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 June 30, 2005
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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
Commission file number: 0-10990
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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 Incorporation or Organization) (I.R.S. Employer
Identification No.)
357 South Gulph Road, Suite 260, King of Prussia, Pennsylvania 19406
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(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code (610) 992-9900
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(Former Name, Former Address and Former Fiscal Year, if Changed Since
Last Report)
Indicate by check [CHECK MARK] whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days
Yes [CHECK MARK] No .
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Indicate by check [CHECK MARK] whether the registrant is an accelerated
filer (as defined in Rule 12b-2 of the Exchange Act)
Yes No [CHECK MARK].
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Indicate the number of shares outstanding of each of the issuer's
classes of common stock as of the latest practicable date: 7,215,360 shares of
Common Stock, $.50 par value, outstanding as of August 16, 2005.
CASTLE ENERGY CORPORATION
INDEX
PAGE #
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Part I. Financial Information
Item 1. Financial Statements:
Consolidated Balance Sheets - June 30, 2005 (Unaudited) and September
30, 2004............................................................... 2
Consolidated Statements of Operations - Three Months Ended June 30,
2005 and 2004 (Unaudited).............................................. 3
Consolidated Statements of Operations - Nine Months Ended June 30, 2005
and 2004 (Unaudited)................................................... 4
Condensed Consolidated Statements of Cash Flows - Nine Months Ended
June 30, 2005 and 2004 (Unaudited)..................................... 5
Consolidated Statements of Stockholders' Equity and Other Comprehensive
Income - Year Ended September 30, 2004 and Nine Months Ended June
30, 2005 (Unaudited)................................................... 6
Notes to Consolidated Financial Statements (Unaudited)................. 7
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.......................................................... 17
Item 3. Qualitative and Quantitative Disclosures About Market Risk............. 21
Item 4. Controls and Procedures................................................ 21
Part II. Other Information
Item 1. Legal Proceedings...................................................... 22
Item 6. Exhibits............................................................... 22
Signature ............................................................................... 23
-1-
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CASTLE ENERGY CORPORATION
CONSOLIDATED BALANCE SHEETS
("$000'S" OMITTED EXCEPT SHARE AMOUNTS)
JUNE 30, SEPTEMBER 30,
2005 2004
-------- -------------
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents......................................................... $ 29,627 $ 33,742
Restricted cash................................................................... 898 120
Accounts receivable............................................................... 732 582
Account receivable - Delta Petroleum Corporation.................................. 339
Marketable securities............................................................. 19
Prepaid expenses and other current assets......................................... 82 203
Note receivable - Networked Energy LLC, net of allowance for doubtful account
of $125.........................................................................
-------- --------
Total current assets............................................................ 31,339 35,005
Property, plant and equipment, net:
Furniture, fixtures, equipment and vehicles....................................... 195 111
Oil and gas properties, net (full cost method):
Proved properties............................................................... 8,657 9,012
Unproved properties not being amortized.........................................
Marketable securities................................................................ 94,624
Investment in Networked Energy LLC, net of impairment reserve of $354................ 6
Investment in Delta Petroleum Corporation............................................ 39,698
-------- --------
Total assets.................................................................... $134,821 $ 83,826
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Dividend payable.................................................................. $ 361 $ 343
Accounts payable.................................................................. 448 749
Contingent note payable...........................................................
Accrued expenses.................................................................. 321 906
Asset retirement obligations...................................................... 3 3
Net refining liabilities retained................................................. 1,552
-------- --------
Total current liabilities....................................................... 2,685 2,001
Net refining liabilities retained.................................................... 2,404
Asset retirement obligations......................................................... 250 227
Deferred income taxes................................................................ 25,572 5,171
Other liabilities.................................................................... 20 19
-------- --------
Total liabilities............................................................... 28,527 9,822
-------- --------
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;
12,126,404 shares issued at June 30, 2005 and 11,781,404 shares issued at
September 30, 2004.............................................................. 6,064 5,891
Additional paid-in capital........................................................ 88,500 85,691
Accumulated other comprehensive income, net of $19,698 taxes in 2005 and $1,165
taxes in 2004................................................................... 35,018 170
Retained earnings................................................................. 43,379 48,919
-------- --------
172,961 140,671
Treasury stock at cost - 4,911,044 shares at June 30, 2005 and 4,911,020 shares
at September 30, 2004.......................................................... (66,667) (66,667)
-------- --------
Total stockholders' equity...................................................... 106,294 74,004
-------- --------
Total liabilities and stockholders' equity...................................... $134,821 $ 83,826
======== ========
The accompanying notes are an integral part of these financial statements
-2-
CASTLE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
THREE MONTHS ENDED JUNE 30,
-------------------------------
2005 2004
------------ -----------
Revenue:
Gas sales................................................................. $ 456 $ 491
------------ -----------
456 491
------------ -----------
Expenses:
General and administrative................................................ 1,036 1,006
Oil and gas production.................................................... 180 133
Depreciation, depletion and amortization.................................. 130 128
Litigation provision (recovery)........................................... (845) 825
------------ -----------
501 2,092
------------ -----------
Operating income (loss)...................................................... (45) (1,601)
------------ -----------
Other income (expense):
Gain on sale of Delta Petroleum Corporation investment.................... 5,664
Interest income........................................................... 188 30
Other income (expense).................................................... 23 (1)
Equity in income of Delta Petroleum Corporation........................... 350
Equity in income (loss) of Networked Energy LLC........................... (1)
------------ -----------
210 6,043
------------ -----------
Income (loss) before provision for income taxes.............................. 165 4,442
------------ -----------
Provision for (benefit of) income taxes:
State..................................................................... 21 37
Federal................................................................... 640 1,692
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661 1,729
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Net income (loss)............................................................ ($ 496) $ 2,713
============ ===========
Net income (loss) per share:
Basic..................................................................... ($ .07) $ .40
============ ===========
Diluted................................................................... ($ .07) $ .39
============ ===========
Weighted average number of common and potential dilutive common shares
outstanding:
Basic..................................................................... 7,111,458 6,715,112
============ ===========
Diluted................................................................... 7,111,458 7,018,712
============ ===========
Dividends declared per share................................................. $ 1.05 $ .05
============ ===========
The accompanying notes are an integral part of these financial statements
-3-
CASTLE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
("000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
NINE MONTHS ENDED JUNE 30,
-------------------------------
2005 2004
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Revenue:
Gas sales................................................................ $ 1,967 $ 491
