SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
(Mark One)
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2002
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or
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period ended
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Commission file number: 0-10990
CASTLE ENERGY CORPORATION
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(Exact Name of Registrant as Specified in its Charter)
Delaware 76-0035225
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(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
One Radnor Corporate Center, Suite 250, 100 Matsonford Road, Radnor, Pennsylvania 19087
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(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code (610) 995-9400
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(Former Name, Former Address and Former Fiscal Year,
if Changed Since Last Report)
Indicate by check /X/ 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 _X_ No___.
Indicate the number of shares outstanding of each of the issuer's
classes of common stock as of the latest practicable date: 6,632,884 shares of
Common Stock, $.50 par value outstanding as of May 7, 2002.
CASTLE ENERGY CORPORATION
INDEX
Page #
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Part I. Financial Information
Item 1. Financial Statements:
Consolidated Balance Sheets - March 31, 2002 (Unaudited) and September
30, 2001...................................................................................... 1
Consolidated Statements of Operations - Three Months Ended March 31,
2002 and 2001 (Unaudited)..................................................................... 2
Consolidated Statements of Operations - Six Months Ended March 31, 2002
and 2001 (Unaudited).......................................................................... 3
Condensed Consolidated Statements of Cash Flows - Six Months Ended
March 31, 2002 and 2001 (Unaudited)........................................................... 4
Consolidated Statements of Stockholders' Equity and Other Comprehensive
Income - Year Ended September 30, 2001 and Six Months Ended March 31,
2002 (Unaudited).............................................................................. 5
Notes to the Consolidated Financial Statements (Unaudited).................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations......................................................................... 12
Item 3. Qualitative and Quantitative Disclosures About Market Risk.................................... 19
Part II. Other Information
Item 1. Legal Proceedings............................................................................. 19
Item 4. Submission of Matters to a Vote of Security Holders........................................... 19
Item 6. Exhibits and Reports on Form 8-K.............................................................. 19
Signature ........................................................................................................ 20
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CASTLE ENERGY CORPORATION
CONSOLIDATED BALANCE SHEETS
("000's" Omitted Except Share Amounts)
March 31, September 30,
2002 2001
--------------------------------------
ASSETS (Unaudited)
Current assets:
Cash and cash equivalents..................................................... $ 4,254 $ 5,844
Restricted cash............................................................... 210 370
Accounts receivable........................................................... 2,247 2,787
Marketable securities......................................................... 6,836 6,722
Prepaid expenses and other current assets..................................... 288 277
Estimated realizable value of discontinued net refining assets................ 612
Deferred income taxes......................................................... 2,276 1,879
-------- -------
Total current assets........................................................ 16,111 18,491
Property, plant and equipment, net:
Oil and gas properties - subject to a plan of sale............................ 37,986
Natural gas transmission...................................................... 49 51
Furniture, fixtures and equipment............................................. 171 222
Oil and gas properties, net (full cost method):
Proved properties..................................................... 39,843
Unproved properties not being amortized............................... 314 110
Estimated realizable value of discontinued net refining assets.................... 612
Investment in Networked Energy LLC................................................ 469 401
-------- -------
Total assets.......................................................... $ 55,712 $59,118
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Dividend payable.............................................................. $ 331
Accounts payable.............................................................. $ 1,379 3,543
Accrued expenses.............................................................. 149 292
Accrued taxes on appreciation of marketable securities...................... 1,014 900
Net refining liabilities retained........................................... 3,016
-------- -------
Total current liabilities................................................... 2,542 8,082
Net refining liabilities retained................................................. 3,016
Long-term liabilities............................................................. 10 9
--------- -------
Total liabilities..................................................... 5,568 8,091
-------- -------
Commitments and contingencies.....................................................
Stockholders' equity:
Series B participating preferred stock; par value - $1.00; 10,000,000 shares
authorized; no shares issued
Common stock; par value - $0.50; 25,000,000 shares authorized;
11,503,904 shares issued at March 31, 2002 and September 30, 2001........... 5,752 5,752
Additional paid-in capital.................................................... 67,365 67,365
Accumulated other comprehensive income - unrealized gains on
marketable securities, net of taxes......................................... 1,804 1,600
Retained earnings............................................................. 41,729 42,816
-------- -------
116,650 117,533
Treasury stock at cost - 4,871,020 shares at March 31, 2002 and
September 30, 2001........................................................ (66,506) (66,506)
-------- -------
Total stockholders' equity.................................................. 50,144 51,027
-------- -------
Total liabilities and stockholders' equity.................................. $ 55,712 $59,118
======== =======
The accompanying notes are an integral part of these financial statements.
-1-
CASTLE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
("000's" Omitted Except Share Amounts)
(Unaudited)
Three Months Ended March 31,
----------------------------
2002 2001
---- ----
Revenues:
Oil and gas sales.................................................. $ 3,258 $ 6,316
--------- ---------
Expenses:
Oil and gas production............................................. 1,359 1,998
General and administrative......................................... 1,227 1,416
Depreciation, depletion and amortization........................... 1,172 728
--------- ---------
3,758 4,142
--------- ---------
Operating income (loss)................................................ (500) 2,174
--------- ---------
Other income (expense):
Interest income................................................ 10 232
Other income................................................... 2
Equity in loss of Networked Energy LLC......................... (48) (17)
Impairment provision - marketable securities................... (204)
--------- ---------
(242) 217
--------- ---------
Income (loss) before provision for income taxes........................ (742) 2,391
--------- ---------
Provision for (benefit of) income taxes:
State.......................................................... (8) 24
Federal........................................................ (259) 836
--------- ---------
(267) 860
--------- ---------
Net income (loss)...................................................... ($ 475) $ 1,531
========= =========
Net income (loss) per share:
Basic.......................................................... ($ .07) $ .23
========= =========
Diluted........................................................ ($ .07) $ .22
========= =========
Weighted average number of common and potential dilutive common
shares outstanding:
Basic............................................................ 6,632,884 6,634,204
========= ==========
Diluted.......................................................... 6,760,235 6,814,491
========= ==========
The accompanying notes are an integral part of these financial statements.
-2-
CASTLE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
("000's" Omitted Except Share Amounts)
(Unaudited)
Six Months Ended March 31,
--------------------------
2002 2001
---- ----
Revenues:
Oil and gas sales.................................................... $ 6,699 $ 11,710
--------- ---------
Expenses:
Oil and gas production............................................... 2,613 3,402
General and administrative........................................... 2,598 3,174
Depreciation, depletion and amortization............................. 2,414 1,427
--------- ---------
7,625 8,003
--------- ---------
Operating income (loss).................................................. (926) 3,707
--------- ---------
Other income (expense):
Interest income.................................................. 43 444
Other income..................................................... 1 8
Equity in loss of Networked Energy LLC........................... (82) (33)
Impairment provision - marketable securities..................... (204)
--------- ---------
(242) 419
--------- ---------
Income (loss) before provision for income taxes.......................... (1,168) 4,126
--------- ---------
Provision for (benefit of) income taxes:
State............................................................ (12) 41
Federal.......................................................... (409) 1,444
--------- ---------
(421) 1,485
--------- ---------
Net income (loss) ....................................................... ($ 747) $ 2,641
========= =========
Net income (loss) per share:
Basic............................................................ ($ .11) $ .40
========= =========
Diluted.......................................................... ($ .11) $ .39
========= =========
Weighted average number of common and potential dilutive common shares
outstanding:
Basic............................................................. 6,632,884 6,654,524
========== ==========
Diluted.......................................................... 6,756,927 6,855,192
========== ==========
The accompanying notes are an integral part of these financial statements.
