UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-Q
[x] Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended September 30, 2001
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the transition period from _______ to ________
Commission File No. 1-16295
ENCORE ACQUISITION COMPANY
(Exact name of registrant as specified in its charter)
Delaware 75-2759650
------------------------------- -----------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
777 Main Street, Suite 1400, Ft. Worth, Texas 76102
--------------------------------------------------------------------
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: (817) 877-9955
Not applicable
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [x] No [ ]
<Table>
Number of shares of Common Stock outstanding as
of November 1, 2001.............................................30,029,961
</Table>
ENCORE ACQUISITION COMPANY
INDEX
PART I. FINANCIAL INFORMATION
<Table>
<Caption>
Page
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2001 and
December 31, 2000............................................ 3
Consolidated Statements of Operations for the three and
nine months ended September 30, 2001 and 2000................ 4
Consolidated Statements of Stockholders' Equity for the nine
months ended September 30, 2001.............................. 5
Consolidated Statements of Cash Flows for the nine
months ended September 30, 2001 and 2000..................... 6
Notes to Consolidated Financial Statements...................... 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............................. 12
Item 3. Quantitative and Qualitative Disclosure about Market
Risk............................................................ 16
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K.......................... 17
Signatures........................................................ 18
</Table>
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ENCORE ACQUISITION COMPANY
CONSOLIDATED BALANCE SHEETS
(in thousands except per share data)
<Table>
<Caption>
SEPTEMBER 30, DECEMBER 31,
2001 2000
----------- -----------
(unaudited)
ASSETS
Current Assets:
Cash and cash equivalents ......................................... $ 155 $ 876
Accounts receivable ............................................... 19,067 21,210
Other current assets .............................................. 11,646 4,171
----------- -----------
Total Current Assets ....................................... 30,868 26,257
----------- -----------
Properties and Equipment, at cost -- successful efforts method:
Producing properties .............................................. 397,230 333,892
Undeveloped properties ............................................ 864 624
Accumulated depletion, depreciation, and amortization ............. (49,909) (26,868)
----------- -----------
348,185 307,648
----------- -----------
Other property and equipment ...................................... 2,793 1,910
Accumulated depletion, depreciation, and amortization ............. (1,066) (621)
----------- -----------
1,727 1,289
----------- -----------
Other Assets ........................................................ 5,727 8,562
----------- -----------
Total Assets ............................................... $ 386,507 $ 343,756
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable .................................................. $ 7,855 $ 8,840
Current portion of note payable ................................... 4,594 16,438
Other current liabilities ......................................... 21,923 16,254
----------- -----------
Total Current Liabilities .................................. 34,372 41,532
----------- -----------
Long-term debt ...................................................... 64,000 144,500
Note payable ........................................................ -- 1,107
Other liabilities ................................................... 24,743 8,806
----------- -----------
Total Liabilities .......................................... 123,115 195,945
----------- -----------
Commitments and Contingencies ....................................... -- --
Stockholders' Equity:
Preferred stock, $.01 par value, 5,000,000 shares authorized,
none issued and outstanding ..................................... -- --
Class A common stock, $.01 par value, 75,000 shares
authorized, none and 73,725 issued and outstanding............... -- 1
Class B common stock, $.01 par value, 300,000 shares
authorized, none and 294,901 issued and outstanding.............. -- 3
Common stock, $.01 par value, 50,000,000 shares authorized,
30,029,961 and none issued and outstanding ...................... 300 --
Additional paid-in capital ........................................ 248,786 147,968
Notes receivable -- officers and employees ........................ -- (21)
Retained earnings (deficit) ....................................... 15,667 (140)
Accumulated other comprehensive income ............................ (1,361) --
----------- -----------
Total Stockholders' Equity ................................. 263,392 147,811
----------- -----------
Total Liabilities and Stockholders' Equity ................. $ 386,507 $ 343,756
=========== ===========
</Table>
The accompanying notes are an integral part of these consolidated financial
statements.
3
ENCORE ACQUISITION COMPANY
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands except per share data)
(unaudited)
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------- --------------------------
2001 2000 2001 2000
----------- ----------- ----------- -----------
Revenues:
Oil ....................................................... $ 28,034 $ 25,654 $ 81,916 $ 65,345
Natural gas ............................................... 6,505 5,437 23,452 9,566
----------- ----------- ----------- -----------
Total revenues .............................................. 34,539 31,091 105,368 74,911
Expenses:
Production --
Direct lifting costs ................................... 6,323 4,443 18,744 12,373
Production, ad valorem, and severance taxes ............ 3,496 4,066 11,406 10,675
General and administrative (excluding non-cash stock
based compensation) .................................... 1,282 932 3,804 3,045
Non-cash stock based compensation ......................... -- 11,931 9,587 24,959
Depreciation, depletion, and amortization ................. 8,107 6,419 23,495 14,856
Derivative fair value loss ................................ 257 -- 396 --
Other operating expenses .................................. 419 -- 419 --
----------- ----------- ----------- -----------
Total expenses .............................................. 19,884 27,791 67,851 65,908
----------- ----------- ----------- -----------
Operating income ............................................ 14,655 3,300 37,517 9,003
----------- ----------- ----------- -----------
Other income (expenses):
Interest .................................................. (1,152) (2,874) (4,865) (7,358)
Other ..................................................... 83 99 144 416
----------- ----------- ----------- -----------
Total other income (expenses) ............................... (1,069) (2,775) (4,721) (6,942)
----------- ----------- ----------- -----------
Income (loss) before income taxes ........................... 13,586 525 32,796 2,061
Provision for income taxes - Current ........................ (537) (1,999) (1,741) (4,535)
Provision for income taxes - Deferred ....................... (4,626) (2,594) (14,364) (5,883)
----------- ----------- ----------- -----------
Income (loss) before accounting change ...................... 8,423 (4,068) 16,691 (8,357)
Cumulative effect of accounting change (net of income
taxes of $541) ............................................ -- -- (884) --
----------- ----------- ----------- -----------
Net income (loss) ........................................... $ 8,423 $ (4,068) $ 15,807 $ (8,357)
=========== =========== =========== ===========
Income (loss) per common share before accounting change:
Basic ..................................................... $ 0.28 $ (0.18) $ 0.59 $ (0.37)
Diluted ................................................... 0.28 (0.18) 0.59 (0.37)
Income (loss) per common share after accounting change:
Basic ..................................................... $ 0.28 $ (0.18) $ 0.56 $ (0.37)
Diluted ................................................... 0.28 (0.18) 0.56 (0.37)
Weighted average common shares outstanding:
Basic ..................................................... 30,030 22,836 28,275 22,781
Diluted ................................................... 30,030 22,836 28,277 22,781
</Table>
The accompanying notes are an integral part of these consolidated financial
statements.
4
ENCORE ACQUISITION COMPANY
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
SEPTEMBER 30, 2001
(in thousands)
(unaudited)
<Table>
<Caption>
NOTES ACCUMULATED
RETAINED CLASS A CLASS B RECEIVABLE OTHER
EARNINGS COMMON COMMON COMMON PAID-IN OFFICERS/ COMPREHENSIVE STOCKHOLDERS'
(DEFICIT) STOCK STOCK STOCK CAPITAL EMPLOYEES INCOME EQUITY
--------- --------- --------- --------- --------- --------- ------------ -------------
BALANCE AT DECEMBER 31,
2000 ................................ $ (140) $ 1 $ 3 $ -- $ 147,968 $ (21) $ -- $ 147,811
Proceeds from initial public
offering (net of offering costs
of $1,568) .......................... -- -- -- 71 91,456 -- -- 91,527
Non-cash stock based compensation ..... -- -- -- -- 9,587 -- -- 9,587
Recapitalization ...................... -- (1) (3) 229 (225) -- -- --
Repayment of notes receivable ......... -- -- -- -- -- 21 -- 21
Components of comprehensive income:
Net income ......................... 15,807 -- -- -- -- -- -- 15,807
Change in deferred hedge loss
(net of income taxes of $8,286) .. -- -- -- -- -- -- 13,520 13,520
Cumulative effect of accounting
change (net of income taxes of
$9,121) ......................... -- -- -- -- -- -- (14,881) (14,881)
---------
Total comprehensive income ... 14,446
--------- --------- --------- --------- --------- --------- --------- ---------
BALANCE AT SEPTEMBER 30,
2001 ................................ $ 15,667 $ -- $ -- $ 300 $ 248,786 $ -- $ (1,361) $ 263,392
========= ========= ========= ========= ========= ========= ========= =========
</Table>
The accompanying notes are an integral part of these consolidated
financial statements.
5
ENCORE ACQUISITION COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
<Table>
<Caption>
NINE MONTHS ENDED
SEPTEMBER 30,
--------------------------
2001 2000
----------- -----------
Operating Activities
Net income (loss) .................................................... $ 15,807 $ (8,357)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation, depletion, and amortization .......................... 23,495 14,856
Deferred taxes ..................................................... 13,607 7,826
Non-cash stock based compensation .................................. 9,587 24,959
Non-cash cumulative accounting change .............................. 884 --
Non-cash derivative fair value loss ................................ 396 --
Other non-cash charges ............................................. 1,357 94
Loss on disposition of assets ...................................... 33 --
Changes in operating assets and liabilities:
Accounts receivable ................................................ 2,143 (9,587)
Other current assets ............................................... (1,563) (2,984)
Other assets ....................................................... 143 (5,285)
Accounts payable and other current liabilities ..................... (457) 8,089
----------- -----------
Cash Provided by Operating Activities ................................ 65,432 29,611
Investing Activities
Proceeds from disposition of assets ................................ 211 --
Purchases of other property and equipment .......................... (885) (386)
Acquisition of oil and gas properties .............................. (1,130) (65,755)
Development of oil and gas properties .............................. (62,446) (16,711)
----------- -----------
Cash Used by Investing Activities .................................... (64,250) (82,852)
Financing Activities
Proceeds from capital calls ........................................ -- 21,510
Repurchase of common stock ......................................... -- (95)
Issuance of treasury stock ......................................... -- 95
Proceeds from initial public offering .............................. 93,095 --
Offering costs paid ................................................ (1,568) --
Proceeds from notes receivable - officers and employees ............ 21 2
Proceeds from long-term debt ....................................... 115,000 88,000
Payments on long-term debt ......................................... (195,500) (61,166)
Payments on note payable ........................................... (12,951) --
----------- -----------
Cash Provided by (Used by) Financing Activities ...................... (1,903) 48,346
Decrease in Cash and Cash Equivalents ................................ (721) (4,895)
Cash and Cash Equivalents, Beginning of Period ....................... 876 6,497
----------- -----------
Cash and Cash Equivalents, End of Period ............................. $ 155 $ 1,602
=========== ===========
Supplemental disclosure of non-cash investing and financing
activities:
Note payable issued for purchase of oil and gas properties ......... $ -- $ 35,200
Notes received from officers and employees in connection with
capital calls ................................................... $ -- $ 23
</Table>
The accompanying notes are an integral part of these consolidated
financial statements.
6
ENCORE ACQUISITION COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. FORMATION OF ENCORE
Encore Acquisition Company ("Encore"), a Delaware Corporation, is an
independent (non-integrated) oil and natural gas company in the United States.
We were organized in April 1998 and are engaged in the acquisition, development,
exploitation, and production of North American oil and natural gas reserves. Our
oil and natural gas reserves are concentrated in fields located in the Williston
Basin of Montana and North Dakota, the Permian Basin of Texas and New Mexico,
the Anadarko Basin of Oklahoma, and the Powder River Basin of Montana.
2. BASIS OF PRESENTATION
In the opinion of management, the unaudited consolidated financial
statements of Encore include all adjustments necessary to present fairly our
financial position as of September 30, 2001, results of operations for the three
and nine months ended September 30, 2001 and 2000, and cash flows for the nine
months ended September 30, 2001 and 2000. All adjustments are of a recurring
nature. These interim results are not necessarily indicative of results for an
entire year. Certain amounts of prior periods have been reclassified in order to
conform to the current period presentation.
Certain disclosures have been condensed or omitted from these consolidated
financial statements pursuant to the rules and regulations of the Securities and
Exchange Commission. Therefore, these financial statements should be read in
conjunction with Encore's 2000 consolidated financial statements and related
notes thereto included in Encore's registration statement filed on Form S-1
(Registration No. 333-47540, effective March 8, 2001).
Effective January 1, 2001, Encore adopted Statement of Financial Accounting
Standards No. 133 ("SFAS 133"), "Accounting for Derivative Instruments and
Hedging Activities". This standard requires us to recognize all of our
derivative and hedging instruments in our statements of financial position as
either assets or liabilities and measure them at fair value. If a derivative
does not qualify for hedge accounting, it must be adjusted to fair value through
earnings. However, if a derivative does qualify for hedge accounting, depending
on the nature of the hedge, changes in fair value can be offset against the
change in fair value of the hedged item through earnings or recognized in other
comprehensive income until such time as the hedged item is recognized in
earnings. In addition, all hedging relationships must be designated, documented,
and reassessed periodically. The impact of adopting SFAS 133 on January 1, 2001
was to record the fair value of our derivatives as a reduction in assets of $1.1
million and as a liability in the amount of $24.4 million. Additionally, we
recorded a reduction in earnings as the cumulative effect of an accounting
change of $0.9 million (net of taxes of $0.5 million) and a decrease to
stockholders' equity for other comprehensive income in the amount of $14.9
million (net of taxes of $9.1 million).
Currently, all of Encore's derivative financial instruments that qualify for
hedge accounting are designated as cash flow hedges. These instruments hedge the
exposure of variability in expected future cash flows that is attributable to a
particular risk. The effective portion of the gain or loss on these derivative
instruments is recorded in other comprehensive income in stockholders' equity
and reclassified into earnings in the same period in which the hedged
transaction affects earnings. Any ineffective portion of the gain or loss is
recognized into earnings immediately.
In August 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 143 ("SFAS 143"), "Accounting for Asset
Retirement Obligations", which Encore will be required to adopt as of January
1, 2003. This statement requires us to record a liability in the period in which
an asset retirement obligation ("ARO") is incurred. Also, upon initial
recognition of the liability, we must capitalize additional asset cost equal to
the amount of the liability. In addition to any obligations that arise after the
effective date of SFAS 143, upon initial adoption we must recognize (1) a
liability for any existing AROs (2) capitalized cost related to the liability
and (3) accumulated depreciation on that capitalized cost. We are currently
reviewing the provisions of the statement and assessing their impact on our
financial statements. We do not currently know the effect, if any, the adoption
of SFAS 143 will have on our financial statements.
7
3. IPO AND RECAPITALIZATION
On March 8, 2001, Encore priced its shares to be issued in its initial
public offering ("IPO") and began trading on the New York Stock Exchange the
following day under the ticker symbol "EAC". Immediately prior to the IPO, all
of the outstanding shares of Class A and Class B stock held by management and
institutional investors were converted into 2,630,203 and 20,249,758 shares,
respectively, of a single class of common stock. Through the IPO, Encore sold an
additional 7,150,000 shares of common stock to the public at the offering price
of $14.00 per share, resulting in total outstanding shares of 30,029,961. Encore
received $91.5 million in net proceeds after deducting the underwriter's
discounts and commissions and related offering expenses. The proceeds received
from the IPO were used to pay down debt outstanding under our credit facility.
4. INDEBTEDNESS
As a result of the application of proceeds from the IPO and scheduled note
repayments, Encore has substantially reduced overall indebtedness since December
31, 2000. The following table summarizes the activity of Encore's debt balances
from December 31, 2000 through September 30, 2001 (in thousands):
<Table>
CREDIT FACILITY:
December 31, 2000......................... $ 144,500
Application of IPO proceeds............. (91,456)
Net borrowings and payments............. 10,956
---------
September 30, 2001........................ $ 64,000
=========
NOTE PAYABLE:
December 31, 2000......................... $ 17,545
Scheduled payments...................... (12,951)
---------
September 30, 2001........................ $ 4,594
=========
</Table>
5. NON-CASH STOCK BASED COMPENSATION EXPENSE ON CLASS A STOCK
Encore follows variable plan accounting for the Class A stock sold to
management. Accordingly, compensation expense is based on the excess of the
estimated fair value of the Class A stock over the amount paid by the management
stockholders. Compensation expense is recorded over the service period of the
Class A stock, which is based on a vesting schedule. The Class A stock vests 25%
upon issuance and an additional 15% per year for the following five years. Prior
to Encore's IPO, compensation expense was adjusted in each reporting period
based on the most recent fair value estimates. Using available fair value
estimates, during the three and nine months ended September 30, 2000, Encore
recorded $11.9 million and $25.0 million, respectively, in non-cash compensation
expense. On March 8, 2001, the date of the IPO, the measurement date occurred,
because after this date the Class A stockholders were no longer required to make
future capital contributions. Total compensation expense on the Class A shares
using the IPO price of $14.00 per share is $35.6 million. Encore recorded the
final $9.6 million of compensation expense related to the Class A shares in the
first quarter of 2001.
6. OTHER OPERATING EXPENSE
During the third quarter of 2001, Encore granted severance packages to two
former Encore officers. For the three and nine months ended September 30, 2001,
Encore recorded $0.4 million related to this in other operating expense. Encore
did not record any similar operating expense for the same respective periods in
2000.
8
7. EARNINGS PER SHARE (EPS)
The following table sets forth basic and diluted earnings per share
computations for the three and nine months ended September 30, 2001 and 2000 (in
thousands, except per share data):
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- --------------------
2001 2000 2001 2000
-------- -------- -------- --------
NUMERATOR:
Income (loss) before accounting change .................................. $ 8,423 $ (4,068) $ 16,691 $ (8,357)
======== ======== ======== ========
Net income (loss) ....................................................... $ 8,423 $ (4,068) $ 15,807 $ (8,357)
======== ======== ======== ========
DENOMINATOR:
Denominator for basic earnings per share -
weighted average shares outstanding ................................... 30,030 22,836 28,275 22,781
Effect of dilutive securities:
Dilutive options ...................................................... -- -- 2 --
-------- -------- -------- --------
Denominator for diluted earnings per share .............................. 30,030 22,836 28,277 22,781
======== ======== ======== ========
Basic income (loss) per common share before accounting change............ $ 0.28 $ (0.18) $ 0.59 $ (0.37)
Cumulative effect of accounting change, net of tax ...................... -- -- (0.03) --
Basic income (loss) per common share after accounting change ............ $ 0.28 $ (0.18) $ 0.56 $ (0.37)
======== ======== ======== ========
Diluted income (loss) per common share before accounting change ......... $ 0.28 $ (0.18) $ 0.59 $ (0.37)
Cumulative effect of accounting change, net of tax ...................... -- -- (0.03) --
Diluted income (loss) per common share after accounting change .......... $ 0.28 $ (0.18) $ 0.56 $ (0.37)
======== ======== ======== ========
</Table>
Earnings per share and weighted average shares outstanding for the three and
nine months ended September 30, 2000 have been restated to reflect the
conversion of the outstanding Class A and Class B shares into one class of
common stock in conjunction with the IPO (see note 3).
8. DERIVATIVE FINANCIAL INSTRUMENTS
Encore hedges commodity price risk with swap contracts, put contracts, and
collar contracts and interest rate risk with a swap contract. Swap contracts
provide a fixed price for a notional amount of sales volume in the case of
commodity hedges or a fixed interest rate for notional amount of principal in
the case of interest rate hedges. Put contracts provide a fixed floor price on a
notional amount of sales volume while allowing full price participation if the
relevant index price closes above the floor price. Collar contracts provide a
floor price for Encore for a notional amount of sales volume while allowing some
additional price participation if the relevant index price closes above the
floor price. From time to time, Encore also enters into swaption contracts,
which are options to enter into a swap in the future. However, no swaptions were
outstanding at September 30, 2001. Additionally, Encore occasionally finances
the purchase of collar contracts through the short sale of put contracts with a
strike price well below the floor price of the collar. These short put contracts
do not qualify for hedge accounting under SFAS 133, and accordingly, the
mark-to-market change in the value of these contracts each quarter is recorded
as fair value gain/loss in the income statement. At September 30, 2001, Encore
had two such contracts in place representing 1,500 Bbl/D with a strike price of
$20.00 per barrel.
Except as noted above, all of Encore's derivative financial instruments
qualify for hedge accounting in accordance with SFAS 133 and have been
designated as cash flow hedges. As a result, to the extent the hedges are
effective, all unrealized gains or losses due to marking these derivatives to
market have been recorded in other comprehensive income as a component of
stockholders' equity. These amounts will be reclassified into earnings when the
hedged transaction is recognized in earnings. However, to the extent the hedges
were ineffective, the ineffective portion of the gain or loss has been
recognized in earnings in the current period.
9
Excluding the $0.9 million net of tax loss recorded as a cumulative effect
of accounting change, during the nine months ended September 30, 2001, Encore
recognized a $0.4 million loss related to the ineffective portion of the total
deferred hedge loss and the mark-to-market loss on our short puts. Additionally,
the $24.4 million liability recorded on January 1, 2001 as a cumulative effect
of accounting change was reduced in the first nine months of the year to $8.6
million at September 30, 2001 ($5.7 million is included in other current
liabilities and $2.9 million in other liabilities on the balance sheet). The
value of our derivative assets has increased by $5.9 million since January 1,
2001, to $9.6 million at September 30, 2001 ($6.8 million is included in other
current assets and $2.8 million in other assets on the balance sheet). These
changes in the market value of our derivatives since January 1, 2001 were due
primarily to a reduction in the market price of natural gas, the expiration of
part of our 2001 contracts, and additional floors, collars, and swaps entered
into during the year. While Encore does not intend to terminate any of these
arrangements, the unrealized mark-to-market loss upon termination of all
outstanding commodity and interest rate derivatives as of September 30, 2001 was
approximately $2.2 million.
The following tables summarize our open hedging positions as of September 30,
2001:
OIL HEDGES AS OF SEPTEMBER 30, 2001
<Table>
<Caption>
DAILY FLOOR DAILY CAP DAILY SWAP
FLOOR VOLUME PRICE CAP VOLUME PRICE SWAP VOLUME PRICE
PERIOD (Bbl) (per Bbl) (Bbl) (per Bbl) (Bbl) (per Bbl)
---------------- ------------- ---------- ----------- ---------- ----------- ---------
2001............... 3,500 $ 21.00 1,000 $ 22.05 3,000 $ 19.88
Jan - June 2002.... 6,500 $ 23.11 1,500 $ 28.03 2,500 $ 19.47
July - Dec 2002.... 5,500 $ 22.95 1,500 $ 28.03 2,500 $ 19.47
2003............... -- $ -- -- $ -- 500 $ 23.20
</Table>
NATURAL GAS HEDGES AS OF SEPTEMBER 30, 2001
<Table>
<Caption>
DAILY FLOOR DAILY CAP DAILY SWAP
FLOOR VOLUME PRICE CAP VOLUME PRICE SWAP VOLUME PRICE
PERIOD (Mcf) (per Mcf) (Mcf) (per Mcf) (Mcf) (per Mcf)
---------------- ------------- ---------- ----------- ----------------------- ---------
2001............ 6,000 $ 3.21 -- $ -- 9,500 $ 3.09
2002............ 10,000 $ 3.09 2,500 $ 8.05 3,500 $ 3.31
2003............ -- $ -- -- $ -- 2,500 $ 3.11
</Table>
INTEREST RATE HEDGES AS OF SEPTEMBER 30, 2001
<Table>
<Caption>
FIXED
SWAP INTEREST SWAP
PERIOD RATE NOTIONAL
---------------- ------------- -----------
2001............ 6.72% $30,000,000
2002............ 6.72% $30,000,000
2003............ 6.72% $30,000,000
2004............ 6.72% $30,000,000
2005............ 6.72% $30,000,000
</Table>
The actual gains or losses we realize from our hedge transactions may vary
significantly from the fair market values disclosed above due to the fluctuation
of prices in the commodity markets and/or fluctuations in the floating LIBOR
interest rate.
9. TAXES
During the first nine months of 2001, excluding the benefit related to the
cumulative effect of accounting change, Encore incurred $16.1 million of income
tax expense. Of this amount, $14.4 million is deferred income tax expense and
relates primarily to intangible drilling costs incurred during the year, which
are deductible for income tax purposes but have been capitalized in properties
and equipment for book purposes. These amounts will be depleted and transferred
to earnings over the productive life of the wells. The related deferred tax
liability is included in other liabilities on the balance sheet.
Income tax expense recorded during the first nine months of 2001 and 2000 is
substantially greater than if calculated using income before income taxes at the
statutory rate. This results from the non-cash stock based compensation expense
recorded by Encore during the first nine months of 2001 and 2000 of $9.6 million
and $25.0 million, respectively, not being deductible for tax purposes. Thus,
these amounts must be added back to income before income taxes to arrive at
taxable income.
10
Primarily as a result of the net deferred hedge loss recorded in other
comprehensive income during the first nine months of 2001, Encore has a
long-term deferred tax asset in the amount of $0.7 million as of September 30,
2001, which has been netted with our deferred tax liability and included in
other liabilities on the balance sheet.
10. OTHER COMPREHENSIVE INCOME
With the adoption of SFAS 133 on January 1, 2001, Encore began recording
deferred hedge gains and losses as other comprehensive income. For the nine
months ended September 30, 2001, comprehensive income totaled $14.4 million,
while net income totaled $15.8 million. The difference between net income and
comprehensive income is the result of recording a $14.9 million deferred hedge
loss as a cumulative effect of accounting change, offset by an decrease in the
deferred hedge loss of $13.5 million since January 1, 2001. The reduction in the
deferred hedge loss since January 1, 2001 resulted from the expiration of a
portion of the term of some derivative contracts, as well as a reduction in the
market price of natural gas during the year. At September 30, 2001, Encore had
$1.4 million in net of tax deferred hedge losses in accumulated other
comprehensive income, shown as a component of equity on the balance sheet.
11
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This document contains forward-looking statements that involve risks and
uncertainties that are made pursuant to the Safe Harbor Provisions of the
Private Securities Litigation Reform Act of 1995. See "Information Regarding
Forward-Looking Statements" in Encore's registration statement filed on Form S-1
(Registration No. 333-47540, effective March 8, 2001). Actual results may differ
materially from those anticipated in our forward-looking statements due to many
factors, including, but not limited to, those set forth under "Risk Factors" in
the registration statement. In addition, the terrorist attacks that took place
on September 11, 2001 may affect our operations by causing reduced airline and
other travel, which reduces demand for petroleum products, and causing a general
downturn in U.S. economic activity, which also reduces demand for petroleum
products. The following discussion should be read in conjunction with the
consolidated financial statements and notes thereto included in this document
and Encore's registration statement filed on Form S-1 (Registration No.
333-47540, effective March 8, 2001).
OVERVIEW
Because of our rapid growth through acquisitions since formation, our
historical results of operations and period-to-period comparisons of such
results and certain financial data may not be meaningful or indicative of future
results. Our acquisition history through September 30, 2001 is as follows:
<Table>
<Caption>
ASSET DATE ACQUIRED
----- -------------
Cedar Creek Anticline (CCA)..... June 1, 1999
Crockett County................. March 30, 2000
Lodgepole....................... March 31, 2000
Indian Basin/Verden............. August 24, 2000
Bell Creek...................... November 29, 2000
</Table>
We use the successful efforts method of accounting for our oil and natural
gas properties. Under this method, all acquisition costs and development costs
of proved properties are capitalized and amortized on a unit-of-production basis
over the remaining life of proved developed reserves or proved reserves, as
applicable. Exploration expenses, including geological and geophysical expenses
and lease rentals, are charged to expense as incurred.
RESULTS OF OPERATIONS
The following table sets forth operating information of Encore for the
periods presented:
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- INCREASE ------------------ INCREASE
2001 2000 (DECREASE) 2001 2000 (DECREASE)
---------- ---------- ---------- --------- ---------- ----------
Operating Results (in thousands):
Oil and natural gas revenues ........................ $ 34,539 $ 31,091 $ 3,448 $105,368 $ 74,911 $ 30,457
Direct lifting costs ................................ 6,323 4,443 1,880 18,744 12,373 6,371
Production, ad valorem, and severance taxes ......... 3,496 4,066 (570) 11,406 10,675 731
Daily production:
Oil volumes (Bbls) .................................. 13,928 12,583 1,345 13,594 11,646 1,948
Natural gas volumes (Mcf) ........................... 22,451 15,024 7,427 21,948 9,840 12,108
Combined volumes (BOE) .............................. 17,670 15,087 2,583 17,252 13,286 3,966
Average prices:
Oil (per Bbl) ....................................... $ 21.88 $ 22.16 $ (0.28) $ 22.07 $ 20.48 $ 1.59
Natural gas (per Mcf) ............................... 3.15 3.93 (0.78) 3.91 3.55 0.36
Combined volumes (per BOE) .......................... 21.25 22.40 (1.15) 22.37 20.58 1.79
Average costs (per BOE):
Direct lifting costs ................................ $ 3.89 $ 3.20 $ 0.69 $ 3.98 $ 3.40 $ 0.58
Production, ad valorem, and severance taxes ......... 2.15 2.93 (0.78) 2.42 2.93 (0.51)
G&A (excluding non-cash stock based compensation) ... 0.79 0.67 0.12 0.81 0.84 (0.03)
DD&A ................................................ 4.99 4.62 0.37 4.99 4.08 0.91
</Table>
Average prices shown in the table are net of net profits interest
payments and the effects of hedging transactions. As a result of hedging
transactions, oil and natural gas revenues were reduced by $2.4 million and
$13.7 million for the three and nine months ended September 30, 2001,
respectively, and $6.7 million and $14.8 million for the same respective
periods in 2000. As a result of our net profits interest payments, oil and
natural gas revenues were reduced by $0.2 million and $2.8 million for the
three and nine months ended September 30, 2001, respectively, and $2.9
million and $9.5 million for the same respective periods in 2000.
12
COMPARISON OF QUARTER ENDED SEPTEMBER 30, 2001 TO QUARTER ENDED SEPTEMBER 30,
2000
Set forth below is our comparison of operations during the third quarter of
2001 with the third quarter of 2000.
REVENUES. Oil and natural gas revenues for the third quarter of 2001
increased as compared to 2000 by $3.4 million, from $31.1 million to $34.5
million. The increase resulted from additional production associated with the
Indian Basin/Verden acquisition, which closed during the third quarter of 2000,
and the Bell Creek acquisition, which closed subsequent to September 30, 2000,
as well as additional production resulting from our successful development and
exploitation program in CCA and Crockett County. Decreases in our realized net
oil and natural gas prices, which include the effects of hedging and net profits
interest payments, offset some of our increase in volumes. Our realized net oil
price for the third quarter of 2001 compared to 2000 decreased by $0.28 per Bbl,
from $22.16 to $21.88 per Bbl. Our realized net natural gas price for the third
quarter of 2001 compared to 2000 decreased by $0.78 per Mcf, from $3.93 to $3.15
per Mcf. Hedging had the effect of reducing oil and natural gas revenues by $2.4
million, or $1.45 per BOE, during the third quarter of 2001 and decreasing oil
and natural gas revenues by $6.7 million, or $4.83 per BOE, during the third
quarter of 2000. Net profits interest payments had the effect of reducing oil
and natural gas revenues by $0.2 million, or $0.13 per BOE, during the third
quarter of 2001 and decreasing oil and natural gas revenues by $2.9 million, or
$2.07 per BOE, during the third quarter of 2000. The reduction in net profits
interest payments resulted from increased capital expenditures in CCA and lower
commodity prices.
DIRECT LIFTING COSTS. Direct lifting costs increased from $4.4 million in
the third quarter of 2000 to $6.3 million in the third quarter of 2001. The
increase in direct lifting costs resulted from additional production costs
associated with the Indian Basin/Verden acquisition, which closed during the
third quarter of 2000, and the Bell Creek acquisition, which closed subsequent
to September 30, 2000. On a per BOE basis, direct lifting costs increased from
$3.20 to $3.89, primarily reflecting the increased cost for services.
PRODUCTION, AD VALOREM, AND SEVERANCE TAXES. Production, ad valorem, and
severance taxes for the third quarter of 2001 decreased as compared to the third
quarter of 2000 by approximately $0.6 million, from $4.1 million to $3.5
million. The decrease in production, ad valorem, and severance taxes resulted
primarily from the decrease in commodity prices offset by additional production
associated with the Indian Basin/Verden acquisition, which closed during the
third quarter of 2000, and the Bell Creek acquisition, which closed subsequent
to September 30, 2000. As a percent of oil and natural gas revenues (excluding
the effects of hedging transactions and net profits interest payments),
production, ad valorem, and severance taxes decreased from 10.0% to 9.4%. The
decrease in production, ad valorem, and severance taxes as a percent of revenue
was a result of a lower tax rate on production in our CCA asset for newly
drilled wells compared with the rates on older wells. Additionally, the tax
rates in New Mexico and Oklahoma associated with the Indian Basin/Verden
acquisitions completed during the third quarter of 2000 are lower than the rates
in Montana.
DEPLETION, DEPRECIATION, AND AMORTIZATION (DD&A) EXPENSE. DD&A expense
increased from $6.4 million in the third quarter of 2000 to $8.1 million in the
third quarter of 2001. The increase in DD&A resulted from additional production
associated with the Indian Basin/Verden acquisition, which closed during the
third quarter of 2000, and the Bell Creek acquisition, which closed subsequent
to September 30, 2000. The average DD&A rate of $4.99 per BOE of production
during the third quarter of 2001 represents an increase of $0.37 per BOE from
the $4.62 per BOE recorded in the third quarter of 2000. The increase was
attributable to higher per BOE acquisition costs associated with the Indian
Basin/Verden and Bell Creek acquisitions completed during and after the third
quarter of 2000.
GENERAL AND ADMINISTRATIVE (G&A) EXPENSE. G&A expense increased from $0.9
million in the third quarter of 2000 to $1.3 million in the third quarter of
2001 (excluding non-cash stock based compensation of $11.9 million in the third
quarter of 2000). The increase in G&A resulted from the additional staff and
lease space necessary to accommodate our rapid growth through acquisitions and
development and exploitation drilling. On a per BOE basis, G&A expense rose to
$0.79 for the third quarter of 2001 as compared to $0.67 for the third quarter
of 2000.
NON-CASH STOCK BASED COMPENSATION EXPENSE. Non-cash stock based compensation
expense decreased from $11.9 million in the third quarter of 2000 to zero in the
third quarter of 2001. This non-cash stock based compensation expense is
associated with the purchase by our management stockholders of Class A common
stock under our management stock plan adopted in August 1998 and was recorded as
compensation in accordance with variable plan accounting under APB 25. The
non-cash compensation expense recorded in the first quarter of 2001 represented
the final amount of expense to be recorded related to the Class A stock.
13
INTEREST EXPENSE. Interest expense for the third quarter of 2001 was $1.2
million compared to $2.9 million for the third quarter of 2000. The decrease in
interest expense is directly attributable to the reduction of debt as a result
of the application of proceeds from Encore's IPO. The weighted average interest
rate, including hedges, for the third quarter of 2001 was 6.5% compared to 7.3%
for the third quarter of 2000.
COMPARISON OF NINE MONTHS ENDED SEPTEMBER 30, 2001 TO NINE MONTHS ENDED
SEPTEMBER 30, 2000
Set forth below is our comparison of operations during the first nine
months of 2001 with the first nine months of 2000.
REVENUES. Oil and natural gas revenues for the nine months ended September
30, 2001 increased as compared to the same period in 2000 by $30.5 million, from
$74.9 million to $105.4 million. The increase resulted primarily from increased
volumes associated with our acquisition program for 2000, which resulted in our
Crockett County, Lodgepole, Indian Basin/Verden, and Bell Creek acquisitions, as
well as additional production resulting from our successful development and
exploitation program in CCA and Crockett County. Increases in our realized net
oil and natural gas prices, which include the effects of hedging and net profits
interest payments, further increased our revenues. Our realized net oil price
for the first nine months of 2001 compared to the first nine months of 2000
increased by $1.59 per Bbl, from $20.48 to $22.07 per Bbl. Our realized net
natural gas price for the first nine months of 2001 compared to the first nine
months in 2000 increased by $0.36 per Mcf, from $3.55 to $3.91 per Mcf. Our
realized net oil and natural gas prices include the effects of hedging
transactions and net profits interest payments. Hedging transactions had the
effect of reducing oil and natural gas revenues by $13.7 million, or $2.92 per
BOE, during the nine months ended September 30, 2001 and decreasing oil and
natural gas revenues by $14.8 million, or $4.08 per BOE, during the nine months
ended September 30, 2000. Net profits interest payments had the effect of
reducing oil and natural gas revenues by $2.8 million, or $0.59 per BOE, during
the nine months ended September 30, 2001 and decreasing oil and natural gas
revenues by $9.5 million or $2.62 per BOE, during the same period in 2000. The
reduction in net profits interest payments resulted from increased capital
expenditures in CCA.
DIRECT LIFTING COSTS. Direct lifting costs for the first nine months of
2001 increased as compared to the first nine months of 2000, from $12.4 million
to $18.7 million. The increase in direct lifting costs resulted from additional
production costs associated with our Crockett County, Lodgepole, and Indian
Basin/Verden acquisitions, which occurred during the first nine months of 2000,
and the Bell Creek acquisition which occurred subsequent to September 30, 2000.
On a per BOE basis, direct lifting costs increased from $3.40 to $3.98,
primarily as a result of higher workover and contract labor costs in CCA related
to the relatively harsh winter and the increased cost for services.
PRODUCTION, AD VALOREM, AND SEVERANCE TAXES. Production, ad valorem, and
severance taxes for the first nine months of 2001 increased as compared to the
first nine months of 2000 by approximately $0.7 million, from $10.7 million to
$11.4 million. The increase in production, ad valorem, and severance taxes
resulted from additional production associated with the Crockett County,
Lodgepole, and Indian Basin/Verden acquisitions, completed during the first nine
months of 2000, and the Bell Creek acquisition completed after September 30,
2000. As a percent of oil and natural gas revenues (excluding the effects of
hedging transactions and net profits interest payments), production, ad valorem,
and severance taxes decreased from 10.8% to 9.4%. The decrease in production, ad
valorem and severance taxes as a percent of revenue was a result of the higher
production, ad valorem, and severance tax rates in Montana associated with our
CCA asset versus the tax rates in Texas, North Dakota, New Mexico, and Oklahoma
associated with our Crockett County, Lodgepole, and Indian Basin/Verden assets,
respectively.
DEPLETION, DEPRECIATION, AND AMORTIZATION (DD&A) EXPENSE. DD&A expense for
the nine months ended September 30, 2001 increased by approximately $8.6
million, from $14.9 million to $23.5 million as compared to the nine months
ended September 30, 2000. The increase in DD&A resulted from additional
production associated with the Crockett County, Lodgepole, and Indian
Basin/Verden acquisitions, completed during the first nine months of 2000 and
the Bell Creek acquisition completed after September 30, 2000. The average DD&A
rate of $4.99 per BOE of production during the first nine months of 2001
represents an increase of $0.91 per BOE from the $4.08 per BOE recorded in the
first nine months of 2000. The increase was attributable to higher per BOE
acquisition costs associated with the Crockett County, Lodgepole, Indian
Basin/Verden, and Bell Creek acquisitions.
GENERAL AND ADMINISTRATIVE (G&A) EXPENSE. G&A expense increased $0.8
million for the first nine months of 2001 as compared to the first nine months
of 2000, from $3.0 million to $3.8 million (excluding non-cash stock based
compensation of $9.6 million in the first nine months of 2001 and $25.0 million
in the first nine months of 2000). The increase in G&A resulted from the
additional staff and lease space necessary to accommodate our rapid growth
through acquisitions and development and exploitation drilling. On a per BOE
basis, G&A expense fell to $0.81 for the first nine months of 2001 from $0.84
for the same period in 2000.
14
NON-CASH STOCK BASED COMPENSATION EXPENSE. Non-cash stock based
compensation expense decreased $15.4 million from the first nine months of 2000,
$25.0 million, to the first nine months of 2001, $9.6 million. This non-cash
stock based compensation expense is associated with the purchase by our
management stockholders of Class A common stock under our management stock plan
adopted in August 1998 and was recorded as compensation in accordance with
variable plan accounting under APB 25. The non-cash compensation expense
recorded in the first quarter of 2001 represented the final amount of expense to
be recorded related to the Class A stock.
INTEREST EXPENSE. Interest expense for the nine months ended September 30,
2001 was $4.9 million compared to $7.4 million for the nine months ended
September 30, 2000. The decrease in interest expense is directly attributable to
the reduction of debt in conjunction with Encore's IPO. The weighted average
interest rate, net of hedges, for the first nine months of 2001 and 2000 was
6.9% and 6.8%, respectively.
LIQUIDITY AND CAPITAL RESOURCES
Principal uses of capital have been for the acquisition and development of
oil and natural gas properties.
During the nine months ended September 30, 2001, net cash provided by
operations was $65.4 million, an increase of $35.8 million compared to the nine
months ended September 30, 2000. This increase is a result of cash flows
provided by the Crockett County, Lodgepole, and Indian Basin/Verden
acquisitions, which occurred during the first nine months of 2000, and the Bell
Creek acquisition, which occurred subsequent to September 30, 2000.
We anticipate that our capital expenditures will total approximately $28
million for the fourth quarter of 2001. The level of these and other future
expenditures is largely discretionary, and the amount of funds devoted to any
particular activity may increase or decrease significantly, depending on
available opportunities and market conditions. We plan to finance our ongoing
development and acquisition expenditures using internally generated cash flow,
available cash, and our existing credit agreement.
At September 30, 2001, Encore had total assets of $386.5 million net of
depreciation, depletion, and amortization. Total capitalization was $327.4
million, of which 80.5% was represented by stockholders' equity and 19.5% by
senior debt.
Encore's operating subsidiary currently maintains a credit agreement with a
group of banks that matures in May 2004. Encore has guaranteed the subsidiary's
obligations under the credit agreement and has pledged the stock and other
equity interests of its subsidiaries to secure the guaranty. Borrowings under
the credit agreement totaled $64.0 million as of September 30, 2001. The
borrowing base, as established in the credit agreement, was $180.0 million as of
September 30, 2001. During the first nine months of 2001, the weighted average
interest rate under the facility, net of hedges, was 7.3%. The remaining
borrowing base available under the credit agreement at September 30, 2001, was
$116.0 million. Encore pays certain fees based on the unused portion of the
borrowing base. We were in compliance with all of our credit agreement covenants
as of September 30, 2001.
Encore issued a $35.2 million note payable associated with the Lodgepole
acquisition. The note requires monthly principal payments over a period of 22
months ending January 31, 2002. The note bears monthly compounded interest at
the rate of 4.0% per year on the outstanding principal plus accrued interest.
Principal payments remaining as of September 30, 2001 total $3.5 million for
2001 and $1.1 million for 2002. Accrued interest as of September 30, 2001
totaled $1.2 million. All of the remaining principal and interest outstanding,
less a demand premium, is callable at any time with 45 days notice. In the event
the note is called, our credit agreement allows additional borrowings to meet
the demand payment.
INFLATION AND CHANGES IN PRICES
While the general level of inflation affects certain of our costs, factors
unique to the petroleum industry result in independent price fluctuations.
Historically, significant fluctuations have occurred in oil and natural gas
prices. In addition, changing prices often cause costs of equipment and supplies
to vary as industry activity levels increase and decrease to reflect perceptions
of future price levels. Although it is difficult to estimate future prices of
oil and natural gas, price fluctuations have had, and will continue to have, a
material effect on us.
15
The following table indicates the average oil and natural gas prices
received for the three and nine months ended September 30, 2001 and 2000.
Average equivalent prices for the first nine months of 2001 and 2000 were
decreased by $2.92 and $4.08 per BOE, respectively, as a result of our hedging
activities. Average prices per equivalent barrel indicate the composite impact
of changes in oil and natural gas prices. Natural gas production is converted to
oil equivalents at the conversion rate of six Mcf per Bbl. Average prices shown
in the following table are net of net profits interest payments.
<Table>
<Caption>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -------------------------
2001 2000 2001 2000
----------- ----------- ----------- -----------
NET PRICE REALIZATION WITH HEDGES:
Oil (per Bbl) ............................... $ 21.88 $ 22.16 $ 22.07 $ 20.48
Natural Gas (per Mcf) ....................... 3.15 3.93 3.91 3.55
Equivalent Oil (per BOE) .................... 21.25 22.40 22.37 20.58
AVERAGE WELLHEAD PRICE:
Oil (per Bbl) ............................... $ 23.87 $ 29.65 $ 24.47 $ 24.76
Natural Gas (per Mcf) ....................... 3.05 4.59 4.71 3.99
Equivalent Oil (per BOE) .................... 22.70 29.30 25.29 24.66
</Table>
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information included in "Quantitative and Qualitative Disclosures About
Market Risk" in Encore's registration statement on Form S-1 (Registration No.
333-47540, effective March 8, 2001) is incorporated herein by reference. Such
information includes a description of Encore's potential exposure to market
risks, including commodity price risk and interest rate risk. Encore's open
commodity positions as of September 30, 2001 are presented in Note 8 to the
accompanying financial statements. While Encore does not intend to terminate any
of these arrangements, the unrealized mark-to-market loss upon termination of
outstanding commodity and interest rate derivatives as of September 30, 2001 was
approximately $2.2 million.
16
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Exhibits
3.1 Second Amended and Restated Certificate of Incorporation of
Encore Acquisition Company.
3.2 Second Amended and Restated By-laws of Encore Acquisition
Company.
10.1 2000 Incentive Stock Plan of Encore Acquisition Company.
Reports on Form 8-K
None.
17
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.
ENCORE ACQUISITION COMPANY
Date: November 6, 2001 By: /s/ Morris B. Smith
---------------------------------------------------
Morris B. Smith
Chief Financial Officer, Treasurer, Executive
Vice President and Principal Financial Officer
Date: November 6, 2001 By: /s/ Robert C. Reeves
---------------------------------------------------
Robert C. Reeves
Vice President, Controller and Principal
Accounting Officer
18
<Table>
<Caption>
EXHIBIT
NUMBER DESCRIPTION
------ -----------
3.1 Second Amended and Restated Certificate of Incorporation of
Encore Acquisition Company.
3.2 Second Amended and Restated By-laws of Encore Acquisition
Company.
10.1 2000 Incentive Stock Plan of Encore Acquisition Company.
</Table>