------------ -----------
1,967 491
------------ -----------
Expenses:
General and administrative................................................ 3,242 3,430
Oil and gas production.................................................... 423 133
Depreciation, depletion and amortization.................................. 400 153
Litigation provision (recovery)........................................... (845) 825
------------ -----------
3,220 4,541
------------ -----------
Operating income (loss)...................................................... (1,253) (4,050)
------------ -----------
Other income (expense):
Gain on sale of marketable securities..................................... 538
Gain on sale of Delta Petroleum Corporation investment.................... 3,066 18,211
Interest income........................................................... 468 102
Other income.............................................................. 24 447
Equity in income of Delta Petroleum Corporation........................... 1,690 856
Equity in income of Networked Energy LLC.................................. 7
------------ -----------
5,255 20,154
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Income (loss) before provision for income taxes.............................. 4,002 16,104
------------ -----------
Provision for (benefit of) income taxes:
State..................................................................... 38 58
Federal................................................................... 1,237 2,413
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1,275 2,471
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Net income (loss)............................................................ $ 2,727 $ 13,633
============ ===========
Net income (loss) per share:
Basic..................................................................... $ .39 $ 2.05
============ ===========
Diluted................................................................... $ .38 $ 1.98
============ ===========
Weighted average number of common and potential dilutive common shares
outstanding:
Basic..................................................................... 6,996,767 6,652,995
============ ===========
Diluted................................................................... 7,154,841 6,886,691
============ ===========
Dividends declared per share................................................. $ 1.15 $ .15
============ ===========
The accompanying notes are an integral part of these financial statements
-4-
CASTLE ENERGY CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
("000'S" OMITTED)
(UNAUDITED)
NINE MONTHS ENDED JUNE 30,
--------------------------
2005 2004
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Net cash flow provided by (used in) operating activities..................... ($2,530) ($ 3,272)
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Cash flows from investing activities:
Investment in furniture, fixtures and equipment........................... (119) (43)
Investment in oil and gas properties...................................... (9,282)
Proceeds from sale of marketable securities............................... 2,809
Proceeds from sale of Delta Petroleum Corporation shares.................. 4,800 29,339
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Net cash provided by (used in) investing activities 4,681 22,823
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Cash flows from financing activities:
Dividends paid to stockholders............................................ (8,251) (995)
Proceeds from exercise of stock options................................... 1,985 715
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Net cash provided by (used in) financing activities..................... (6,266) (280)
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Net increase (decrease) in cash and cash equivalents......................... (4,115) 19,271
Cash and cash equivalents - beginning of period.............................. 33,742 10,615
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Cash and cash equivalents - end of period.................................... $29,627 $29,886
======= =======
The accompanying notes are an integral part of these financial statements
-5-
CASTLE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND
OTHER COMPREHENSIVE INCOME
("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS)
YEAR ENDED SEPTEMBER 30, 2004 AND NINE MONTHS ENDED JUNE 30, 2005 (UNAUDITED)
----------------------------------------------------------------------------------
ACCUMULATED
COMMON STOCK ADDITIONAL OTHER
--------------------- PAID-IN COMPREHENSIVE COMPREHENSIVE RETAINED
SHARES AMOUNT CAPITAL INCOME INCOME (LOSS) EARNINGS
-------- -------- ---------- ------------- ------------- --------
Balance - October 1, 2003................... 11,503,904 $5,752 $68,532 $ 1,383 $36,643
Options exercised........................... 277,500 139 1,232
Tax benefit of options exercised............ 468
Issuance of additional stock by Delta
Petroleum Corporation, net of $4,595 tax.. 15,459
Dividends declared ($.20 per share)......... (1,344)
Comprehensive income (loss):
Net income (loss)......................... $13,620 13,620
Other comprehensive income (loss):
Reclassification adjustment, net of
$649 tax.............................. (1,153) (1,153)
Equity in other comprehensive
income (loss) of Delta Petroleum
Corporation, net of $32 tax benefit... (60) (60)
---------- ------ ------- ------- ------- -------
$12,407
Balance - September 30, 2004................ 11,781,404 5,891 85,691 ======= 170 48,919
Treasury stock surrendered..................
Options exercised........................... 345,000 173 1,812
Tax benefit of options exercised............ 677
Issuance of additional stock by Delta
Petroleum Corporation, net of $180 tax.... 320
Dividends declared ($1.15 per share)........ (8,267)
Comprehensive income (loss):
Net income (loss)......................... $2,727 2,727
Other comprehensive income (loss):
Equity in other comprehensive
income (loss) of Delta Petroleum
Corporation, net of $600 tax benefit.. (1,067) (1,067)
Reversal of cumulative equity in
comprehensive income (loss) of Delta
as of April 1, 2005, net of $506 tax.. 900 900
Unrealized gain on marketable
securities, net of $19,698 tax........ 35,015 35,015
-------
---------- ------ ------- $37,575 ------- -------
Balance - June 30, 2005..................... 12,126,404 $6,064 $88,500 ======= $35,018 $43,379
========== ====== ======= ======= =======
TREASURY STOCK
---------------------
SHARES AMOUNT TOTAL
-------- -------- -------
Balance - October 1, 2003................... 4,911,020 ($66,667) $45,643
Options exercised........................... 1,371
Tax benefit of options exercised............ 468
Issuance of additional stock by Delta
Petroleum Corporation, net of $4,595 tax.. 15,459
Dividends declared ($.20 per share)......... (1,344)
Comprehensive income (loss):
Net income (loss)......................... 13,620
Other comprehensive income (loss):
Reclassification adjustment, net of
$649 tax.............................. (1,153)
Equity in other comprehensive
income (loss) of Delta Petroleum
Corporation, net of $32 tax benefit... (60)
--------- ------- -------
Balance - September 30, 2004................ 4,911,020 (66,667) 74,004
Treasury stock surrendered.................. 24
Options exercised........................... 1,985
Tax benefit of options exercised............ 677
Issuance of additional stock by Delta
Petroleum Corporation, net of $180 tax.... 320
Dividends declared ($1.15 per share)........ (8,267)
Comprehensive income (loss):
Net income (loss)......................... 2,727
Other comprehensive income (loss):
Equity in other comprehensive
income (loss) of Delta Petroleum
Corporation, net of $600 tax benefit.. (1,067)
Reversal of cumulative equity in
comprehensive income (loss) of Delta
as of April 1, 2005, net of $506 tax..
Unrealized gain on marketable
securities, net of $19,698 tax........ 35,915
--------- ------- --------
Balance - June 30, 2005..................... 4,911,044 ($66,667) $106,294
========= ======= ========
The accompanying notes are an integral part of these financial statements.
-6-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AND PER 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 ("SEC"). Certain
reclassifications have been made, where applicable, 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 and nine month periods ended June 30, 2005 are not necessarily
indicative of the results that may be expected for the fiscal year ending
September 30, 2005 or for subsequent 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, 2004.
In the opinion of the Company, the unaudited consolidated financial
statements contain all adjustments (normal and recurring) necessary for a fair
statement of the results of operations for the three and nine month periods
ended June 30, 2005 and 2004 and for a fair statement of financial position at
June 30, 2005.
Note 2 - September 30, 2004 Balance Sheet
The amounts presented in the balance sheet as of September 30, 2004
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, 2004.
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. The Company's refining subsidiaries own no refining assets, have
been inactive for over nine years and are 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. Net refining liabilities retained represent the
remaining liabilities from discontinued refining operations. Such amounts remain
on the consolidated balance sheet pending final resolution. Such liabilities
have been classified as current at June 30, 2005 because the presumptive trial
date for related Chevron litigation has been set for November 2005 (see Note 4).
Note 4 - Environmental Liabilities/Litigation
Chevron Litigation
On August 13, 2002, three subsidiaries of Chevron filed Cause No.
