Epsilon Energy Ltd. [EPSN] Filings

10-Q 1 epsn-20230331x10q.htm 10-Q

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2023

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 001-38770

EPSILON ENERGY LTD.

(Exact name of registrant as specified in its charter)


Alberta, Canada		98-1476367
(State or other jurisdiction of incorporation or organization)		(I.R.S Employer Identification No.)

500 Dallas Street, Suite 1250

Houston, Texas 77002

(281) 670-0002

(Address of principal executive offices including zip code and

telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:


Title of each class	Trading Symbol	Name of each exchange on which registered
Common Shares, no par value	EPSN	NASDAQ Global Market

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 ⌧ No ◻

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).

Yes ⌧ No ◻

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.


Large accelerated filer ◻	Accelerated filer ◻	Non-accelerated filer ⌧	Smaller reporting company ☒	Emerging growth company ☒

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

Yes ☐ No ⌧

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ☐ No ⌧

As of May 9, 2023, there were 22,926,444 Common Shares outstanding.

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Contents

FORWARD-LOOKING STATEMENTS		4
PART I-FINANCIAL INFORMATION		5
ITEM 1. FINANCIAL STATEMENTS		5
Unaudited Condensed Consolidated Balance Sheets		5
Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income (Loss)		6
Unaudited Condensed Consolidated Statements of Changes in Shareholders’ Equity		7
Unaudited Condensed Consolidated Statements of Cash Flows		8
Notes to the Unaudited Condensed Consolidated Financial Statements
1.	Description of Business	9
2.	Basis of Preparation	9
	Interim Financial Statements	9
	Principles of Consolidation	9
	Use of Estimates	9
	Reclassification	9
	Recently Issued Accounting Standards	9
3.	Cash, Cash Equivalents, and Restricted Cash	10
4.	Short Term Investments	10
5.	Property and Equipment	11
	Property Impairment	11
6.	Revolving Line of Credit	11
7.	Shareholders’ Equity	12
8.	Revenue Recognition	16
9.	Income Taxes	17
10.	Commitments and Contingencies	17
	Litigation	17
11.	Leases	18
12.	Net Income Per Share	19
13.	Operating Segments	20
14.	Commodity Risk Management Activities	22
	Commodity Price Risks	22
	Commodity Derivative Contracts	22
15.	Asset Retirement Obligations	23
16.	Fair Value Measurements	23
17.	Current Expected Credit Loss	24
18.	Subsequent Events	24
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		25
	Overview	25
	Business Strategy	25
	Operational Highlights	25
	Non-GAAP Financial Measures-Adjusted EBITDA	26
	Net Operating Revenues	27
	Operating Costs	28
	Depletion, Depreciation, Amortization and Accretion	28

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	General and Administrative	29
	Loss on Derivative Contracts	29
	Capital Resources and Liquidity	29
	Cash Flow	29
	Credit Agreement	30
	Repurchase Transactions	30
	Derivative Transactions	31
	Contractual Obligations	31

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		31
	Gathering System Revenue Risk	31
	Interest Rate Risk	32
	Derivative Contracts	32
ITEM 4. CONTROLS AND PROCEDURES		32
	Disclosure Controls and Procedures	32
	Changes in Internal Control Over Financial Reporting	32
	Inherent Limitations on Effectiveness of Controls	32
PART II OTHER INFORMATION		33
ITEM 1. LEGAL PROCEEDINGS		33
ITEM 1A. RISK FACTORS		33
ITEM 2. UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS		33
ITEM 3. DEFAULTS UPON SENIOR SECURITIES		34
ITEM 4. MINE SAFETY DISCLOSURES		34
ITEM 5. OTHER INFORMATION		34
ITEM 6. EXHIBITS		35
SIGNATURES		35

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FORWARD-LOOKING STATEMENTS

Certain statements contained in this report constitute forward-looking statements. The use of any of the words ‘‘anticipate,’’ ‘‘continue,’’ ‘‘estimate,’’ ‘‘expect,’’ ‘‘may,’’ ‘‘will,’’ ‘‘project,’’ ‘‘should,’’ ‘‘believe,’’ and similar expressions and statements relating to matters that are not historical facts constitute ‘‘forward looking information’’ within the meaning of applicable securities laws. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results or events to differ materially from those anticipated. Such forward-looking statements are based on reasonable assumptions, but no assurance can be given that these expectations will prove to be correct and the forward-looking statements included in this report should not be unduly relied upon. These statements are made only as of the date of this report. All statements that address operating performance, events or developments that we expect or anticipate will occur in the future — including statements relating to natural gas and oil production rates, commodity prices for crude oil or natural gas, supply and demand for natural gas and oil; the estimated quantity of natural gas and oil reserves, including reserve life; future development and production costs, and statements expressing general views about future operating results — are forward-looking statements. Management believes that these forward-looking statements are reasonable as and when made. However, caution should be taken not to place undue reliance on any such forward-looking statements because such statements speak only as of the date when made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In addition, forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our present expectations or projections. These risks and uncertainties include, but are not limited to, those described in our Annual Report on Form 10-K for the year ended December 31, 2022, and those described from time to time in our future reports filed with the Securities and Exchange Commission. You should consider carefully the statements under Item 1A. Risk Factors included in our Annual Report on Form 10-K for the year ended December 31, 2022. Our Annual Report on Form 10-K for the year ended December 31, 2022 is available on our website at www.epsilonenergyltd.com.