-3-
CASTLE ENERGY CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
("000's" Omitted)
(Unaudited)
Six Months Ended March 31,
---------------------------
2002 2001
---- ----
Net cash flow provided by (used in) operating activities................. ($ 61) $ 4,466
-------- -------
Cash flows from investing activities:
Investment in furniture, fixtures and equipment................... (5) (27)
Investment in oil and gas properties.............................. (703) (2,104)
Investment in Networked Energy LLC................................ (150)
-------- -------
Net cash used in investing activities................... (858) (2,131)
-------- -------
Cash flows from financing activities:
Dividends paid to stockholders.................................. (671) (664)
Acquisition of treasury stock................................... (572)
-------- -------
Net cash used in financing activities (671) (1,236)
-------- -------
Net increase (decrease) in cash and cash equivalents..................... (1,590) 1,099
Cash and cash equivalents - beginning of period.......................... 5,844 11,525
-------- -------
Cash and cash equivalents - end of period................................ $ 4,254 $12,624
======== =======
The accompanying notes are an integral part of these financial statements.
-4-
CASTLE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND
OTHER COMPREHENSIVE INCOME
("000's" Omitted Except Share Amounts)
Year Ended September 30, 2001 and Six Months Ended March 31, 2002 (Unaudited)
-------------------------------------------------------------------------------------------------
Accumulated
Common Stock Additional Other Treasury Stock
------------------ Paid-In Comprehensive Comprehensive Retained --------------
Shares Amount Capital Income Income Earnings Shares Amount Total
------ ------ ---------- ------------- ------------- --------- ------ ------ -------
Balance - October 1, 2001...... 11,503,904 $5,752 $67,365 $4,671 $42,422 4,791,020 ($65,934) $54,276
Stock acquired................. 80,000 (572) (572)
Dividends declared ($.20 per
share)........................ (1,322) (1,322)
Comprehensive income (loss):
Net income................... $1,716 1,716 1,716
Other comprehensive income:
Unrealized (loss) on
marketable securities,
net of tax............... (3,071) (3,071) (3,071)
------- -------
($1,355)
---------- ------ ------- ======= ------- --------- ------- -------
Balance - September 30, 2001... 11,503,904 5,752 67,365 1,600 42,816 4,871,020 (66,506) 51,027
Dividend adjustment............ (9) (9)
Dividends declared ($.20 per
share) ....................... (331) (331)
Comprehensive income (loss):
Net (loss)................... (747) (747) (747)
Other comprehensive income
(loss):
Unrealized (loss) on
marketable securities,
net of tax.............. 204 204 204
-------
($ 543)
---------- ------ ------- ======= ------- ------- --------- ------- -------
Balance - March 31, 2002....... 11,503,904 $5,752 $67,365 $1,804 $41,729 4,871,020 ($66,506) $50,144
========== ====== ======= ======= ======= ========= ======= =======
The accompanying notes are an integral part of these financial statements.
-5-
Castle Energy Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except share amounts)
(Unaudited)
Note 1 - Basis of Preparation
The unaudited consolidated financial statements of Castle Energy
Corporation (the "Company") included herein have been prepared pursuant to the
rules and regulations of the Securities and Exchange Commission. Certain
reclassifications have been made to make the periods presented comparable.
Although certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted accounting
principles have been condensed or omitted pursuant to such rules and
regulations, the Company believes that the disclosures included herein are
adequate to make the information presented not misleading. Operating results for
the three-month and six-month periods ended March 31, 2002 are not necessarily
indicative of the results that may be expected for the fiscal year ending
September 30, 2002 or subsequent fiscal periods. These unaudited consolidated
financial statements should be read in conjunction with the financial statements
and the notes thereto included in the Company's Annual Report on Form 10-K for
the fiscal year ended September 30, 2001.
In the opinion of the Company, the unaudited consolidated financial
statements contain all adjustments necessary for a fair statement of the results
of operations for the three month and six month periods ended March 31, 2002 and
2001 and for a fair statement of financial position at March 31, 2002.
Note 2 - September 30, 2001 Balance Sheet
The amounts presented in the balance sheet as of September 30, 2001
were derived from the Company's audited consolidated financial statements which
were included in its Annual Report on Form 10-K for the fiscal year ended
September 30, 2001.
Note 3 - Discontinued Operations
From August 1989 to September 30, 1995, several of the Company's
subsidiaries conducted refining operations. By December 12, 1995, the Company's
refining subsidiaries had sold all of their refining assets and the purchasers
had assumed all related liabilities, including contingent environmental
liabilities. In addition, in 1996, Powerine Oil Company ("Powerine"), one of the
Company's former refining subsidiaries, merged into a subsidiary of the
purchaser of the refining assets sold by Powerine and is no longer a subsidiary
of the Company. The Company's remaining refining subsidiaries own no refining
assets, have been inactive for over six years, and are inactive and in the
process of liquidation. As a result, the Company has accounted for its refining
operations as discontinued operations. Such discontinued refining operations
have not impacted the Company's operations since September 30, 1995, although
they may impact the Company's future operations.
Note 4 - Contingencies/Litigation
Contingent Environmental Liabilities
In December 1995, Indian Refining I Limited Partnership ("IRLP"), an
inactive subsidiary of the Company, sold its refinery, the Indian Refinery, to
American Western Refining L.P. ("American Western"), an unaffiliated party. As
part of the related purchase and sale agreement, American Western assumed all
environmental liabilities and indemnified IRLP with respect thereto.
Subsequently, American Western filed for bankruptcy and sold the Indian Refinery
to an outside party pursuant to a bankruptcy proceeding. The outside party has
substantially dismantled the Indian Refinery. American Western filed a Plan of
Liquidation in 2001. American Western anticipated that the Plan of Liquidation
would be confirmed in January 2002 but confirmation has been delayed because of
legal challenges by ChevronTexaco, the parent of Texaco Refining and Marketing
("Texaco"), the operator of the Indian Refinery for over 50 years.
During fiscal 1998, the Company was informed that the United States
Environmental Protection Agency ("EPA") had investigated offsite acid sludge
waste found near the Indian Refinery and had investigated and remediated
surface contamination on the Indian Refinery property. Neither the Company nor
IRLP was initially named with respect to these two actions.
-6-
Castle Energy Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except share amounts)
(Unaudited)
In October 1998, the EPA named the Company and two of its inactive
refining subsidiaries as potentially responsible parties for the expected
clean-up of the Indian Refinery. In addition, eighteen other parties were named
including Texaco. A subsidiary of Texaco had owned the refinery until December
of 1988. The Company subsequently responded to the EPA indicating that it was
neither the owner nor the operator of the Indian Refinery and thus not
responsible for its remediation.
In November 1999, the Company received a request for information from
the EPA concerning the Company's involvement in the ownership and operation of
the Indian Refinery. The Company responded to the EPA information request in
January 2000.
On August 7, 2000, the Company received notice of a claim against it
and two of its inactive refining subsidiaries from Texaco and its parent. Texaco
had made no previous claims against the Company although the Company's
subsidiaries had owned the refinery from August 1989 until December 1995. In its
claim, Texaco demanded that the Company and its former subsidiaries indemnify
Texaco for all liability resulting from environmental contamination at and
around the Indian Refinery. In addition, Texaco demanded that the Company assume
Texaco's defense in all matters relating to environmental contamination at and
around the Indian Refinery, including lawsuits, claims and administrative
actions initiated by the EPA, and indemnify Texaco for costs that Texaco has
already incurred addressing environmental contamination at the Indian Refinery.