02-4162-JPG in the United States District Court for the Southern District of
Illinois against the Company, as well as against two inactive subsidiaries of
the Company and three unrelated parties. The lawsuit seeks damages and
declaratory relief under contractual and statutory claims arising from
environmental damage at the now dismantled Indian Refinery. In particular, the
lawsuit claims that the Company is contractually obligated to indemnify and
defend Chevron against all liability and costs, including lawsuits, claims and
administrative actions initiated by the United States Environmental Protection
Agency ("EPA") and others, that Chevron has incurred or will incur as a result
of environmental contamination at and around the Indian Refinery, even if that
environmental contamination was caused by Texaco, Inc. and its present and
former subsidiaries ("Texaco" - now merged into Chevron (previously
ChevronTexaco)), which previously owned the refinery for over 75 years. The suit
also seeks costs, damages and declaratory relief against the Company under the
Federal Comprehensive Environmental
-7-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
Response Compensation Liability Act ("CERCLA"), the Oil Pollution Act of 1990
("OPA") and the Solid Waste Disposal Act, as amended, ("RCRA").
History
In December 1995, Indian Refining Limited Partnership, an inactive
refining subsidiary of the Company ("IRLP"), 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 large
portions of 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 liquidation plan in 2001. American Western anticipated
that the liquidation plan would be confirmed in January 2002 but confirmation
was delayed primarily because of legal challenges by Texaco, and subsequently
Chevron. American Western's liquidation plan was confirmed in April 2003. In the
plan, IRLP reduced a $5,400 secured claim against American Western to $800. In
exchange the EPA and Illinois EPA entered into an Agreement and Covenant Not to
Sue with IRLP, which extinguished all CERCLA claims against IRLP. Under the
American Western liquidation plan, IRLP received $599 which it distributed to
its creditors.
During fiscal 1998, the Company was informed that the 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.
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 an area of approximately 1,000 acres, which the EPA later designated
as the Indian Refinery-Texaco Lawrenceville Superfund Site. In addition,
eighteen other parties were named including Texaco and a subsidiary of Texaco
which 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.
Claims by Texaco
On August 7, 2000, the Company received notice of a claim against it
and two of its inactive refining subsidiaries from Texaco. 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 had already incurred addressing
environmental contamination at the Indian Refinery. Finally, Texaco also claimed
that the Company and two of its inactive subsidiaries were liable to Texaco
under the CERCLA as owners and operators of the Indian Refinery. The Company
responded to Texaco disputing the factual and legal contentions 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. ChevronTexaco then recently changed its
name to Chevron.
In May 2002, the Company received a letter from Chevron which asserted
a new claim against the Company and its subsidiaries pursuant to OPA for costs
and damages incurred or to be incurred by Chevron resulting from actual or
threatened discharges of oil to navigable waters at or near the Indian Refinery.
Chevron estimated these costs and damages to be $20,500.
-8-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
The Company subsequently corresponded with Chevron and voluntarily
provided a number of documents requested by Chevron. In June 2002, Chevron
indicated to the Company that Chevron did not intend to sue the Company.
Subsequently, Chevron requested additional documents from the Company, which the
Company promptly and voluntarily again supplied to Chevron.
In August 2002, the Company's management and special counsel met with
legal and management representatives of Chevron in an effort to resolve
outstanding issues. At the meeting a special outside counsel of Chevron asserted
claims against the Company based upon newly expressed legal theories. Chevron
also informed the Company that residential landowners adjacent to the Indian
Refinery site had recently filed a toxic torts suit against Chevron in Illinois
state court. The meeting ended in an impasse.
Litigation
On August 13, 2002, Chevron filed the above litigation in federal
court. By letter dated August 28, 2002, Chevron tendered the Illinois state
court litigation to the Company for indemnification, but the Company promptly
responded, denying responsibility. Following the initiation of litigation the
Company retained Bryan Cave LLP as trial counsel.
On October 25, 2002, the Company filed motions to dismiss as a matter
of law the contractual claims in Texaco's complaint, as well as the OPA and RCRA
claims. At the same time, the Company filed its answer to Chevron's lawsuit on
the remaining CERCLA claim. A pre-trial scheduling conference was held May 5,
2003 and on May 8, 2003 two unrelated defendants were dismissed from the case
with prejudice under a stipulation with Chevron on undisclosed terms. On June 2,
2003, the Federal District Court denied the Company's motions to dismiss,
following which, on July 9, 2003, the Company filed answers to the contractual,
OPA and RCRA claims.
The parties are currently conducting discovery and depositions. The
presumptive trial date for this case has been set for November 2005 by the
Federal District Court.
The central argument to both Chevron's contractual and statutory claims
is that the Company should be treated as a "successor" and "alter ego" of
certain of its present and former subsidiaries, and thereby should be held
directly liable for Chevron's claims against those entities. Chevron makes this
argument notwithstanding the fact that the Company never directly owned the
refinery and never was a party to any of the disputed contracts. Chevron has
also claimed that the Company itself directly operated the refinery. The leading
opinion in this area of the law, as 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), supports the Company's positions.
Estimated gross undiscounted clean-up costs for this refinery are at
least $80,000-$150,000 according to public statements by Texaco to the Company
and third parties. In January 2003, the United States and the State of Illinois
filed a motion in the American Western bankruptcy case which stated that the
estimated total response costs for one portion of the site alone could range
from $109,000 to $205,000. Chevron has asserted in its contractual claim that
the Company should indemnify Chevron for all environmental liabilities related
to the Indian Refinery. If Chevron were to prevail on this theory, the Company
could be held liable for the entirety of the estimated clean up costs, a sum far
in excess of the Company's financial capability. On the other hand, if the
Company were found liable by reason of Chevron's statutory claims for
contribution and reimbursement under CERCLA and/or OPA, the Company could be
required to pay a percentage of the clean-up costs based on equitable allocation
factors such as comparative time of ownership and operation, toxicity and amount
of hazardous materials released, remediation funded to date, as well as other
factors. Since the Company's subsidiary only operated the Indian Refinery five
years, whereas Texaco operated it over seventy-five years, the Company would
expect that its share of remediation liability would at a minimum be reduced to
an amount proportional to the years of operation by its subsidiary, although
such may not be the case. Additionally, since Texaco
-9-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
and its subsidiaries intentionally disposed of hazardous wastes on site at the
Indian Refinery while the Company's subsidiary arranged to remove for offsite
destruction and disposal any hazardous wastes it may have generated, any
allocation to the Company and/or its subsidiaries might be further reduced.
The Company and its special counsel, Reed Smith LLP, do not consider an
unfavorable outcome for the Company in Chevron's lawsuit to be probable, and the
Company intends to vigorously defend itself against all of Chevron's claims in
the litigation and any lawsuits that may follow. In addition to the numerous
defenses that the Company has against Chevron's contractual claim for indemnity,
the Company and its special counsel believe that by the express language of the
agreement which Chevron construes to create an indemnity, Chevron has
irrevocably elected to forego all rights of contractual indemnification it might
otherwise have had against the Company.
Contingent Environmental Liabilities
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 or timing of these
matters due to inherent uncertainties. If funds for environmental clean-up are
not provided by former and/or present owners, it is possible that the Company
and/or one of its former refining subsidiaries could be held responsible or
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.
Although any environmental liabilities related to the Indian 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, emerged from bankruptcy and is in the process of
liquidation.
As noted above, the EPA named the Company as a potentially responsible
party for remediation of the Indian Refinery and requested and received relevant
information from the Company and Chevron has tendered the defense of a state
court toxic torts action to the Company. Whether or not the Company is
ultimately held liable in the current litigation or other proceedings, it is
probable that the Company will incur substantial legal fees and experience a
diversion of corporate resources from other opportunities.