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PART I-FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Balance Sheets


	March 31,		December 31,
	2023		2022
ASSETS
Current assets
Cash and cash equivalents	$	19,110,225	$	45,236,584
Accounts receivable		4,805,320		7,201,386
Short term investments		30,138,743		—
Fair value of derivatives		1,927,450		1,222,090
Prepaid income taxes		—		1,140,094
Other current assets		496,731		632,154
Operating lease right-of-use assets		—		31,383
Total current assets		56,478,469		55,463,691
Non-current assets
Property and equipment:
Oil and gas properties, successful efforts method
Proved properties		149,323,372		148,326,265
Unproved properties		18,275,226		18,169,157
Accumulated depletion, depreciation, amortization and impairment		(109,194,701)		(107,729,293)
Total oil and gas properties, net		58,403,897		58,766,129
Gathering system		42,660,626		42,639,001
Accumulated depletion, depreciation, amortization and impairment		(34,778,321)		(34,500,740)
Total gathering system, net		7,882,305		8,138,261
Land		637,764		637,764
Buildings and other property and equipment, net		318,805		286,035
Total property and equipment, net		67,242,771		67,828,189
Other assets:
Operating lease right-of-use assets, long term		532,013		—
Restricted cash		571,324		570,363
Total non-current assets		68,346,108		68,398,552
Total assets	$	124,824,577	$	123,862,243

LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities
Accounts payable trade	$	1,900,847	$	1,695,353
Gathering fees payable		867,533		935,012
Royalties payable		1,898,177		2,223,043
Income taxes payable		196,131		—
Accrued capital expenditures		348,135		41,694
Accrued compensation		233,172		598,351
Other accrued liabilities		257,788		690,655
Operating lease liabilities		2,756		35,299
Total current liabilities		5,704,539		6,219,407
Non-current liabilities
Asset retirement obligations		2,801,056		2,780,237
Deferred income taxes		10,605,286		10,617,394
Operating lease liabilities, long term		541,396		—
Total non-current liabilities		13,947,738		13,397,631
Total liabilities		19,652,277		19,617,038
Commitments and contingencies (Note 10)
Shareholders' equity
Preferred shares, no par value, unlimited shares authorized, none issued or outstanding		—		—
Common shares, no par value, unlimited shares authorized and 22,926,444 shares issued and 22,879,224 shares outstanding at March 31, 2023 and 23,117,144 issued and outstanding at December 31, 2022		122,789,659		123,904,965
Treasury shares, at cost, 47,220 at March 31, 2023 and 0 at December 31, 2022		(252,119)		—
Additional paid-in capital		10,035,977		9,856,229
Accumulated deficit		(37,173,168)		(39,290,540)
Accumulated other comprehensive income		9,771,951		9,774,551
Total shareholders' equity		105,172,300		104,245,205
Total liabilities and shareholders' equity	$	124,824,577	$	123,862,243

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

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EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income


	Three months ended March 31,
	2023		2022
Revenues from contracts with customers:
Gas, oil, NGL, and condensate revenue	$	6,969,581	$	11,479,325
Gas gathering and compression revenue		2,386,695		2,120,773
Total revenue		9,356,276		13,600,098

Operating costs and expenses:
Lease operating expenses		1,404,279		1,405,490
Gathering system operating expenses		651,341		524,375
Development geological and geophysical expenses		—		2,386
Depletion, depreciation, amortization, and accretion		1,773,006		1,389,219
General and administrative expenses:
Stock based compensation expense		179,748		142,302
Other general and administrative expenses		2,023,773		1,171,132
Total operating costs and expenses		6,032,147		4,634,904
Operating income		3,324,129		8,965,194

Other income (expense):
Interest income		490,762		15,221
Interest expense		(28,437)		(15,319)
Gain (loss) on derivative contracts		1,068,660		(971,904)
Other income (expense)		1,635		(5,406)
Other income (expense), net		1,532,620		(977,408)

Net income before income tax expense		4,856,749		7,987,786
Income tax expense		1,326,922		2,181,898
NET INCOME	$	3,529,827	$	5,805,888
Currency translation adjustments		(2,600)		5,402
NET COMPREHENSIVE INCOME	$	3,527,227	$	5,811,290