Finally, Texaco also claimed that the Company and two of its inactive
subsidiaries are liable to Texaco under the Federal Comprehensive Environmental
Response Compensation and Liability Act ("CERCLA") as owners and operators of
the Indian Refinery. The Company responded to Texaco disputing the factual and
theoretical basis for Texaco's claims against the Company. The Company's
management and special counsel subsequently met with representatives of Texaco
but the parties disagreed concerning Texaco's claims.
In October 2001, Texaco merged with Chevron and the merged Company was
named ChevronTexaco. The Company's general counsel has subsequently corresponded
with ChevronTexaco but no progress has been made in resolving ChevronTexaco's
claims.
The Company and its special counsel, Reed Smith LLP, believe that
ChevronTexaco's claims are utterly without merit and the Company intends to
vigorously defend itself against ChevronTexaco's claims and any lawsuits that
may follow. In addition to the numerous defenses that the Company has against
ChevronTexaco's contractual claim for indemnity, the Company and its special
counsel believe that by the express language of the agreement which
ChevronTexaco construes to create an indemnity, ChevronTexaco has irrevocably
elected to forgo all rights of contractual indemnification it might otherwise
have had against any person, including the Company. The Company and its special
counsel also believe that ChevronTexaco's only claim against the Company is
limited to liabilities arising under CERCLA and that ChevronTexaco's
indemnification claims against the Company are contrary to CERCLA.
In September 1995, Powerine sold the Powerine Refinery to Kenyen
Resources ("Kenyen"), an unaffiliated party. In January 1996, Powerine merged
into a subsidiary of Energy Merchant Corp. ("EMC"), an unaffiliated party, and
EMC assumed all environmental liabilities of Powerine. In August 1998, EMC sold
the Powerine Refinery, which it had subsequently acquired from Kenyen, to a
third party.
In July of 1996, the Company was named a defendant in a class action
lawsuit concerning emissions from the Powerine Refinery. In April of 1997, the
court granted the Company's motion to quash the plaintiff's summons based upon
lack of jurisdiction and the Company is no longer involved in the case.
-7-
Castle Energy Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except share amounts)
(Unaudited)
Although any environmental liabilities related to the Indian Refinery
and Powerine Refinery have been transferred to others, there can be no assurance
that the parties assuming such liabilities will be able to pay them. American
Western, owner of the Indian Refinery, filed for bankruptcy and is in the
process of liquidation. EMC, which assumed the environmental liabilities of
Powerine, sold the Powerine Refinery to an unrelated party, which we understand
is still seeking financing to restart that refinery. Furthermore, as noted
above, the EPA named the Company as a potentially responsible party for
remediation of the Indian Refinery and has requested and received relevant
information from the Company. Estimated gross undiscounted clean-up costs for
this refinery are at least $80,000- $150,000 according to public statements by
Texaco and third parties. If the Company were found liable for the remediation
of the Indian Refinery, it could be required to pay a percentage of the clean-up
costs. Since the Company's subsidiary only operated the Indian Refinery five
years, whereas Texaco and others operated it over fifty years, the Company would
expect that its share of remediation liability would be proportional to its
years of operation, although such may not be the case. Furthermore, as noted
above, ChevronTexaco has claimed that the Company indemnified it for all
environmental liabilities related to the Indian Refinery. If ChevronTexaco were
to sue the Company on this theory and prevail in court, the Company could be
held responsible for the entire estimated clean up costs of $80,000- $150,000 or
more. In such a case, this cost would be far in excess of the Company's
financial capability.
An opinion issued by the U.S. Supreme Court in June 1998 in the
comparable matter of United States v. Bestfoods, 524 U.S. 51, 118 S.Ct. 1876
(1998), and a recent opinion by the U.S. Appeals Court for the Fifth Circuit in
Aviall Services, Inc. v. Cooper Industries Inc., 263 F.3rd 134 (5th Cir. 2001)
vacated and reh'g granted, 278 F.3d 416 (Dec. 19, 2001) support the Company"s
positions. Nevertheless, if funds for environmental clean-up are not provided by
these former and/or present owners, it is possible that the Company and/or one
of its former refining subsidiaries could be named parties in additional legal
actions to recover remediation costs. In recent years, government and other
plaintiffs have often sought redress for environmental liabilities from the
party most capable of payment without regard to responsibility or fault. Whether
or not the Company is ultimately held liable in such a circumstance, should
litigation involving the Company and/or IRLP occur, the Company would probably
incur substantial legal fees and experience a diversion of management resources
from other operations.
Although the Company does not believe it is liable for any of its
subsidiaries' clean-up costs and intends to vigorously defend itself in such
regard, the Company cannot predict the ultimate outcome of these matters due to
inherent uncertainties.
Litigation
Long Trusts Lawsuit
In November 2000, the Company and three of its subsidiaries were
defendants in a jury trial in Rusk County, Texas. The plaintiffs in the case,
the Long Trusts, are non-operating working interest owners in wells previously
operated by Castle Texas Production Limited Partnership ("CTPLP"), an inactive
exploration and production subsidiary of the Company. The wells were among those
sold to Union Pacific Resources Corporation ("UPRC") in May 1997. The Long
Trusts claimed that CTPLP did not allow them to sell gas from March 1, 1996 to
January 31, 1997 as required by applicable joint operating agreements, and they
sued CTPLP and the other defendants, claiming (among other things) breach of
contract, breach of fiduciary duty, conversion and conspiracy. The plaintiffs
sought actual damages, exemplary damages, pre-judgment and post-judgment
interest, attorney's fees and court costs. CTPLP counterclaimed for
approximately $150 of unpaid joint interests billings plus interest, attorneys'
fees and court costs.
After a three-week trial, the District Court in Rusk County
submitted 36 questions to the jury which covered all of the claims and
counterclaims in the lawsuit. Based upon the jury's answers, the District Court
entered judgement granting plaintiffs' claims against the Company and its
subsidiaries, as well as CTPLP's counterclaim against the plaintiffs. The
District Court issued an amended judgement on September 5, 2001 which became
final December 19, 2001. The net amount awarded to the plaintiffs was
approximately $2,700. The Company and its subsidiaries and the plaintiffs
subsequently filed notices of appeal and each party submitted legal briefs with
the Tyler Court of Appeals in April 2002. The Company and its special counsel
expect that the Tyler Court of Appeals will hear the appeal case during the fall
of 2002.
-8-
Castle Energy Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except share amounts)
(Unaudited)
Special counsel to the Company, Jenkens & Gilchrist, does not
consider an unfavorable outcome to this lawsuit probable. The Company's
management and special counsel believe that several of the plaintiffs' primary
legal theories are contrary to established Texas law and that the Court's charge
to the jury was fatally defective. They further believe that any judgment for
plaintiffs based on those theories or on the jury's answers to certain questions
in the charge cannot stand and will be reversed on appeal. As a result, the
Company has not accrued any liability for this litigation. Nevertheless, to
pursue the appeal, the Company and its subsidiaries were required to post a bond
to cover the gross amount of damages awarded to the plaintiffs and to maintain
that bond until the resolution of the appeal, which may take several years.
Originally, the Company and its subsidiaries anticipated posting a bond of
approximately $3,000 based upon the net amount of damages but the Company and
its subsidiaries later decided to post a bond of $3,886 based upon the gross
damages in order to avoid on-going legal expenses and to expeditiously move the
case to the Tyler Court of Appeals. The letter of credit supporting this bond
was provided by the Company's lender pursuant to the Company's $40,000 line of
credit with that lender.
