10-Q 1 epsn-20220331x10q.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, 2022

  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.)

16945 Northchase Drive, Suite 1610

Houston, Texas 77060

(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 10, 2022, there were 23,773,203 Common Shares outstanding.

Table of Contents

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

9

1.

Description of Business

9

2.

Basis of Preparation

9

Interim Financial Statements

9

Principles of Consolidation

9

Use of Estimates

9

Recently Issued Accounting Standards

9

3.

Cash, Cash Equivalents, and Restricted Cash

10

4.

Property and Equipment

11

Property Impairment

11

5.

Revolving Line of Credit

11

6.

Shareholders’ Equity

12

7.

Revenue Recognition

16

8.

Income Taxes

17

9.

Commitments and Contingencies

18

Litigation

18

10.

Net Income Per Share

18

11.

Operating Segments

19

12.

Risk Management Activities

21

Commodity Price Risks

21

Commodity Derivative Contracts

21

13.

Asset Retirement Obligations

22

14.

Fair Value Measurements

22

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

24

Overview

24

Business Strategy

24

Operational Highlights

25

Non-GAAP Financial Measures-Adjusted EBITDA

26

Net Operating Revenues

27

Operating Costs

28

Depletion, Depreciation, Amortization and Accretion (“DD&A”)

28

General and Administrative

29

Interest Expense

29

(Loss) Gain on Commodity Contracts

29

Other Income (Expense)

30

Capital Resources and Liquidity

30

Cash Flow

30

Credit Agreement

30

Derivative Transactions

31

Contractual Obligations

32

Off-Balance Sheet Arrangements

32

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

32

Gathering System Revenue Risk

32

Interest Rate Risk

32

Derivative Contracts

33

ITEM 4. CONTROLS AND PROCEDURES

33

Disclosure Controls and Procedures

33

Changes in Internal Control Over Financial Reporting

33

Inherent Limitations on Effectiveness of Controls

33

PART II OTHER INFORMATION

33

ITEM 1. LEGAL PROCEEDINGS

33

ITEM 1A. RISK FACTORS

34

ITEM 2. UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS

34

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

34

ITEM 4. MINE SAFETY DISCLOSURES

34

ITEM 5. OTHER INFORMATION

34

ITEM 6. EXHIBITS

35

SIGNATURES

35

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, 2021, 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, 2021. Our Annual Report on Form 10-K for the year ended December 31, 2021 is available on our website at www.epsilonenergyltd.com.

4

PART I-FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Balance Sheets

    

March 31, 

    

December 31, 

2022

2021

ASSETS

Current assets

Cash and cash equivalents

$

30,070,813

$

26,497,305

Accounts receivable

6,468,261

4,596,931

Other current assets

465,694

569,870

Total current assets

37,004,768

31,664,106

Non-current assets

Property and equipment:

Oil and gas properties, successful efforts method

Proved properties

140,557,389

138,032,413

Unproved properties

21,793,526

21,700,926

Accumulated depletion, depreciation, amortization and impairment

(103,558,669)

(102,480,972)

Total oil and gas properties, net

58,792,246

57,252,367

Gathering system

42,490,479

42,475,086

Accumulated depletion, depreciation, amortization and impairment

(33,727,110)

(33,443,949)

Total gathering system, net

8,763,369

9,031,137

Land

637,764

637,764

Buildings and other property and equipment, net

300,318

309,102

Total property and equipment, net

68,493,697

67,230,370

Other assets:

Restricted cash

568,854

568,118

Total non-current assets

69,062,551

67,798,488

Total assets

$

106,067,319

$

99,462,594

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities

Accounts payable trade

$

1,820,112

$

1,189,905

Gathering fees payable

843,523

963,546

Royalties payable

1,956,002

1,853,508

Income taxes payable

3,255,717

1,098,425

Accrued capital expenditures

732,523

1,016,830

Other accrued liabilities

802,188

1,098,127

Fair value of derivatives

239,824

Asset retirement obligations

11,209

85,207

Total current liabilities

9,421,274

7,545,372

Non-current liabilities

Asset retirement obligations

2,774,709

2,748,449

Deferred income taxes

9,928,126

9,905,440

Total non-current liabilities

12,702,835

12,653,889

Total liabilities

22,124,109

20,199,261

Commitments and contingencies (Note 9)