Net income per share, basic	$	0.15	$	0.25
Net income per share, diluted	$	0.15	$	0.24
Weighted average number of shares outstanding, basic		22,990,893		23,677,842
Weighted average number of shares outstanding, diluted		23,027,684		23,862,428

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

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EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Changes in Shareholders’ Equity


									Accumulated
									Other				Total
	Common Shares Issued			Treasury Shares			Additional		Comprehensive		Accumulated		Shareholders'
	Shares	Amount		Shares	Amount		paid-in Capital		Income		Deficit		Equity
Balance at January 1, 2023	23,117,144	$	123,904,965	—	$	—	$	9,856,229	$	9,774,551	$	(39,290,540)	$	104,245,205
Net income	—		—	—		—		—		—		3,529,827		3,529,827
Dividends paid	—		—	—		—		—		—		(1,412,455)		(1,412,455)
Stock-based compensation expense	—		—	—		—		179,748		—		—		179,748
Buyback of common shares	—		—	(237,920)		(1,367,425)		—		—		—		(1,367,425)
Retirement of treasury shares	(190,700)		(1,115,306)	190,700		1,115,306		—		—		—		—
Other comprehensive loss	—		—	—		—		—		(2,600)		—		(2,600)
Balance at March 31, 2023	22,926,444	$	122,789,659	(47,220)	$	(252,119)	$	10,035,977	$	9,771,951	$	(37,173,168)	$	105,172,300


									Accumulated
									Other				Total
	Common Shares Issued			Treasury Shares			Additional		Comprehensive		Accumulated		Shareholders'
	Shares	Amount		Shares	Amount		paid-in Capital		Income		Deficit		Equity
Balance at January 1, 2022	24,202,218	$	131,815,739	(534,015)	$	(2,423,007)	$	8,835,203	$	9,818,605	$	(68,783,207)	$	79,263,333
Net income	—		—	—		—		—		—		5,805,888		5,805,888
Dividends paid	—		—	—		—		—		—		(1,483,027)		(1,483,027)
Stock-based compensation expense	—		—	—		—		142,302		—		—		142,302
Exercise of stock options	38,750		209,312	—		—		—		—		—		209,312
Retirement of treasury shares	(534,015)		(2,423,007)	534,015		2,423,007		—		—		—		—
Other comprehensive income	—		—	—		—		—		5,402		—		5,402
Balance at March 31, 2022	23,706,953	$	129,602,044	—	$	—	$	8,977,505	$	9,824,007	$	(64,460,346)	$	83,943,210

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

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EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Cash Flows


	Three months ended March 31,
	2023		2022
Cash flows from operating activities:
Net income	$	3,529,827	$	5,805,888
Adjustments to reconcile net income to net cash provided by operating activities:
Depletion, depreciation, amortization, and accretion		1,773,006		1,389,219
(Gain) loss on derivative contracts		(1,068,660)		971,904
Settlement received (paid) on derivative contracts		363,300		(1,211,728)
Settlement of asset retirement obligation		—		(73,998)
Stock-based compensation expense		179,748		142,302
Deferred income tax expense (benefit)		(12,108)		22,686
Changes in assets and liabilities:
Accounts receivable		2,396,066		(1,871,330)
Other assets and liabilities		143,646		104,177
Accounts payable, royalties payable and other accrued liabilities		(1,062,898)		267,058
Income taxes payable		1,336,225		2,157,292
Net cash provided by operating activities		7,578,152		7,703,470
Cash flows from investing activities:
Additions to unproved oil and gas properties		(106,069)		(92,600)
Additions to proved oil and gas properties		(621,132)		(2,771,925)
(Additions) disposals to gathering system properties		(12,423)		3,612
Additions to land, buildings and property and equipment		(42,703)		—
Purchases of short term investments		(30,138,743)		—
Net cash used in investing activities		(30,921,070)		(2,860,913)
Cash flows from financing activities:
Buyback of common shares		(1,367,425)		—
Exercise of stock options		—		209,312
Dividends paid		(1,412,455)		(1,483,027)
Net cash used in financing activities		(2,779,880)		(1,273,715)
Effect of currency rates on cash, cash equivalents, and restricted cash		(2,600)		5,402
(Decrease) increase in cash, cash equivalents, and restricted cash		(26,125,398)		3,574,244
Cash, cash equivalents, and restricted cash, beginning of period		45,806,947		27,065,423
Cash, cash equivalents, and restricted cash, end of period	$	19,681,549	$	30,639,667

Supplemental cash flow disclosures:
Interest paid	$	17,216	$	17,501

Non-cash investing activities:
Change in proved properties accrued in accounts payable and accrued liabilities	$	375,242	$	(253,632)
Change in gathering system accrued in accounts payable and accrued liabilities	$	9,201	$	19,005
Asset retirement obligation asset additions and adjustments	$	736	$	6,684

