Amplify Energy Corp. - Quarter Report: 2012 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

 

FORM 10-Q

 

 

(Mark One)

 

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

 

For the quarterly period ended September 30, 2012

 

OR

 

o         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: 001-35512

 

 

MIDSTATES PETROLEUM COMPANY, INC.

(Exact name of registrant as specified in its charter)

 

 

 

(713) 595-9400

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post such files). Yes x No o

 

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

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

 

The number of shares outstanding of our common stock at November 5, 2012 is shown below:

 

 

 

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MIDSTATES PETROLEUM COMPANY, INC.

QUARTERLY REPORT ON

FORM 10-Q

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2012

 

TABLE OF CONTENTS

 

	Page
Glossary of Oil and Natural Gas Terms	i
PART I - FINANCIAL INFORMATION
Item 1.- Financial Statements
Condensed Consolidated Balance Sheets at September 30, 2012 and December 31, 2011 (unaudited)	1
Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2012 and 2011 (unaudited)	2
Condensed Consolidated Statements of Changes in Stockholders’/Members’ Equity for the Nine Months Ended September 30, 2012 (unaudited)	3
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2012 and 2011 (unaudited)	4
Notes to Unaudited Condensed Consolidated Financial Statements	5
Item 2. - Management’s Discussion and Analysis of Financial Condition and Results of Operations	20
Item 3. - Quantitative and Qualitative Disclosures About Market Risk	34
Item 4. - Controls and Procedures	35
PART II - OTHER INFORMATION
Item 1. - Legal Proceedings	35
Item 1A. - Risk Factors	35
Item 2. - Unregistered Sales of Equity Securities and Use of Proceeds	40
Item 3. - Defaults upon Senior Securities	40
Item 4. - Mine Safety Disclosures	41
Item 5. - Other Information	41
Item 6. - Exhibits	41
SIGNATURES	42
EXHIBIT INDEX	43

 

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GLOSSARY OF OIL AND NATURAL GAS TERMS

 

Bbl: One stock tank barrel, of 42 U.S. gallons liquid volume, used herein in reference to oil, condensate or natural gas liquids.

 

Boe: Barrels of oil equivalent, with 6,000 cubic feet of natural gas being equivalent to one barrel of oil.

 

Boe/d: Barrels of oil equivalent per day.

 

Completion:  The process of treating a drilled well followed by the installation of permanent equipment for the production of natural gas or oil, or in the case of a dry hole, the reporting of abandonment to the appropriate agency.

 

Dry hole: A well found to be incapable of producing hydrocarbons in sufficient quantities such that proceeds from the sale of such production do not exceed production expenses and taxes.

 

Exploratory well: A well drilled to find a new field or to find a new reservoir in a field previously found to be productive of natural gas or oil in another reservoir.

 

MMBoe: One million barrels of oil equivalent.

 

Net acres: The percentage of total acres an owner has out of a particular number of acres, or a specified tract. An owner who has 50% interest in 100 acres owns 50 net acres.

 

NYMEX: The New York Mercantile Exchange.

 

Proved reserves: Those quantities of oil and gas, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible — from a given date forward, from known reservoirs, and under existing economic conditions, operating methods, and government regulations — prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation. The project to extract the hydrocarbons must have commenced or the operator must be reasonably certain that it will commence the project within a reasonable time. The area of the reservoir considered as proved includes (i) the area identified by drilling and limited by fluid contacts, if any, and (ii) adjacent undrilled portions of the reservoir that can, with reasonable certainty, be judged to be continuous with it and to contain economically producible oil or gas on the basis of available geoscience and engineering data. In the absence of data on fluid contacts, proved quantities in a reservoir are limited by the lowest known hydrocarbons, LKH, as seen in a well penetration unless geoscience, engineering, or performance data and reliable technology establishes a lower contact with reasonable certainty. Where direct observation from well penetrations has defined a highest known oil, HKO, elevation and the potential exists for an associated gas cap, proved oil reserves may be assigned in the structurally higher portions of the reservoir only if geoscience, engineering, or performance data and reliable technology establish the higher contact with reasonable certainty. Reserves which can be produced economically through application of improved recovery techniques (including, but not limited to, fluid injection) are included in the proved classification when (i) successful testing by a pilot project in an area of the reservoir with properties no more favorable than in the reservoir as a whole, the operation of an installed program in the reservoir or an analogous reservoir, or other evidence using reliable technology establishes the reasonable certainty of the engineering analysis on which the project or program was based; and (ii) the project has been approved for development by all necessary parties and entities, including governmental entities. Existing economic conditions include prices and costs at which economic producibility from a reservoir is to be determined. The price shall be the average price during the 12-month period prior to the ending date of the period covered by the report, determined as an unweighted arithmetic average of the first-day-of-the-month price for each month within such period, unless prices are defined by contractual arrangements, excluding escalations based upon future conditions.

 

Reasonable certainty: A high degree of confidence.

 

Recompletion: The process of re-entering an existing wellbore that is either producing or not producing and completing new reservoirs in an attempt to establish or increase existing production.

 

Reserves: Estimated remaining quantities of oil and natural gas and related substances anticipated to be economically producible as of a given date by application of development projects to known accumulations.

 

Reservoir: A porous and permeable underground formation containing a natural accumulation of producible natural gas and/or oil that is confined by impermeable rock or water barriers and is individual and separate from other reservoirs.

 

Spud or Spudding: The commencement of drilling operations of a new well.

 

Wellbore: The hole drilled by the bit that is equipped for oil or gas production on a completed well. Also called well or borehole.

 

Working interest: The right granted to the lessee of a property to explore for and to produce and own oil, gas, or other minerals. The working interest owners bear the exploration, development, and operating costs on either a cash, penalty, or carried basis.