Shareholders' equity

Common shares, no par value, unlimited shares authorized and 23,706,953 issued and outstanding at March 31, 2022 and 24,202,218 issued and 23,668,203 shares outstanding at December 31, 2021.

129,602,044

131,815,739

Treasury shares, 0 at March 31, 2022 and 534,015 at December 31, 2021

(2,423,007)

Additional paid-in capital

8,977,505

8,835,203

Accumulated deficit

(64,460,346)

(68,783,207)

Accumulated other comprehensive income

9,824,007

9,818,605

Total shareholders' equity

83,943,210

79,263,333

Total liabilities and shareholders' equity

$

106,067,319

$

99,462,594

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

5

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income (Loss)

Three months ended March 31, 

    

2022

    

2021

Revenues from contracts with customers:

Gas, oil, NGL, and condensate revenue

$

11,479,325

$

6,439,155

Gas gathering and compression revenue

2,120,773

2,002,157

Total revenue

13,600,098

8,441,312

Operating costs and expenses:

Lease operating expenses

1,770,654

1,594,188

Gathering system operating expenses

159,211

190,947

Development geological and geophysical expenses

2,386

11,539

Depletion, depreciation, amortization, and accretion

1,389,219

1,682,860

General and administrative expenses:

Stock based compensation expense

142,302

202,499

Other general and administrative expenses

1,171,132

1,327,161

Total operating costs and expenses

4,634,904

5,009,194

Operating income

8,965,194

3,432,118

Other income (expense):

Interest income

15,221

7,813

Interest expense

(15,319)

(27,073)

(Loss) gain on derivative contracts

(971,904)

465,341

Other (expense) income

(5,406)

1,941

Other (expense) income, net

(977,408)

448,022

Net income before income tax expense

7,987,786

3,880,140

Income tax expense

2,181,898

1,144,573

NET INCOME

$

5,805,888

$

2,735,567

Currency translation adjustments

5,402

242

NET COMPREHENSIVE INCOME

$

5,811,290

$

2,735,809

Net income per share, basic

$

0.25

$

0.11

Net income per share, diluted

$

0.24

$

0.11

Weighted average number of shares outstanding, basic

23,677,842

23,947,222

Weighted average number of shares outstanding, diluted

23,862,428

24,030,104

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

6

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, 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

(1,483,027)

(1,483,027)

Stock-based compensation expenses

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

    

  

  

  

  

  

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, 2021

23,985,799

$

131,730,401

$

$

7,879,119

$

9,820,647

$

(80,410,724)

$

69,019,443

Net income

2,735,567

2,735,567

Stock-based compensation expenses

202,499

202,499

Buyback of common shares

(123,200)

(492,479)

(492,479)

Other comprehensive income

242

242

Balance at March 31, 2021

23,985,799

131,730,401

(123,200)

(492,479)

8,081,618

9,820,889

(77,675,157)

$

71,465,272

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

7

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Cash Flows

Three months ended March 31, 

    

2022

    

2021

Cash flows from operating activities:

Net income

$

5,805,888

$

2,735,567

Adjustments to reconcile net income to net cash provided by operating activities:

Depletion, depreciation, amortization, and accretion

1,389,219

1,682,860

Plug and abandon of proved properties

(73,998)

Loss (gain) on derivative contracts

971,904

(465,341)

Settlement (paid) received on derivative contracts

(1,211,728)

64,200

Settlement of asset retirement obligation

(3,483)