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

1. Description of Business

Epsilon Energy Ltd. (the “Company” or “Epsilon” or “we”) was incorporated under the laws of the Province of Alberta, Canada on March 14, 2005. On October 24, 2007, the Company became a publicly traded entity trading on the Toronto Stock Exchange (“TSX”) in Canada. On February 14, 2019, Epsilon’s registration statement on Form 10 was declared effective by the United States Securities and Exchange Commission and on February 19, 2019, we began trading in the United States on the NASDAQ Global Market under the trading symbol “EPSN.” Effective as of the close of trading on March 15, 2019, Epsilon voluntarily delisted its common shares from the TSX. Epsilon is a North American on-shore focused independent natural gas and oil company engaged in the acquisition, development, gathering and production of natural gas and oil reserves.

2. Basis of Preparation

Interim Financial Statements

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the appropriate rules and regulations of the SEC. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. All adjustments which are, in the opinion of management, necessary for a fair statement of the financial position and results of operations for the interim periods presented have been included. The interim financial information and notes hereto should be read in conjunction with the Company’s consolidated financial statements as of and for the year ended December 31, 2022. The results of operations for interim periods are not necessarily indicative of results to be expected for a full fiscal year.

Principles of Consolidation

The Company’s unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Epsilon Energy USA, Inc. and its wholly owned subsidiaries, Epsilon Midstream, LLC, Dewey Energy GP, LLC, Dewey Energy Holdings, LLC, Epsilon Operating, LLC, and Altolisa Holdings, LLC. With regard to the gathering system, in which Epsilon owns an undivided interest in the asset, proportionate consolidation accounting is used. All inter-company transactions have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates pertain to proved natural gas and oil reserves and related cash flow estimates used in impairment tests of natural gas and oil, and gathering system properties, asset retirement obligations, accrued natural gas and oil revenues and operating expenses, accrued gathering system revenues and operating expenses, as well as the valuation of commodity derivative instruments. Actual results could differ from those estimates.

Reclassification

The consolidated financial statements for the prior periods include certain reclassifications that were made to conform to the current period presentation. Such reclassifications have no impact on previously reported consolidated financial position, results of operations or cash flows.

Recently Issued Accounting Standards

The Company, an emerging growth company (“EGC”), has elected to take advantage of the benefits of the extended transition period provided for in Section 7(a)(2)(B) of the Securities Act, for complying with new or revised

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

accounting standards which allows the Company to defer adoption of certain accounting standards until those standards would otherwise apply to private companies.

In June 2016 the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which removes the thresholds that companies apply to measure credit losses on financial instruments measured at amortized cost, such as loans, receivables, and held-to-maturity debt securities. Under current U.S. GAAP, companies generally recognize credit losses when it is probable that the loss has been incurred. The revised guidance removes all recognition thresholds and requires companies to recognize an allowance for credit losses for the difference between the amortized cost basis of a financial instrument and the amount of amortized cost that the Company expects to collect over the instrument’s contractual life. Epsilon has adopted ASU 2016-13 as of January 1, 2023. There was no impact from the adoption of this ASU.

In 2020, the FASB issued ASU 2020-04, Facilitation of the Effects of Reference Rate Reform on Financial Reporting, which, for a limited period of time, adds ASC 848 to the Codification providing entities with certain practical expedients and exceptions from applying modification accounting if certain criteria are met. The amendments are designed to reduce operational challenges that entities will face in applying modification accounting to all contracts that will be revised due to reference rate reform. The guidance in ASC 848 was triggered by the pending discontinuation of certain benchmark reference rates and, in some cases, their replacement by new rates that are more observable or transaction-based and, therefore, less susceptible to manipulation, than certain interest-rate benchmark reference rates commonly used today, including the London Interbank Offered Rate (LIBOR). This process of reference rate reform will require entities to modify certain contracts by removing the discontinued rates and including new rates. Epsilon has adopted ASU 2020-04 as of January 1, 2023.

3. Cash, Cash Equivalents, and Restricted Cash

Cash and cash equivalents include cash on hand and short term, highly liquid investments with original maturities of three months or less that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

Restricted cash consists of amounts deposited to back bonds or letters of credit for potential well liabilities. The Company presents restricted cash with cash and cash equivalents in the Consolidated Statements of Cash Flows.

The following table provides a reconciliation of cash, cash equivalents, and restricted cash reported in the Consolidated Balance Sheets to the total of the amounts in the Consolidated Statements of Cash Flows as of March 31, 2023 and December, 31 2022:


	March 31,		December 31,
	2023		2022
Cash and cash equivalents	$	19,110,225	$	45,236,584
Restricted cash included in other assets		571,324		570,363
Cash, cash equivalents, and restricted cash in the statement of cash flows	$	19,681,549	$	45,806,947

4. Short Term Investments

Short term investments are highly liquid investments with original maturities between three and twelve months. The Company’s short term investments consist of US Treasury Notes. These investments are classified as held-to-maturity and are carried at amortized cost with the intent to be held to maturity. Interest on these investments is presented as interest income in the Consolidated Statements of Operations and Comprehensive Income.