 

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PART I - FINANCIAL INFORMATION

 

MIDSTATES PETROLEUM COMPANY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands, except share amounts)

 

		September 30, 2012			December 31, 2011
ASSETS
CURRENT ASSETS:
Cash and cash equivalents		$	4,674		$	7,344
Accounts receivable:
Oil and gas sales		22,599			23,792
Severance tax refund		187			3,413
Other		521			249
Prepayments		270			2,642
Inventory		7,036			5,713
Commodity derivative contracts		987			4,957
Total current assets		36,274			48,110
PROPERTY AND EQUIPMENT:
Oil and gas properties, on the basis of full-cost accounting:
Proved properties		936,476			644,393
Unevaluated properties		102,173			76,857
Other property and equipment		2,758			1,672
Less accumulated depreciation, depletion, and amortization		(235,444		)	(148,843		)
Net property and equipment		805,963			574,079
OTHER ASSETS:
Commodity derivative contracts		594			588
Other noncurrent assets		13,454			1,879
Total other assets		14,048			2,467
TOTAL		$	856,285		$	624,656
LIABILITIES AND EQUITY
CURRENT LIABILITIES:
Accounts payable		$	39,488		$	35,731
Accrued liabilities		64,507			37,524
Commodity derivative contracts		9,244			12,599
Total current liabilities		113,239			85,854
LONG-TERM LIABILITIES:
Asset retirement obligations		11,804			7,627
Commodity derivative contracts		3,978			10,178
Long-term debt		216,300			234,800
Deferred income taxes		157,326			—
Other long-term liabilities		573			695
Total long-term liabilities		389,981			253,300
COMMITMENTS AND CONTINGENCIES (Note 12)
STOCKHOLDERS’/MEMBERS’ EQUITY
Capital contributions		—			322,496
Preferred stock, $0.01 par value, 49,675,000 shares authorized; no shares issued or oustanding		—			—
Series A mandatorily convertible preferred stock, $1,000 liquidation value; 8% cumulative dividends; 325,000 shares designated, no shares issued or outstanding		—			—
Common stock, $0.01 par value, 300,000,000 shares authorized; 66,533,872 shares issued and oustanding		665			—
Additional paid-in-capital		537,082			—
Retained deficit/accumulated loss		(184,682		)	(36,994		)
Total stockholders’/members’ equity		353,065			285,502
TOTAL		$	856,285		$	624,656

 

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

 

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MIDSTATES PETROLEUM COMPANY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)

 

		For the Three Months Ended September 30,						For the Nine Months Ended September 30,
		2012			2011			2012			2011
REVENUES:
Oil sales		$	53,143		$	41,241		$	146,281		$	122,817
Natural gas sales		2,257			5,779			8,086			14,813
Natural gas liquid sales		4,134			4,732			14,307			9,949
Gains (Losses) on commodity derivative contracts — net		(33,726		)	40,560			(10,249		)	22,442
Other		124			146			331			260
Total revenues		25,932			92,458			158,756			170,281
EXPENSES:
Lease operating and workover		6,569			3,861			18,957			10,136
Severance and other taxes		6,450			(443		)	18,098			9,052
Asset retirement accretion		165			119			463			205
General and administrative		7,948			17,064			18,966			31,608
Acquisition and transition costs		2,675			—			2,675			—
Depreciation, depletion, and amortization		30,692			22,747			86,601			62,631
Total expenses		54,499			43,348			145,760			113,632
OPERATING INCOME (LOSS)		(28,567		)	49,110			12,996			56,649
OTHER INCOME (EXPENSE)
Interest income		80			3			229			15
Interest expense — net of amounts capitalized		(908		)	(601		)	(3,587		)	(735		)
Total other income (expense)		(828		)	(598		)	(3,358		)	(720		)
INCOME (LOSS) BEFORE TAXES		(29,395		)	48,512			9,638			55,929
Income tax expense (benefit)		(11,592		)	—			157,326			—
NET INCOME (LOSS)		$	(17,803	)	$	48,512		$	(147,688	)	$	55,929
Loss per share (1)
Basic and Diluted (Note 11)		$	(0.27	)	N/A			$	(2.54	)	N/A
Weighted average shares outstanding (1)
Basic and Diluted (Note 11)		65,634			N/A			58,080			N/A

 

(1)         For the nine months ended September 30, 2012, the calculations of loss per share and weighted average shares outstanding are pro forma. See Note 11.

 

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

 

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MIDSTATES PETROLEUM COMPANY, INC.

CONDENSED STATEMENT OF CHANGES IN STOCKHOLDERS’/MEMBERS’ EQUITY

(Unaudited)

(In thousands, except share amounts)

 

		Common Stock														Total
		Number of Shares		Amount			Capital Contributions			Additional Paid- in-Capital			Retained deficit/ accumulated loss			Stockholders’/ Members’ Equity
Balance as of December 31, 2011		—		$	—		$	322,496		$	—		$	(36,994	)	$	285,502
Issuance of common stock		47,634,353		476			(476		)	—			—			—
Reclassification of members’ contributions		—		—			(322,020		)	322,020			—			—
Proceeds from the sale of common stock		18,000,000		180			—			213,407			—			213,587
Share-based compensation		916,594		9						1,655			—			1,664
Forfeitures of restricted stock		(17,075	)	—						—			—			—
Net loss		—		—			—			—			(147,688		)	(147,688		)
Balance as of September 30, 2012		66,533,872		$	665		$	—		$	537,082		$	(184,682	)	$	353,065

 

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

 

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MIDSTATES PETROLEUM COMPANY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

 

		Nine months ended September 30,
		2012			2011
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)		$	(147,688	)	$	55,929
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Unrealized (gains) losses on commodity derivative contracts, net		(5,591		)	(34,536		)
Asset retirement accretion		463			205
Depreciation, depletion, and amortization		86,601			62,631
Share-based compensation		1,568			20,128
Deferred income taxes		157,326			—
Amortization of deferred financing costs		583			605
Change in operating assets and liabilities:
Accounts receivable — oil and gas sales		1,193			(3,759		)
Accounts receivable — other		2,954			(5,112		)
Prepayments and other assets		(2,224		)	(221		)
Inventory		(1,323		)	(1,255		)
Accounts payable		(1,211		)	(4,677		)
Accrued liabilities		2,151			12,681
Other		(122		)	649
Net cash provided by operating activities		$	94,680		$	103,268
CASH FLOWS FROM INVESTING ACTIVITIES:
Investment in property and equipment		(284,875		)	(162,692		)
Net cash used in investing activities		$	(284,875	)	$	(162,692	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from long-term borrowings		84,667			109,000
Repayment of long-term borrowings		(103,167		)	—
Proceeds from issuance of mandatorily redeemable convertible preferred units		65,000			—
Repayment of mandatorily redeemable convertible preferred units		(65,000		)	—
Proceeds from sale of common stock, net of initial public offering expenses of $6.4 million		213,587			—
Deferred financing costs		(7,562		)	(863		)
Cash received for units		—			170
Distributions to members		—			(50,572		)
Other		—			(8		)
Net cash provided by financing activities		$	187,525		$	57,727
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(2,670		)	(1,697		)
Cash and cash equivalents, beginning of period		7,344			11,917
Cash and cash equivalents, end of period		$	4,674		$	10,220
SUPPLEMENTAL INFORMATION:
Non-cash transactions — investments in property and equipment accrued — not paid		$	90,614		$	56,030
Non-cash member’s contribution		$	—		$	2,700
Cash paid for interest, net of capitalized interest of $3.2 million and $2.0 million, respectively		$	3,176		$	735

 

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

 

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MIDSTATES PETROLEUM COMPANY, INC.