Stock-based compensation expense

142,302

202,499

Deferred income tax expense

22,686

805,359

Changes in assets and liabilities:

Accounts receivable

(1,871,330)

454,740

Prepaid income taxes and other current assets

104,177

161,374

Accounts payable, royalties payable and other accrued liabilities

267,058

(349,705)

Income taxes payable

2,157,292

336,798

Net cash provided by operating activities

7,703,470

5,624,868

Cash flows from investing activities:

Additions to unproved oil and gas properties

(92,600)

(23,702)

Additions to proved oil and gas properties

(2,771,925)

(481,021)

Additions to gathering system properties

3,612

(40,963)

Additions to land, buildings and property and equipment

(5,745)

Prepaid drilling costs

156

Net cash used in investing activities

(2,860,913)

(551,275)

Cash flows from financing activities:

Buyback of common shares

(492,479)

Exercise of stock options

209,312

Dividends

(1,483,027)

Net cash used in financing activities

(1,273,715)

(492,479)

Effect of currency rates on cash, cash equivalents and restricted cash

5,402

242

Increase in cash, cash equivalents and restricted cash

3,574,244

4,581,356

Cash, cash equivalents and restricted cash, beginning of period

27,065,423

13,836,771

Cash, cash equivalents and restricted cash, end of period

$

30,639,667

$

18,418,127

Supplemental cash flow disclosures:

Interest paid

$

17,501

$

29,562

Non-cash investing activities:

Change in unproved properties accrued in accounts payable and accrued liabilities

$

$

(65,000)

Change in proved properties accrued in accounts payable and accrued liabilities

$

(253,632)

$

468,972

Change in gathering system accrued in accounts payable and accrued liabilities

$

19,005

$

(27,679)

Asset retirement obligation asset additions and adjustments

$

6,684

$

(21,554)

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, the Company 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. The Company is engaged in the acquisition, development, gathering and production of primarily natural gas reserves in the United States.

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 presentation 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, 2021. 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.

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

In March 2020, the FASB issued ASU No. 2020-04 - Reference Rate Reform (Topic 848), codified as ASC 848 (“ASC 848”). This was followed by ASU No. 2021-01, Reference Rate Reform (Topic 848): Scope (“ASU 2021-01”), issued in January 2021. The purpose of ASC 848 is to provide optional guidance to ease the potential effects on financial

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

reporting of the market-wide migration away from Interbank Offered Rates (“IBORs”) to alternative reference rates. ASC 848 applies only to contracts, hedging relationships, and other transactions that reference a reference rate expected to be discontinued because of reference rate reform. The guidance may be applied upon issuance of ASC 848 through December 31, 2022. We do not expect a material impact from the adoption of this ASU.

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 will remove all recognition thresholds and will require 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. ASU 2016-13 is effective for fiscal years beginning after December 15, 2022, and interim periods within those fiscal years, and must be applied retrospectively. Early adoption is permitted. Epsilon will adopt ASU 2016-13 as of January 1, 2023.

In February 2016, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, Leases (Topic 842), which will require lessees to recognize a right of use asset and a lease liability on their balance sheet for all leases, including operating leases, with a term of greater than 12 months. In July 2018, the FASB issued ASU 2018-11, which adds a transition option permitting entities to apply the provisions of the new standard at its adoption date instead of the earliest comparative period presented in the consolidated financial statements. Under this transition option, comparative reporting would not be required, and the provisions of the standard would be applied prospectively to leases in effect at the date of adoption.

The Company has determined its portfolio of leased assets and is completing its review of all related contracts to determine the impact the adoption will have on its consolidated financial statements and related disclosures. Upon adoption, the Company will recognize a right of use asset and lease liability for certain commitments related to office space that will be accounted for as an operating lease. To track these lease arrangements and facilitate compliance with this ASU, the Company is in the process of designing processes and internal controls.