As of March 31, 2023, there was $30.1 million in short term investments, $29.9 million of adjusted cost basis and $0.2 million in unrecognized gains.

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

5. Property and Equipment

The following table summarizes the Company’s property and equipment as of March 31, 2023 and December 31, 2022:


	March 31,		December 31,
	2023		2022
Property and equipment:
Oil and gas properties, successful efforts method
Proved properties	$	149,323,372	$	148,326,265
Unproved properties		18,275,226		18,169,157
Accumulated depletion, depreciation, amortization and impairment		(109,194,701)		(107,729,293)
Total oil and gas properties, net		58,403,897		58,766,129
Gathering system		42,660,626		42,639,001
Accumulated depletion, depreciation, amortization and impairment		(34,778,321)		(34,500,740)
Total gathering system, net		7,882,305		8,138,261
Land		637,764		637,764
Buildings and other property and equipment, net		318,805		286,035
Total property and equipment, net	$	67,242,771	$	67,828,189

Property Impairment

We perform a quantitative impairment test whenever events or changes in circumstances indicate that an asset group's carrying amount may not be recoverable, over proved properties using the published NYMEX forward prices, timing, methods and other assumptions consistent with historical periods. When indicators of impairment are present, GAAP requires that the Company first compare expected future undiscounted cash flows by asset group to their respective carrying values. If the carrying amount exceeds the estimated undiscounted future cash flows, a reduction of the carrying amount of the natural gas properties to their estimated fair values is required. Additionally, if an exploratory well is determined not to have found proved reserves, the costs incurred, net of any salvage value, should be charged to expense.

During the three months ended March 31, 2023 and 2022, no impairment was recorded.

6. Revolving Line of Credit

The Company has a senior secured credit facility which includes a total commitment of up to $100 million. The effective borrowing base is $30 million, which is subject to semi-annual redetermination. There are currently no borrowings under the facility. If we decide to access the facility, depending on the level of borrowing, we might need to increase our hedging activity. Hedging requirements were amended to be between 0%-62.5% of the 24-month projected production volumes, based on percentage utilization on the facility. Borrowings from the Facility may be used for the acquisition and development of oil and gas properties, investments in cash flow generating assets complimentary to the production of oil and gas, and for letters of credit and other general corporate purposes. Upon each advance, interest is charged at the highest of a) the Prime Rate, or b) the sum of the Federal Funds Rate plus 0.5%, plus an applicable margin (0.25%-1.25%, based on percentage utilization on the facility). The facility matures on March 1, 2024.

On February 10, 2023, Epsilon Energy USA entered into the Ninth Amendment of the Credit Agreement. The borrowing base was increased to $30 million. Per ASC 848, Facilitation of the Effects of Reference Rate Reform on Financial Reporting, LIBOR was removed as a reference option in the calculation of interest. Hedging requirements were amended to be between 0%-62.5% of the 24-month projected production volumes, based on percentage utilization on the facility. Also, cash distributions to the parent company (Epsilon Energy Ltd.) were allowed if the facility is < 80% utilized and the leverage ratio (total debt / income adjusted for interest, taxes and non-cash amounts) is less than 2 to 1.

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The bank has a first priority security interest in the tangible and intangible assets of Epsilon Energy USA, Inc. to secure any outstanding amounts under the agreement. Under the terms of the agreement, the Company must maintain the following covenants:

●

Interest coverage ratio greater than 3 to 1 (income adjusted for interest, taxes and non-cash amounts / cash interest expense)

●

Current ratio greater than 1 to 1 (current assets / current liabilities)

●

Leverage ratio less than 3.5 to 1 (total debt / income adjusted for interest, taxes and non-cash amounts)

We were in compliance with the financial covenants of the agreement as of March 31, 2023.

7. Shareholders’ Equity

(a)Authorized shares

The Company is authorized to issue an unlimited number of Common Shares with no par value and an unlimited number of Preferred Shares with no par value.

(b)Purchases of Equity Shares

Normal Course Issuer Bid

On March 9, 2023, the Board of Directors authorized a new share repurchase program of up to 2,292,644 common shares, representing 10% of the outstanding common shares of Epsilon, for an aggregate purchase price of not more than US $15.0 million. The program is pursuant to a normal course issuer bid and will be conducted in accordance with Rule 10b-18 under the Exchange Act. The program commenced on March 27, 2023 and will end on March 26, 2024, unless the maximum amount of common shares is purchased before then or Epsilon provides earlier notice of termination. During the three months ended March 31, 2023, we repurchased 47,220 common shares at an average price of $5.32 per share (excluding commissions).