OTHER 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 certain 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 Company's other subsidiaries, claiming (among other
things) breach of contract, breach of fiduciary duty, conversion and conspiracy.
The Long Trusts sought actual damages, exemplary damages, prejudgment and
post-judgment interest, attorney's fees and court costs. CTPLP counterclaimed
for approximately $150 of unpaid joint interest billings plus interest,
attorney's fees and court costs.
After a three-week trial, the District Court in Rusk County submitted 36
questions to the jury which covered the claims and counterclaim in the lawsuit.
Based upon the jury's answers, the District Court entered judgment on some of
the Long Trusts' claims against the Company and its subsidiaries, as well as
CTPLP's counterclaim against the Long Trusts. The District Court issued an
amended judgment on September 5, 2001 which became final December 19, 2001. The
net amount awarded to the plaintiffs was approximately $2,700.
-10-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
The Company and its subsidiaries and the Long Trusts subsequently filed
notices of appeal, submitted legal briefs in April 2002, reply briefs in June
and July 2002, and ultimately argued the case before the 12th Court of Appeals
in Tyler, Texas in October 2002. On July 31, 2003, that court reversed and
remanded in part the trial court's judgment against the Company and its
subsidiaries while affirming the judgment against the Long Trusts which had
awarded damages on the counterclaim asserted by CTPLP. In its decision, the
appellate court held that the trial court had submitted erroneous theories to
the jury, expressly rejecting the Long Trusts' claims for breach of fiduciary
duty, conversion, implied covenants and exemplary damages. It also remanded the
Long Trusts' claims for breach of contract to the district court for retrial.
The appellate court upheld the trial court's award to CTPLP on its counterclaim
for approximately $150 of unpaid joint interests billings, $450 in attorneys'
fees, plus interest and court costs. Both the Company and its subsidiaries and
the Long Trusts thereafter submitted motions for a rehearing on certain rulings
to the 12th Court of Appeals. That court denied both motions for a rehearing.
The Long Trusts subsequently filed a petition for review with the
Supreme Court of Texas. On March 26, 2004, the Texas Supreme Court denied the
Long Trusts petition for review and the Long Trusts filed a petition for
rehearing with that court two weeks later. That petition was also subsequently
denied, whereupon the Court of Appeals issued its mandate on June 9, 2004,
completing the appellate process. Certain breach of contract claims by the Long
Trusts which were reversed and remanded by the appellate court may be retried by
the plaintiffs. Based on the evidence at the initial trial coupled with the
guidance to the trial court given in the appellate decision, the Company
believes that it will be able to prove that there was no breach of contract and
that Long Trusts suffered no damages, and that any such breach of contract
claims, even if decided adversely to the Company, will not result in a material
loss to the Company.
Pursuant to the mandate of the Texas Court of Appeals, the Company moved
to sever CTPLP's claims against the Long Trusts from any retrial of the Long
Trust's contract claims against the Company and to collect on CTPLP's judgment
against the Long Trusts which is secured by a letter of credit posted by the
Long Trusts with the trial court. The Company estimates the judgment to be in
excess of $1,000, including accrued interest, as of June 30, 2005. Subsequent to
June 30, 2004, upon issue of the mandate by the Texas Court of Appeals, the
Company's $3,886 supersedeas bond was released under Texas law. The Company's
$4,110 letter of credit, including accrued interest, securing that bond, was
also released and those funds were no longer restricted cash.
On September 17, 2004, the Long Trusts filed a Motion for Clarification
with the Court of Appeals which in essence sought to reverse that court's
severance of CTPLP's claims from the retrial of the Long Trusts' breach of
contract claims. A Petition for Writ of Mandamus was filed with the Court of
Appeals by the Company on December 3, 2004, requesting that the trial court be
stayed from proceeding further, and be ordered to comply with the June mandate
of the Court of Appeals. On January 31, 2005, the Court of Appeals stayed the
trial court from proceeding and subsequently denied the Motion for Clarification
on March 3, 2005 and the Petition for Writ of Mandamus on March 16, 2005. On May
2, 2005, the trial court from the bench announced that CTPLP's severed claim
would be assigned a new case number, but took all other requests for action from
the parties under advisement. In August 2005, the Company filed a second
Petition for Writ of Mandamas with the Court of Appeals requesting that the
calculation of interest due from the Long Trusts be made without a new trial and
that Long Trusts be ordered to pay the judgement against it plus interest
without delay.
The Company has not accrued any recoveries for this litigation as of
June 30, 2005, but will record recoveries if and when they are ultimately
realized (collected).
Pilgreen Litigation
As part of the oil and gas properties acquired from AmBrit Energy
Corporation ("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
-11-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
subsidiary. Because the operator suspended revenue attributable to the ORRI from
first production due to title disputes, AmBrit, the previous owner, 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. In August 2002,
$282 was released to the Company of which $249 was recorded as income by the
Company and the remaining $33 paid to Delta Petroleum Corporation ("Delta").
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 $120 of
suspended CTOGLP Pilgreen #2ST production proceeds for the Company's account.
(The Company sold all of its oil and gas assets, including the Pilgreen #2ST
well, to Delta on May 31, 2002 but effective as of October 1, 2001.) The Company
has named Dominion as a defendant in a legal action seeking a declaratory
judgment that the Company is entitled to its full 10.65% overriding royalty
interest in the 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. The litigation is related to the Dominion litigation (see below). The
Company and its counsel are currently reviewing the effect of the Court of
Appeals' opinion issued in the Dominion litigation on the Company's claims in
this litigation. Since the Company has not recorded any revenue related to the
$120 of suspended revenue, it expects to record $120 of revenue if and when such
revenue is realized (collected), but no expense if it fails in this litigation.
CTOGLP, along with several unrelated parties, has also filed suit to
collect production proceeds from an additional well on the Simpson lease in
which CTOLGP had a 5.325% ORRI suspended by the operator because of title
disputes. The Company intends to contest this matter vigorously. At the present
time, the amount held in escrow applicable to the additional well attributable
to the Company's interest is approximately $66 although approximately $22 of
that amount would be subject to Dominion's claims in the Pilgreen Litigation.
The Company has not recorded any of the $66 of suspended revenue as income but
will record it as income when and if it is realized (collected).
Dominion Litigation
On 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 judgment in a title action that the ORRI held by CTOGLP in these
wells should be deemed to be burdened by certain other ORRI's aggregating 3.55%
and should 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 currently estimates the amount in
controversy to be approximately $783. Dominion threatened to suspend all revenue
payable to the Company from the Mitchell and Migl-Mitchell to offset its claim.
The Company and Dominion subsequently examined the land and lease documents
concerning the ORRI's. The Company believes that Dominion's title exception to
CTOGLP's ORRI is erroneous and notes that several previous title opinions have
confirmed the validity of CTOGLP's interest.
In July 2003, Dominion filed a motion for partial summary judgment
concerning the Company's claim that it had assumed the liabilities of its
predecessor in interest and CTOGLP filed its response to Dominion's motion as
well as its own cross motion for partial summary judgment. In September 2003,
the District Court of Lavaca County granted Dominion's partial motion for
partial summary judgment. In January 2004, Dominion filed a motion for final
summary judgment on this matter to which CTOGLP and the other defendants filed a
response. In May 2004, the District Court of Lavaca County granted Dominion's
motion for final summary judgment following the Company's appeal of both the
District Court's summary judgments with the Court of Appeals in Corpus Christi.