Pilgreen Litigation
As part of the oil and gas properties acquired from AmBrit Energy
Corp. ("AmBrit") in June 1999, Castle Exploration Company, Inc., a wholly-owned
subsidiary of the Company ("CECI") acquired a 10.65% overriding royalty interest
("ORRI") in the Simpson lease in south Texas, including the Pilgreen #2ST gas
well. CECI subsequently transferred that interest to Castle Texas Oil and Gas
Limited Partnership ("CTOGLP"), an indirect wholly-owned subsidiary. Because the
operator suspended revenue attributed to the ORRI since first production due to
title disputes, AmBrit had previously filed claims against the operator of the
Pilgreen well, and CTOGLP acquired rights in that litigation with respect to the
period after January 1, 1999. The Company now believes that operator will
release approximately two thirds of the suspended revenue attributable to
CTOGLP's ORRI in the Pilgreen #2ST well in the near future. Because of a claim
by Dominion Oklahoma Texas Exploration and Production, Inc. ("Dominion") (see
below), a working interest owner in the same well, that CTOGLP's ORRI in the
Simpson lease should be deemed burdened by 3.55% overriding royalty interest,
there is still a title dispute as to approximately 33% of the suspended CTOGLP
Pilgreen production proceeds. The Company has named Dominion as a defendant in a
legal action to seeking a declaratory judgment that the Company is entitled to
its full 10.65% overriding royalty interest in Pilgreen well. The Company
believes that Dominion's title exception to CTOGLP's overriding royalty interest
is erroneous and notes that several previous title opinions have confirmed the
validity of CTOGLP's interest. CTOGLP has also been informed that production
proceeds from an additional well on the Simpson lease in which CTOGLP has a
5.325% overriding royalty interest have been suspended by the court because of
title disputes. The Company intends to contest this matter vigorously. At the
present time, the amount held in escrow applicable to the Company's interests in
both wells is approximately $512.
The Company's policy with respect to the $512 of potential recovery
is to record any amounts recovered as income only when and if such amounts are
actually received.
Dominion Litigation
In March 18, 2002, Dominion, operator of the Mitchell and
Migl-Mitchell wells in the Southwest Speaks field in south Texas and a working
interest owner in the Pilgreen #2ST well, filed suit in Texas against CTOGLP
seeking declaratory judgement in a title action that the overriding royalty
interest held by CTOGLP in these wells should be deemed to be burdened by
certain other overriding royalty interests and therefore be reduced from 10.65%
to 7.10%. Dominion is also seeking an accounting and refund of payments for
overriding royalty to CTOGLP in excess of the 7.10% since April 2000. The
Company preliminarily estimates the amount in controversy to be approximately
$1,180, including $136 of the $512 held in escrow under the Pilgreen litigation
(see above). Dominion has threatened to suspend all revenue payable to the
Company from the Mitchell and Migl-Mitchell to offset their claim. The Company
believes that Dominion's title exception to CTOGLP's overriding royalty interest
is erroneous and notes that several previous title opinions have confirmed the
validity of CTOGLP's interest. The Company intends to contest this matter
vigorously and has accordingly made no provision for Dominion's claim in its
March 31, 2002 financial statements.
-9-
Castle Energy Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except share amounts)
(Unaudited)
Note 5 - Information Concerning Reportable Segments
For the periods ended March 31, 2001 and 2002, the Company operated in
only one segment of the energy industry, oil and gas exploration and production.
Until May 31, 1999, the Company also operated in the natural gas marketing
segment of the energy industry.
Note 7 - Sale of Domestic Exploration and Production Assets
On January 15, 2002, the Company entered into an agreement to sell its
domestic oil and gas properties to Delta Petroleum Company, a public exploration
and production company headquartered in Denver, Colorado ("Delta"). The purchase
price is $20,000 plus 9,566,000 shares of Delta's common stock, which would
result in the Company owning approximately 43% of Delta. The effective date of
the sale is October 1, 2001. Pursuant to the terms of the purchase and sale
agreement, the cash portion of the purchase price will be reduced by the cash
flow from the properties between the effective date and the closing date. Each
party is subject to penalties for failure to close the transaction. In addition,
Delta may repurchase up to 3,188,667 of its shares from Castle for $4.50 per
share for a period of one year after closing and Delta agreed to nominate three
additional directors selected by the Company to Delta's Board of Directors,
which is currently comprised of four directors. The agreement also includes a
provision whereby Delta may pay a portion of the cash purchase price with a 270
day note bearing interest of 8% if Delta is unable to fund the entire cash
portion of the purchase price. The note plus accrued interest is payable in cash
or Delta's common stock (at $3.00/share) at Delta's option. Pursuant to an
amendment to the purchase and sale agreement the Company agreed that it would
not acquire more than 49.9% of Delta in the event that Delta paid a portion of
the purchase price with a 270 day note and then subsequently was unable to pay
off the note in cash. In such case the unpaid portion of the note would continue
beyond 270 days until such time as it was repaid in cash or in Delta stock so
long as the Company interest in Delta did not exceed 49.9% of Delta's
outstanding shares. As the result of this provision and other provisions in the
purchase and sale agreement, the management of both the Company and Delta
strongly believe that Delta will be the acquiring entity for purposes of
generally accepted accounting principles. If, nevertheless, Delta were deemed
the acquired entity, the Company would account for the transaction as the
Company's acquisition of Delta using the purchase method of accounting and would
accordingly include the financial results of Delta in its consolidated financial
statements.
Closing of the Delta transaction is subject to approval by Delta's
shareholders. Delta recently sent proxies to its stockholders to approve the
transaction and the Company and Delta expect to close the sale on May 31, 2002,
assuming approval by Delta's shareholders.
The Company currently expects that the proceeds from the sale will exceed the
current carrying value of the oil and gas properties to be sold. Any resultant
gain recorded by the Company upon sale will be dependent to a large extent upon
the market price of Delta's common stock at the time the transaction closes and
the nature of the proceeds received. It is anticipated that the fair value of
Delta's option to repurchase the 3,188,667 shares at $4.50 will be recorded as a
reduction of the sales proceeds (At May 7, 2002, Delta's stock price was
approximately $4.00/share.) Given the volatility of oil and gas prices, the fact
that Delta shareholders have still not approved the transaction and other
factors, there can be no assurance that the transaction will close as planned or
that the Company will recognize a gain on the transaction in its financial
statements. Portions of any gain recorded will be deferred due to the Company's
indirect retention of interest in the properties sold as a result of its
ownership interest in Delta after the sale. If at any time prior to the
completion of the sale the Company estimates that it would record a loss on
disposition, the loss would be recorded when estimated in accordance with
Statement of Financial Accounting Standards No. 121. After the sale, the Company
expects to hold approximately 43% of Delta's outstanding stock which would be
recorded on the equity method. Under this method the Company records its share
of Delta's income or loss with an offsetting entry to the carrying value of the
Company's investment. Cash distributions, if any, are recorded as a reduction in
the carrying value of the Company's investment. Furthermore, the Company expects
that its resulting investment in Delta will be substantially in excess of the
Company's proportionate share of Delta's equity and that such excess will be
recorded as goodwill on the Company's consolidated balance sheets subsequent to
closing. Such goodwill will be accounted for in accordance with Statement of
Financial Accounting Standards No. 142 ("SFAS 142"). Pursuant to the provisions
of SFAS 142, the Company will be required to evaluate the recoverability of such
goodwill periodically and write off or reduce it if it is no longer deemed
recoverable commencing October 1, 2002.