Commencing on March 8, 2022, we implemented a plan to repurchase our issued and outstanding common shares and to return capital to our shareholders. We used cash on hand to fund these repurchases. During the year ended December 31, 2022, we repurchased 982,500 common shares of the maximum of 1,183,410 authorized for repurchase and spent $6,234,879 under the plan. The repurchased stock had an average price of $6.32 per share (excluding commissions) and was subsequently retired during the year ended December 31, 2022.

Under the same plan, in 2023, we repurchased and retired 190,700 common shares at an average price of $5.82 per share (excluding commissions) before the plan terminated on March 7, 2023.

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table contains activity relating to our acquisition of equity securities during the three months ended March 31, 2023:


				Maximum number
				of shares
	Total number	Average price		remaining to be
	of shares	paid per		purchased under
	purchased	share		the program
Beginning of normal-course issuer bid, March 8, 2022⁽¹⁾					1,183,410
January 2023	125,200	$	5.96
February 2023	65,500	$	5.63
Total as of March 7, 2023	190,700	$	5.82		10,210

Beginning of normal-course issuer bid, March 27, 2023⁽²⁾					2,292,644
March 2023	47,220	$	5.32
Total as of March 31, 2023	47,220	$	5.32		2,245,424

(1)

Epsilon repurchased these shares under its 2022-2023 share repurchase program that commenced on March 8, 2022 and terminated on March 7, 2023, as described above.

(2)

Epsilon repurchased these shares under its 2023-2024 share repurchase program that commenced on March 27, 2023, as described above.

(c)Equity Incentive Plan

Epsilon’s board of directors (the “Board”) adopted the 2020 Equity Incentive Plan (the “2020 Plan”) on July 22, 2020 subject to approval by Epsilon’s shareholders at Epsilon’s 2020 Annual General and Special Meeting of Shareholders, which occurred on September 1, 2020 (the “Meeting”). Shareholders approved the 2020 Plan at the Meeting. Following Epsilon’s listing on the NASDAQ Global Market, the Board determined that it is in the best interest of the shareholders to approve a new incentive plan that is compliant with U.S. public company equity plan rules and practices that would replace Epsilon’s Amended and Restated 2017 Stock Option Plan (including its predecessors) and the Share Compensation Plan (collectively referred to as the “Predecessor Plans”). No further awards will be granted under the Predecessor Plans.

The 2020 Plan provides for incentive compensation in the form of stock options, stock appreciation rights, restricted stock and stock units, performance shares and units, other stock-based awards and cash-based awards. Under the 2020 Plan, Epsilon will be authorized to issue up to 2,000,000 Common Shares.

Restricted Stock Awards

For the three months ended March 31, 2023, no shares of Restricted Stock were awarded to the Company’s board of directors and employees. For the year ended December 31, 2022, 289,231 common shares of Restricted Stock with a weighted average market price at the grant date of $6.28 were awarded to the Company’s officers, employees, and board of directors. These shares vest over a three or four-year period, with an equal number of shares being issued per period on the anniversary of the award resolution. The vesting of the shares is contingent on the individuals’ continued employment or service. The Company determined the fair value of the granted Restricted Stock-based on the market price of the common shares of the Company on the date of grant.

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table summarizes Restricted Stock activity for the three months ended March 31, 2023, and the year ended December 31, 2022:


	Three months ended		Year ended
	March 31, 2023		December 31, 2022
	Number of	Weighted	Number of	Weighted
	Restricted	Average	Restricted	Average
	Shares	Remaining Life	Shares	Remaining Life
	Outstanding	(years)	Outstanding	(years)
Balance non-vested Restricted Stock at beginning of period	298,210	1.74	166,002	1.38
Granted	—	—	289,231	1.86
Vested	—	—	(157,023)	—
Balance non-vested Restricted Stock at end of period	298,210	1.49	298,210	1.74

Stock compensation expense for the granted Restricted Stock is recognized over the vesting period. Stock compensation expense recognized during the three months ended March 31, 2023 and 2022 was $165,064 and $95,112, respectively.

At March 31, 2023, the Company had unrecognized stock-based compensation related to these shares of $1,503,501 to be recognized over a weighted average period of 1.4 years (at December 31, 2022: $1,668,564 over 1.55 years).

Performance Share Unit Awards (“PSU”)

For the three months ended March 31, 2023, no PSUs vested and were issued. For the year ended December 31, 2022, a total of 135,667 common shares vested and were issued. The Company grants PSUs, which are paid in stock, to certain key employees. The PSUs will vest on the last day of the performance period. The number of PSUs that will ultimately vest is based on two performance targets as follows:

●

The targets for the PSUs are based on (i) the relative total stockholder return (“TSR”) percentile ranking and (ii) the relative cash flow per debt adjusted share – growth (“CFDAS Growth”) percentile ranking of the Company, each as compared to the Company’s Performance Peer Group during the applicable one-year performance period ending on December 31.

●

Cash Flow per Debt Adjusted Share (“CFDAS”) is defined as EBITDA (earnings before interest, taxes, depreciation and amortization) divided by the sum of the 1) the total debt plus the value of preferred stock minus cash and the amount of dividends paid for the year divided by the share price at the end of the year; and 2) the actual share count at year end.

●

The vesting of each PSU Award will be based 50% on TSR performance and 50% based on CFDAS Growth performance.

●

The recipient of the award must be employed with the Company at the time of vesting.

The number of shares ultimately issued under these awards can range from zero to 200% of target award amounts at the discretion of the Compensation Committee of the Board of Directors.

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table summarizes PSUs for the three months ended March 31, 2023 and the year ended December 31, 2022:


	Three months ended		Year ended
	March 31, 2023		December 31, 2022
	Number of	Weighted	Number of	Weighted
	Performance	Average	Performance	Average
	Shares	Remaining Life	Shares	Remaining Life
	Outstanding	(years)	Outstanding	(years)
Balance non-vested PSUs at beginning of period	15,833	1.00	151,500	3.84
Vested	—	—	(135,667)	—
Balance non-vested PSUs at end of period	15,833	0.75	15,833	1.00

Stock compensation expense for the granted PSUs is recognized over the vesting period. Stock compensation expense recognized during the three months ended March 31, 2023 and 2022 related to PSUs was $14,684 and $47,190, respectively.

At March 31, 2023, the Company had unrecognized stock-based compensation related to these shares of $44,053 to be recognized over a weighted average period of 0.50 years (at December 31, 2022: $63,328 over 0.63 years).

Stock Options

As of March 31, 2023, the Company had outstanding stock options covering 70,000 Common Shares at an overall average exercise price of $5.03 per Common Share to directors, officers, and employees of the Company and its subsidiaries. These 70,000 options have a weighted average expected remaining term of approximately 0.80 years.

The following table summarizes stock option activity for the three months ended March 31, 2023 and the year ended December 31, 2022:


	Three months ended			Year ended
	March 31, 2023			December 31, 2022
		Weighted				Weighted
	Number of	Average		Number of		Average
	Options	Exercise		Options		Exercise
Exercise price in US$	Outstanding	Price		Outstanding		Price⁽¹⁾
Balance at beginning of period	70,000	$	5.03		218,750	$	5.28
Exercised	—	$	—		(138,750)	$	5.38
Expired/Forfeited	—	$	—		(10,000)	$	5.51
Balance at period-end	70,000	$	5.03		70,000	$	5.03

Exercisable at period-end	70,000	$	5.03		70,000	$	5.03

At March 31, 2023, the Company had unrecognized stock-based compensation, related to these options, of nil (at December 31, 2022: nil). The aggregate intrinsic value at March 31, 2023 was $21,700 (at December 31, 2022: $112,000).

During the three months ended March 31, 2023 and the year ended December 31, 2022, the Company awarded no stock options.

(d) Dividends

On March 3, 2023, the Board declared quarterly dividends of $0.0625 per common share (annualized $0.25 per common share) totaling in aggregate an amount of approximately $1.41 million that was paid on March 31, 2023.

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

8. Revenue Recognition

Revenues are comprised of sales of natural gas, oil and NGLs, along with the revenue generated from the Company’s ownership interest in the gas gathering system in the Auburn field in Northeastern Pennsylvania.

Overall, product sales revenue generally is recorded in the month when contractual delivery obligations are satisfied, which occurs when control is transferred to the Company’s customers at delivery points based on contractual terms and conditions. In addition, gathering and compression revenue generally is recorded in the month when contractual service obligations are satisfied, which occurs as control of those services is transferred to the Company’s customers.

The following table details revenue for the three months ended March 31, 2023 and 2022.


	Three Months Ended March 31,
	2023		2022
Operating revenue
Natural gas	$	6,256,178	$	10,703,084
Natural gas liquids		196,295		314,428
Oil and condensate		517,108		461,813
Gathering and compression fees		2,386,695		2,120,773
Total operating revenue	$	9,356,276	$	13,600,098

Product Sales Revenue

The Company enters into contracts with third party purchasers to sell its natural gas, oil, NGLs and condensate production. Under these product sales arrangements, the sale of each unit of product represents a distinct performance obligation. Product sales revenue is recognized at the point in time that control of the product transfers to the purchaser based on contractual terms which reflect prevailing commodity market prices. To the extent that marketing costs are incurred by the Company prior to the transfer of control of the product, those costs are included in lease operating expenses on the Company’s consolidated statements of operations.

Settlement statements for product sales, and the related cash consideration, are generally received from the purchaser within 30 days. As a result, the Company must estimate the amount of production delivered to the customer and the consideration that will ultimately be received for sale of the natural gas, oil, NGLs, or condensate. Estimated revenue due to the Company is recorded within the receivables line item on the accompanying consolidated balance sheets until payment is received.

Gas Gathering and Compression Revenue

The Company also provides natural gas gathering and compression services through its ownership interest in the gas gathering system in the Auburn field. For the provision of gas gathering and compression services, the Company collects its share of the gathering and compression fees per unit of gas serviced and recognizes gathering revenue over time using an output method based on units of gas gathered.

The settlement statement from the operator of the Auburn GGS is received two months after gathering and compression has occurred. As a result, the Company must estimate the amount of production that was gathered and compressed within the system. Estimated revenue due to the Company is recorded within the receivables line item on the accompanying consolidated balance sheets until payment is received.

Allowance for Credit Losses

The Company records an allowance for credit losses on a case-by-case basis once there is evidence that collection is not probable. For the three months ended March 31, 2023, there were no accounts for which collection was not probable.

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table details accounts receivable as of March 31, 2023 and December 31, 2022.


	March 31,		December 31,
	2023		2022
Accounts receivable
Natural gas and oil sales	$	2,593,604	$	5,696,419
Joint interest billing		17,476		20,454
Gathering and compression fees		1,765,871		1,483,956
Other		428,369		557
Total accounts receivable	$	4,805,320	$	7,201,386

9. Income Taxes

Income tax provisions for the three months ended March 31, 2023 and 2022 are as follows:


	Three months ended March 31,
	2023		2022
Current:
Federal	$	960,508	$	1,466,896
State		378,522		692,316
Total current income tax expense		1,339,030		2,159,212
Deferred:
Federal		(17,278)		22,015
State		5,170		671
Total deferred tax expense		(12,108)		22,686
Income tax expense	$	1,326,922	$	2,181,898

The Company files federal income tax returns in the United States and Canada, and various returns in state and local jurisdictions.

The Company believes it has no uncertain income tax positions. The Company's tax returns are open to audit under the statute of limitations for the years ending December 31, 2019 through December 31, 2022. To the extent we utilize net operating losses generated in earlier years, such earlier years may also be subject to audit.

Our effective tax rate will typically differ from the statutory federal rate primarily as a result of state income taxes and the valuation allowance against the Canadian net operating loss. The effective tax rate for the three months ended March 31, 2023 was higher than the statutory federal rate as a result of the state income taxes and the valuation allowance against the Canadian net operating loss.

10. Commitments and Contingencies

The Company enters into commitments for capital expenditures in advance of the expenditures being made. As of March 31, 2023, the Company had commitments of $0.2 million for capital expenditures.

Litigation

On March 10, 2021, Epsilon filed a complaint against Chesapeake Appalachia, LLC (“Chesapeake”) in the United States District Court for the Middle District of Pennsylvania, Scranton, Pennsylvania (“Middle District”). Epsilon claims that Chesapeake has breached a settlement agreement and several operating agreements (“JOAs”) to which Epsilon and Chesapeake are parties. Epsilon asserts that Chesapeake has failed to cooperate with Epsilon’s efforts to develop resources in the Auburn Development, located in Northeast Pennsylvania, as required under both the settlement agreement and JOAs.

The accompanying notes are an integral part of these interim unaudited condensed consolidated financial statements

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Epsilon requested a preliminary injunction but was unsuccessful in obtaining that injunction. Epsilon filed a motion to amend its original Complaint. Chesapeake opposed. The Court ruled in Epsilon’s favor and allowed Epsilon’s amendment. Chesapeake moved to dismiss the amended Complaint. The Court granted the motion to dismiss without prejudice to Epsilon’s right to file a new lawsuit based on new proposals made after the Court’s decision. Epsilon filed a motion for reconsideration of that decision, but the court denied the motion for reconsideration on January 18, 2022.

Epsilon filed a notice of appeal on February 15, 2022 challenging both the motion to dismiss and motion for reconsideration decisions. Chesapeake filed a cross-appeal on March 1, 2022. A briefing schedule was set and briefing closed October 14, 2022. Oral argument was held in January 2023. A decision on the appeal is not expected until mid-2023.

Epsilon re-filed a complaint against Chesapeake in the Middle District on May 9, 2022. Epsilon generally asserts similar claims as in the previous suit, pursuing declaratory judgment claims regarding Chesapeake’s obligation to Epsilon to cooperate with Epsilon’s efforts in the Auburn Development and regarding Chesapeake’s obstruction of Epsilon’s efforts with the Pennsylvania Department of Environmental Protection permitting process but not based on specific well proposals. Chesapeake filed a motion to stay pending a decision on the Third Circuit appeal, which was granted. The matter is stayed pending a decision from the Third Circuit.

11. Leases

Under ASC 842, Leases, the Company recognized an operating lease related to its corporate office as of March 31, 2023 summarized in the following table: