also required to repay any amounts owed to Milam upon the sale of the Nixon Facility or the recovery of property or casualty insurance proceeds relating to the Nixon Facility. As security for amounts owed to Milam under the Construction and Funding Agreement, LE granted to Milam a security interest in all of LE’s assets.
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
Restrictions on LE: The Construction and Funding Agreement places restrictions on LE, which prohibit LE from:
| ● | incurring any debt (except debt that is subordinated to amounts owed to Milam or GEL); |
| ● | selling, discounting or factoring its accounts receivable or its negotiable instruments outside the ordinary course of business while no default exists; |
| ● | suffering any change of control or merging with or into another entity; |
| ● | acquiring or agreeing to acquire any material portion of the assets or equity interests of another entity; |
| ● | transferring, or granting another party an option to acquire, any of its assets with a fair market value, individually or in the aggregate, of more than $100,000 in any six-month period except for the sale of worn, surplus or obsolete equipment; |
| ● | entering into any joint venture or other partnership arrangement relating to the Nixon Facility or its assets with any party without the consent of Milam; |
| ● | entering into any contracts with any third-parties which would materially affect or impair Milam’s or its affiliates’ rights under the Construction and Funding Agreement, the Joint Marketing Agreement or the Crude Supply Agreement without the consent of Milam or its affiliates, as applicable; or |
| ● | moving its executive offices, changing its company name, changing its corporate form to another type of entity, or moving to another jurisdiction of organization other than Delaware. |
Suspension of Advances; Additional Advances: During the construction period, Milam has the right to suspend advances under the Construction and Funding Agreement under certain circumstances. However, Milam continues to make advances, on a case-by-case basis, to make certain upgrades and other capital expenditures in respect of the Nixon Facility. These advances are discretionary and can be declined and/or terminated at any time by Milam. Such advances are added to the total outstanding balance under the Construction and Funding Agreement.
Termination: Milam has the right to terminate the Construction and Funding Agreement, in its sole discretion, by written notice to LE at any time if: (a) Milam determines that the amount of funds necessary to complete the Project and provide the services described under the Construction and Funding Agreement are in excess of the Funding Amount Limit or (b) upon termination of the Forbearance Agreement with First International Bank (which, together with its successors in interest, are referred to as “FIB”)(the “Refinery Loan Forbearance Agreement”). With respect to clause (a), although Milam has advanced more than the Funding Amount Limit, Milam has not terminated the Construction and Funding Agreement. If Milam terminates the Construction and Funding Agreement, then: (i) Milam and LE are contractually obligated to execute a forbearance agreement, the form of which has been previously agreed to, pursuant to which LE will pay Milam a fee of $150,000 per month in order to maintain the forbearance (such amount shall be credited against the amount owed) for a period of six months (during which time, Milam will agree not to foreclose pursuant to the Construction and Funding Agreement and, thus, LE has the right to find financing to pay off such amounts), (ii) Milam shall be entitled to receive payment in full for all obligations owed under the Construction and Funding Agreement, (iii) all liens in favor of Milam will remain in full force and effect until released in accordance with the terms of the Construction and Funding Agreement and (iv) upon repayment of all obligations owed to Milam pursuant to the terms of the forbearance agreement executed by Milam and LE, LE shall have no further obligations to Milam or its affiliates under the Construction and Funding Agreement.
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
Joint Marketing Agreement
The Joint Marketing Agreement sets forth the terms of the agreement between LE and GEL pursuant to which the parties will market and sell the output produced at the Nixon Facility and share the Gross Profits (as defined below) from such sales.
Marketing: Pursuant to the Joint Marketing Agreement, LE is responsible for entering into contracts with customers for the purchase and sale of output produced at the Nixon Facility and handling all billing and invoicing relating to the same. However, all payments for the sale of output produced at the Nixon Facility are made directly to GEL and all customers must satisfy GEL’s customer credit approval process.
LE Information Production Requirements: LE is required to supply GEL with certain information including operating information relating to the Nixon Facility within 24 hours of the end of each business day. LE is also required to supply GEL with LE’s financial statements. LE is entitled to be reimbursed for any costs and expenses up to $50,000 from Gross Profits (as defined below) relating to the preparation of its financial statements (the “Accounting Fees”), provided that LE can produce adequate documentation relating to such Accounting Fees.
Collections and Bank Accounts: GEL serves as collection agent for LE under the Joint Marketing Agreement. Pursuant to this arrangement, GEL set up a bank account (the “Nixon Product Sales Account”) into which all proceeds received from the sale of output from the Nixon Facility are placed. GEL also opened up a sub-account into which the first $150,000 received under the Joint Marketing Agreement was placed with such amount held in escrow during the term of the Joint Marketing Agreement. This amount will be kept in the sub-account unless LE is unable to make a required monthly payment under the Construction and Funding Agreement in which case such amount owed will be paid to GEL.
Sharing of Gross Profits: The Joint Marketing Agreement defines “Gross Profit” to mean, for a calendar month, the total revenue from the sale of output from the Nixon Facility minus the cost of crude oil (as established pursuant to the formula described above in the discussion of the Crude Supply Agreement). Exhibit B to the Joint Marketing Agreement sets forth how the parties have agreed to distribute the Gross Profit. However, the method for the distribution of Gross Profits set forth in Exhibit B to the Joint Marketing Agreement has been temporarily superseded by the method in the Third Letter Agreement (as defined and more fully described below in “— Clarifications of and Modifications to the Rights of the Parties under the Joint Marketing Agreement – Third Letter Agreement”). When the method for distributing Gross Profits set forth in the Third Letter Agreement ceases to be effective, the method for distributing Gross Profits will revert to the method set forth in Exhibit B to the Joint Marketing Agreement, which is as follows:
| (a) | First, prior to the date on which Milam has recouped all amounts advanced to LE under the Construction and Funding Agreement (the “Investment Threshold Date”), $150,000 (the “Base Construction Payment”) shall be paid to GEL (for remittance to Milam) each calendar month to satisfy amounts owed under the Construction and Funding Agreement; if, however, Gross Profits in any calendar month are insufficient to satisfy the Base Construction Payment, then 100% of the Gross Profit in subsequent calendar months shall be paid to GEL (for remittance to Milam) until any such deficiencies have been satisfied in full (in either instance, such payment is referred to as a “Construction Payment”). |
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
| (b) | Second, prior to and as of the Investment Threshold Date and subject to increases in the percentage to be paid to GEL to satisfy the Base Construction Payment insufficiencies set forth in (a) above, LE shall receive weekly payments (the “Operations Payments”) based on revenues from the sale of diesel blendstocks processed by the Nixon Facility in an amount not to exceed $750,000 per month plus the amount of any Accounting Fees. LE is required to apply such amounts to the payment of monthly operating expenses for the Nixon Facility. If any monthly reconciliation conducted by GEL shows that the Gross Profits for a monthly period are less than $900,000, then LE’s Operations Payments shall be reduced to equal to the difference between the Gross Profits for such monthly period and the proceeds discussed in (a) above. |
| (c) | Third, prior to the Investment Threshold Date and subject to the payment of the Base Construction Payment and the Operations Payments to be paid to GEL and LE respectively, pursuant to (a) and (b) above, an amount shall be paid to GEL from Gross Profits equal to: (i) expenses incurred by GEL for the transportation of output produced at the Nixon Facility for the applicable calendar month, (ii) the Tank Storage Fee and (iii) any fee paid by LE to GEL for GEL’s preparation of the financial statements required to be delivered by LE pursuant to the Joint Marketing Agreement (the “Financial Statement Preparation Fee”), after which GEL shall be paid 80% of the remaining Gross Profits (any percentage of Gross Profits distributed to GEL, the “GEL Profit Share”) and LE shall be paid 20% of the remaining Gross Profits (any percentage of Gross Profits distributed to LE, the “LE Profit Share”). |
| (d) | Fourth, as of the Investment Threshold Date and subject to the payment of, first, an amount equal to $150,000 paid to GEL as an administrative fee relating to the performance of its obligations under the Joint Marketing Agreement (the “Performance Fee”) and, second, the Operations Payments to be paid to LE pursuant to (b) above (in that order), for each applicable calendar month an amount shall be paid to GEL from the Gross Profits equal to: (i) the expenses incurred by GEL for the transportation of output produced at the Nixon Facility for the applicable calendar month, (ii) the Tank Storage Fee and (ii) the Financial Statement Preparation Fee. After the payment to LE and GEL of the amounts set forth in the preceding sentence, 30% of the remaining Gross Profit up to $600,000 (the “Threshold Amount”) shall be paid to GEL as the GEL Profit Share and LE shall be paid 70% of the remaining Gross Profit as the LE Profit Share. Any amount of remaining Gross Profit that exceeds the Threshold Amount for such calendar month shall be paid to GEL and LE in the following manner: GEL shall be paid 20% of the remaining Gross Profits over the Threshold Amount as the GEL Profit Share, and LE shall be paid 80% of the remaining Gross Profits over the Threshold Amount as the LE Profit Share. |
| (e) | Notwithstanding anything to the contrary in the Joint Marketing Agreement, if, after the Investment Threshold Date, GEL sustains any losses and does not receive any portion of the Performance Fee, the expenses incurred by GEL for the transportation of the output from the Nixon Facility, the Tank Storage Fee or the Financial Statement Preparation Fee owed to it under (d) above due to a failure of the Nixon Facility to generate sufficient Gross Profits during a calendar month (a “Deficit Month”), for each subsequent month after such Deficit Month, GEL and LE shall be paid, respectively, (after payment of the Performance Fee and the Operations Payments to GEL and LE, respectively, for each subsequent month) 80% of the remaining Gross Profits as the GEL Profit Share and 20% of such remaining Gross Profit shall be the LE Profit Share, until such time as GEL is repaid in the following order: (i) for such losses incurred during such Deficit Month, (ii) the portion of the Performance Fee not paid during such Deficit Month, (iii) the portion of the amount equal to the Tank Storage Fee not paid during such Deficit Month and (iv) the portion of the Financial Statement Preparation Fee that would have otherwise been paid to GEL during such Deficit Month. The parties shall be paid pursuant to (d) above beginning in the month after which all losses incurred by GEL during any Deficit Month and all amounts otherwise owed to GEL that were not paid during any Deficit Month are paid to GEL in full. |
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
Notwithstanding the distributions of Gross Profit set forth above, if the LE Profit Share due and owing to LE is more than the amount remaining in the Nixon Product Sales Account after the payment of the Construction Payment and the “Allowable Payments” (such term meaning all payments to GEL other than Construction Payments), LE shall only be entitled to receive such amount in the Nixon Product Sales Account as its profit share for the applicable calendar month. Additionally, after the Investment Threshold Date, prior to any other distribution set forth above, and as an advance against the sums to be paid to LE pursuant to (b) above, GEL shall distribute 10% of all diesel revenue to LE weekly during the term of the Joint Marketing Agreement to the extent that such distributions do not exceed $750,000 in any calendar month.
Withholding Payments to LE: The Joint Marketing Agreement also provides several scenarios in which GEL may withhold payments to which LE is otherwise entitled. For instance, GEL may, subject to the request of FIB and without notice to LE, directly pay to FIB from the LE Profit Share any amounts then due and owing by LE to FIB. Additionally, the Acknowledgement Letter and the Third Letter Agreement (as described below) both provide GEL mechanisms to withhold payments LE is otherwise entitled to. GEL has exercised its rights under the Acknowledgement Letter and the Third Letter Agreement and, pursuant to the terms thereof, is withholding payments that would otherwise have been paid to LE under the Joint Marketing Agreement. GEL shall continue to exercise its right until all Deficiency Amounts have been satisfied in their entirety.
Restrictions on LE: The Joint Marketing Agreement contains negative covenants that restrict LE’s actions. LE is prohibited from making any modification to the Nixon Facility or entering into any contracts with third-parties which would materially affect or impair GEL’s or its affiliates’ rights under the Joint Marketing Agreement, the Construction and Funding Agreement or the Crude Supply Agreement without first obtaining GEL’s prior written consent.
Term and Termination: The Joint Marketing Agreement has an initial term of three years expiring on August 12, 2014. After the expiration of its initial term, the Joint Marketing Agreement shall be automatically renewed for successive one year terms unless either party within 90 days of the expiration of the then current term notifies the other party of its election to terminate the Joint Marketing Agreement. The Joint Marketing Agreement also provides that it may be terminated prior to the end of its then current term if (a) both parties agree to the termination in writing, (b) one party has materially breached the Joint Marketing Agreement and fails to cure such breach within 30 days of receiving notice thereof, (c) GEL, in its sole discretion, chooses to terminate based on a breach of the Crude Supply Agreement or the Construction and Funding Agreement by LE after GEL or Milam (as applicable) elects to terminate either of those agreements or (d) GEL or Milam terminates the Construction and Funding Agreement pursuant to the elective termination provisions thereof.
Clarifications of and Modifications to the Rights of the Parties under the Joint Marketing Agreement
We have entered into several letter agreements amending the terms of the Joint Marketing Agreement, the terms of which are discussed below. We entered into these amendments as a result of certain deficits incurred in operating the Nixon Facility during May and June 2012. The effect of these amendments has been to reduce our liquidity until such deficits have been repaid. However, LE’s repayment of such deficits under the amendments will be at reasonable commercial terms and are expected to be on a timelier basis. (See the “Liquidity and Capital Resources” section below for further discussion.)
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
Acknowledgement Letter: On June 1, 2012, LE entered into an Acknowledgment Letter with GEL (the “Acknowledgement Letter”). The Acknowledgement Letter clarified certain terms of the Joint Marketing Agreement. Pursuant to the Acknowledgment Letter, LE agreed that GEL will not pay to LE the LE Profit Share until the month subsequent to when the profits from the sale of output from the Nixon Facility have been sufficient to repay GEL, or any future Deficit Amounts that have not been paid are paid in full.
First Letter Agreement: On June 25, 2012, LE entered into a Letter Agreement with GEL (the “First Letter Agreement”). The First Letter Agreement further clarifies the payment of expenses and the reservation of certain rights of the parties under the Joint Marketing Agreement. Pursuant to the First Letter Agreement, GEL and Milam have been providing weekly payments to LE each in the amount of $187,500 (which includes $170,250 paid directly to LE and $17,250 paid directly to American First National Bank (“AFNB”), successor to FIB). According to the First Letter Agreement, these payments began on June 25, 2012 and were due to terminate on July 30, 2012 (later amended pursuant to the Second Letter Agreement). The funds received by LE pursuant to the First Letter Agreement are for the sole and exclusive purpose of paying operating expenses of the Nixon Facility. The First Letter Agreement further states that neither GEL or Milam is required to provide any additional payments relating to the operating expenses of the Nixon Facility beyond GEL’s express obligations under the Joint Marketing Agreement.
Second Letter Agreement: On July 30, 2012, LE entered into an amendment to the First Letter Agreement with GEL (the “Second Letter Agreement”). The Second Letter Agreement extended the period of time during which GEL and/or Milam will provide weekly payments to LE to cover operating expenses at the Nixon Facility from July 30, 2012 to August 31, 2012. Additionally, the Second Letter Agreement clarified that such payments may be made by either GEL or Milam as determined by GEL or Milam.
Third Letter Agreement: On August 1, 2012, LE entered into another Letter Agreement with GEL (the “Third Letter Agreement”). In the Third Letter Agreement LE acknowledged that LE owed GEL the principal sum of approximately $4.3 million (the “Deficit Amount”) as of June 30, 2012. Of the Deficit Amount, approximately $2.3 million was for crude oil costs delivered pursuant to the Crude Supply Agreement during May and June 2012 (the “Deficit Crude Amount”). Under the terms of the Joint Marketing Agreement and the Crude Supply Agreement, the Deficit Crude Amount must be paid from revenue received from the sale of output from the Nixon Facility in subsequent months. The remaining portion of the Deficit Amount resulted from amounts LE owed to GEL or Milam due to losses sustained by LE during months in which total revenue from the sale of output from the Nixon Facility were not sufficient (the “Other Deficit Amounts”). The Third Letter Agreement further amended the distribution of “Available Proceeds” (with such term being defined in the Third Letter Agreement to mean the sum of total revenue from the sale of output from the Nixon Facility for a calendar month less the costs of crude oil for such calendar month less the costs of crude oil unpaid for any prior months (other than the Deficit Crude Amount)) by requiring Available Proceeds be distributed:
| (a) | in an amount equal to the Advanced Lazarus Profit Share (as defined below) shall be paid directly to AFNB to be applied by AFNB in accordance with the terms of the loan agreement governing the debt owed by LE to AFNB; and |
| (b) | the remaining Available Proceeds, to the extent sufficient, shall be distributed in the following order of priority: (1) to GEL in an amount equal to the then outstanding balance of the Deficit Crude Amount, (2) to GEL in an amount equal to the Construction Payment, (3) to LE in an amount equal to the Operations Payment, (4) to GEL in an amount equal to the expenses incurred by GEL for the transportation of output from the Nixon Facility, (5) to GEL in amount equal to the Financial Statement Preparation Fees, (6) to GEL in an amount equal to the Tank Storage Fees paid by GEL to LE in the amount of approximately $3,000, (7) to GEL in an amount equal to the Other Deficit Amounts, (8) to GEL as the GEL Profit Share, an amount equal to 80% of the sum of the remaining balance plus the Advanced Lazarus Profit Share for the applicable month, and (9) any remaining amounts to LE as the LE Profit Share; provided, however, that if in any month the Advanced Lazarus Profit Share is greater than the LE Profit Share, the amount of such excess shall be paid to GEL the following months out of the LE Profit Share. |
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
The “Advanced Lazarus Share” is determined by taking the amount of Available Proceeds minus the sum of the Construction Payment for the applicable month, the Operations Payment for the applicable month, transportation expenses for the applicable month, the Financial Statement Preparation Fee for the applicable month and Tank Storage Fees for the applicable month, excluding any arrearages in such items attributable to prior months.
The Third Letter Agreement replaces the process for distributing Gross Profit as set forth in the Joint Marketing Agreement with the process for distributing Available Proceeds set forth above if the two are in conflict until the earlier of (i) the termination of the Forbearance Period and the Extended Forbearance Period (as such terms are defined in the Refinery Loan Forbearance Agreement), (ii) a notice of termination is delivered by GEL to LE stating that GEL elects to terminate the distribution provisions found in the Third Letter Agreement, which LE acknowledges that GEL may do in its sole discretion, or (iii) GEL has been paid in full all Deficit Amounts and has received an amount equal to 80% of all amounts paid to AFNB pursuant the provision of the Third Letter Agreement requiring payment to AFNB of an amount equal to the Advanced Lazarus Profit Share. Whenever the distribution provisions of the Third Letter Agreement cease to be effective, all provisions of the Joint Marketing Agreement shall apply to any future distributions of Gross Profits, and the Deficit Crude Amount remaining unpaid, if any, shall be paid from the total revenue from the sale of output from the Nixon Facility in subsequent months.
The Third Letter Agreement further provides that any costs of crude oil delivered after June 2012 which are not paid for in full from total revenue from the sale of output from the Nixon Facility in the applicable calendar month shall be paid from total revenue received from the sale of output from the Nixon Facility in subsequent months prior to the determination of Gross Profits or Available Proceeds, until such amounts are paid in full. Further, the Deficit Amount, until paid in full, shall constitute and be part of the Obligations (as such term is defined in the Construction and Funding Agreement).
Clarification of Amounts Owed to Genesis and its Affiliates
As of June 30, 2012, total advances under the Construction and Funding Agreement were approximately $7.6 million. Pursuant to amendments and clarifications to the Joint Marketing Agreement, Deficit Amounts of approximately $4.3 million are included in our accounts payable at June 30, 2012. Subsequent to the end of the quarter, we paid approximately $1.8 million of the Deficit Amounts.
Results of Operations
Blue Dolphin acquired LE effective February 15, 2012. Under reverse acquisition accounting LE (the legal subsidiary) has been treated as the accounting parent (acquirer) and Blue Dolphin (the legal parent) has been treated as the accounting subsidiary (acquiree). Accordingly, the financial statements subsequent to the date of the transaction are presented as the continuation of LE. LE’s operations, the primary asset of which is the Nixon Facility, had no operations during the three months ended June 30, 2011 (the “prior quarter”) and the six months ended June 30, 2011 (the “prior period”).
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
Three Months Ended June 30, 2012 Compared to Three Months Ended June 30, 2011
For the three months ended June 30, 2012 (the “current quarter”), we reported a net loss of $7,397,834 on total revenue of $84,790,853. The net loss was primarily attributable to: (i) negative gross margins generated from (a) initial costs related to acquisition of specifically desired feedstocks and (b) lower refined product prices due to significant discounts offered to new customers, particularly for certain initial refined product runs that did not conform to normal specifications and (ii) the write-down of initial refined product inventory during the current quarter and (iii) the overhand related to processing of unhedged, higher-cost feedstock.
During the current quarter, we took steps to improve the quality, consistency and availability of the specifically desired feedstocks processed by our Nixon Facility, as well as to improve the quality, consistency and market acceptance of our refined products. We also instituted an inventory risk management program with Genesis, the purpose of which is to reduce the risk of having a mismatch of crude oil and refined products inventory at higher prices when crude oil and refined product prices are decreasing. Under the inventory risk management program, Genesis may, but is not required to, initiate a hedge on our refined products when our inventory levels exceed targeted levels (currently 1.5 days of production). Although the decision to execute a hedge is made solely by Genesis, Genesis typically confers with management as part of their decision making process.
Substantially all of our revenue came from the Nixon Facility, which generated revenue of $84,416,296 in the current quarter. The Nixon Facility operated for a total of 88 days during the current quarter. On average during the current quarter, the Nixon Facility operated at a rate of approximately 8,900 bpd, or 59% of operating capacity. Management anticipates that the Nixon Facility may approach its operating capacity throughput of 15,000 bpd on a consistent basis during the second half of 2012.
We recorded Nixon Facility operating expenses of $2,239,914 in the current quarter, all of which was for services provided by LEH to manage and operate the Nixon Facility.
Depletion, depreciation, and amortization increased from $4,306 in the prior quarter to $520,390 in the current quarter primarily as a result of the Nixon Facility having operations in the current quarter compared to no operations in the prior quarter.
General and administrative expenses increased from $177,112 in the prior quarter to $734,720 in the current quarter. The expenses in the current quarter were primarily related to leased corporate personnel costs, stock maintenance fees, consulting, legal, audit and office expenses.
We recognized $81,364 in net tank rental revenue in the current quarter compared to $353,709 in the prior quarter. This decline was driven by expiring contracts and the use of our tanks for our own operations. In the future, we do not expect net tank rental revenue at the Nixon Facility to be a significant source of income for our business.
See Note (4), “Business Segment Information” in Item 1 of this report for additional information regarding the results of operations of our business segments in the current quarter compared to the prior quarter.
Six Months Ended June 30, 2012 Compared to Six Months Ended June 30, 2011
For the six months ended June 30, 2012 (the “current period”) we reported a net loss of 9,367,728 on total revenue of $130,832,066. The net loss was primarily attributable to: (i) negative gross margins generated from (a) initial costs related to acquisition of specifically desired feedstocks and (b) lower refined product prices due to significant discounts offered to new customers, particularly for certain initial refined product runs that did not conform to normal specifications and (ii) the write-down of initial refined product inventory during the current quarter and (iii) the overhand related to processing of unhedged, higher-cost feedstock.
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
During the current quarter, we took steps to improve the quality, consistency and availability of the specifically desired feedstocks processed by our Nixon Facility, as well as to improve the quality, consistency and market acceptance of our refined products. We also instituted an inventory risk management program with Genesis, the purpose of which is to reduce the risk of having a mismatch of crude oil inventory at higher prices when crude oil and refined product prices are decreasing. Under the inventory risk management program, Genesis may, but is not required to, initiate a hedge on our refined products when our inventory levels exceed targeted levels (currently 1.5 days production). Although the decision to execute a hedge is made solely by Genesis, Genesis typically confers with management as part of its decision making process.
Substantially all of our revenue came from the Nixon Facility, which generated revenue of $130,187,259 in the current period. The Nixon Facility, which began operations on a reduced basis in February 2012, operated for a total of 148 days during the current period. On average during the current period, the Nixon Facility operated at a rate of approximately 8,000 bpd, or 53% of operating capacity. Management anticipates that the Nixon Facility may approach its operating capacity throughput of 15,000 bpd on a consistent basis during the second half of 2012.
We recorded Nixon Facility operating expenses of $3,302,665 in the current period, all of which was for services provided by LEH to manage and operate the Nixon Facility.
Depletion, depreciation, and amortization increased from $8,614 in prior period to $798,352 in the current period primarily as a result of the Nixon Facility having operations in the current period compared to no operations in the prior period.
General and administrative expenses increased from $290,940 in the prior period to $1,260,307 in the current period. The expenses in the current period were primarily related to leased corporate personnel costs, stock maintenance fees, consulting, legal, audit and office expenses.
We recognized $175,319 in net tank rental revenue in the current period compared to $696,454 in the prior period. This decline was driven by expiring contracts and the use of our tanks for our own operations. In the future, we do not expect net tank rental revenue at the Nixon Facility to be a significant source of income for our business.
See Note (4), “Business Segment Information” in Item 1 of this report for additional information regarding the results of operations of our business segments in the current period compared to the prior period.
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
Liquidity and Capital Resources
Sources and Uses of Cash. At June 30, 2012, our current available cash was $478,288.
| | | For Six Months Ended June 30, | |
| | | 2012 | | | 2011 | |
| | | | | | | |
| Adjusted income (loss) from operations | | $ | (8,241,034 | ) | | $ | 404,431 | |
| Change in current assets and liabilities | | | 5,223,772 | | | | 127,338 | |
| | | | | | | | | |
| Total cash flow from operations | | | (3,017,262 | ) | | | 531,769 | |
| | | | | | | | | |
| Cash inflows (outflows) | | | | | | | | |
| Proceeds from issuance of debt | | | 4,759,393 | | | | - | |
| Payments on long term debt | | | (847,197 | ) | | | (21,066 | ) |
| Cash acquired on Acquisition | | | 1,674,594 | | | | - | |
| Capital expenditures | | | (2,074,137 | ) | | | (505,670 | ) |
| Payments on note payble | | | (18,925 | ) | | | (5,034 | ) |
| | | | | | | | | |
| Total cash inflows (outflows) | | | 3,493,728 | | | | (531,770 | ) |
| | | | | | | | | |
| Total change in cash flows | | $ | 476,466 | | | $ | (1 | ) |
Management assesses our liquidity by our ability to generate cash to fund our operations. Significant factors in the management of liquidity are: funds generated by operations; levels of accounts receivable, inventories, accounts payable and capital expenditures; adequate access to credit; and financial flexibility to attract long-term capital on satisfactory terms. Our sources of cash are cash on hand, tank rental income and advances for funding under the Construction and Funding Agreement. Although we anticipate being able to support our short-term liquidity and operating needs for the remainder of 2012 largely through cash generated from operations at the Nixon Facility, during the second quarter, we experienced negative cash flow from operations of approximately $3.0 million. In addition, our current liabilities increased by approximately $7.6 million relative to current assets during the second quarter, resulting, primarily from our net loss of approximately $7.4 million for the current quarter.
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
Several factors contributed to our liquidity constraint during the current quarter, including: (i) lower and, in some cases, negative refined product sales margins as a result of crude oil and refined product commodity price decreases and higher crude prices from crude purchased earlier in the period, (ii) non-payment by Genesis of May and June operating expenses of approximately $1.0 million as a result of negative gross margins at the Nixon Facility, (iii) non-payment of accounts payable related to capital items previously funded by Genesis of approximately $500,000 and (iv) non-payment of crude oil lifting revenue by our Indonesian oil production operator of approximately $340,000. As a result of these factors, as well as a significant increase in the Deficiency Amount due to GEL, we have constrained liquidity and fell behind in the payment of certain third-party vendors, one of which placed a mechanics lien on the Nixon Facility due to late payments.
As a result of these liquidity constraints, which were largely due to a volatile and declining price environment in the late first quarter and the second quarter, we took a number of steps in the second quarter to improve liquidity as follows:
| (a) | Improving and Generating More Consistent Margins Through Better Inventory Risk Management. Together with Genesis, we implemented an inventory risk management policy that seeks to stabilize our commodity price exposure for our refined products inventory and generate a more consistent gross margin for each barrel of refined product. Although this strategy will limit potential gains in certain quarters, it may also limit potential losses. Under this plan, we will strive to maintain no more than 1.5 days of refined products inventory. Although the decision to execute a hedge is made solely by Genesis, Genesis typically confers with management as part of their decision making process. We expect that this policy will reduce the risk of a future mismatch between higher crude oil costs and lower refined product prices that could negatively impact our average gross margin per barrel; |
| (b) | Increasing the Amount of Throughput Generated by Nixon facility. Currently, we are generating a positive gross margin on each refined unit of crude oil and have a relatively constant fixed cost base to cover. Accordingly, each additional unit of crude oil refined makes a more significant contribution to our cash flow. A significant part of our business strategy is to operate the Nixon Facility at capacity in the coming months and generate sufficient cash flow to enable us to terminate the Third Letter Agreement with GEL, which will result in the restoration to us of the gross profit sharing provisions of the Joint Marketing Agreement. Under the Joint Marketing Agreement, we have the opportunity to receive a significantly greater share of gross profits from the Nixon Facility than we are currently receiving under the Third Letter Agreement. (See “— Joint Marketing Agreement – Sharing of Gross Profits,” and “— Clarifications and Modifications to the Rights of the Parties Under the Joint Marketing Agreement — Third Letter Agreement.”) |
| (c) | Focusing on a Capital Expenditure Program to Immediately Increase Throughput and Improve Margins. We are approximately half way through a $1 million to $1.5 million capital expenditure program, previously financed primarily through discretionary advances made by Milam under the Construction and Funding Agreement, to refurbish a naptha stabilizer and depropanizer unit at the Nixon Facility. Refurbishment of the stabilizer will improve the quality of naptha that we produce, thereby enhancing the pricing amount we expect to receive for certain of our refined products. In addition, refurbishment of the stabilizer will increase the amount of throughput that can be processed by the Nixon Facility. Milam has not, however, made any further advances to complete refurbishment of the naptha stabilizer, nor is Milam obligated to. Our ability to complete this project is dependent upon further advances being made by Milam under the Construction and Funding Agreement and/or generating sufficient cash from operations to eliminate the Deficiency Amount, thereby increasing our allocation portion of the Gross Profit in amounts sufficient to cover such refurbishment costs. There is no assurance that either will be done. |
Management believes that the first two steps, (a) and (b) above, will, over the next several months, result in improved cash flow. Under the Joint Marketing Agreement, we have the opportunity to receive a significantly greater share of gross profits from the Nixon Facility than we are currently receiving under the Third Letter Agreement. (See “— Joint Marketing Agreement – Sharing of Gross Profits,” and “— Clarifications and Modifications to the Rights of the Parties Under the Joint Marketing Agreement — Third Letter Agreement.”) We are working with our vendors to ensure that they understand our focus on liquidity and desire to bring our outstanding accounts payable current as expeditiously as possible. In addition, we believe that once the Nixon Facility generates more consistent refining Gross Profits, Milam will be more inclined to make further advances under the Construction and Funding Agreement to complete refurbishment of the naptha stabilizer, which would increase throughput volumes and improve margins. However, there can be no assurances that our liquidity plan as set forth above will be successful. In the event that our plan is not successful, we will experience a significant and material negative adverse effect on our operations, liquidity and financial condition.
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
In addition to our results of operations, we received financing proceeds of $4,743,393from advancements under the Construction and Funding Agreement during the current quarter. Our capital expenditures in the current quarter were $2,074,137, all of which related to refurbishment of the Nixon Facility, including certain aspects of the naptha stabilizer. Specifically, these capital expenditures included repair costs, construction and commissioning of pumps, motors, lines, tanks, vessels and processing units. We expect to fund additional capital expenditures at the Nixon Facility primarily through the Construction and Funding Agreement or cash from operations once the Deficiency Amount is satisfied in full. The principal balance owed to Milam under the Construction and Funding Agreement was $7,572,040 and $3,319,193 at June 30, 2012 and December 31, 2011, respectively, excluding Deficiency Amounts.
The principal balance outstanding on a loan payable to AFNB under a promissory note in the amount of $10,000,000 (the “Refinery Loan”), which is currently in default, was $9,315,826 and $9,669,173 at June 30, 2012 and December 31, 2011, respectively. Management believes that we have satisfied the forbearance extension conditions under the Refinery Loan (the “Forbearance Extension Conditions”). If the Refinery Loan Forbearance Agreement is rightfully terminated, AFNB can demand payment of all of the amounts owed under the Refinery Loan. As of the date of filing of this report, management believes that no termination event under the Refinery Loan Forbearance Agreement has occurred.
After all past due principal, interest, costs, fees and tax have been paid under the Refinery Loan Forbearance Agreement, LE is required to pay $83,333.33 per month for a period of twelve consecutive months to AFNB in order to replenish the $1.0 million payment reserve required by the Refinery Loan Agreement. After all past due principal and interest (as well as costs, fees and taxes) have been paid, the Refinery Loan will be re-amortized and have a maturity date of October 1, 2028.
The principal balance outstanding on the Notre Dame Debt note, which is currently in default, was $1,300,000 at June 30, 2012 and December 31, 2011. There are no financial covenants associated with this debt.
See Notes (10), “Long-Term Debt” and (17), “Subsequent Events” in Item 1 of this report for additional disclosures related to liquidity and capital resources.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Commodity Price Risk. We are exposed to market price risk related to our refined products inventory. The spread between crude oil and refined product prices is the primary factor affecting our operations, liquidity and financial condition. Our crude acquisition costs and refined products sales prices depend on numerous factors beyond our control. These factors include the supply of and demand for crude oil, gasoline, NRLM and other refined products. Supply and demand for these products depend, among other things, on changes in domestic and foreign economies; weather conditions; domestic and foreign political affairs; production levels; availability of imports and exports; marketing of competitive fuels; and government regulation.
In May 2012, we implemented an inventory risk management policy under which Genesis may, but is not required to, use derivative instruments as certain refined product inventories exceed maximum thresholds in an effort to reduce our refined products inventory commodity price risk. However, Genesis’ execution of the inventory risk management plan is outside of our control. Accordingly, there could be situations in which Genesis fails to execute on the plan or executes on the plan in a manner that causes significant losses to us, all of which are beyond our control. In the event that our inventory risk management system fails and/or is implemented poorly or not at all, we could experience a material and negative adverse effect on our operations, liquidity and financial condition.
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report, we carried out an evaluation under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial Officer, of 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). Based upon this evaluation, as of June 30, 2012, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act, are recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information 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.
Changes in Internal Controls over Financial Reporting
On February 15, 2012, we acquired LE through a reverse acquisition. Our management is analyzing, evaluating and, where necessary, implementing changes in controls and procedures. Due to the significance of this acquisition and the limited period of time since the acquisition date, we did not have sufficient resources available to assess the internal controls of LE for the six months ended June 30, 2012. Therefore, we excluded LE from our evaluation of internal controls over financial reporting contained in this quarterly report. However, management considers the LE acquisition material to our results of operations, cash flows and financial positions and believes that the disclosure controls and procedures of LE will have a material effect on internal controls over financial reporting. LE will be included in the overall assessment of, and report on, internal controls over financial reporting as of December 31, 2012.
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
PART II. OTHER INFORMATION
Pursuant to a Settlement Agreement and Mutual Release dated February 15, 2012, by and among Blue Dolphin, LEH and Lazarus Louisiana Refinery II, LLC (“LLRII”), the parties agreed to settle and compromise all disputes between them in connection with closing of the Acquisition. LEH agreed to file a non-suit with prejudice of all pending claims against Blue Dolphin under Cause No. 210-32561, styled Blue Dolphin Energy Company v. Lazarus Energy Holdings, L.L.C. and Lazarus Louisiana Refinery II, L.L.C., in the 129th District Court of Harris County, Texas (the “Lawsuit”). Blue Dolphin agreed that it will not execute or attempt to execute on an order that was signed on May 16, 2011 in the Lawsuit severing LEH’s counterclaims into Cause No. 2010-32561-A, which resulted in a Partial Summary Judgment becoming a final judgment in Blue Dolphin’s favor.
Pursuant to an Order of Nonsuit and Dismissal with Prejudice, a presiding judge ordered, adjudged and decreed that counter-plaintiff LEH’s claims and causes of action in the Lawsuit were dismissed on July 6, 2012.
From time to time we are subject to various lawsuits, claims, liens and administrative proceedings that arise out of the normal course of business. During the second quarter, a vendor placed a mechanic’s lien on the Nixon Facility as protection during construction activities. As described further under Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources,” management is executing a liquidity plan to address outstanding payables due to third-parties, although there can be no assurance that the liquidity plan will be successful, management does not believe that the lien will have a material adverse effect on our results of operations.
We have updated risk factors affecting our business since those presented in Part I, Item 1A in our Annual Report on Form 10-K for the year ended December 31, 2011 (the “Annual Report”) and Part II, Item 1A in our Quarterly Report on Form 10-Q for the three months ended March 31, 2012 (the “Quarterly Report”). Except for the additions below, there have been no material changes in our assessment of our risk factors from those set forth in our Annual Report and Quarterly Report.
Genesis’ hedging on our refined products inventory may limit our gains and expose us to other risks.
We are exposed to market price risk related to our refined products inventory. The spread between crude oil and refined product prices is the primary factor affecting our operations, liquidity and financial condition. Our crude acquisition costs and refined products sales prices depend on numerous factors beyond our control. These factors include the supply of and demand for crude oil, gasoline, NRLM and other refined products. Supply and demand for these products depend, among other things, on changes in domestic and foreign economies; weather conditions; domestic and foreign political affairs; production levels; availability of imports and exports; marketing of competitive fuels; and government regulation.
In May 2012, we implemented an inventory risk management policy under which Genesis may, but is not required to, use derivative instruments as certain refined product inventories exceed maximum thresholds in an effort to reduce our refined products inventory commodity price risk. However, Genesis’ execution of the inventory risk management plan is outside of our control. Accordingly, there could be situations in which Genesis fails to execute on the plan or executes on the plan in a manner that causes significant losses to us, all of which are beyond our control. In the event that our inventory risk management system fails and/or is implemented poorly or not at all, we could experience a material and negative adverse effect on our operations, liquidity and financial condition.
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
If our liquidity plan is not successful, there will be a material adverse effect on our operations, liquidity and financial condition.
We have implemented a liquidity plan to address near-term liquidity issues, as set forth in Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources.” If the liquidity plan is not successful, there will be a material adverse effect on our operations, liquidity and financial condition.
Our operations are highly dependent on our relationship with Genesis and its affiliates, and, if we are unable to successfully maintain this relationship, our operations, liquidity and financial condition will be harmed.
We are party to a variety of contracts and agreements with Genesis and its affiliates that enable the purchase of crude oil, transportation of crude oil, provision of accounting and other services, joint marketing of our refined products and funding of renovations, expansion and other capital expenditures relating to the Nixon Facility. Further, we have an understanding with Genesis relating to an inventory risk management system, which is intended to reduce the commodity price risk of our finished products inventory and generate a more consistent gross margin for each barrel of refined product. These agreements and understandings require us to have a close working relationship with Genesis and its affiliates in order for us to be successful in fully executing our business strategy. If we are unable to maintain such a relationship or our relationship is not on good terms, we believe that it could have a material adverse effect on our operations, liquidity and financial condition. We believe that, as of the date hereof, our relationship with Genesis and its affiliates is on good terms.
Our loan with AFNB is in default; there can be no assurance that the Refinery Loan Forbearance Agreement will remain in effect.
Although the Refinery Loan with AFNB, successor to FIB, is in default, AFNB and LE entered into the Refinery Loan Forbearance Agreement, which automatically extended for another one year term on August 12, 2012 if we met certain conditions, including: (a) FIB’s receipt of certain monthly payments during the Initial Forbearance Period, (b) Milam’s completion of the services under the Construction and Funding Agreement; and (c) the Nixon Facility being operational and, among other things, generating a Gross Profit such that FIB received its 50% of an LE profits distribution during the Initial Forbearance Period.
AFNB has sent the Borrowers (including LE) a letter notifying them of certain possible contraventions under the Refinery Loan, the Refinery Loan Forbearance Agreement, the Deed of Trust and the Security Agreement. These contraventions include an assertion that the merger between Blue Dolphin and LE represented a change of control of LE. The Borrowers responded to AFNB expressing a belief that they are in compliance with the provisions of the Refinery Loan, the Refinery Loan Forbearance Agreement, the Deed of Trust and the Security Agreement. Further, management believes that all such conditions to the Refinery Loan Forbearance Agreement have been met and, as a result, that the Initial Forbearance Period is thereby extended by another year. However, to the extent that AFNB asserts otherwise and prevails, then the Refinery Loan would become immediately due and payable and we would have to pay off such loan, make other accommodations with AFNB or face foreclosure, which would have a material adverse effect on our operations, liquidity and financial condition.
Our primary source of crude oil supply experiences significant price swings, which impacts our crude oil acquisition cost.
The Nixon Facility is located in the heart of the Eagle Ford Shale play, an abundant source of domestic petroleum production. The gathering infrastructure in this area is developing such that, occasionally, large inventories of local crude oil may be transported in bulk away from the Nixon Facility. When this occurs, we may experience wider than normal swings in crude oil prices in order to obtain our desired levels of crude oil.
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
In 2014, new environmental regulations become effective that reduce the allowable sulfur content for commercially sold diesel in the United States. Unless the Nixon Facility undergoes significant capital upgrades, we may be limited to selling “off specification” diesel at lower prices.
New environmental regulations will become effective in 2014 that reduce the sulfur content that is permitted to be contained in diesel sold commercially in the United States. In order to meet the higher content standards, the Nixon Facility will have to undergo capital upgrades in excess of approximately $50 million. In order to complete the required capital upgrades, we will have to finance such capital expenditures primarily through the issuance of debt and/or equity, which would result in dilution to existing stockholders and/or subject us to higher debt levels. There can be no assurance that we can obtain such financing at rates or at terms acceptable to us, if at all.
ITEM 2.UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3.DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4.MINE SAFETY DISCLOSURES
Not applicable.
ITEM 5.OTHER INFORMATION
None.
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
ITEM 6. EXHIBITS
| (a) | Exhibits: |
| | |
| | The following exhibits are filed herewith: |
| | |
| | 10.1 | Crude Oil Supply and Throughput Services Agreement by and between GEL Tex Marketing, LLC and Lazarus Energy, LLC dated as of August 12, 2011. |
| | 10.2 | Construction and Funding Contract by and between Lazarus Energy, LLC dated as of August 12, 2011. |
| | 10.3 | Joint Marketing Agreement by and between GEL Tex Marketing, LLC and Lazarus Energy, LLC dated as of August 12, 2011. |
| | 10.4 | Acknowledgment Letter between Lazarus Energy, LLC and GEL Tex Marketing, LLC dated June 1, 2012. |
| | 10.5 | Letter Agreement between Lazarus Energy, LLC and GEL Tex Marketing, LLC dated June 25, 2012. |
| | 10.6 | Letter Agreement between Lazarus Energy, LLC and GEL Tex Marketing, LLC dated July 30, 2012. |
| | 10.7 | Letter Agreement between Lazarus Energy, LLC and GEL Tex Marketing, LLC dated August 1, 2012. |
| | 31.1 | Jonathan P. Carroll Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 302 of the Sarbanes-Oxley Act of 2002. |
| | 31.2 | Tommy L. Byrd Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 302 of the Sarbanes-Oxley Act of 2002. |
| | 32.1 | Jonathan P. Carroll Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002. |
| | 32.2 | Tommy L. Byrd Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002. |
| | 101.INS | XBRL Instance Document. |
| | 101.SCH | XBRL Taxonomy Schema Document. |
| | 101.CA | XBRL Calculation Linkbase Document. |
| | 101.LAB | XBRL Label Linkbase Document. |
| | 101.PRE | XBRL Presentation Linkbase Document. |
| | 101.DEF | XBRL Definition Linkbase Document. |
BLUE DOLPHIN ENERGY COMPANY & SUBSIDIARIES
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| | | By: BLUE DOLPHIN ENERGY COMPANY | |
| | | | |
| | | | |
| August 14, 2012 | | /s/ JONATHAN P. CARROLL | |
| | | Jonathan P. Carroll Chief Executive Officer, President, Assistant Treasurer and Secretary (Principal Executive Officer) | |
| | | | |
| August 14, 2012 | | /s/ TOMMY L. BYRD | |
| | | Tommy L. Byrd Interim Chief Financial Officer, Treasurer and Assistant Secretary (Principal Financial Officer) | |
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