-10-
Castle Energy Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands, except share amounts)
(Unaudited)
The net cash flow (oil and gas sales less oil and gas production
expenses) from the Company's oil and gas properties from October 1, 2001 to the
expected closing of the Delta transaction will reduce the cash portion of the
purchase price the Company expects to receive from the sale of its domestic oil
and gas properties to Delta. Accordingly, the net cash flow for the six months
ended March 31, 2002 of $4,086, subject to some minor adjustments, will
ultimately accrue to Delta's account rather than to the Company's account if the
sale to Delta is ultimately consummated as planned.
-11-
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
("$000's" Omitted Except Share and Per Unit Amounts)
RESULTS OF OPERATIONS
All statements other than statements of historical fact contained in
this report are forward-looking statements. Forward-looking statements in this
report generally are accompanied by words such as "anticipate," "believe,"
"estimate," or "expect" or similar statements. Although the Company believes
that the expectations reflected in such forward-looking statements are
reasonable, no assurance can be given that such expectations will prove correct.
Factors that could cause the Company's results to differ materially from the
results discussed in such forward-looking statements are disclosed in this
report, including without limitation in conjunction with the expected cash flow
projections discussed below. All forward-looking statements in this Form 10-K
are expressly qualified in their entirety by the cautionary statements in this
paragraph.
From August 1989 to September 30, 1995, two of the Company's
subsidiaries conducted refining operations. By December 12, 1995, the Company's
refining subsidiaries had sold all of their refining assets. In addition,
Powerine merged into a subsidiary of EMC and was no longer a subsidiary of the
Company. The Company's other refining subsidiaries own no refining assets and
are in the process of liquidation. As a result, the Company accounted for its
refining operations as discontinued operations in the Company's financial
statements as of September 30, 1995 and retroactively. Accordingly, discussion
of results of operations has been confined to the results of continuing
exploration and production operations and the anticipated impact, if any, of
liquidation of the Company's remaining inactive refining subsidiaries and
contingent environmental liabilities of the Company and its refining
subsidiaries.
Exploration and Production
Key exploration and production data for the six month periods ended
March 31, 2002 and 2001 are as follows:
Six Months Ended March 31,
---------------------------
2002 2001
---- ----
Production Volumes:
Barrels of crude oil (net)............................... 137,830 133,291
Mcf (thousand cubic feet) of natural gas (net)........... 1,653,036 1,583,791
Mcf equivalents (mcfe) (net) *........................... 2,480,016 2,383,537
Oil/Gas Prices:-
Crude Oil/Barrel:
Gross................................................ $19.50 $27.28
Hedging effects......................................
------ ------
Net of hedging....................................... $19.50 $27.28
====== ======
Natural Gas/Mcf:
Gross................................................ $ 2.43 $ 5.10
Hedging effects......................................
------ ------
Net of hedging....................................... $ 2.43 $ 5.10
====== ======
Oil and Gas Production Expenses/Mcf Equivalent................... $ 1.05 $ 1.43
====== ======
- ------------------
* Barrels of crude oil have been converted to mcf based upon relative energy
content of 6 mcf of natural gas per barrel of crude oil.
Oil and gas sales decreased approximately $5,271 from the first half
of fiscal 2001 to the first half of fiscal 2002 due to significant decreases in
oil and gas prices. The average price per mcfe decreased from $4.91/mcfe for the
six months ended March 31, 2001 to $2.70/mcfe for the six months ended March 31,
2002. The decline in the price received for natural gas was especially
precipitous. For the six months ended March 31, 2001, the average price recorded
per mcf of natural gas sold was $5.10 versus only $2.43 per mcf for the six
months ended March 31, 2002. Since the Company has not hedged its oil and gas
production, the Company's oil and gas sales can be expected to generally
increase or decrease roughly parallel with increases and decreases in oil and
gas prices. Such prices, however, have proved to be extremely volatile in the
past. Changes in weather, the economy, international politics and other factors
could cause similar volatility in oil and gas prices in the future.
-12-
Oil and gas sales increased approximately $260 as a result of increases
in oil and gas production. From the six months ended March 31, 2001 to the six
months ended March 31, 2002 oil production increased by 4,539 barrels
(approximately 25 barrels a day) and natural gas production increased 69,245 mcf
(approximate1y 380 mcf/day). The increase in production is primarily due to
production from the acquisition of interests in twenty-one East Texas oil and
gas wells on April 30, 2001, recompletions and reworks on existing wells in
which the Company owns an interest as well as several successful new wells in
which the Company participated during the last nine months. Such increases in
production more than offset the natural depletion (and thus decreased
production) of the Company's remaining wells.
As a result of the $5,271 decrease in oil and gas sales due to oil and
gas prices and the $260 increase due to oil and gas production, there was a net
decrease of $5,011 or 42.8% in oil and gas sales from the six months ended March
31, 2001 to the six months ended March 31, 2002.
Oil and gas production expenses decreased $789 or 23.2% from the first
six months of fiscal 2001 to the first six months of fiscal 2002. For the six
months ended March 31, 2002, such expenses were $1.05 per equivalent mcf of
production versus $1.43 per equivalent mcf of production for the six months
ended March 31, 2001. The decrease is primarily attributable to a higher amount
of nonrecurring repairs and maintenance incurred during the six months ended
March 31, 2001 than were incurred during the six months ended March 31, 2002.
The higher level of repairs and maintenance expenses incurred during the six
month period ended March 31, 2001 related primarily to the wells acquired from
AmBrit in June 1999 since it appeared AmBrit did not repair such wells pending
their sale to the Company. Furthermore, oil and gas production expenses are
typically not incurred ratably throughout any given year but are incurred when
and if certain wells require repair and maintenance. As a result, such
comparisons are more appropriate on an annual or a multi-year basis than on a
six month basis.
As noted above, the net cash flow (oil and gas sales less oil and gas
production expenses) from the Company's oil and gas properties from October 1,
2001 to the expected closing of the Delta transaction will reduce the cash
portion of the purchase price the Company expects to receive from the sale of
its domestic oil and gas properties to Delta. Accordingly, the net cash flow for
the six months ended March 31, 2002 of $4,086, subject to some minor
adjustments, will ultimately accrue to Delta's account rather than to the
Company's account if the sale to Delta is ultimately consummated as planned.
(See Note 7 to the consolidated financial statements.)
General and administrative expenses decreased $576 or 18.1% from the
six months ended March 31, 2001 to the six months ended March 31, 2002. The
decrease was primarily attributable to decreased legal expenses and $181 of
non-recurring costs incurred during the six months ended March 31, 2001 related
to the Company's previous effort to sell its oil and gas properties that
terminated in December 2000 without a sale.
Depreciation, depletion and amortization increased $987 or 69.2% from
the first six months of fiscal 2001 to the first six months of fiscal 2002. This
net increase consists of a decrease of $7 in depreciation of equipment and
furniture and fixtures from $65 to $58 and a $994 increase in depletion of oil
and gas properties from $1,362 to $2,356. The increase in depletion is primarily
attributable to an increase in the depletion rate. For the six months ended
March 31, 2002, the depletion rate was $.95 per mcfe versus $.57 per mcfe for
the six months ended March 31, 2001. The increase in depletion rate is
indirectly attributable to the significant decreases in oil and gas prices that
occurred between the two periods being compared. The reserve reports used to
compute depletion rates are prepared annually as of September 30, the Company's
fiscal year end. As a result of lower oil and gas prices at September 30, 2001
as compared to those at September 30, 2000, the Company's economic oil and gas
reserves decreased significantly and the resultant cost per mcfe and depletion
rate per mcfe increased significantly.
Interest income decreased $401 from the first six months of fiscal 2001
to the first six months of fiscal 2002. The decrease was caused by a significant
decrease in invested cash and a decrease in the rate of interest earned on such
invested cash.
-13-
The Company's equity in the loss of Networked Energy LLC ("Networked")
increased $49 from $33 for the six months ended March 31, 2001 to $82 for the
six months ended March 31, 2002. The increase results from increased expenses
incurred by Networked, a start up company that has not yet earned operating
revenue.
The Company recorded a $204 impairment provision on its marketable
securities during the six months ended March 31, 2002 for an other than
temporary decline in the market value of the Company's existing investment in
Delta's common stock, 382,289 shares. Under such circumstances, Statement of
Financial Accounting Standards No. 115 requires the Company to write down its
Delta stock to the market value of such stock at March 31, 2002 - with the
related charge to operations rather than to accumulated other comprehensive
income. If the Company consummates its planned transaction with Delta, the
Company expects to record its investment in Delta, including that applicable to
the 382,289 Delta common shares currently owned, using the equity method of
accounting (see below and Note 7 to the consolidated financial statements) and
the provisions of SFAS No. 115 would no longer apply.
The tax benefit for the six months ended March 31, 2002 was provided at
an effective tax rate of 36%. Such tax loss was estimated as part of the overall
taxable gain the Company expects to recognize when it sells its domestic oil and
gas assets to Delta (see Note 7 to the consolidated financial statements) and
for which the Company recorded a deferred tax asset (net of a valuation
allowance) at September 30, 2001. If the sale to Delta does not close as
anticipated and oil and gas prices do not improve, the Company expects it will
then increase the valuation allowance applicable to its gross deferred tax
asset.
The tax provision for the six months ended March 31, 2001 represents the
utilization of a net deferred tax asset recorded at September 30, 2000 at an
effective tax rate of 36%. The deferred tax asset at September 30, 2000 resulted
when the Company reevaluated its ability to generate sufficient taxable income
to utilize the gross deferred tax asset attributable to its tax carryforwards.
Since November of 1996, the Company has reacquired 4,871,020 shares or
69% of its common stock (after taking into account a three for one stock split
in January 2000). As a result of these share acquisitions, earnings and losses
per outstanding share have been higher than would be the case if no shares had
been repurchased.
LIQUIDITY AND CAPITAL RESOURCES
All statements other than statements of historical fact contained in this
report are forward-looking statements. Forward-looking statements in this report
generally are accompanied by words such as "anticipate," "believe," "estimate,"
or "expect" or similar statements. Although the Company believes that the
expectations reflected in such forward-looking statements are reasonable, no
assurance can be given that such expectations will prove correct. Factors that
could cause the Company's results to differ materially from the results
discussed in such forward-looking statements are disclosed in this report,
including without limitation in conjunction with any cash flow projections
discussed below. All forward-looking statements in this Form 10-Q are expressly
qualified in their entirety by the cautionary statements in this paragraph.
During the six months ended March 31, 2002, the Company used $61 of cash
in operating activities. During the same period the Company invested $703 in oil
and gas properties. In addition, it paid $671 in stockholder dividends. At March
31, 2002, the Company had $4,254 of unrestricted cash, $13,569 of working
capital and no long-term debt.
Although the Company's former and present subsidiaries have exited the
refining business and third parties have assumed environmental liabilities, if
any, of such subsidiaries, the Company and several of its subsidiaries may
remain liable for contingent environmental liabilities (see Note 4 to the
consolidated financial statements included in Item 1 of this Form 10-Q).
As noted in Note 7 to the consolidated financial statements, the Company
entered into a definitive agreement to sell all of its domestic oil and gas
properties to Delta. Closing has been set for May 31, 2002, but is subject to
prior approval by Delta's shareholders. Assuming closing occurs when expected,
the Company anticipates the following expenditures from investing and financing
activities from April 1, 2002 to May 31, 2002:
Dividends to shareholders (subsequently paid).............. $331
Recompletions and reworks on existing wells................ 150
----
$481
====
The Company believes it has sufficient unrestricted cash to make these
expenditures.
-14-
If the Delta transaction closes as anticipated, the Company currently
anticipates that Delta will be able to pay the entire cash portion of the
purchase price in cash rather than partially through a note given the current
higher prices being received for oil and gas production and Delta's resultant
probable ability to finance 100% of the cash portion of the purchase price. If
such is the case, the Company expects to receive approximately $18,000 cash and
9,566,000 shares of Delta's common stock at closing. As a result, the Company's
principal assets after closing would consist of approximately $23,500 working
capital (primarily cash), 1,343,000 shares of the common stock of Penn Octane
Corporation, 9,948,289 shares of Delta's commons stock (representing
approximately 43% of Delta), a 50% interest in a drilling concession in Romania,
and a 45% interest in Networked. Against such assets the Company would have
$2,404 of net accrued refining liabilities related to its inactive refining
subsidiaries as well as contingent liabilities related to three legal matters -
the Texaco claim, the Long Trusts litigation and the Dominion litigation. The
net refining liabilities essentially represent the excess of liabilities that
were accrued at September 30, 1995 (when the Company discontinued its refining
operations) over liabilities incurred to date. The Company may or may not
ultimately pay such liabilities (see Critical Accounting Policies below). The
Company expects that it will be able to utilize its tax carryforwards to offset
all of the Federal tax liability and most of the state tax liability that would
otherwise result from the anticipated gain on the Delta transaction.
If the Delta transaction closes on May 31, 2002 as anticipated, the
Company's directors may resolve to liquidate the Company or, alternatively, to
acquire other assets and operations and continue the Company's corporate
existence. Factors favoring liquidating include ever increasing regulatory and
other costs of being a public company as well as the difficulty in achieving a
critical mass over which to apply the Company's general and administrative
expense burden. As a result of recent concerns over public company reporting,
the Company's management expects that regulatory burdens and costs will probably
increase and could increase geometrically. In addition, other recent factors
favoring liquidation include increased insurance costs (resulting primarily from
the events of September 11, 2001), increased legal and accounting costs
(resulting to some extent from the recent Enron debacle), and the increasing
involvement of management in regulatory and investor-related activities rather
than in activities that increase the Company's operating profit. Should the
Company not liquidate, it intends to be engaged primarily, as soon as is
reasonably possible, but in no event later than one year, in a business other
than that of investing, reinvesting, owning, holding or trading in securities.
LIQUIDATION
If a decision is made to liquidate, it is anticipated that the Company
anticipates that it would distribute some cash and Delta shares to its
stockholders in complete liquidation of their stock, as soon as possible, while
retaining sufficient net assets to provide for liabilities reasonably
anticipated from the three aforementioned legal matters. Such provision would
most probably also include the Company collateralizing the $3,886 letter of
credit provided for its supersedeas bond as required by the Company's appeal of
the Long Trust litigation until such appeal is resolved (see Note 4 to the
consolidated financial statements). If any net assets remain after the Company
pays or provides for any remaining liabilities, the net proceeds of such assets
would then be distributed to stockholders as a final distribution. Such a plan
of liquidation or any other plan of liquidation would be subject to prior
approval by the Company's stockholders. The primary risks associated with such a
liquidation scenario are as follows:
a. Litigation - As noted above, the Company is a party in two
significant unsettled lawsuits and has received a claim from
ChevronTexaco for environmental remediation costs of
$80,000-$150,000. Although the Company does not believe it has any
liabilities with respect to either lawsuit or with respect to
ChevronTexaco's claim, these parties may undertake legal actions
to prevent the Company from making liquidating distributions to
its stockholders. Any resulting litigation could not only cause
the Company to incur significant legal costs but could also delay
any distributions to stockholders for years and/or reduce or
eliminate entirely such distributions. If ChevronTexaco were to
litigate and prevail in such litigation (see Note 4 to the March
31, 2002 consolidated financial statements), ChevronTexaco's
recovery could conceivably exceed the Company's net worth and
prevent liquidating distributions to stockholders. ChevronTexaco
could also conceivably sue larger stockholders of the Company
after a distribution has been made.
b. Company Stockholder Approval - The Company's stockholders could
vote against liquidation, in which case the Company would continue
to exist and there would be no liquidation distributions to
stockholders. In such a case, the Company would continue to incur
many costs associated with being a public company and would have
to replace all its reserves or acquire a new business since it
would have sold all of its revenue producing assets to Delta and
would not want to continue merely as an investment company.
-15-
c. Tax Risks - Although the Company does not anticipate a significant
tax liability on any sale to Delta as a result of its tax
carryforwards, the amount of gain ultimately realized by the
Company depends, to a large measure, on the price of Delta's stock
at closing. If such stock price is significantly higher than the
current price, approximately $4.00 per share, a larger tax
liability to the Company could result at closing. Furthermore, if
the Delta stock price increases between closing and any
distribution to stockholders, the Company could be subject to
federal and state income tax at the corporate level on the interim
appreciation of Delta's stock if the Company's remaining tax
carryforwards are not sufficient to offset such additional tax.
Such could be the case if there are delays between closing and
distributions to stockholders and Delta's stock price increases in
the interim. Any resulting gain would essentially constitute
phantom income to the Company since the Company would realize a
taxable gain without any related proceeds.
d. Continuing Public Company Administrative Burden - If the Company's
directors decide to liquidate, the Company will probably seek
relief from most of its public company reporting requirements. If
such a request is denied by the SEC, the Company would be forced
to incur many of the costs of being a public company while having
no operating revenues to absorb such costs. The result would be a
diminution of assets available for distribution to stockholders.
e. Lack of Liquidity - If the Company's directors decide to
liquidate, it is likely that the Company's stock would cease to
trade after a plan of liquidation is approved by stockholders. In
such a case stockholders would not be able to trade their stock
which may or may not have residual value when all of the Company's
liabilities are settled.
f. Liquidation of Assets - Assuming closing of the Delta transaction
as expected, the Company's primary remaining assets will consist
of the Company's investments in Penn Octane Corporation ("Penn
Octane") (1,343,000 shares) and Delta (9,948,289 shares). Most of
the Delta shares will initially not be registered although the
Company does have registration rights with respect to such stock.
Since both Penn Octane and Delta are small, thinly capitalized
companies with small trading volumes, the Company may not be able
to sell its Penn Octane and/or Delta stock for their listed market
prices if the Company needs cash or wants to distribute cash to
its stockholders. In addition, the Company owns a 50% interest in
a Romanian drilling concession and has tentatively planned to
participate in the drilling of an additional wildcat well in the
Black Sea. If the Company decides to sell its interest, it may not
be able to do so and recover any proceeds. Conversely, if the
Company participates in the wildcat well and it results in a dry
hole, the Company will have spent at least $1,000 by participating
and this would reduce the cash available for distributions to
stockholders.
g. Delta Repurchase Option - As noted above, Delta has the option to
repurchase up to 3,188,667 of its shares from Castle for a year
after closing at $4.50/share. As a result, the Company will not be
able to distribute or sell these shares for at least a year after
closing unless Delta exercises or waives its option sooner.
If the Delta transaction closes as anticipated, the Company's directors
may nevertheless decide not to liquidate. In such case, the Company would be
exposed to several of the risks listed above including litigation, continuing
public company administrative burdens, unfavorable liquidation of assets, lack
of liquidity, and the Delta repurchase option. In addition, the Company would
lack operating assets, operating personnel (since almost all of its personnel
would have by then been severed) and a business to operate. Under such
circumstances, the Company would be subject to many competitive disadvantages if
it again decides to acquire energy assets or other assets and businesses.
Although some analysts believe it may be possible to acquire oil and gas
properties at favorable prices at the present time or in the near future, there
can be no assurance that such will be the case. Many energy companies have more
financial resources than the Company and could easily outbid the Company in such
an acquisition scenario. Failure by the Company to be engaged primarily in a
business other than that of investing, reinvesting, owning, holding or trading
in securities within one year following closing of the sale to Delta could
subject the Company to federal regulation under the Investment Company Act of
1940, and would result in even more significant regulatory compliance costs and
obligations.
Although no decision has been reached, the Company's directors consider
liquidation to be the most likely outcome.
If the Delta transaction does not close as planned and the Company's
directors decide to continue operations, the Company may decide to undertake new
drilling activities and would also expect to have available its $40,000 line of
credit from its energy lender. Such line is currently unused except for the
$3,886 letter of credit provided for the bond related to the Long Trusts'
litigation (see Note 4 to the consolidated financials statements). The Company
estimates that it would be able to draw at least $12,000 based upon its current
reserves and current oil and gas pricing, in addition to the $3,886 letter of
credit already outstanding, but there can be no assurance that such would be the
case.
-16-
If the Delta transaction does not close and if the Company ends up
continuing current exploration and production operations, the Company would
continue to be subject to the following risk factors:
a. Contingent environmental liabilities (see Note 4 to the
consolidated financial statements).
b. Reserve price risk - the effect of price changes on the Company's
unhedged oil and gas production.
c. Exploration and development reserve risk - the effect of not
finding the oil and gas reserves sought during new drilling.
d. Reserve risk - the effect of differences between estimated and
actual reserves and production for existing wells (see below).
e. Public market for Company's stock - the small trading volumes in
the Company's stock may create liquidation problems for large
investors in the Company.
f. Foreign operation risks - the possibility that the Company's costs
to participate in the drilling of and, if successful, production
from the wildcat well planned for the Black Sea will significantly
exceed those estimated by the Company due to foreign political,
operating and insurance risks.
g. Other risks including general business risks, insurance claims
against the Company in excess of insurance recoveries, tax
liabilities resulting from tax audits, drilling risks and
litigation risk. (See Note 4 to the consolidated financial
statements.)
h. The Company has consented to the sale by Delta at auction in June
2002 of the Company's Oklahoma oil and gas properties. Even if the
Delta transaction does not close, these properties will most
probably be sold. There can be no assurance that bids received
will exceed the Company's carrying costs for these properties.
CRITICAL ACCOUNTING POLICIES:
The accounting policies critical to the Company in the future depend, to
a large extent, upon whether the Delta transaction closes as planned. If the
Delta transaction closes as planned, the following would be the accounting
policies most critical to the Company:
Equity Method of Accounting
If the Delta transaction closes as planned, the Company would own
approximately 43% of Delta and would be required to account for its resultant
investment in Delta using the equity method of accounting. Under this method,
the Company is required to increase its investment by its share of Delta's
future income and decrease such investment by its share of Delta's future losses
and any distributions from Delta. If Delta incurs future operating losses, the
Company would thus include its share of such losses in its consolidated
statement of operations. In addition, the Company expects that its investment in
Delta will be substantially in excess of the Company's proportionate share of
Delta's equity after closing and that such excess will result in substantial
goodwill on the Company's consolidated balance sheets subsequent to closing.