The adoption of this ASU will increase asset and liability balances on the consolidated balance sheets due to the required recognition of a right of use asset and corresponding lease liabilities and will result in changes to the Company’s existing accounting policies, business processes, and internal controls. The Company plans to elect the available package practical expedients provided in the standard and adopt Topic 842 as of January 1, 2022 at December 31, 2022 on its Form 10-K for the year ending December 31, 2022, using the optional transition method provided by ASU 2018-11 and continues to assess potential effects of the standard.

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.

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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, 2022 and December, 31 2021:

    

March 31, 

    

December 31,

2022

2021

Cash and cash equivalents

$

30,070,813

$

26,497,305

Restricted cash included in other assets

568,854

568,118

Cash, cash equivalents and restricted cash in the statement of cash flows

$

30,639,667

$

27,065,423

4.  Property and Equipment

The following table summarizes the Company’s property and equipment as of March 31, 2022 and December 31, 2021:

    

March 31, 

    

December 31, 

2022

2021

Property and equipment:

Oil and gas properties, successful efforts method

Proved properties

$

140,557,389

$

138,032,413

Unproved properties

21,793,526

21,700,926

Accumulated depletion, depreciation, amortization and impairment

(103,558,669)

(102,480,972)

Total oil and gas properties, net

58,792,246

57,252,367

Gathering system

42,490,479

42,475,086

Accumulated depletion, depreciation, amortization and impairment

(33,727,110)

(33,443,949)

Total gathering system, net

8,763,369

9,031,137

Land

637,764

637,764

Buildings and other property and equipment, net

300,318

309,102

Total property and equipment, net

$

68,493,697

$

67,230,370

Property Impairment

Epsilon performs a quantitative impairment test quarterly or 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 compares 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 oil and natural gas properties to their estimated fair values is required, which is determined based on discounted cash flow techniques using significant assumptions including projected revenues, future commodity prices, and a market-specific weighted average cost of capital which are affected by expectations about future market and economic conditions. During the three months ended March 31, 2022 and 2021, no impairment was required.

5. Revolving Line of Credit

The Company has a senior secured revolving credit facility (“Facility”) which includes a total commitment of up to $100 million. The current borrowing base is $14 million, which is subject to semi-annual redetermination. There are currently no borrowings under the Facility. If Epsilon decided to access the Facility, depending on the level of borrowing, the Company might need to increase its hedging activity. 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) rate of LIBOR plus an applicable margin (2.75%-3.75% based on the percent of the line of credit utilized), b) the Prime Rate, or c) the sum of the Federal Funds Rate plus 0.5%.

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Effective April 6, 2021, the agreement was amended to extend the maturity date to March 1, 2024. In addition, the agreement was amended to include a Benchmark Replacement definition and transition plan to be used at such time when the LIBOR rate is discontinued.

On November 23, 2021, the borrowing base of $14 million was reaffirmed until the next periodic redetermination of the borrowing base.

The lender under the Credit Facility has a first priority security interest in the tangible and intangible assets, including the gathering system, 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 based on income adjusted for interest, taxes and non-cash amounts.

Current ratio, adjusted for line of credit amounts used and available and non-cash amounts, greater than 1.

Leverage ratio less than 3.0 based on income adjusted for interest, taxes and non-cash amounts.

The Company was in compliance with the financial covenants of the Credit Facility as of March 31, 2022 and expects to be in compliance with the financial covenants for the next 12 months.

A commitment fee of 0.50% is assessed quarterly on the daily average unused borrowing base on the Credit Facility.

    

Balance at

    

Balance at

    

    

March 31, 

    

December 31, 

Current

Interest Rate

    

2022

2021

    

Borrowing Base

    

3 mo.

Revolving line of credit

$

$

$

14,000,000

LIBOR + 3.25% (1)

(1)At March 31, 2022, the interest rate was 3.50%.

6. 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

Commencing on January 1, 2022, the Company entered into a share repurchase program on the NASDAQ conducted in accordance with Rule 10b-18 promulgated under the Securities Exchange Act of 1934. The Company is authorized to repurchase up to 1,183,410 of its outstanding common shares up to an aggregate purchase price limit of $8 million, representing 5% of the outstanding common shares of Epsilon as of January 1, 2022. The program will end on December 31, 2022 unless the common shares or purchase price limits are reached before then or Epsilon provides earlier notice of termination. For the three months ended March 31, 2022, no shares had been repurchased.

Commencing on January 1, 2021, Epsilon conducted a normal course issuer bid (“NCIB”) to repurchase our issued and outstanding common shares, when doing so was accretive to management's estimates of intrinsic value per share. The NCIB ended on December 31, 2021. The Company used discretionary cash to fund these repurchases. During the year ended December 31, 2021, Epsilon repurchased 534,015 common shares of the authorized 1,193,000 purchase

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

amount and spent $2,423,007 under the NCIB. The repurchased stock had an average price of $4.54 per share and were subsequently cancelled during the three months ended March 31, 2022.

Repurchases may be made at management’s discretion from time to time through the facilities of the NASDAQ Global Market. The price paid for the common shares will be, subject to applicable securities laws, the prevailing market price of such common shares on the NASDAQ Global Market at the time of such purchase. The Company intends to fund the purchase out of available cash and does not expect to incur debt to fund the share repurchase program. The shares are accounted for as treasury shares until such a time as they are cancelled.

(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. As of December 31, 2021, the Company granted, after the Compensation Committee approved the terms, target formulas, and peer group applicable to the performance incentive awards, 20,834 common shares and 48,000 time-based restricted shares to the CEO and the board of directors.

Restricted Stock Awards

For the three months ended March 31, 2022, no shares of Restricted Stock were awarded. For the year ended December 31, 2021, 48,000 common shares of Restricted Stock with a weighted average market price at the grant date of $5.04 were awarded to the Company’s board of directors. These shares vest over a three-year period, with one-third of the 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.

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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, 2022, and the year ended December 31, 2021:

Three months ended

Year ended

March 31, 2022

December 31, 2021

Weighted

Weighted

Number of

Average

Number of

Average

Shares

Remaining Life

Shares

Remaining Life

    

Outstanding

    

(years)

    

Outstanding

    

(years)

Balance non-vested Restricted Stock at beginning of period

166,002

1.38

290,070

1.60

Granted

48,000

3.00

Vested

(137,668)

Forfeited

(34,400)

Balance non-vested Restricted Stock at end of period

166,002

1.13

166,002

1.38

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, 2022 and 2021 was $95,112 and $137,206, respectively.

At March 31, 2022, the Company had unrecognized stock-based compensation related to these shares of $534,748 to be recognized over a weighted average period of 1.01 years (at December 31, 2021: $696,833 over 1.11 years).

Performance Share Unit Awards (“PSU”)

For the three months ended March 31, 2022, no PSUs were awarded. For the year ended December 31, 2021, a total of 62,501 common shares vested and were issued, of which 20,834 of the common shares were granted as a result of the Company exceeding its 2020 TSR performance target. The Company grants PSUs, which are paid in stock, to certain key employees. PSUs are based on a three-year performance period with performance being measured each year at December 31. 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.

The PSUs are accounted for as equity awards. The fair value of the 50% for performance based on CFDAS Growth was determined as the market price of the common shares of the Company on the date of grant. Weighted average fair value of CFDAS PSUs granted during the year ended December 31, 2021 was $3.41 per unit. The fair value of the 50% for performance based on TSR was determined on the grant date by the application of a Monte Carlo simulation

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

model.  For the year ended December 31, 2021, the Compensation Committee did not approve the issuance of any new PSU’s.

The Monte Carlo simulation model utilizes multiple input variables that determine the probability of satisfying the market condition stipulated in the performance stock awards, to calculate the fair value of the awards. Expected volatilities in the model were estimated using a historical period consistent with the expected term for each annual performance period of the awards. The risk-free interest rate was based on the United States Treasury rate measured over a term commensurate with the expected term for each annual performance period of the awards. The expected term is based on the time between the valuation date and the end of each annual performance period of the awards. The valuation model assumes dividends are immediately reinvested.

The following table summarizes PSUs for the three months ended March 31, 2022 and the year ended December 31, 2021:

Three months ended

Year ended

March 31, 2022

December 31, 2021

Weighted

Weighted

Number of

Average

Number of

Average

Shares

Remaining Life

Shares

Remaining Life

    

Outstanding

    

(years)

    

Outstanding

    

(years)

Balance non-vested PSUs at beginning of period

151,500

0.75

193,167

1.60

Granted

20,834

Vested

(62,501)

Balance non-vested PSUs at end of period

151,500

0.72

151,500

0.75

Stock compensation expense for the granted PSUs is recognized over the vesting period. Stock compensation expense recognized during the three months ended March 31, 2022 and 2021 related to PSUs was $47,190 and $65,293, respectively.

At March 31, 2022, the Company had unrecognized stock-based compensation related to these shares of $260,225 to be recognized over a weighted average period of 0.90 years (at December 31, 2021: $310,790 over 1.01 years).

Stock Options

Through March 31, 2022, the Company had outstanding stock options covering 180,000 Common Shares at an overall average exercise price of $5.25 per Common Share to directors, officers, and employees of the Company and its subsidiaries. These 180,000 options have a weighted average expected remaining term of approximately 1.07 years.

The following table summarizes stock option activity for the three months ended March 31, 2022 and the year ended December 31, 2021:

Three months ended

Year ended

March 31, 2022

December 31, 2021

Weighted

Weighted

Number of

Average

Number of

Average

Options

Exercise

Options

Exercise

Exercise price in US$

    

Outstanding

    

Price (1)

    

Outstanding

    

Price (1)

Balance at beginning of period

218,750

$

5.28

245,000

$

5.27

Exercised

(38,750)

$

5.40

(16,250)

$

5.25

Expired/Forfeited

(10,000)

$

5.50

Balance at period-end

180,000

$

5.25

218,750

$

5.28

Exercisable at period-end

180,000

$

5.25

218,750

$

5.28

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

(1)Exercise price has been converted to US$ using the rate of Cdn$1.33 to US$1, the rate on March 15, 2019, the date Epsilon Energy, Ltd was delisted from the TSX.

At March 31, 2022, using the Black Scholes model, the Company had unrecognized stock-based compensation, related to these options, of nil (at December 31, 2021: nil). The aggregate intrinsic value at March 31, 2022 was nil (at December 31, 2021: nil).

During the three months ended March 31, 2022 and the year ended December 31, 2021, the Company awarded no stock options.

(d) Dividends

On February 25, 2022, the Board declared a quarterly dividend of $0.0625 per common share (annualized $0.25 per common share) totaling in aggregate an amount of approximately $1.5 million that was paid on March 31, 2022.

7. Revenue Recognition

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

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 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, 2022 and 2021.

Three Months Ended March 31, 

    

2022

    

2021

Operating revenue

Natural gas

$

10,703,084

$

6,332,099

Natural gas liquids

314,428

45,621

Oil and condensate

461,813

61,435

Gathering and compression fees

2,120,773

2,002,157

Total operating revenue

$

13,600,098

$

8,441,312

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 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.

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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 Gas Gathering System is received two months after transmission and compression has occurred. As a result, the Company must estimate the amount of production that was transmitted 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 Doubtful Accounts

The Company records an allowance for doubtful accounts on a case-by-case basis once there is evidence that collection is not probable. For the three months ended March 31, 2022, there were no accounts for which collection was not probable.

The following table details accounts receivable as of March 31, 2022 and December 31, 2021.

    

March 31, 

    

December 31, 

2022

2021

Accounts receivable

Natural gas and oil sales

$

4,702,314

$

2,996,344

Joint interest billing

96,459

60,134

Gathering and compression fees

1,545,035

1,539,976

Other

124,453

477

Total accounts receivable

$

6,468,261

$

4,596,931

8. Income Taxes

Income tax provisions for the three months ended March 31, 2022 and 2021 are as follows:

Three months ended March 31, 

    

2022

    

2021

Current:

Federal

$

1,466,896

$

155,370

State

692,316

183,844

Total current income tax expense

2,159,212

339,214

Deferred:

Federal

22,015

663,202

State

671

142,157

Total deferred tax expense

22,686

805,359

Income tax expense

$

2,181,898

$

1,144,573

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 appropriate support for the income tax positions taken and to be taken on our tax returns and that the accruals for tax liabilities are adequate for all open years based on our assessment of various factors including past experience and interpretations of tax law applied to the facts of each matter. The Company's tax returns are

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

open to audit under the statute of limitations for the years ending December 31, 2018 through December 31, 2021. 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, 2022 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.

9. Commitments and Contingencies

The Company’s future minimum lease commitments as of March 31, 2022 are summarized in the following table:

Year ended

    

December 31, 

    

Payments

2022

$

140,189

2023

62,444

$

202,633

The Company enters into commitments for capital expenditures in advance of the expenditures being made. As of March 31, 2022, the Company had commitments of $1.03 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 North-Central Pennsylvania, as required under both the settlement agreement and JOAs.

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 on a narrow issue 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 court-mandated mediation was set for June 9, 2022.  A briefing schedule has not yet been set, and accordingly, a decision on the appeal is not expected until early to mid-2023.

Epsilon re-filed a complaint against Chesapeake in the Middle District on May 9, 2022.  Epsilon generally asserts the 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.  Chesapeake’s response to the complaint is expected in June 2022.  

10. Net Income Per Share

Basic net income per share is computed on the basis of the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed based upon the weighted-average number of

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

common shares outstanding during the period plus the assumed issuance of common shares for all potentially dilutive securities.

The net income used in the calculation of basic and diluted net income per share is as follows:

Three months ended March 31, 

    

2022

    

2021

Net income available to shareholders

$

5,805,888

$

2,735,567

In calculating the net income per share, basic and diluted, the following weighted-average shares were used:

Three months ended March 31, 

    

2022

    

2021

Basic weighted-average number of shares outstanding

23,677,842

23,947,222

Dilutive stock options

16,728

Unvested time-based restricted shares

 

65,395

 

29,034

Unvested performance-based restricted shares

 

102,463

 

53,848

Diluted weighted average shares outstanding

 

23,862,428

 

24,030,104

The company excluded the following shares from the diluted EPS because their inclusion would have been anti-dilutive.

Three months ended March 31, 

    

2022

    

2021

Anti-dilutive options

163,272

245,000

Anti-dilutive unvested time-based restricted shares

100,607

239,036

Anti-dilutive unvested performance-based restricted shares

49,037

139,319

Total Anti-dilutive shares

 

312,916

 

623,355

11. Operating Segments

Operating segments are reported in a manner consistent with the internal reporting provided to the chief operating decision-maker. The chief operating decision-maker, who is responsible for allocating resources and assessing performance of the operating segments, has been identified as executive management. Segment performance is evaluated based on operating profit or loss as shown in the table below. Interest income and expense, and income taxes are managed separately on a group basis.

The Company’s reportable segments are as follows:

a.The Upstream segment activities include acquisition, development and production of oil, natural gas, and other liquid reserves on properties within the United States;
b.The Gas Gathering segment partners with two other companies to operate a natural gas gathering system; and
c.The Corporate segment activities include corporate listing and governance functions of the Company.

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Segment activity as of, and for the three months ended March 31, 2022 and 2021 is as follows: