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 December 31, 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 (I.R.S. Employer
or Organization) 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
----------------
- --------------------------------------------------------------------------------
(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 by check |X| whether the Registrant is a large accelerated
filer, an accelerated filer or a non-accelerated filer.
Large Accelerated Filer ___ Accelerated Filer ___ Non-Accelerated Filer |X|
Indicate by check |X| whether the Registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act) Yes __ No |X|
Indicate the number of shares outstanding of each of the issuer's
classes of common stock as of the latest practicable date: 7,305,360 shares of
Common Stock, $.50 par value, outstanding as of February 10, 2006.
CASTLE ENERGY CORPORATION
INDEX
PAGE #
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Part I. Financial Information
---------------------
Item 1. Financial Statements:
Consolidated Balance Sheets - December 31, 2005 (Unaudited) and September 30,
2005......................................................................... 2
Consolidated Statements of Operations - Three Months Ended December 31, 2005
and 2004 (Unaudited)......................................................... 3
Condensed Consolidated Statements of Cash Flows - Three Months Ended December
31, 2005 and 2004 (Unaudited)................................................ 4
Consolidated Statements of Stockholders' Equity and Other Comprehensive
Income - Year Ended September 30, 2005 and Three Months Ended December 31,
2005 (Unaudited)............................................................. 5
Notes to the Consolidated Financial Statements (Unaudited)................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations .................................................................. 15
Item 3. Qualitative and Quantitative Disclosures About Market Risk................... 22
Item 4. Controls and Procedures...................................................... 22
Part II. Other Information
-----------------
Item 1. Legal Proceedings............................................................ 23
Item 1A. Risk Factors................................................................. 23
Item 6. Exhibits and Reports on 8-K.................................................. 23
Signature ....................................................................................... 24
-1-
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CASTLE ENERGY CORPORATION
CONSOLIDATED BALANCE SHEETS
("$000'S" OMITTED EXCEPT SHARE AMOUNTS)
DECEMBER 31, SEPTEMBER 30,
2005 2005
------------ -------------
(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents .................................................... $ 21,928 $ 27,759
Restricted cash .............................................................. 921 898
Accounts receivable .......................................................... 729 674
Marketable securities ........................................................ 20 23
Prepaid expenses and other current assets .................................... 202 252
Note receivable - Networked Energy LLC, net of allowance for doubtful account
of $125 ..................................................................
Investment in Networked Energy LLC, net of impaired reserve of $354 .......... 5
-------- --------
Total current assets ....................................................... 23,805 29,606
Property, plant and equipment, net:
Furniture, fixtures, equipment and vehicles .................................. 173 188
Oil and gas properties, net (full cost method):
Proved properties ............................................................ 8,531 8,564
Marketable securities ............................................................. 145,859 139,360
Investment in Delta Petroleum Corporation (equity method) ......................... 5
-------- --------
Total assets ................................................................ $178,368 $177,723
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Dividend payable ............................................................. $ 365 $ 361
Accounts payable ............................................................. 541 667
Accrued expenses ............................................................. 477 476
Litigation settlement payable on discontinued refining operations ............ 5,750
Asset retirement obligations ................................................. 4 3
-------- --------
Total current liabilities ................................................. 1,387 7,257
Asset retirement obligations ...................................................... 322 254
Deferred income taxes ............................................................. 41,297 39,422
Other liabilities ................................................................. 22 21
-------- --------
Total liabilities ......................................................... 43,028 46,954
-------- --------
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; 12,216,404
shares issued at December 31, 2005 and 12,126,404 shares issued
at September 30, 2005 ..................................................... 6,109 6,064
Additional paid-in capital ................................................... 89,358 88,500
Accumulated other comprehensive income, net of taxes ......................... 68,330 64,172
Retained earnings ............................................................ 38,210 38,700
-------- --------
202,007 197,436
Treasury stock at cost - 4,911,044 shares at December 31, 2005 and
September 30, 2005 ....................................................... (66,667) (66,667)
-------- --------
Total stockholders' equity ................................................ 135,340 130,769
-------- --------
Total liabilities and stockholders' equity ................................ $178,368 $177,723
======== ========
The accompanying notes are an integral part of these
consolidated financial statements
-2-
CASTLE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS)
(UNAUDITED)
THREE MONTHS ENDED DECEMBER 31,
-------------------------------
2005 2004
--------- ---------
Revenue:
Gas sales ............................................................. $ 926 $ 699
-------- ---------
926 699
-------- ---------
Expenses:
Gas production.......................................................... 142 95
General and administrative.............................................. 1,036 943
Depreciation, depletion and amortization................................ 110 129
-------- ---------
1,288 1,167
-------- ---------
Operating income (loss)...................................................... (362) (468)
-------- ---------
Other income (expense):
Interest income......................................................... 108 140
Other income............................................................ 35 9
Equity in income of Delta Petroleum Corporation......................... 842
-------- ---------
143 991
-------- ---------
Income (loss) before provision for (benefit of) income taxes................. (219) 523
-------- ---------
Provision for (benefit of) income taxes:
State (3) 5
Federal................................................................. (91) 175
-------- ---------
(94) 180
-------- ---------
Net income (loss)............................................................ ($ 125) $ 343
-------- ---------
Net income (loss) per share:
Basic................................................................... ($ .02) $ .05
========= =========
Diluted................................................................. ($ .02) $ .05
========= =========
Weighted average number of common and potential dilutive common shares
outstanding:
Basic................................................................ 7,262,340 6,892,389
========= =========
Diluted.............................................................. 7,262,340 7,114,870
========= =========
The accompanying notes are an integral part of these
consolidated financial statements
-3-
CASTLE ENERGY CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
("000'S" OMITTED)
(UNAUDITED)
THREE MONTHS ENDED DECEMBER 31,
------------------------------
2005 2004
------- -------
Cash flows from (used in) operating activities........................... ($ 6,003) ($ 575)
------- -------
Cash flows from investing activities:
Purchase of furniture, fixture, equipment and vehicles........... (85)
-------
Net cash provided by (used in) investing activities............ (85)
-------
Cash flows from financing activities:
Proceeds from exercise of stock options............................. 533 364
Dividends paid to stockholders...................................... (361) (343)
------- -------
Net cash provided by (used in) financing activities.............. 172 21
------- -------
Net increase (decrease) in cash and cash equivalents..................... (5,831) (639)
Cash and cash equivalents - beginning of period.......................... 27,759 33,742
------- -------
Cash and cash equivalents - end of period................................ $21,928 $33,103
======= =======
The accompanying notes are an integral part of these
consolidated financial statements
-4-
CASTLE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
AND OTHER COMPREHENSIVE INCOME
("$000'S" OMITTED EXCEPT PER SHARE AMOUNTS)
YEAR ENDED SEPTEMBER 30, 2005 AND THREE MONTHS ENDED DECEMBER 31, 2005 (UNAUDITED)
----------------------------------------------------------------------------------------
ACCUMULATED
OTHER
ADDI- COMPRE- COMPRE-
COMMON STOCK TIONAL HENSIVE HENSIVE TREASURY STOCK
----------------- PAID-IN INCOME INCOME RETAINED --------------------
SHARES AMOUNT CAPITAL (LOSS) (LOSS) EARNINGS SHARES AMOUNT TOTAL
------ ------ ------- ------- ------- --------- ------- ------- ------
Balance - October 1, 2005.............. 11,781,404 $5,891 $85,691 $ 170 $48,919 4,911,020 ($66,667) $ 74,004
Treasury stock surrendered............. 24
Options exercised...................... 345,000 173 1,812 1,985
Tax benefit of options exercised....... 677 677
Issuance of additional stock by Delta
Petroleum Corporation, net of $180 tax 320 320
Dividends declared ($1.20 per share)... (8,628) (8,628)
Comprehensive income (loss):
Net income (loss)..................... ($ 1,591) (1,591) (1,591)
Other comprehensive income (loss):
Equity in other comprehensive
income (loss) of Delta Petroleum (1,067) (1,067) (1,067)
Corporation, net of $600 tax benefit
Reversal of cumulative equity in
comprehensive income (loss) of Delta
as of April 1, 2005, net of $506 tax 900 900 900
Unrealized gain on marketable
securities, net of $35,811 tax ..... 64,169 64,169 64,169
---------- ------ ------- ------- ------- ------- --------- -------- --------
Total comprehensive income (loss)...... $62,411
=======
Balance - September 30, 2005........... 12,126,404 6,064 88,500 64,172 38,700 4,911,044 (66,667) 130,769
Options exercised...................... 90,000 45 488 533
Tax benefit of options exercised....... 370 370
Dividends declared ($.05 per share).... (365) (365)
Comprehensive income (loss):
Net income (loss).................... ($ 125) (125) (125)
Other comprehensive income (loss):
Unrealized gain on marketable
securities, net of $2,339 taxes ... 4,158 4,158 4,158
-------
Total comprehensive income (loss)...... $ 4,033
---------- ------ ------- ======= ------- ------- --------- -------- --------
Balance - December 31, 2005............ 12,216,404 $6,109 $89,358 $68,330 $38,210 4,911,044 ($66,667) $135,340
========== ====== ======= ======= ======= ========= ======== ========
The accompanying notes are an integral part of these
consolidated financial statements
-5-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED 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 ("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 accounting
principles generally accepted in the United States 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 period ended December 31, 2005
are not necessarily indicative of the results that may be expected for the
fiscal year ending September 30, 2006 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, 2005.
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 periods ended December 31, 2005 and 2004 and
for a fair statement of financial position at December 31, 2005.
Note 2 - September 30, 2005 Balance Sheet
- -----------------------------------------
The amounts presented in the balance sheet as of September 30, 2005
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, 2005.
Note 3 - Discontinued Operations
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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 ten years and are in the process of liquidation. As a
result, the Company accounted for its refining operations as discontinued
operations. Such discontinued refining operations did not impact the Company's
operations from October 1, 1995 through June 30, 2005.
In August 2002, Texaco Inc. and certain other subsidiaries of Chevron
Corporation (collectively "Chevron") sued the Company and two of its inactive
subsidiaries concerning environmental liabilities related to a refinery
previously owned by one of the Company's refining subsidiaries. In September
2005, the Company and its subsidiaries settled the lawsuit for $5,750, which the
Company paid on October 26, 2005. As a result of this settlement, the Company
recorded a loss from discontinued refining operations of $3,392, net of $1,505
of tax recoveries, in the fiscal year ended September 30, 2005.
Note 4 - Environmental Liabilities/Litigation
- ---------------------------------------------
ENVIRONMENTAL LIABILITIES/LITIGATION
Chevron Litigation
On September 20, 2005, the Company settled its long-standing litigation
with Chevron. In exchange for a payment of $5,750 the Company negotiated a
settlement agreement which provided mutual releases and a complete and
comprehensive indemnification by Texaco Inc. of the Company and related entities
and persons against losses or liabilities arising out of or related to the now
dismantled Indian Refinery and related properties.
-6-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AMOUNTS)
(UNAUDITED)
Chevron had filed the lawsuit against the Company and two of its
inactive subsidiaries in August 2002, seeking damages and declaratory relief
under contractual and statutory claims arising from environmental contamination
at the Indian Refinery. A now inactive subsidiary of the Company had operated
that refinery for approximately five years subsequent to approximately
seventy-five years of operation by Chevron. The lawsuit claimed that the Company
was 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 had incurred or might incur as a result of environmental
contamination at and around the Indian Refinery, even if that environmental
contamination had been caused by Chevron. The suit also sought costs, damages
and declaratory relief against the Company under the Federal Comprehensive
Environmental Response Compensation Liability Act ("CERCLA"), the Oil Pollution
Act of 1990 ("OPA") and the Solid Waste Disposal Act, as amended, ("RCRA").
Chevron had also tendered to the Company the defense of certain third party
claims against Chevron in Illinois state court. The Company disputed and
contested the claims made by Chevron and denied all liability.
All claims in this litigation, as well as any other claims tendered by
Chevron, have been resolved by the settlement and the litigation was dismissed
with prejudice on October 12, 2005. At September 30, 2005, the Company accrued
the $5,750 settlement which it paid on October 26, 2005.
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 on
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.
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.
-7-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AMOUNTS)
(UNAUDITED)
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. The supersedeas bond posted by the Company was
released, along with a $4,110 letter of credit, including accrued interest, that
secured the bond. 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. 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. The Company filed a Petition for Writ of Mandamus
with the Court of Appeals 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 Mandamus 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 judgment against it plus interest
without delay.
The Company estimates the judgment to be $1,067, including accrued
interest, as of December 31, 2005. The Company has not accrued any recoveries
for this litigation as of December 31, 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
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 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
-8-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AMOUNTS)
(UNAUDITED)
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 suspended revenue is realized (collected), but no
expense if it fails in this litigation.
Christiansen Litigation
CTOGLP, along with Delta and several unrelated parties, has also filed
suit to collect production proceeds from an additional well on the Simpson lease
in which CTOGLP had a 5.325% ORRI suspended by the operator because of title
disputes. At the present time, the amount held in escrow applicable to the
additional well attributable to the Company's interest is approximately $44. The
Company has not recorded any of the net $44 of suspended revenue as income, but
will record it as income when and if it is realized (collected). There is no
claim or contingent liability against the Company or its subsidiaries in this
matter, just a contingent gain if CTOGLP were to prevail.
On December 21, 2005, the district court granted a motion for summary
judgment in this case, which denied CTOGLP's claim. The Company is currently
consulting with its co-plaintiffs in this litigation to assess a possible appeal
of this adverse judgement.
Dominion Litigation
On March 18, 2002, Dominion, operator of the Mitchell and Migl-Mitchell
wells in the Southwest Speaks field in south Texas 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
also sought 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.
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 which the Company appealed both of
the District Court's summary judgments to 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. Dominion petitioned the Supreme Court of Texas for review of this
decision. The Texas Supreme Court has requested legal briefs from both sides but
has not granted Dominion's petition. The promissory note issued by CTOGLP will
be cancelled and the restricted cash account of CTOGLP released when and if the
Court of Appeals judgment against Dominion becomes final and non-appealable.
-9-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AMOUNTS)
(UNAUDITED)
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's motions for summary judgment in May 2004. The Company reversed
that provision plus $20 of accrued interest on the contingent note during fiscal
2005 primarily because the Court of Appeals reversed that District Court
judgment 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 judgment becomes non-appealable. If the Supreme
Court grants Dominion petition and 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
- --------------------------------------
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) became effective for the Company beginning October 1, 2005. SFAS
No. 123(R) has not had any impact on the Company's operations or net income
(loss) to date and the Company does not expect SFAS No. 123(R) to have any
impact on its future results of operations or net income (loss) since the
Company has not issued any stock options since January 2002 and all stock
options issued were vested by July 31, 2002. In addition, at December 31, 2005
no options were outstanding and the Company does not anticipate issuing stock
options in the future.
In May 2005, the FASB issued SFAS No. 154 Accounting Changes and Error
Corrections - a Replacement of APB Opinion No. 20 and FASB Statement No. 3
("SFAS 154"). SFAS 154 requires retrospective application to prior periods'
financial statements for changes in accounting principle, unless it is
impracticable to determine either the period-specific effects or the cumulative
effect of the change. SFAS 154 also requires that a change in depreciation,
amortization, or depletion method for long-lived, non-financial assets be
accounted for as a change in accounting estimate affected by a change in
accounting principle. SFAS 154 is effective for accounting changes and
corrections of errors made in fiscal years beginning after December 15, 2005.
The implementation of FAS 154 is not expected to have a material impact on the
Company's consolidated results of operations, financial position or cash flows.
In March 2005, the FASB issued FASB Interpretation 47 ("FIN 47"), an
interpretation of SFAS No. 143, "Accounting for Asset Retirement Obligations"
("SFAS No. 143"). FIN 47 clarifies the term "conditional asset retirement
obligation" as it is used in SFAS No. 143. The Company applied the guidance of
FIN 47 commencing October 1, 2005 and recorded an increase in asset retirement
obligations of $64 effective October 1, 2005. The offsetting entry was to oil
and gas properties.
-10-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AMOUNTS)
(UNAUDITED)
Note 6 - Restricted Cash
- -------------------------
Restricted cash consists of the following:
DECEMBER 31, 2005 SEPTEMBER 30, 2005
----------------- ------------------
(UNAUDITED)
Certificate of deposit supporting operating bonds..... $110 $110
Deposit securing contingent promissory note in
Dominion litigation............................... 788 788
Other................................................. 23
---- ----
$921 $898
==== ====
The certificates of deposit support letters of credit for operating and
drilling bonds provided to state or county regulatory agencies.
The deposit securing the contingent promissory note in the Dominion
litigation is payable only if there is a final judgment against the Company.
(See Note 4)
Note 7 - Marketable Securities
- ------------------------------
The Company's investment in marketable securities was as follows:
DECEMBER 31, 2005 SEPTEMBER 30, 2005
------------------------- -----------------------------
DELTA DELTA
PETROLEUM PETROLEUM
CHEVRON CORPORATION CHEVRON CORPORATION
----------- ------------ --------- -------------
Common shares owned........................... 354 6,700,000 354 6,700,000
===== =========== === ==========
Cost.......................................... $ 15 $ 39,892 $15 $ 39,892
Unrealized gain (loss)........................ 5 105,967 8 99,468
----- ----------- --- ----------
Book (market) value........................... $ 20 $ 145,859 $23 $ 139,360
===== =========== === ==========
Through March 31, 2005, the Company accounted for its investment in
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 9)
-11-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AMOUNTS)
(UNAUDITED)
Note 8 - Asset Retirement Obligations
- -------------------------------------
Changes in the Company's asset retirement obligations are as follows:
THREE MONTHS ENDED DECEMBER 31,
-------------------------------
2005 2004
---- ----
Balance - beginning of period........................................ $257 $230
Adjustments.......................................................... 64 10
Accretion of discount................................................ 5 4
---- ----
Balance - end of period.............................................. $326 $244
==== ====
Note 9 - 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 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, 2005, the Company owned 6,700,000 shares representing
approximately 14% of Delta. At December 31, 2005, the closing market price of
Delta's common stock was $21.77 per share.
See Notes 7 and 12 and "Critical Accounting Policies."
Note 10 - Comprehensive Income (Loss):
- --------------------------------------
Comprehensive income (loss) is as follows:
THREE MONTHS ENDED DECEMBER 31,
-------------------------------
2005 2004
---- ----
Net income (loss)................................................. ($ 125) $343
Equity in other comprehensive income (loss) of Delta, net of
taxes .......................................................... 118
Unrealized gain (loss) on marketable securities, net of tax....... 4,158
------ ----
$4,033 $461
====== ====
-12-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AMOUNTS)
(UNAUDITED)
Note 11 - Contingent Gain
- -------------------------
GAMXX
On February 27, 1998, the Company entered into an agreement with
Alexander Allen, Inc. ("AA") concerning amounts owed to the Company by AA and
its subsidiary, GAMXX Energy, Inc. ("GAMXX"). The Company had made loans to
GAMXX through 1991 in the aggregate amount of approximately $8,000 and received
a $24,000 mortgage on the GAMXX property, an idle refining plant in Theodore,
Alabama. When GAMXX was unable to obtain financing, the Company recorded a one
hundred percent loss provision on its loans to GAMXX in 1991 and 1992 while
still retaining its lender's lien against GAMXX. The Company subsequently filed
and currently maintains a $10,000 lien on the GAMXX properties.
In September 2005, the Company entered into an agreement to sell its
lender's interest in GAMXX to an outside party for $3,500 in January 2006. The
agreement provided that the purchaser is responsible for unpaid property taxes
(approximately $1,000 at September 30, 2005) on the property as well as for any
environmental remediation that is required. The purchaser made a non-refundable
deposit of $10 upon executing the agreement. In January of 2006 the outside
party failed to fund the purchase and the agreement expired and the Company did
not elect to extend it.
In September 2005, another third party purchased the tax lien on the
property by paying the unpaid property taxes of $1,000. As a result, the Company
or any purchaser of its interest has a year from the date of the purchase of the
tax lien to redeem the tax lien by paying the tax lien purchaser $1,000 plus
interest. If the tax lien is not redeemed in that one-year period, the property
will be owned by the purchaser of the tax lien and the Company's mortgage and
lien on the property will be terminated. The Company continues to market its
lender's interests in GAMXX.
The Company has carried its loans to GAMXX at zero for the last ten
years. The Company will record any proceeds as "other income" if and when it
collects such amount.
Note 12 - Merger Into Delta
- ---------------------------
On November 8, 2005, the Company entered into a merger agreement (the
"Merger Agreement") with Delta. Delta Petroleum Corporation, a newly-formed
Delaware corporation and a wholly-owned subsidiary of Delta ("Delta-Delaware"
and collectively, with Delta "Delta") and DPCA LLC, a Delaware limited liability
company and a newly formed wholly-owned subsidiary of Delta ("DPCA").
Pursuant to the Merger Agreement, the Company will merge with and into
DPCA with DPCA as the surviving company and the Company's stockholders will
receive approximately 1.164 shares of Delta's common stock for each of their
shares of the Company's common stock (or a total of 8,500,000 shares of Delta
common stock in the aggregate) (the "Merger"). In the Merger, the 6,700,000
shares of Delta common stock currently owned by the Company will be cancelled.
The Merger is designed to be a tax-free exchange for stockholders of both Delta
and the Company. The boards of directors of the Company and Delta have approved
the Merger.
-13-
CASTLE ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
("$000'S" OMITTED EXCEPT SHARE AMOUNTS)
(UNAUDITED)
The closing of the Merger is subject to approval of the Merger
Agreement by the holders of a majority of the shares of the Company's
outstanding common stock, review of the related prospectus by regulatory
agencies, receipt of legal opinions and other customary closing conditions set
forth in the Merger Agreement.
The Merger Agreement contains certain termination rights for both Delta
and the Company, and further provides that, upon termination of the Merger
Agreement under specified circumstances, either party may be required to pay the
other a termination fee of $5,000 or reimburse the other party up to $1,000 in
fees and expenses actually incurred relating to the transaction contemplated by
the Merger Agreement. If the Merger is not completed by March 31, 2006, due to
the fault of neither the Company nor Delta, either party can terminate the
Merger without penalty.
Concurrently with the execution of the Merger Agreement and in order to
induce Delta to enter into the Merger Agreement, certain of the Company's
officers and all of its directors and the estate and family of the Company's
founder and former Chief Executive Officer, Joseph L. Castle II, have entered
into voting agreements with Delta pursuant to which they agreed, among other
things, to vote all shares of the Company's common stock held by them in favor
of the adoption of the Merger Agreement and the other transactions contemplated
by the Merger Agreement.
The Company's proxy concerning the Merger is currently being reviewed by the
SEC. As soon as that review is completed, the Company expects to set a meeting
date for a special meeting of its shareholders to vote on the Merger.
Note 13 - Subsequent Events
---------------------------
On February 6, 2006, the Company entered into a purchase and sale
agreement with Networked Energy LLC ("Network"). Pursuant to the terms of that
agreement, the Company sold its 45% membership interest in Network to other
holders of Network membership units and other Network officers for $5, which was
paid to the Company on February 6, 2006. In addition, Network agreed to
modifications in the terms of the $125 note owed to the Company by Network. As a
result of these modifications, the Company agreed to extend the due date of its
note five years until February 6, 2011 and Network and its membership unit
holders and officers agreed to dedicate certain cash flows to payment of that
note. The Company has classified its investment in Network as current at
December 31, 2005.
-14-
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
("$000'S" OMITTED EXCEPT 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.
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 ten 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 did not impact the Company's
operations from October 1, 1995 through June 30, 2005.
In August 2002, Chevron sued the Company and two of its inactive
subsidiaries concerning environmental liabilities related to a refinery
previously owned by one of the Company's inactive refining subsidiaries. In
September 2005, the Company and its subsidiaries settled the lawsuit for $5,750,
which the Company paid on October 26, 2005. As a result of this settlement, the
Company recorded a loss from discontinued refining operations of $3,392, net of
$1,505 of tax recoveries, in the fiscal year ended September 30, 2005. (See Note
4)
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.
Gas sales increased $227 or approximately 32.5% from the quarter ended
December 31, 2004 to the quarter ended December 31, 2005. The increase was
primarily attributable to a significant increase in the price the Company
received for its production. For the quarter ended December 31, 2005, the
Company received an average price of $11.63 per thousand cubic feet of natural
gas versus only $6.48 per thousand cubic feet of natural gas for the quarter
ended December 31, 2004. Production during the quarter ended December 31, 2005
decreased approximately 26.2% from that during the quarter ended December 31,
2004 because of temporary compressor shut downs and other production problems.
Gas production expenses increased $47 or approximately 49.5% from the
quarter ended December 31, 2004 to the quarter ended December 31, 2005. The
increase was caused by well repair and maintenance costs incurred during the
quarter ended December 31, 2005. Such expenses do not generally occur evenly
throughout a given fiscal period and are best compared on an annual basis.
-15-
Depreciation, depletion and amortization expense decreased $19 or
approximately 14.7% from the quarter ended December 31, 2004 to the quarter
ended December 31, 2005 primarily as a result of a decrease in the production of
natural gas during the periods being compared and also as a result of a slightly
lower depletion rate per thousand cubic feet of natural gas produced during the
quarter ended December 31, 2005.
General and administrative costs increased $93 or approximately 9.9%
from the quarter ended December 31, 2004 to the quarter ended December 31, 2005.
The increase was caused primarily by increased compensation costs and
non-recurring expenses related to the merger with Delta.
Interest income decreased $32 or approximately 22.9% from the quarter
ended December 31, 2004 to the quarter ended December 31, 2005 primarily because
the Company's excess cash decreased. This decrease was caused, to a large
extent, by the payment of $5,750 to Chevron in October 2005 (see Note 4).
The Company's equity in Delta's net income decreased from $842 for the
quarter ended December 31, 2004 to zero in the quarter ended December 31, 2005.
The decrease resulted because the Company commenced accounting for its
investment in Delta as a marketable available-for-sale security on April 1,
2005, whereas it had previously accounted for that investment using the equity
method and accordingly recorded its proportionate share of Delta's income.
The $94 tax recovery for the quarter ended December 31, 2005 resulted
primarily from the tax effect of the Company's tax loss during this quarter,
offset by the tax benefit related to options exercised during the period. The
entire tax recovery for the three months ended December 31, 2005 represents
deferred income taxes - not income taxes currently payable.
The $180 tax provision for the quarter ended December 31, 2004
represented 34% of pre-tax income and approximated the Company's blended
(Federal and state combined) tax rate of 35%. The entire tax provision for the
three months ended December 31, 2004 represents deferred income taxes - not
income taxes currently payable.
LIQUIDITY AND CAPITAL RESOURCES
During the three months ended December 31, 2005, the Company used
$6,003 in operating activities. During the same period the Company paid $361 for
dividends to stockholders. At December 31, 2005, the Company had $21,928 of
unrestricted cash, $22,418 of working capital and no long-term debt.
As previously reported, the Company entered into the Merger Agreement
with Delta on November 8, 2005. Pursuant to that agreement, the Company is to
merge into a subsidiary of Delta. The Company is currently involved in clearing
its proxy for this merger with the SEC. Closing is expected in late-March 2006,
but that date could be delayed or accelerated by regulatory approvals and other
factors beyond the Company's control. If the Company or Delta terminates the
planned Merger, it is likely that the Company will liquidate although it may
continue to operate. Accordingly, the discussion below addresses all three
alternatives: completion of the Merger into Delta, liquidation and continuing to
operate.
Merger into Delta
-----------------
Pursuant to the Merger Agreement, the Company would merge into a subsidiary
of Delta, all of the Company's outstanding shares of common stock would be
cancelled and the Company's stockholders would receive 8,500,000 shares of Delta
or approximately 1.164 shares of Delta for each share of the Company's
outstanding common stock. As part of the Merger, Delta would also reacquire the
-16-
6,700,000 shares of Delta's stock the Company currently owns, resulting in a net
issuance of 1,800,000 shares by Delta.
The risks that the Merger will not be consummated include but are not
limited to the following:
a. The stockholders of the Company do not approve the Merger (approval
of Delta's stockholders is not required).
b. Regulatory reviews or other factors will delay the Merger past
April 1, 2006, in which case either party can terminate the Merger
without penalty or prevent the Merger from being consummated. The
Company and Delta submitted a draft proxy to the SEC on December
22, 2005 and are currently involved in answering the SEC's
questions/requests concerning that draft proxy.
c. The requisite legal opinions and regulatory approvals will
ultimately not be received.
d. Either the Company or Delta unintentionally or intentionally does
not consummate the Merger despite penalty provisions of up $1,000
and $5,000, respectively, in such cases.
Although the Company would consider termination if Delta's stock price
were to decline precipitously before closing despite the $5,000 penalty, the
Company may nevertheless decide to complete the transaction under such
circumstances for two primary reasons. First, approximately 81% of the Company's
asset value is currently in the 6,700,000 shares of Delta stock that the Company
already holds and thus the Company is already a significant investor in Delta to
the extent of those 6,700,000 shares. Furthermore, pursuant to the Merger
Agreement, the Company has agreed not to dispose of these shares before the
Merger is consummated or the Merger is terminated. Second, by effecting the
Merger, the Company will avoid income taxes on the unrealized gain on its
6,700,000 Delta shares. At December 31, 2005, such gain would have been
approximately $127,400 and the related income taxes approximately $44,600
(before offset by approximately $3,300 related to tax carryforwards).
Nevertheless, if the Company's directors believe that Delta's stock price will
decline significantly in the future and remain depressed, they may elect to
terminate the Merger, pay the required penalty and sell or distribute Delta's
stock to the Company's stockholders after paying the related income taxes on
such sale or distribution. Since Delta's stock price has increased from
approximately $18.00/share at the time the Merger Agreement was entered into to
approximately $20.50 per share currently, it appears unlikely at the present
time that the Company's directors will terminate the Merger because of a decline
in Delta's stock price.
Even if the Company intends to complete the Merger, it is possible that
Delta may elect to terminate the Merger despite the penalty provisions. Whether
the Merger is terminated by the Company or Delta, the Company would have to
decide whether to liquidate or continue to operate if such were the case.
If the Merger is completed, the future risk factors applicable to the
Company's stockholders become primarily those concerning Delta - not those
concerning the Company, whose separate corporate existence would cease upon
merging into a subsidiary of Delta. The risk factors concerning Delta's
operations and stock are described in Delta's Form 10-K for the year ended June
30, 2005. Such factors include but are not limited to changes in oil and gas
prices, drilling and exploration and production risks, Delta's ability to
finance its planned drilling activities, Delta's compliance with its debt
covenants, severe weather threats to Delta's production in the Gulf Coast region
of the United States, Delta's policy of paying no dividends on its common stock
and other factors. These risk factors are discussed in greater detail in the
proxy statement/prospectus that will be sent to the Company's stockholders in
connection with their consideration of the proposed Merger.
-17-
If the Merger is completed as anticipated, the Company's stockholders
will own stock in a company whose assets and liabilities consist of Delta's
assets and liabilities and the Company's assets and liabilities excluding the
6,700,000 Delta shares owned by the Company prior to the Merger. As a result,
the price of the Delta shares to be owned by the Company's stockholders will
depend to a large degree upon the subsequent operations of Delta and the factors
noted above concerning Delta. Since the Company's non-cash assets, which Delta
will receive under the Merger Agreement, are immaterial compared to Delta's
assets, the performance and value of the Company's non-cash assets (oil and gas
properties and investment in GAMXX) are not expected to have a material effect
on Delta's performance after the Merger. If Delta's post-Merger stock price
declines, such decline will affect the value received by the Company's
stockholders. Although Delta's average trading volume is currently in excess of
700,000 shares daily versus only approximately 40,000 average shares daily for
the Company's stock, Delta's stock price could decline after the Merger if a
large number of the Company's stockholders or Delta stockholders attempt to sell
their shares shortly after the Merger thus depressing the demand for the stock.
Liquidation
-----------
If the Merger is not completed as planned it is probable that the
Company would liquidate given its small market capitalization, limited operating
assets, the increased cost to acquire additional operating assets in the current
environment and the ever-increasing regulatory and other costs of remaining a
public company.
If a decision is made to liquidate, the Company anticipates that it
would distribute some cash and/or Delta shares to its stockholders in complete
liquidation of their stock as soon as possible while retaining sufficient assets
to reasonably provide for existing and anticipated future liabilities, including
those related to the current litigation. Such provision would include sufficient
assets to provide a reasonable reserve for the Company's current litigation in
the event the Company were to receive adverse judgments. If any net assets
remain after the Company pays or provides for such remaining liabilities, the
net proceeds of such assets would then be distributed to stockholders as a final
distribution. The Company would probably also file a no action letter with the
SEC seeking relief from continuing SEC reporting requirements during the winding
down of its business. 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 and costs associated with such a liquidation scenario are as
follows:
a. Litigation - As noted above, the Company remains a defendant in two
unsettled lawsuits. Although the Company does not believe it has any
material liabilities with respect to either of these lawsuits and
expects to receive a recovery in the Long Trusts' litigation (see
Note 4 to this Form 10-Q), any or several of the plaintiffs in these
lawsuits could undertake legal actions to delay such litigation or
to prevent the Company from making liquidating distributions to its
stockholders and/or delay resolution of related litigation. 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 such distributions. In
addition, even if the Company's stockholders approve any future plan
of liquidation, dissident stockholders of the Company could
conceivably also take legal actions to prevent the Company from
implementing any liquidation plan.
b. Tax Risks - The Company currently owns 6,700,000 shares of Delta.
The Company's tax basis in such Delta shares is approximately
$18,500. Such Delta shares constitute the Company's largest asset.
If the Company sells its Delta stock or distributes the Delta stock
to its stockholders in liquidation or as a special dividend, the
Company will incur a tax liability equal to approximately 35% of the
difference between the Company's tax basis and the fair market value
of the 6,700,000 Delta shares on the date of distribution. (At
December 31, 2005, such fair market value was $145,859.) The tax
treatment would be the same as if the Company had sold its Delta
shares for their fair market value and then distributed the proceeds
to it stockholders.
-18-
At December 31, 2005, the Company's unrealized appreciation on its
Delta stock was approximately $127,400 and the related tax liability
approximately $44,600 (before offset by approximately $3,300 related
to tax carryforwards). Any such tax income tax liability would
significantly reduce distributions available to stockholders.
Furthermore, if Delta's stock price increases further, income taxes
payable by the Company upon distribution of Delta stock would also
increase.
c. 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 continue incurring
the costs of being a public company while having fewer or no
operating revenues to absorb such costs. Such costs are significant
and probably will increase in the future given the myriad of
post-Enron regulatory requirements that are currently being
mandated. The result would be a diminution of assets available for
distribution to stockholders. For example, commencing September 30,
2006, the Company would face internal control attestation
requirements and the costs to comply with such requirements could
easily exceed $500 initially.
d. Lack of Liquidity - If the Company's directors decide to liquidate
and the related plan of liquidation is approved by the Company's
stockholders, it is likely that the Company's stock would cease to
trade in the Nasdaq National Market after the plan of liquidation is
approved. In such case, the market for the Company's stock would be
very limited. Stockholders who have used their Company stock as
collateral for margin loans would probably be required to provide
other collateral to support such loans. Even if the Company is able
to distribute Delta stock as part of its initial distribution to
stockholders without any legal challenges or other delays, there
could be a delay between the date the Company's stock is delisted
and the date when the Company's stockholders receive Delta shares
that could be substituted as collateral for a margin loan.
Stockholders would presumably have to provide other collateral in
the interim.
e. Liquidation of Assets - The Company's primary remaining assets
consist of cash and cash equivalents and the Company's investment in
Delta (6,700,000 shares). The Company also owns a lender's interest
in GAMXX. Although the value of the Company's gas properties
increased in November and December 2005, as the price of natural gas
increased, the value of such properties has recently decreased due
to significant recent decreases in natural gas prices. Such prices
have been extremely volatile in the last 3-4 years and the value of
the Company's gas properties can be expected to change as natural
gas prices and forecasted natural gas prices change. Moreover, as
noted above, Delta's stock has been highly volatile, fluctuating
from $8.99 per share to over $24.00 per share during the last year.
The amount realized on any sale of the Company's Delta stock would
be largely determined by the price of Delta's stock at the time of
any sale. Increases or decreases in the price of Delta's stock at
the time of sale or distribution to stockholders would, however, be
partially offset by increases or decreases in any resulting income
tax liability to the Company.
f. Legal Uncertainties in Litigation - There is little case law and
precedent under applicable Delaware statutes concerning liquidation
of a public company such as the Company. Several years may be
required to liquidate and application of governing laws may be
uncertain.
Continuing to Operate
---------------------
If the Company does not merge with Delta or liquidate but instead
continues to operate, it would be subject to oil and gas price risks, drilling
risks, production risks, litigation risks, insurance coverage risks and other
general risks inherent in the oil and gas business. In addition, the Company
would continue to be exposed to the continuing public company administrative and
regulatory burden. At the present time, the Company estimates its annual public
company administrative costs to be $600-$800. When the Company becomes subject
to internal control attestation requirements (currently expected to be September
30, 2006), such annual public company costs are expected to increase
significantly. In addition, the Company faces risks related to its experienced
employees. If one or more of its key employees departs, the Company believes it
-19-
would be extremely difficult to replace such employees since most experienced
oil and gas employees reside in areas where the oil and gas industry is
concentrated - not in the Philadelphia area where the Company has most of its
offices. Finally, the Company's existing gas operations are minuscule compared
to those of its competitors yet the Company incurs substantial fixed costs to
provide the requisite legal, accounting and production systems to operate and
account for its production and to comply with public company reporting
requirements. If the Company continues to operate, it would be faced with the
prospect of acquiring more oil and gas assets to support its fixed overhead at a
time when the prices being paid for oil and gas properties are high, making such
investment more risky than previously. Under such circumstances the Company may
find it impossible to make the acquisitions it needs to rationalize its fixed
operating and public company costs. In addition to the foregoing, if the Company
continued to operate it would face risks related to the lack of liquidity for
its stockholders (see above discussion under "Liquidation").
At the present time, the Company's anticipated future cash expenditures
are primarily recurring general and administrative costs, including legal costs
(see Note 4 this Form 10-Q), recurring dividends and lease operating costs
related to the Company's gas properties. In addition, the Company would 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 gas operations, the Company could fund such expenditures using its
available cash. If the Company were to make another substantial acquisition at a
price in excess of its current cash and other excess 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 would be subject to the following
risks:
a. Litigation - As noted above, the Company is still a defendant in two
significant unsettled lawsuits. Although the Company does not
believe it has any material 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
could cause the Company to incur significant legal costs.
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, 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 have then significantly decreased in early 2006 and could
either increase or decrease by similar percentages 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 per mcf
sold. The Company paid for its gas reserve acquisitions using such
pricing. If natural gas prices increase or decrease in the future,
the increases or decreases 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's quarterly or 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 by operating approximately 130 gas wells - including the
risk of gas leaks, resulting environmental damage, third party
liability claims related to operations, including those in excess of
the Company's liability insurance coverage and including claims by
landowners where the operated wells are located, as well as other
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. This volatility may adversely
affect the market price and liquidity of the Company's common stock.
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CRITICAL ACCOUNTING POLICIES:
The accounting policies critical to the Company are as follows:
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 December 31, 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.
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 Note 9). 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.
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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. 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 December 31, 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 December 31, 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 significant changes in the Company's internal controls
during the quarter ended December 31, 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.
Effective September 30, 2006, the Company expects that it will be subject
to certain attestation requirements concerning the effectiveness of its internal
controls pursuant to Section 404 of the Sarbanes Oxley Act. 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.
Although the Company has worked diligently to comply with these
requirements, the Company has only ten 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.
If the Company completes its Merger with Delta as planned, the Company
will not become subject to these internal control attestation requirements.
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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, 2005. Also see Note 4 to the December 31, 2005 consolidated financial
statements included in Part I of this Form 10-Q.
ITEM 1A. RISK FACTORS
See "Liquidation and Capital Resources" above.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) 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)
(B) Reports on Form 8-K Report dated November 3, 2005 concerning
expiration of Registrant's preferred stock
purchase right plan
Report dated November 8, 2005 concerning
planned Merger into subsidiary of Delta
Petroleum Corporation
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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: February 10, 2006 CASTLE ENERGY CORPORATION
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/s/Richard E. Staedtler
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Richard E. Staedtler
Chief Executive Officer
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