Such goodwill will be accounted for in accordance with SFAS 142 commencing
October 1, 2002. Pursuant to the provisions of SFAS 142, the Company would be
required to evaluate the recoverability of such goodwill periodically and write
off or reduce it to the extent it is not deemed recoverable. If at any time
prior to the completion of the sale the Company estimates that it would record a
loss on disposition, the loss would be recorded when estimated. If Delta incurs
recurring operating losses or the market value of its stock declines
significantly, the Company's goodwill resulting from the Delta transaction may
be impaired and the Company may then be required to write off or reduce its
recorded goodwill.
Discontinued Refining Operations
At March 31, 2002, the Company had recorded net refining liabilities
retained of $3,016 and an estimated value of discontinued net refining assets of
$612, resulting in a net recorded liability of $2,404. As noted in Note 4 to the
consolidated financial statements, ChevronTexaco has made a claim against the
-17-
Company for future environmental costs that have been estimated at
$80,000-$150,000. The Company's accounting policy with respect to contingent
environmental liabilities is to record environmental liabilities when and if
environmental assessment and/or remediation costs are probable and can be
reasonably estimated. Although the Company and its special counsel believe that
ChevronTexaco's claims are utterly without merit, the Company would be required
to record additional environmental liabilities if it becomes probable that the
Company will incur liabilities related to ChevronTexaco's claims or other
environmental liabilities and such liabilities exceed $2,404. As noted above, if
such probable liabilities exceed the value of the Company's assets, the Company
would not have the financial capability to pay such liabilities. The Company has
classified the estimated realizable value of discontinued net refining assets
and net refining liabilities retained as non current because it appears that
these items will not be realized in the next year given the recent legal
challenges by ChevronTexaco against the Plan of Liquidation of American Western
(see Note 4 to the consolidated financial statements).
Gain Recognized on Delta Sale
See Note 7 to the consolidated financial statements.
In addition, pursuant to the terms of the definitive agreement governing
the Company's sale of its domestic oil and gas assets to Delta, Delta has an
option to repurchase up to 3,188,667 shares of its common stock from the Company
for a period of one year after closing. It is anticipated that the fair value of
this option will be recorded as a reduction in the proceeds of the sale to Delta
with an offsetting liability attributed to the value of the option.
If the Delta transaction does not close as planned and the Company
continues to operate as currently, the following additional accounting policies
remain critical to the Company:
Valuation Allowance for Deferred Income Tax Asset
At March 31, 2002, the Company has recorded a valuation allowance
offsetting its gross deferred tax asset based upon the tax carryforwards it
expects to realize from the Delta transaction. If the Delta transaction does not
close as planned, it is probable that the Company will increase its valuation
allowance (and thereby decrease its net deferred tax asset and net income) based
upon its expected future taxable income. Such future expected taxable income
would, in turn, depend upon many factors - especially future oil and gas prices
and projected production. If the Delta transaction closes as planned, the future
taxable income expected by the Company will depend, to a large degree, upon the
valuation of the Delta stock to be received at closing and the valuation
allowance can be expected to increase or decrease based upon the value of the
actual consideration received at closing. Such value may differ from that
estimated by the Company.
Valuation of Certain Marketable Equity Securities
The Company currently classifies its investment securities as
available-for-sale securities. Pursuant to SFAS No. 115, such securities are
measured at fair market value in the financial statements with unrealized gains
or losses recorded in other comprehensive income until the securities are sold
or otherwise disposed of. However, in accordance with SFAS No. 115, a decline in
fair market value below cost that is other than temporary is accounted for as a
realized loss.
The Company currently owns 382,289 shares of the common stock of Delta.
The Company's per share cost for the 382,289 Delta shares currently owned was
approximately $5.06/share. Pursuant to SFAS No. 115, the Company was required to
write down its current investment in Delta stock to the market value of such
stock at March 31, 2002 as a charge to operations, resulting in a reduced cost
per share of $4.53 at March 31, 2002. If the market price of Delta's stock
remains below $4.53 for an extended period of time in the future, the Company
may again write down the value attributable to the Delta shares it currently
owns. Although any market write downs are charged to its operations, any
subsequent increases in the market value after a market write down are recorded
as a component of other comprehensive income - not a component of current
operations.
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Full Cost Method of Accounting for Oil and Gas Properties
The Company accounts for its oil and gas properties using the full cost
method. Under this method, the Company is required to record a permanent
impairment provision if the net book value of its oil and gas properties less
related deferred taxes exceeds a ceiling value equal to the present value of
future cash inflows from proved reserves, tax effected and discounted at 10%.
The ceiling test is computed at the end of each quarter. The oil and gas prices
used in calculating such future cash inflows are based upon the market price on
the last day of the accounting period. Due to the volatility of oil and gas
prices, the oil and gas prices used in the ceiling computation have
significantly differed from the actual prices the Company ultimately receives
for its production. If the market prices on the last day of the Company's
quarterly reporting period are low, it is possible that the Company will be
required to record an impairment provision related to its oil and gas
properties. If such market prices subsequently increase, the Company would not
reverse any impairment provisions previously recorded. Instead, the Company
would record lower depletion expense in the future since any prior ceiling
impairment provisions would have reduced the net book value of the Company's oil
and gas properties and would thus reduce the depletion cost per mcfe of natural
produced thereafter.
Item 3. QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK
The Company has not hedged its remaining expected crude oil and natural
gas production. As a result, the Company remains at risk with respect to such
unhedged expected production. If oil and gas market prices increase, oil and gas
sales applicable to the unhedged production will increase. If oil and gas market
prices decrease, oil and gas sales related to such unhedged production will
decrease.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
For information regarding lawsuits and legal matters, reference is made
to Item 3 of the Company's Form 10-K (Annual Report) for the fiscal year ended
September 30, 2001. Also see Note 4 to the March 31, 2002 consolidated financial
statements included in Part I.
Item 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of Stockholders was held on March 14, 2002. Proxies
were solicited pursuant to the Notice of Annual Meeting of Stockholders, dated
January 30, 2002. A total of 5,853,140 shares (representing approximately 88% of
outstanding shares) were present in person or by proxy.
Messrs. Martin R. Hoffmann and Russell S. Lewis were elected to serve
as directors until the 2003 Annual Meeting. The number of votes cast with
respect to Messrs. Hoffmann and Lewis were as follows:
For Withheld
----- --------
Martin R. Hoffmann 5,823,843 29,297
Russell S. Lewis 5,825,343 27,797
At the Annual Meeting, the stockholders also approved the appointment
of KPMG LLP as the Company's independent accountants for the fiscal year ending
September 30, 2002 by a vote of 5,796,494 votes for such appointment, 36,001
against and 20,645 abstentions.
In addition to the above, Joseph L. Castle II, John P. Keller, Sidney
F. Wentz and Richard E. Staedtler continued on the Board of Directors.
Item 6. Exhibits and Reports on Form 8-K
(A) Exhibits:
Exhibit 11.1 - Statement re: Computation of Earnings Per Share
Exhibit 10.145 Amendment Number One to Purchase and Sale Agreement, between Delta
Petroleum Company and Castle Energy Corporation, March 2002.
(B) Reports on Form 8-K: None
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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.
Date: May 13, 2002 CASTLE ENERGY CORPORATION
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/s/Richard E. Staedtler
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Richard E. Staedtler
Chief Financial Officer
Chief Accounting Officer
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