By agreement with Dominion, CTOGLP executed a promissory note for $783
guaranteed by the Company and deposited this amount in a separate restricted
cash account of CTOGLP to support the note and to avoid the cost of a
supersedeas bond. On July 28, 2005, the Court of Appeals issued a Memorandum
Opinion that affirmed Dominion's claims to reduce the ORRI, but only to take
effect at a date after CTOGLP had sold the ORRI. The Court of Appeals overturned
that portion of the judgment that required CTOGLP to refund any money received
by it. The Company does
-12-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
not at this time know if Dominion intends to petition the Supreme Court of Texas
for review of this decision. The promissory note issued by CTOGLP will be
cancelled and the restricted cash account of CTOGLP released when and if this
judgment becomes final and non-appealable.
In fiscal 2004, the Company recorded an $825 loss provision related to
the Dominion litigation - primarily as a result of the District Court's granting
of Dominion' motion for summary judgment in May 2004. The Company has reversed
that provision plus $20 of accrued interest on the contingent note during the
quarter ended June 30, 2005 primarily because the Court of Appeals reversed that
District Court judgement against the Company. Nevertheless, the Company's
contingent note payable to Dominion and CTOGLP's restricted cash account are
required to remain in place until the Appeals Court judgement becomes
non-appealable. Dominion may appeal the Appeal's Court judgement to the Texas
Supreme Court and if that Court reverses the Appeals Court decision, the Company
would then become liable for the contingent note to Dominion plus interest or
some portion thereof. In such case, the Company would again record a loss
provision.
Note 5 - New Accounting Pronouncements
On September 28, 2004, the Securities and Exchange Commission issued
Staff Accounting Bulletin No. 106 ("SAB No. 106"). SAB No. 106 applies to
companies using the full cost method of accounting for oil and gas properties
and equipment costs, such as the Company. SAB No. 106 affects the way in which
the Company calculates its full cost ceiling limitation (the Company now
excludes future cash outflows associated with settling asset retirement
obligations that are accrued on the balance sheet related to proved developed
properties in the calculation of the ceiling) and the way the Company calculates
depletion on its proved undeveloped gas properties. The Company adopted SAB No.
106 on October 1, 2004. The effects of adoption of SAB No. 106 to date have been
immaterial.
In December 2004, the FASB issued Statement of Financial Accounting
Standards No. 123 (revised 2004), "Share-Based Payment" ("SFAS No. 123(R)").
SFAS No. 123(R) requires an entity to recognize the grant-date fair value of
stock options and other equity-based compensation issued to employees in the
income statement. Pursuant to a delay in the implementation date by the SEC,
SFAS No. 123(R) will be effective for the Company beginning October 1, 2005. The
Company does not expect SFAS No. 123(R) to have a material impact on its results
of operations. The Company has not issued any stock options since January 2002
and all stock options issued were vested by July 31, 2002.
In December 2004, the FASB issued FASB Staff Position FAS 109-1,
"Application of FASB Statement No. 109, Accounting for Income Taxes, for the Tax
Deduction Provided to U.S. Based Manufacturers by the American Jobs Creation Act
of 2004" ("FSP 109"). FSP 109 clarifies how to apply Statement No. 109 to the
new tax deduction for income attributable to "domestic production activities."
The Company expects that the new tax deduction will first be effective for the
Company's fiscal year ending September 30, 2006 and that the affect on future
income tax expense, deferred income taxes and income taxes payable will be
immaterial.
Note 6 - Restricted Cash
Restricted cash consists of the following:
JUNE 30, SEPTEMBER 30,
2005 2004
-------- -------------
Certificates of deposit supporting operating bonds........... $110 $120
Deposit securing contingent promissory note in Dominion
litigation, plus accrued interest........................... 788
---- ----
$898 $120
==== ====
The certificates of deposit support letters of credit for operating and
drilling bonds provided to state or county regulatory agencies.
-13-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
Note 7 - Marketable Securities
The Company's investment in marketable securities was as follows:
JUNE 30, 2005
---------------------------
DELTA SEPTEMBER 30, 2004
PETROLEUM --------------------
CHEVRON CORPORATION TOTAL CHEVRON TOTAL
------- ----------- ----- ------- -----
Common shares owned..................... 354 6,700,000 354 354
=== ========= === ===
Cost.................................... $15 $ 39,892 $39,907 $15 $15
Unrealized gain (loss).................. 4 54,713 54,717 4 4
--- --------- ------- --- ---
Book (market) value..................... $19 $ 94,605 $94,624 $19 $19
=== ========= ======= === ===
Through March 31, 2005, the Company accounted for its investment in Delta
Petroleum Corporation, a public oil and gas exploration and production company
headquartered in Denver, Colorado ("Delta"), using the equity method. Commencing
April 1, 2005, the Company accounted for its investment in Delta as
available-for-sale marketable securities (see Note 11 and "Critical Accounting
Policies").
At June 30, 2005, the closing share price of Delta's common stock was
$14.12. By August 10, 2005, the Delta share price had increased to $17.47 per
share.
Note 8 - Acquisition of Oil and Gas Properties
On March 31, 2004, the Company acquired interests in 138 western
Pennsylvania gas wells from Delta. The Company previously owned most of these
properties through May 31, 2002 when it sold all of its United States oil and
gas properties to Delta. The purchase price paid by the Company was effective
January 1, 2004 and was reduced by purchase price adjustments to the closing
date of March 31, 2004. For accounting purposes the Company allocated $43 of the
purchase price to trucks and the remainder to oil and gas properties.
The Company owned approximately 25% of Delta (see Note 11) at the time of
purchase, and three of the Company's directors were then also directors of
Delta. Prior to approving the purchase, the Company appointed a committee of
independent directors to evaluate and make a recommendation to the Board of
Directors with respect to the proposed transaction. The Committee engaged an
outside consultant to evaluate the fairness of the proposed purchase. Based upon
that consultant's recommendation that the purchase price was reasonable and fair
and the favorable recommendation of the committee, the full Board of Directors
of the Company unanimously approved the transaction.
At the same time the Company also purchased another owner's interests in
the same gas properties for $334 subject to similar final closing adjustments.
The other owner's interests in the properties were approximately four percent of
Delta's interests in the same properties.
On March 30, 2004, the Company acquired interests in 28 western
Pennsylvania gas wells for $1,100 from five limited partnerships effective
January 1, 2004. That transaction closed March 30, 2004. The President of the
general partner of the five selling limited partnerships was and still is an
officer and director of the Company. As a result, the Company appointed a
committee of independent directors to evaluate and make recommendations to the
Board with respect to the proposed transaction. The committee engaged an outside
consultant to evaluate the fairness of the proposed purchase. Based upon that
consultant's opinion that the proposed purchase price was reasonable and fair
and the favorable recommendation of the committee, the full Board of Directors
of the Company unanimously approved the transaction.
-14-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
The final adjusted purchase price for all of the oil and gas properties
acquired in March 2004 was $8,985.
The Company's petroleum reservoir engineer estimated the proved reserves
applicable to the three Pennsylvania purchases to be approximately eight billion
cubic feet of natural gas, of which approximately 87% represents proved
producing reserves, while the remaining 13% represents behind pipe and
undeveloped reserves. Approximately 130 of 166 wells in which the Company
acquired interests are operated by the Company. The Company also entered into an
operations management agreement with Delta whereby Delta performed certain well
operations functions for the Company on a transitional basis from April 1, 2004
to September 30, 2004. That agreement terminated September 30, 2004 and the
Company is now performing the well operations functions previously performed by
Delta.
Note 9 - Asset Retirement Obligations
Changes in the Company's asset retirement obligations are as follows:
NINE MONTHS ENDED JUNE 30,
---------------------------
2005 2004
------ ------
Balance - beginning of period.................................. $230
Acquisitions................................................... $222
Adjustments.................................................... 10 5
Accretion of discount.......................................... 13
---- ----
Balance - end of period........................................ $253 $227
==== ====
Note 10 - Investment in Networked Energy LLC ("Network")
At March 31, 2003, the Company recorded a $480 impairment provision
related to its investment in Network. This provision consisted of $354 provision
related to the Company's 45% equity investment in Network and a $125 provision
related to the Company's $125 note receivable from Network. As a result of these
impairment provisions, the Company's investment in Network was reduced to zero
and the Company ceased recording any share of Network's losses since the Company
had no obligation to fund such losses. The impairment provisions were recorded
because Network had not entered into any revenue-generating contracts by May 7,
2003.
Subsequently, Network entered into several revenue-generating contracts;
and, as of June 30, 2005, Network's revenues for the period April 1, 2003 to
March 31, 2005 exceeded its expenses for the same period by $21. As a result,
the Company resumed recording its share of Network's net income (loss) under the
equity method of accounting. Whereas the Company previously owned 45% of Network
at March 31, 2003, its ownership percentage had been reduced to 40% by March 31,
2005 (and at June 30, 2005) as a result of the issuance of additional membership
units to officers of Network. As a result, the Company recorded $8 of equity
income from its investment in Network during the quarter ended March 31, 2005.
Network lost $3 for the quarter ended June 30, 2005 and the Company recorded $1
of equity loss from its investment in Network for the quarter ended June 30,
2005.
Note 11 - Investment in Delta
Through March 31, 2005, the Company accounted for its investment in
Delta using the equity method. Initially, in May 2002, the Company had owned 44%
of Delta and three of the Company's directors constituted three of seven Delta
directors. By April 1, 2005, the Company's ownership of Delta had decreased to
16% (approximately 15% fully diluted) and the Company's directors only comprised
two of nine Delta directors. As a result of these developments, the Company
believed it no longer had significant influence on Delta's management and thus,
effective April 1, 2005, the Company commenced accounting for its investment in
Delta as a marketable available-for-sale security. As a result of the change in
accounting method, the book value of the Company's investment in Delta and the
Company's cumulative equity in
-15-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
Delta's comprehensive income (loss) at April 1, 2005, under the equity method of
accounting, $39,892, became the Company's value of the Delta stock as a
marketable security on April 1, 2005.
In June 2005, another director of the Company resigned from Delta's
Board of Directors resulting in the Company having only one director remaining
among Delta's nine directors.
At September 30, 2004, the Company owned 7,000,000 shares of Delta. In
March 2005, the Company sold 300,000 shares of Delta for net proceeds of $4,800
and recognized a gain of $3,066 on the sale. The book value of the shares sold
was based upon the book value per share of the Company's investment in Delta,
computed using the equity method, on the day of the sale.
See Note 7 and "Critical Accounting Policies."
Note 12 - Compensation Expense
SFAS 123 allows an entity to continue to measure compensation costs in
accordance with Accounting Principles Board Opinion No. 25 ("APB 25"). The
Company has elected to continue to measure compensation cost in accordance with
APB 25 and to comply with the required disclosure-only provisions of SFAS 123.
Pro forma net income (loss) and pro forma net income (loss) per share
are the same as net income (loss) and net income (loss) per share because the
Company has not issued any options since January of 2002 and all options issued
were fully vested by July 31, 2002.
Note 13 - Comprehensive Income (Loss):
Comprehensive income (loss) is as follows:
2005 2004
------- -------
Three Months Ended June 30:
Net income (loss).................................................. ($ 496) $ 2,713
Equity in other comprehensive income (loss) of Delta, net of
taxes...........................................................
Reversal of cumulative equity in other comprehensive income
(loss) of Delta as of April 1, 2005, net of taxes............... 900
Unrealized gain (loss) on marketable securities, net of tax........ 35,015 (17)
------- -------
$35,419 $ 2,696
======= =======
Nine Months Ended June 30:
Net income (loss).................................................. $ 2,727 $13,633
Equity in income (loss) of Delta, net of taxes..................... (1,067)
Reversal of cumulative equity in other comprehensive income
(loss) of Delta as of April 1, 2005, net of taxes............... 900 1
Unrealized gain (loss) on marketable securities, net of tax........ 35,015
Reclassification adjustments, net of taxes......................... (1,153)
------- -------
$37,575 $12,481
======= =======
Note 14 - Subsequent Event
On August 12, 2005, the Company's Board of Directors declared a
recurring quarterly dividend of $.05 per shares to all stockholders of record as
of October 3, 2005.
-16-
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
("$000'S" OMITTED EXCEPT SHARE AND PER SHARE 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 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 period 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 1996,
one refining subsidiary merged into a subsidiary of another unrelated party 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 consolidated financial statements as of September
30, 1995 and retroactively. Accordingly, discussion of results of refining
operations has been confined to 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.
Since November 1996, the Company has reacquired 4,911,044 shares or
approximately 69% of its then outstanding 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 have been the case if no shares had been repurchased.
COMPARISON OF THE NINE MONTHS ENDED JUNE 30, 2005 AND 2004
Gas sales increased $1,476 from the nine months ended June 30, 2004 to the
nine months ended June 30, 2005 as a result of the Company's acquisition of 166
Appalachian gas properties on March 30 and 31, 2004 (see Note 8 to the
consolidated financial statements included in this Form 10-Q). The Company owned
no oil and gas properties from September 2002 to March 30, 2004.
Production expenses increased $290 from the nine months ended June 30,
2004 to the nine months ended June 30, 2005 as a result of the Company's
acquisition of 166 Appalachian gas properties on March 30, and 31, 2004 (see
Note 8 to the consolidated financial statements included in this Form 10-Q). The
Company owned no oil and gas properties from September 2002 to March 30, 2004.
Depreciation, depletion and amortization increased $247 from the first
nine months of fiscal 2004 to the first nine months of fiscal 2005. The increase
was entirely attributable to the gas properties acquired by the Company in March
2004. The Company owned no oil and gas properties from September 2002 to March
30, 2004.
General and administrative costs decreased $188 or 5.5% from the nine
months ended June 30, 2004 to the nine months ended June 30, 2005. The decrease
was caused primarily by decreased legal expenses, offset partially by increased
compensation costs. In addition, during the nine months ended June 30, 2004, the
Company recorded a $86 bad debt provision related to accounts receivable that
were then over eighteen months old. No bad debt provision was recorded for the
nine months ended June 30, 2005.
The Company's equity in Delta's net income increased $834 or 97.4% from
the nine months ended June 30, 2004 to the nine months ended June 30, 2005. The
increase was caused by Delta's increased net income, notwithstanding that the
Company's percentage ownership of Delta decreased from approximately 18% at June
30, 2004 to approximately 16% at March 31, 2005 and the fact that the Company
recorded no Delta equity income after March 31, 2005 (see Notes 7, 11 and
"Critical Accounting Policies").
-17-
The $1,275 tax provision for the nine months ended June 30, 2005
represents approximately 31.9% of pre-tax income and includes the tax effects of
a change in accounting for the Company's investment in Delta from the equity
method to accounting for Delta as available-for-sale marketable securities and
changes in estimates of taxable income.
For the nine months ended June 30, 2004, the Company recorded a tax
provision of $2,471 or 15.3% of pre-tax book income for the period. This
provision was significantly less than that which would be obtained using the
Company's blended tax rate (Federal and state taxes combined) of 36% because the
Company was able to utilize its tax carryforwards and was thus able to release
its valuation allowance. Of this amount, $259 represented alternative minimum
taxes.
COMPARISON OF THE THREE MONTHS ENDED JUNE 30, 2005 AND 2004
Gas sales decreased $35 from the three months ended June 30, 2004 to the
three months ended June 30, 2005. Although gas prices were higher in 2005,
production was lower thus accounting for much of the net decrease.
Oil and gas production expenses increased $47 from the three months ended
June 30, 2004 to the three months ended June 30, 2005 as a result of increased
salaries paid to pumpers and increased well maintenance costs.
The $661 tax provision for the quarter ended June 30, 2005 includes the
tax effects of a change in accounting for the Company's investment in Delta from
the equity method to accounting for Delta as available-for-sale marketable
securities and changes in estimates of taxable income.
The $1,729 tax provision for the quarter ended June 30, 2004, which
represents 38.9% of pre-tax income, approximates the Company's blended (Federal
and state combined) tax rate of 36% and consists primarily of deferred taxes.
LIQUIDITY AND CAPITAL RESOURCES
During the nine months ended June 30, 2005, the Company used $2,529 in
operating activities. During the same period the Company paid $8,251 for
dividends to stockholders, including $7,213 in special dividends ($1.00/share),
and received $1,985 in proceeds from the exercise of stock options. At June 30,
2005, the Company had $28,654 of unrestricted cash, $103,072 of working capital
and no long-term debt.
At the present time, the Company's anticipated future cash expenditures
are primarily recurring general and administrative costs, including substantial
legal costs related to the Chevron litigation (see Note 4 to this Form 10-Q),
recurring dividends and lease operating costs and some minor capital
expenditures related to the Appalachian gas properties acquired by the Company.
In addition, the Company continues to review possible future acquisitions of oil
and gas properties; and, if the Company is successful in such pursuits,
additional expenditures would be required. To the extent that such anticipated
expenditures cannot be funded from cash flow from the Company's oil and gas
operations, the Company can fund such expenditures using its available cash. If
the Company were to make another substantial acquisition in excess of its
current cash and other liquid working capital, the Company believes it could
fund such acquisitions by selling additional shares of Delta or by renewing its
previous oil and gas borrowing arrangements with an energy bank and using the
related loan proceeds for the acquisition.
The Company's future operations are subject to the following risks:
a. Litigation - As noted above, the Company is a defendant in three
significant ongoing lawsuits. Although the Company does not believe
it has any material unrecorded liabilities with respect to any of
these lawsuits, the Company could incur significant liabilities if
it ultimately is judged to be liable in these lawsuits. This
litigation has caused and could continue to cause the Company to
incur significant legal costs. If Chevron were to prevail on its
indemnity claim in its lawsuit (see Note 4 to this Form 10-Q), the
Company could be held liable for the entirety of the estimated
cleanup costs. Although the Company does not believe that the
aggregate clean up costs currently exceeds the Company's financial
capability, such may not be the case and it is possible that such
clean up costs could exceed the Company's financial capacity if the
Company were required to fund the entire clean up.
b. Exploration and Production Price Risk - The Company has not hedged
any of its anticipated future gas production because the cost to do
so appears excessive when compared to the risk involved. As a
result,
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the Company remains exposed to future gas price changes with respect
to all of its anticipated future gas production. Such exposure could
be significant given the volatility of gas prices. For example,
natural gas prices have increased over 50% from 2002 to 2005 and
could either increase or decrease a similar percentage in the
future. When the Company acquired its gas properties in March 2004,
the prices being received for natural gas were $5.00 to $6.00 pe mcf
sold. The Company paid for its gas reserve acquisitions using such
pricing. Subsequent to the acquisitions, natural gas prices have
increased 10% to 20%. If natural gas prices decrease in the future,
the decrease will directly impact the Company's gas sales, operating
income and net income. In addition, if gas prices are low at the end
of the Company quarterly and annual reporting periods, the value of
the Company's gas reserves may decrease such that the Company would
be forced to record an impairment provision - see "Critical
Accounting Policies" below.
c. Exploration and Production Operating Risk - All of the Company's
current gas properties are onshore properties with relatively low
operating risk. Nevertheless, the Company faces the risks
encountered from operating approximately 130 gas wells - including
the risk of gas leaks, resulting environmental damage, third party
liability claims related to operations, claims by landowners where
the operated wells are located, and general operating risks.
d. Public Market for the Company's Stock - Although there presently
exists a market for the Company's stock, such market is volatile and
the Company's stock is thinly traded. The Company's stock price has
fluctuated significantly during recent years. This volatility may
adversely affect the market price and liquidity of the Company's
common stock.
e. Other Risks - In addition to the specific risks noted above, the
Company is subject to general business risks, including insurance
claims in excess of insurance coverage, tax liabilities resulting
from tax audits and the risks associated with increased litigation
generally.
f. Market Value of Delta Stock - The Company currently owns 6,700,000
shares of Delta. At June 30, 2005, the market value of such shares
was $94,605 and constituted the largest asset of the Company. At
August 10, 2005, the market value of the Company's Delta stock had
increased to $117,050. In the past year Delta's stock price has
fluctuated significantly over short periods of time. It is currently
at an all-time high. If Delta's stock price decreases significantly
- especially at a time when the Company expects to liquidate some or
all of its Delta stock - the Company would be adversely affected.
g. Future of the Company - Although the Company acquired interests in
166 gas wells in Pennsylvania in March 2004 (see Note 8), the
Company is smaller than most of its competitors which benefit from
better fixed cost efficiencies than the Company given their larger
sizes and revenues. The Company's fixed costs (computer system,
technical skills, field offices, public company compliance costs,
etc.) have consumed and are expected to continue to consume a
greater percentage of the Company's oil and gas revenues than do
those of most of its large competitors unless the Compan is able to
make additional future acquisitions at favorable prices. Upon
resolution of the Company's outstanding litigation - whether by
settlement or judgment - the Company's directors may consider
options to liquidate the Company or merge the Company into another
company to maximize stockholder value. If such were the case, the
Company would face risks concerning the value of the Delta shares it
owns, resultant tax liabilities and risks in the liquidation of its
assets.
If the Company's directors decide to liquidate the Company and
distribute the 6,700,000 Delta shares owned by the Company to its stockholders
as part of the plan of liquidation, the Company would be subject to a tax
liability on the difference between its tax basis in the Delta stock,
approximately $18,400, and the fair market value of the Delta stock at the time
it is distributed to stockholders. Since the Company has utilized most of its
tax carryovers at June 30, 2005, the Company would face Federal income tax
liabilities of approximately 35% on the difference between the Company's tax
basis in the Delta stock and its fair market value on the date of liquidation.
Such tax liabilities are included in "Deferred Income Taxes" on the Company's
consolidated balance sheet at June 30, 2005. Any such taxes would reduce
distributions available for stockholders.
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CRITICAL ACCOUNTING POLICIES:
The accounting policies critical to the Company are as follows:
METHOD OF ACCOUNTING FOR INVESTMENT IN DELTA
The Company currently owns 6,700,000 shares of Delta. Through March 31,
2005, the Company accounted for its investment in Delta using the equity method
of accounting. Under this method the Company increased its investment by its
share of Delta's income and decreased its investment by its share of Delta's
losses and distributions. The Company also increased its investment for
increases in its share of Delta's equity as a result of Delta's issuances of
additional Delta equity at prices in excess of the Company's book value.
Effective April 1, 2005, the Company commenced accounting for its
investment in Delta as a marketable available- for-sale security (see Notes 7
and 11). As a result, commencing April 1, 2005, pursuant to Statement of
Financial Accounting Standards No. 115 ("SFAS 115"), the Company measures its
investment in Delta's stock at fair market value (closing prices per the stock
exchange) with unrealized gains or losses, net of taxes, recorded in other
comprehensive income until the stock is sold or otherwise disposed of. At such
time gain or loss will be included in earnings. A decline in the market value of
any available for sale security below cost that is deemed to be other than
temporary will result in a reduction in the carrying amount to fair value. The
impairment will be charged to earnings and a new cost basis for the security
will result. Accordingly, the future effect of any change in the market value of
Delta stock will affect the Company's equity but will not be recorded in
operations until the stock is actually sold or disposed of.
DISCONTINUED REFINING OPERATIONS
At June 30, 2005, the Company had recorded net refining liabilities
retained of $1,552. The Company anticipates that it will settle such liabilities
in the next year because the Chevron lawsuit (see Note 4) is scheduled for trial
in November 2005, although that may not be the case and this litigation may
continue several years. As noted in Note 4 to this Form 10-Q, Chevron has sued
the Company for environmental remediation costs that have been estimated at
$80,000 to $150,000. In January 2003, the United States and the State of
Illinois filed a motion which estimated the total costs for just one portion of
the Indian Refinery-Texaco-Lawrenceville Superfund Site to be $109,000 to
$205,000. 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 do not
consider an unfavorable and final outcome for the Company in Chevron's lawsuit
to be probable, the Company would be required to record additional environmental
liabilities if it becomes probable such liabilities would be assessed against
the Company related to Chevron's claims and/or other environmental liabilities
and such liabilities exceed $1,552. As noted above, if such liabilities exceed
the value of the Company's assets, the Company would not have the financial
capability to pay such liabilities. The amounts and classification of the
estimated values of discontinued net refining assets and net refining
liabilities retained could change significantly in the future as a result of
litigation or other factors.
FULL COST METHOD OF ACCOUNTING FOR OIL AND GAS PROPERTIES
The Company follows the full-cost method of accounting for oil and gas
properties and equipment costs. Under this method of accounting, net capitalized
costs, less related deferred income taxes, in excess of the present value of net
future cash inflows (oil and gas sales less production expenses) from proved
reserves, tax effected and discounted at 10%, and the cost of properties not
being amortized, if any, are charged to expense (full cost ceiling test). If at
a future reporting date oil and gas prices decline, it is possible that the
Company's book value will exceed the allowable full cost ceiling and the Company
would have to write down its oil and gas properties. Even if oil and gas prices
subsequently increase, the write down would not be restored under the full cost
method of accounting. Although the Company recorded no full cost ceiling
provision through June 30, 2005, it could be required to record such a provision
in the future - especially if there were a significant decrease in gas prices by
the end of a quarterly or annual financial reporting period.
See "New Accounting Pronouncements."
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ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK
On March 30 and 31, 2004, the Company acquired interests in Pennsylvania
gas wells (see Note 8). The Company has not hedged its share of the expected
natural gas production from these wells. As a result, the Company remains at
risk with respect to such unhedged expected production. If market prices
increase, gas sales applicable to the unhedged production will increase. If
market prices decrease, gas sales and the gross margin related to such unhedged
production will decrease.
At June 30, 2005, the Company owned 6,700,000 shares of Delta. The stock
price of Delta has fluctuated significantly in the last three years; and thus,
the market value of the Company's investment in Delta remains subject to
significant changes in the market price of Delta stock.
ITEM 4. CONTROLS AND PROCEDURES
The conclusions of the Company's Chief Executive Officer and Chief
Financial Officer concerning the effectiveness of the Company's disclosure
controls and procedures and changes in internal controls as of June 30, 2005 are
as follows:
a) They have concluded that the Company's disclosure controls and
procedures are effective in ensuring that information required to be
disclosed by the Company in the reports it files or submits under
the Securities Exchange Act of 1934, as amended, is recorded,
processed, summarized and reported within the time periods specified
in the rules and forms of the SEC.
b) There were no changes in the Company's internal controls during the
quarter ended June 30, 2005 that have materially affected, or are
reasonably likely to materially affect, the Company's internal
control over financial reporting.
See Exhibits 31.1 and 31.2 to this Form 10-Q.
The Company expected that it would be subject to certain attestation
requirements concerning the effectiveness of its internal controls pursuant to
the Section 404 of the Sarbanes Oxley Act, effective September 30, 2005. These
requirements include management's documenting and testing the Company's internal
controls and attesting as to their effectiveness and a reporting by the
Company's independent accountants concerning management's attestation. The SEC
extended by one year the effective date when non-accelerated filers, such as the
Company, would become subject to such requirements.
Although the Company is working to comply with these requirements, the
Company has only eleven employees and these employees work at four widely
scattered locations. The Company's small number of employees and their
geographical separation is expected to make compliance with Section 404 -
especially with segregation of duty control requirements - very difficult and
cost ineffective, if not impossible.
While the SEC had indicated it expects to issue supplementary regulations
easing the burden of Section 404 requirements for small entities like the
Company, such regulations have not yet been issued.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
For additional information regarding lawsuits, reference is made to Item
3 of the Company's Form 10-K (Annual Report) for the fiscal year ended September
30, 2004. Also see Note 4 to the June 30, 2005 consolidated financial statements
included in Part I.
ITEM 6. EXHIBITS
Exhibit 11.1 Statement re: Computation of Earnings Per Share
Exhibit 31.1 Certificate of Chief Executive Officer (Section 302 of Sarbanes Oxley Act)
Exhibit 31.2 Certificate of Chief Financial Officer (Section 302 of Sarbanes Oxley Act)
Exhibit 32.1 Certificate of Chief Executive Officer (Section 906 of Sarbanes Oxley Act)
Exhibit 32.2 Certificate of Chief Financial Officer (Section 906 of Sarbanes Oxley Act)
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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: August 16, 2005 CASTLE ENERGY CORPORATION
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/s/Richard E. Staedtler
---------------------------------
Richard E. Staedtler
Chief Executive Officer
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