Notes to Unaudited Condensed Consolidated Financial Statements

 

1. Organization and Business

 

Midstates Petroleum Company, Inc., through its wholly owned subsidiary Midstates Petroleum Company LLC, engages in the business of drilling for, and production of, oil, natural gas and natural gas liquids. Midstates Petroleum Company, Inc. was incorporated pursuant to the laws of the State of Delaware on October 25, 2011 to become a holding company for Midstates Petroleum Company LLC (“Midstates Sub”), which was previously a wholly-owned subsidiary of Midstates Petroleum Holdings LLC (“Holdings LLC”). Pursuant to the terms of a corporate reorganization that was completed in connection with the closing of Midstates Petroleum Company, Inc.’s initial public offering, all of the interests in Midstates Petroleum Holdings LLC were exchanged for newly issued common shares Midstates Petroleum Company, Inc., and as a result, Midstates Petroleum Company LLC became a wholly-owned subsidiary of Midstates Petroleum Company, Inc. and Midstates Petroleum Holdings LLC ceased to exist as a separate entity. The terms “the Company,” “we,” “us,” “our,” and similar terms when used in the present tense, prospectively or for historical periods since April 25, 2012, refer to Midstates Petroleum Company, Inc. and its subsidiary, and for historical periods prior to April 25, 2012, refer to Midstates Petroleum Holdings LLC and its subsidiary, unless the context indicates otherwise. The term “Holdings LLC” refers solely to Midstates Petroleum Holdings LLC prior to the corporate reorganization.

 

On April 25, 2012, the Company completed its initial public offering of common stock pursuant to a registration statement on Form S-1 (File 333-177966), as amended and declared effective by the SEC on April 19, 2012. Pursuant to the registration statement, the Company registered the offer and sale of 27,600,000 shares of $0.01 par value common stock, which included 6,000,000 shares of stock sold by the selling shareholders and 3,600,000 shares of common stock sold by the selling stockholders pursuant to an option granted to the underwriters to cover over-allotments. The Company’s sale of the shares in its initial public offering closed on April 25, 2012 and its initial public offering terminated upon completion of the closing.

 

The proceeds of the Company’s initial public offering, based on the public offering price of $13.00 per share, were approximately $358.8 million. After subtracting underwriting discounts and commissions of $21.5 million and the net proceeds to the selling stockholders of $117.3 million, the Company received net proceeds of approximately $220.0 million from the registration and sale of 18,000,000 common shares (or $213.6 million net of offering expenses paid directly by the Company). The Company used $67.1 million of the net proceeds to redeem convertible preferred units in Holdings LLC, including interest and other charges, and $99.0 million to pay down a portion of the borrowings under its revolving credit facility. The Company used the remaining $47.5 million to fund the execution of its growth strategy through its drilling program. The Company did not receive any of the proceeds from the sale of the 9,600,000 shares by the selling stockholders.  Immediately after the initial public offering and exercise of the over-allotment option, First Reserve Midstates Interholding LP and its affiliates owned approximately 41.4% of the Company’s outstanding common stock.

 

At September 30, 2012, the Company operated oil and natural gas properties as one reportable segment: the exploration, development and production of oil, natural gas and natural gas liquids. The Company’s management evaluated performance based on one reportable segment as there were not significantly different economic or operational environments within its oil and natural gas properties.

 

All pro forma and per share information presented in the accompanying unaudited financial statements have been adjusted to reflect the effects of the Company’s initial public offering.

 

On October 1, 2012, the Company closed on the acquisition of all of Eagle Energy Production, LLC’s producing properties as well as their developed and undeveloped acreage primarily in the Mississippian Lime oil play in Oklahoma and Kansas for $325 million in cash and 325,000 shares of the Company’s newly designated Series A Preferred Stock with an initial liquidation preference value of $1,000 per share (the “Eagle Energy Acquisition”).  The Company funded the cash portion of the Eagle Energy Acquisition purchase price with a portion of the net proceeds from the private placement (which also closed on October 1, 2012) of $600 million in aggregate principal amount of 10.75% senior unsecured notes due October 1, 2020.  Subsequent to the closing of the Eagle Energy Acquisition, the Company now has oil and gas operations or properties in Louisiana, Oklahoma and Kansas.  See Note 13. For the periods presented in this quarterly report, Midstates Petroleum Company, Inc. operated solely in the state of Louisiana.

 

2. Summary of Significant Accounting Policies

 

Basis of Presentation

 

These interim financial statements are unaudited and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Certain disclosures have been condensed or omitted from these financial statements. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete consolidated financial statements, and should be read in conjunction

 

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with the audited consolidated financial statements and notes thereto included in the Company’s Registration Statement on Form S-1, as amended (Registration No. 333-177966).

 

All intercompany transactions have been eliminated in consolidation. Certain reclassifications have been made to the prior year’s consolidated financial statements and related footnotes to conform them to the current year presentation. In the opinion of the Company’s management, the accompanying unaudited condensed consolidated financial statements include all adjustments, consisting of normal recurring adjustments, necessary to fairly present the financial position as of, and the results of operations for, all periods presented. In preparing the accompanying condensed consolidated financial statements, management has made certain estimates and assumptions that affect reported amounts in the condensed consolidated financial statements and disclosures of contingencies. Actual results may differ from those estimates. The results for interim periods are not necessarily indicative of annual results.

 

Acquisition and Transition Costs

 

The Eagle Energy Acquisition qualifies as the acquisition of a business under Accounting Standards Codification Topic 805, Business Combinations (“ASC 805”). Acquisition and transition costs are costs the Company has incurred as a result of the Eagle Energy Acquisition and include finders’ fees; advisory, legal, accounting, valuation and other professional and consulting fees; and general and administrative costs. ASC 805 requires these types of acquisition related costs to be expensed as incurred and as services are received.

 

Recent Accounting Pronouncements

 

The Company reviewed recently issued accounting pronouncements that became effective during the nine months ended September 30, 2012, and determined that none would have a material impact on the Company’s condensed consolidated financial statements.

 

3. Fair Value Measurements of Financial Instruments

 

The Company uses a valuation framework based upon inputs that market participants use in pricing an asset or liability, which are classified into two categories: observable inputs and unobservable inputs. Observable inputs represent market data obtained from independent sources; whereas, unobservable inputs reflect a company’s own market assumptions, which are used if observable inputs are not reasonably available without undue cost and effort. These two types of inputs are further divided into the following fair value input hierarchy:

 

·                  Level 1 — Inputs are unadjusted quoted prices in active markets for identical assets or liabilities at the measurement date.

·                  Level 2 — Inputs, other than quoted prices included in Level 1, are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar instruments in active markets, and inputs other than quoted prices that are observable for the asset or liability. Fair value assets and liabilities that are generally included in this category are commodity derivative contracts with fair values based on inputs from actively quoted markets. The Company uses a discounted cash flow approach to estimate the fair values of its commodity derivative contracts, utilizing commodity futures price strips for the underlying commodities provided by a reputable third-party.

·                  Level 3 — Inputs are unobservable for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability.

 

Assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect the valuation of the fair value of assets and liabilities and their placement within the fair value hierarchy levels.

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis

 

Derivative Instruments — Commodity derivative contracts reflected in the condensed consolidated balance sheets are recorded at estimated fair value. At September 30, 2012 and December 31, 2011, all of the Company’s commodity derivative contracts were with three and two bank counterparties, respectively, and are classified as Level 2.

 

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		Fair Value Measurements at September 30, 2012
		Quoted Prices in Active Markets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)			Total
		(in thousands)
Assets:
Commodity derivative oil swaps		$	—		$	18,567		$	—		$	18,567
Commodity derivative deferred premium puts		—			140			—			140
Commodity derivative collars		—			53			—			53
Commodity derivative differential swaps		—			3,563			—			3,563
Total assets		—			22,323			—			22,323
Liabilities:
Commodity derivative oil swaps		$	—		$	19,070		$	—		$	19,070
Commodity derivative deferred premium puts		—			209			—			209
Commodity derivative collars		—			3			—			3
Commodity derivative differential swaps		—			14,682			—			14,682
Total liabilities		$	—		$	33,964		$	—		$	33,964
		Fair Value Measurements at December 31, 2011
		Quoted Prices in Active Markets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)			Total
		(in thousands)
Assets:
Commodity derivative oil swaps		$	—		$	—		$	—		$	—
Commodity derivative deferred premium puts		—			1,673			—			1,673
Commodity derivative collars		—			397			—			397
Commodity derivative differential swaps		—			4,200			—			4,200
Total assets		—			6,270			—			6,270
Liabilities:
Commodity derivative oil swaps		$	—		$	23,162		$	—		$	23,162
Commodity derivative deferred premium puts		—			340			—			340
Commodity derivative collars		—			—			—			—
Commodity derivative differential swaps		—			—			—			—
Total liabilities		$	—		$	23,502		$	—		$	23,502

 

Derivative instruments listed above are presented gross and include collars, swaps, and put options that are carried at fair value. The Company records the net change in the fair value of these positions in “Gains (losses) on commodity derivative contracts — net” in the Company’s unaudited condensed consolidated statements of operations. See Note 4 for additional information on the Company’s derivative instruments and balance sheet presentation, see Note 4.

 

4. Risk Management and Derivative Instruments

 

The Company is exposed to fluctuations in crude oil and natural gas prices on its production. The Company believes it is prudent to manage the variability in cash flows by entering into derivative financial instruments to economically hedge a portion of its crude oil and natural gas production. The Company utilizes various types of derivative financial instruments, including swaps, collars and options, to manage fluctuations in cash flows resulting from changes in commodity prices. These derivative contracts are placed with major financial institutions that the Company believes are minimal credit risks. The oil and gas reference prices, upon which the commodity derivative contracts are based, reflect various market indices that management believes have a high degree of historical correlation with actual prices received by the Company for its oil and gas production.

 

Inherent in the Company’s portfolio of commodity derivative contracts are certain business risks, including market risk and credit risk. Market risk is the risk that the price of the commodity will change, either favorably or unfavorably, in response to changing market conditions. Credit risk is the risk of loss from nonperformance by the Company’s counterparty to a contract. The Company does not require collateral from its counterparties but does attempt to minimize its credit risk associated with derivative instruments by entering into derivative instruments only with counterparties that are large financial institutions, which management believes present minimal credit risk. In addition, to mitigate its risk of loss due to default, the Company has entered into agreements with its counterparties on its derivative instruments that allow the Company to offset its asset position with its liability position in the event of default by the counterparty. Due to the netting arrangements, had the Company’s counterparties failed to perform under existing commodity derivative contracts, the maximum loss at September 30, 2012 would have been approximately $1.6 million.

 

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Commodity Derivative Contracts

 

As of September 30, 2012, the Company had the following open commodity positions, all of which were related to crude oil:

 

		Hedged Volume		Weighted-Average Fixed Price
Oil (Bbls):
WTI Swaps — 2012		387,320		$95.75
WTI Swaps — 2013		1,700,874		95.55
WTI Swaps — 2014		809,950		87.33
WTI Collars — 2012		41,400		$85.00 - $127.28
WTI Deferred Premium Puts — 2012 (1)		138,000		$79.01
WTI Basis Differential Swaps — 2012 (2)		490,220		$8.60
WTI Basis Differential Swaps — 2013 (2)		1,602,164		5.89
WTI Basis Differential Swaps — 2014 (2)		501,000		5.35

 

(1)         2012 deferred premium puts represent the net effective floor price of a put with a strike price of $85.00/Bbl and a deferred premium of $5.99/Bbl. The premiums for these instruments are paid each month, concurrently with the settlement of the monthly put contracts.

(2)         The Company enters into swap arrangements intended to capture the positive differential between the Louisiana Light Sweet (“LLS”) pricing and West Texas Intermediate (“NYMEX WTI”) pricing.

 

Balance Sheet Presentation

 

The following table summarizes the gross fair value of derivative instruments by the appropriate balance sheet classification, even when the derivative instruments are subject to netting arrangements and qualify for net presentation in the Company’s condensed consolidated balance sheets at September 30, 2012 and December 31, 2011, respectively (in thousands):

 

Type		Balance Sheet Location (1)		September 30, 2012			December 31, 2011
Oil Swaps		Derivative financial instruments — Current Assets		$	14,159		$	—
Oil Swaps		Derivative financial instruments — Non-Current Assets		4,408			—
Oil Swaps		Derivative financial instruments — Current Liabilities		(12,761		)	(13,046		)
Oil Swaps		Derivative financial instruments — Non-Current Liabilities		(6,309		)	(10,116		)
Deferred Premium Puts		Derivative financial instruments — Current Assets		140			1,673
Deferred Premium Puts		Derivative financial instruments — Non-Current Assets		—			—
Deferred Premium Puts		Derivative financial instruments — Current Liabilities		(209		)	(278		)
Deferred Premium Puts		Derivative financial instruments — Non-Current Liabilities		—			(62		)
Collars		Derivative financial instruments — Current Assets		53			397
Collars		Derivative financial instruments — Non-Current Assets		—			—
Collars		Derivative financial instruments — Current Liabilities		(3		)	—
Collars		Derivative financial instruments — Non-Current Liabilities		—			—
Basis Differential Swaps		Derivative financial instruments — Current Assets		3,463			3,612
Basis Differential Swaps		Derivative financial instruments — Non-Current Assets		100			588
Basis Differential Swaps		Derivative financial instruments — Current Liabilities		(13,100		)	—
Basis Differential Swaps		Derivative financial instruments — Non-Current Liabilities		(1,582		)	—
Total				$	(11,641	)	$	(17,232	)

 

(1)   The fair value of derivative instruments reported in the Company’s condensed consolidated balance sheets are subject to netting arrangements and qualify for net presentation. The following table reports the net derivative fair values as reported in the Company’s condensed consolidated balance sheets as of September 30, 2012 and December 31, 2011, respectively (in thousands):

 

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		September 30, 2012		December 31, 2011
Consolidated balance sheet classification:
Current derivative instruments:
Assets		987		4,957
Liabilities		(9,244	)	(12,599	)
Non-current derivative instruments :
Assets		594		588
Liabilities		(3,978	)	(10,178	)

 

Gains/Losses on Commodity Derivative Contracts

 

The Company does not designate its commodity derivative contracts as hedging instruments for financial reporting purposes. Accordingly, all gains and losses, including unrealized gains and losses from changes in the derivative instruments’ fair values, have been recorded in “Gains (losses) on commodity derivative contracts — net”, within revenues in the condensed consolidated statements of operations.

 

The following table presents realized net gains (losses) and unrealized net gains (losses) recorded by the Company related to the change in fair value of the derivative financial instruments in “Gains (losses) on commodity derivative contracts — net” for the periods presented (in thousands):

 

		For the Three Months Ended September 30,				For the Nine Months Ended September 30,
		2012		2011		2012		2011
Realized net gains (losses)		(4,160	)	(3,958	)	(15,840	)	(12,094	)
Unrealized net gains (losses)		(29,566	)	44,518		5,591		34,536

 

5. Property and Equipment

 

Oil and Gas Properties

 

The Company uses the full-cost method of accounting for its exploration and development activities. Under this method of accounting, the cost of both successful and unsuccessful exploration and development activities are capitalized as property and equipment. This includes any internal costs that are directly related to exploration and development activities, but does not include any costs related to production, general corporate overhead or similar activities. For the three and nine months ended September 30, 2012, the Company capitalized $0.5 million and $0.9 million of internal costs to property and equipment.  Proceeds from the sale or disposition of oil and gas properties are accounted for as a reduction to capitalized costs unless a significant portion (greater than 25%) of the Company’s reserve quantities are sold, in which case a gain or loss is generally recognized in income.

 

Unevaluated Property

 

Oil and gas unevaluated properties and properties under development include costs that are not being depleted or amortized. These costs represent investments in unproved properties. The Company excludes these costs until proved reserves are found, until it is determined that the costs are impaired or until major development projects are placed in service, at which time the costs are moved into oil and natural gas properties subject to amortization. All unproved property costs are reviewed at least annually to determine if impairment has occurred. Unevaluated property increased from $76.9 million at December 31, 2011 to $102.2 million at September 30, 2012, primarily due to $18.2 million in seismic acquisition costs incurred on acreage currently under evaluation or option.

 

Other Property and Equipment

 

Other property and equipment consists of vehicles, furniture and fixtures, and computer hardware and software and are carried at cost. Depreciation is provided principally using the straight-line method over the estimated useful lives of the assets, which range from five to seven years. Maintenance and repairs are charged to expense as incurred, while renewals and betterments are capitalized.

 

Ceiling Test

 

The Company performs a ceiling test on a quarterly basis. The test establishes a limit (ceiling) on the book value of oil and gas properties. The capitalized costs of proved oil and gas properties, net of accumulated depreciation, depletion and amortization (DD&A) and the related deferred income taxes, may not exceed this “ceiling.” The ceiling limitation is equal to the sum of: (i) the present value of estimated future net revenues from the projected production of proved oil and gas reserves, excluding future cash outflows associated with settling ARO’s accrued on the balance sheet, calculated using the average oil and natural gas sales price received by the Company as of the first trading day of each month over the preceding twelve months (such prices are held constant throughout the life of the properties) and a discount factor of 10%; (ii) the cost of unproved and unevaluated properties excluded from

 

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the costs being amortized; (iii) the lower of cost or estimated fair value of unproved properties included in the costs being amortized; and (iv) related income tax effects. If capitalized costs exceed this ceiling, the excess is charged to expense in the accompanying consolidated statements of operations.

 

At September 30, 2012 and 2011, capitalized costs did not exceed the ceiling and no impairment to oil and gas properties was required.

 

6. Asset Retirement Obligations

 

ARO’s represent the future abandonment costs of tangible assets, such as wells, service assets and other facilities. The fair value of the ARO at inception is capitalized as part of the carrying amount of the related long-lived assets. ARO’s approximated $11.8 million and $7.6 million as of September 30, 2012 and December 31, 2011, respectively.

 

The liability has been accreted to its present value as of September 30, 2012 and December 31, 2011. The Company evaluated its wells and determined a range of abandonment dates through 2058.

 

The following table reflects the changes in the Company’s ARO’s for the nine months ended September 30, 2012 (in thousands):

 

Asset retirement obligations at January 1, 2012		$	7,627
Liabilities incurred		2,525
Revisions		1,189
Liabilities settled		—
Current period accretion expense		463
Asset retirement obligations at September 30, 2012		$	11,804

 

7. Long-Term Debt

 

The Company’s long-term debt as of September 30, 2012 and December 31, 2011 is as follows (in thousands):

 

		September 30, 2012			December 31, 2011
Revolving credit facility		$	216,300		$	234,800
Less: current maturities of debt		—			—
Long-term debt		$	216,300		$	234,800

 

The Company’s credit facility at December 31, 2011 and through June 7, 2012, consisted of a $300 million senior revolving credit facility with a borrowing base, as redetermined in March 2012, of $210 million. Prior to the June 8, 2012 amendment discussed below, the revolving credit facility had a maturity date of December 10, 2014 and bore interest at LIBOR plus an applicable margin between 2.00% and 2.75% per annum. In April 2012, the Company repaid $103.2 million of the outstanding revolving credit facility balance.

 

On June 8, 2012, the Company entered into a Second Amended and Restated Credit Agreement among Midstates Sub, as borrower, the Company, as guarantor, the lenders party thereto and SunTrust Bank, as the new administrative agent, consisting of a $500 million senior revolving credit facility (the “Credit Facility”) with an initial borrowing base of $200 million.

 

On September 7, 2012, and again on September 26, 2012, the Company entered into amendments to the Credit Facility among the Company, as parent, Midstates Sub, as borrower, SunTrust Bank, N.A., as administrative agent, and the other lenders and parties party thereto (collectively, the “Amendments”).  The Amendments provided for, among other things, (a) $35 million of non-conforming borrowing base loans (thereby increasing the borrowing base from $200 million to $235 million), and (b) waiver of the requirement to comply with the minimum current ratio financial covenant for the quarter ending September 30, 2012.  Upon the closing of the Eagle Energy Acquisition, the Amendments also provided that the Credit Facility would automatically be amended to (a) accommodate the issuance, incurrence and/or compliance with the terms of the Preferred Stock and the Notes (see Note 13), (b) increase the allowance for the incurrence of certain unsecured indebtedness to allow for the issuance of $600 million of senior unsecured notes without a corresponding reduction in the borrowing base, (c) provide for an initial borrowing base of $250 million and (d) extend the maturity of the Credit Facility to October 1, 2017 (the “Amended Credit Facility”).  These terms became effective with the closing of the Eagle Energy Acquisition on October 1, 2012, and availability of non-conforming borrowing base loans ended as of that date.  See Note 13.

 

Borrowings under the terms of the Amended Credit Facility will continue to bear interest at the same rates applicable to the Credit Facility prior to the September 7, 2012 and September 26, 2012 Amendments. Similarly, commitment fees are at the same rates applicable to the Credit Agreement prior to the Amendments.

 

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Borrowings under the Amended Credit Facility continue to be secured by substantially all of the Company’s oil and natural gas properties and currently bear interest at LIBOR plus an applicable margin between 1.75% and 2.75% per annum. At September 30, 2012 and December 31, 2011, the weighted-average interest rate was 3.0% and 3.2%, respectively.

 

In addition to interest expense, the Amended Credit Facility requires the payment of a commitment fee each quarter. The commitment fee is computed at the rate of either 0.375% or 0.50% per annum based on the average daily amount by which the borrowing base exceeds the outstanding borrowings during each quarter.

 

The borrowing base under the Amended Credit Facility is subject to semiannual redeterminations in March and September and up to one additional time per six month period following each scheduled borrowing base redetermination, as may be requested by the Company or the administrative agent, acting on behalf of lenders holding at least two-thirds of the outstanding loans and other obligations. The next scheduled borrowing base redetermination date is March 2013.

 

Under the terms of the Amended Credit Facility, the Company is required to repay the amount by which the principal balance of its outstanding loans and its letter of credit obligations exceed its redetermined borrowing base. The Company is permitted to make such repayment in six equal successive monthly payments commencing 30 days following the administrative agent’s notice regarding such borrowing base reduction.

 

The Amended Credit Facility contains financial covenants, which, among other things, set a maximum ratio of debt to earnings before interest, income tax, depletion, depreciation, and amortization (EBITDA) of not more than 4.0 to 1, a minimum current ratio (as defined therein) of not less than 1.0 to 1.0 and various other standard affirmative and negative covenants including, but not limited to, restrictions on the Company’s ability to make any dividends, distributions or redemptions.  As of September 30, 2012, in the absence of the waiver discussed above, the Company would not have been in compliance with the minimum current ratio covenant as set forth in the Amended Credit Facility. The Company’s current ratio at September 30, 2012 was 0.53 to 1.0. At September 30, 2012, the Company’s ratio of debt to EBITDA was 1.48.

 

In June 2012, in connection with the Credit Facility, the Company incurred legal fees and fees payable to the lending banks of approximately $2.0 million, which together with the remaining unamortized fees associated with the revolving credit facility prior to the amendment, will be amortized as additional interest expense over the new maturity date of October 1, 2017. In addition, the Company incurred legal fees and fees payable to the lending banks of approximately $4.3 million in connection with the September 7, 2012 and September 26, 2012 Amendments, which will have similar accounting treatment.

 

On October 1, 2012, the Company repaid $182.9 million of the outstanding Credit Facility balance with a portion of the net proceeds from the Company’s Notes offering.  See Note 13.

 

The Company believes the carrying amount of the Credit Facility at September 30, 2012 approximates its fair value (Level 2) due to the variable nature of the applicable interest rate.

 

8. Mandatorily Redeemable Convertible Preferred Units

 

In December 2011, Holdings LLC, FR Midstates Holdings LLC (“FR Midstates”) and Midstates Petroleum Holdings, Inc. (“Petroleum Inc.”) entered into an amended and restated limited liability company agreement, which was later amended in March 2012, to provide for the issuance of up to 65,000, or $65 million in aggregate value, of certain mandatorily redeemable convertible preferred units (the “Preferred Units”) between December 15, 2011 and June 10, 2015. The Preferred Units had a liquidation value of $1,000 per unit and bore interest, compounded quarterly, at a rate of 8% plus the greater of LIBOR or 1.5%. The Preferred Units were convertible into units of Holdings LLC on or after the one year anniversary of the date of issuance into a number of common units with a fair market value (as determined by the Board of Directors) equal to the liquidation value plus any accrued interest and were redeemable for cash at any time at the option of Holdings LLC, but were mandatorily redeemable for cash on June 10, 2015, unless otherwise converted. In addition, a fixed interest charge of 1.5% of the aggregate capital invested in the Preferred Units was payable upon redemption or conversion.

 

On January 4, 2012, and again on February 9, 2012, Holdings LLC issued 20,000 Preferred Units (for a total of 40,000 Preferred Units) to FR Midstates for aggregate cash proceeds of $40.0 million. On April 3, 2012, Holdings LLC issued an additional 25,000 preferred units to FR Midstates for aggregate cash proceeds of $25.0 million.

 

On April 26, 2012, the Company used $67.1 million of the proceeds from its initial public offering to redeem the Preferred Units in full, including interest and other charges. As such, at September 30, 2012, the Preferred Units are no longer outstanding.  The Company recorded $2.1 million related to interest expense associated with these Preferred Units for the nine months ended September 30, 2012.

 

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9. Equity and Share-Based Compensation

 

At December 31, 2011, Holdings LLC had 256,742 common units issued and outstanding. On April 24, 2012, in connection with the Company’s initial public offering, a corporate reorganization occurred and each common unit of Holdings LLC was converted into approximately 185.5 common shares of the Company and as a result, the Company issued 47,634,353 shares of its common stock.

 

On April 25, 2012, the Company completed its initial public offering of common stock pursuant to a registration statement on Form S-1 (File 333-177966), as amended and declared effective by the SEC on April 19, 2012. Pursuant to the registration statement, the Company registered the offer and sale of 27,600,000 shares of $0.01 par value common stock, which included 6,000,000 shares of stock sold by the selling shareholders and 3,600,000 shares of common stock sold by the selling stockholders pursuant to an option granted to the underwriters to cover over-allotments.

 

After the corporate reorganization and the completion of its initial public offering discussed above, the Company is authorized to issue up to a total of 300,000,000 shares of its common stock with a par value $0.01 per share, and 50,000,000 shares of its preferred stock with a par value of $0.01 per share. Holders of the Company’s common shares are entitled to one vote for each share held of record on all matters submitted to a vote of stockholders and to receive ratably in proportion to the shares of common stock held by them any dividends declared from time to time by the board of directors. The common shares have no preferences or rights of conversion, exchange, pre-exemption or other subscription rights. At September 30, 2012, the Company had 66,533,872 shares of its common stock issued and outstanding.

 

With respect to preferred shares, the Company is authorized, without further stockholder approval, to establish and issue from time to time one or more classes or series of preferred stock with such powers, preferences, rights, qualifications, limitations and restrictions as determined by its board of directors.

 

In connection with the Eagle Energy Acquisition, on September 28, 2012, the Company filed a Certificate of Designations with the Secretary of State of the State of Delaware to designate 325,000 shares of Series A Mandatorily Convertible Preferred Stock (the “Series A Preferred Stock”). On October 1, the Company issued 325,000 shares of Series A Preferred Stock in connection with the closing of the Eagle Energy Acquisition (see Note 13). The shares of Series A Preferred Stock have an initial liquidation value of $1,000 per share. The Series A Preferred Stock are convertible into shares of the Company’s common stock on or after October 1, 2013. At such time, the Series A Preferred Stock may be converted, in whole but not in part, at the option of the holders of a majority of the outstanding shares of Series A Preferred Stock, into a number of shares of the Company’s common stock calculated by dividing the then-current liquidation preference by the conversion price of $13.50 per share. If not previously converted, the Series A Preferred Stock will be subject to mandatory conversion into shares of the Company’s common stock on September 30, 2015 at a conversion price based upon the volume weighted average price of the Company’s common stock during the 15 trading days immediately prior to the mandatory conversion date, but in no instance will the price be greater than $13.50 per share or less than $11.00 per share. Dividends on the Series A Preferred Stock will accrue at a rate of 8.0% per annum, payable semiannually, at the Company’s sole option, in cash or through an increase in the liquidation preference. The issuance of the Series A Preferred Stock to Eagle pursuant to the Eagle Purchase Agreement was approved by the Company’s stockholders holding a majority of the outstanding shares of the Company’s common stock.

 

At September 30, 2012, no preferred shares or Series A Preferred Stock were issued or outstanding.

 

Share-Based Compensation, pre Initial Public Offering

 

During the nine months ended September 30, 2011, certain restricted and unrestricted shares in Petroleum Inc., through which Holdings LLC’s founders, members of management and certain employees previously held their equity interests, certain unrestricted units in Holdings LLC, and certain units in Midstates Incentive Holdings, LLC (“Midstates Incentive”) had been issued to employees of Holdings LLC.

 

Additionally, in March 2011, Holdings LLC’s Chief Executive Officer, in connection with the commencement of his employment, purchased 17.3 shares of common stock of Petroleum Inc. and contemporaneously received a grant of 24.6 shares of common stock in Petroleum Inc. that vested as described further below. No other shares or units were issued during the 2011 period. The Company determined the grant date fair value of the share based award to be $80,013 per Petroleum Inc. share ($3.4 million in aggregate), or after taking into account the corporate reorganization attributable to the initial public offering completed on April 25, 2012, $4.26 per share of the Company’s common stock.  The Company recognized stock compensation based upon the grant date fair value and immediately expensed the difference between the grant date fair value and the price paid for the purchased shares of Petroleum Inc., as well as additional compensation expense related to the liability accounting for the Company’s share-based awards discussed below.

 

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Prior to December 5, 2011, due to certain rights to call shares and units in Holdings LLC for cash, Holdings LLC’s share-based payments awarded to employees were accounted for as liability awards. As such, Holdings LLC calculated the fair value of the share-based awards on a quarterly basis using estimated market value and the total fair value of the awards was recorded within “Other long-term liabilities” in Holding LLC’s condensed consolidated balance sheets. Any change in the fair value of the liability awards was recorded as share-based compensation expense within “General and administrative expense” in Holdings LLC’s condensed consolidated statements of operations, which was the same line item as cash compensation paid to the same employees.

 

Historically, Holdings LLC’s determination of the fair value of each of the units was affected by: (i) Holdings LLC’s risk adjusted proved, possible, and probable reserves; (ii) internal assessment of long-term commodity prices; (iii) current values of Holdings LLC’s non-oil and gas assets and liabilities; and (iv) a number of complex and subjective variables. Although the fair value of the share-based payments is determined in accordance with GAAP, that value may not be indicative of the fair value observed in a market transaction between a willing buyer and a willing seller.

 

Effective as of November 22, 2011, the Board of Directors of Petroleum Inc. accelerated the vesting of all restricted stock in Petroleum Inc. The vesting resulted in the recognition of previously unrecognized share-based compensation expense at the estimated fair market value of the restricted stock held by employees at November 22, 2011. Petroleum Inc. determined the fair market value of Petroleum Inc.’s common stock based on management’s estimates.

 

On December 5, 2011, Employment Agreements with employees of Midstates Petroleum Company LLC, a Stockholders’ Agreement by and among stockholders in Petroleum Inc. and a Unitholders’ Agreement by and among the members of Holdings LLC were either terminated or amended such that the rights within those agreements to call shares in Petroleum Inc. and units in Holdings LLC for cash no longer required Holdings LLC’s share-based payments awarded to employees to be accounted for as liability awards.  As a result the Company transitioned as of December 5, 2011 from liability accounting to equity accounting for the Company’s share-based compensation plans and accordingly, the Company no longer recognized changes in the estimated fair value of outstanding share-based awards in the statements of operations.

 

Restricted Shares.

 

Restricted shares in Petroleum Inc. were awarded at no cost to the recipient with a vesting period that commenced on the grant date and terminated on the fifth anniversary or upon certain changes in control of Holdings LLC, including but not limited to mergers, acquisitions, or a public offering.

 

As a result of the vesting on November 22, 2011, as discussed above, there is no unrecognized compensation cost and as a result of the corporate reorganization in April 2012, each share of Petroleum Inc. was converted into 18,762 shares of the Company’s common stock. As a result, there are no outstanding restricted shares in Petroleum Inc. as of September 30, 2012.

 

Unrestricted Shares and Units.

 

Unrestricted shares in Petroleum Inc. and units of Holdings LLC were purchased by the recipient on the grant date and were fully vested upon purchase, or represented restricted shares which have vested. For shares of Petroleum Inc and units of Holdings LLC purchased, any difference between the recipient’s purchase price and the grant date fair value was recognized as compensation expense on the grant date. As a result of the corporate reorganization in April 2012, each share of Petroleum, Inc. and each unit of Holdings LLC were converted into 18,762 and 185.5 shares respectively, of the Company’s common stock. As a result, at September 30, 2012, there are no Petroleum, Inc. shares or Holdings LLC units outstanding.

 

Incentive Units.

 

At September 30, 2012, 1,656 incentive units were issued and outstanding. In connection with the corporate reorganization that occurred immediately prior to our initial public offering, these incentive units held in the Company were contributed to FR Midstates Interholding, LP (“FRMI”) in exchange for incentive units in FRMI. Holders of FRMI incentive units will receive, out of proceeds otherwise distributable to FRMI, a percentage interest in the amounts distributed to FRMI in excess of certain multiples of FRMI’s aggregate capital contributions and investment expenses (“FRMI Profits”). Although any future payments to the incentive unit holders will be made out of the proceeds otherwise distributable to FRMI and not by the Company, the Company will be required to record a non-cash compensation charge in the period any payment is made related to the FRMI incentive units. To date, no compensation expense related to the incentive units has been recognized by the Company, as any payout under the incentive units is not considered probable, and thus, the amount of FRMI Profits, if any, cannot be determined.

 

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Share-based Compensation, Post-Initial Public Offering

 

2012 Long Term Incentive Plan.

 

On April 20, 2012, the Company established the 2012 Long Term Incentive Plan (the “2012 LTIP”) and filed a Form S-8 with the SEC, registering 6,563,435 shares for future issuance under the terms of the 2012 LTIP. The 2012 LTIP provides a means for the Company to attract and retain employees, directors and consultants, and a method whereby employees, directors and consultants of the Company who contribute to its success can acquire and maintain stock ownership or awards, the value of which is tied to the performance of the Company, thereby strengthening their concern for the welfare of the Company and their desire to remain employed.

 

The 2012 LTIP provides for the granting of Options (Incentive and other), Restricted Stock Awards, Restricted Stock Units, Stock Appreciation Rights, Dividend Equivalents, Bonus Stock, Other Stock-Based Awards, Annual Incentive Awards, Performance Awards, or any combination of the foregoing (the “Awards”). Subject to certain limitations as defined in the 2012 LTIP, the terms of each Award are as determined by the Compensation Committee of the Board of Directors. A total of 6,563,435 common share Awards are authorized for issuance under the 2012 LTIP and shares of stock subject to an Award that expire, or are canceled, forfeited, exchanged, settled in cash or otherwise terminated, will again be available for future Awards under the 2012 LTIP.

 

Non-vested Stock Awards.

 

Subsequent to the completion of the Company’s initial public offering and pursuant to the 2012 LTIP, through September 30, 2012 the Company has issued 916,594 shares of restricted common stock to directors, management and employees. Shares granted under the LTIP vest ratably over a period of three years (one-third on each anniversary of the grant).

 

The fair value of restricted stock grants is based on the value of the Company’s common stock on the date of grant. Compensation expense is recognized ratably over the requisite three year service period. As of September 30, 2012, the Company assumed no annual forfeiture rate because of the Company’s minimal turnover for this type of award.

 

The following table summarizes the Company’s non-vested share award activity for the nine months ended September 30, 2012:

 

		Shares		Weighted Average Grant Date Fair Value
Non-vested shares outstanding at December 31, 2011		—
Granted		916,594		$	13.16
Vested		—		$	—
Forfeited		(17,075	)	$	13.21
Non-vested shares outstanding at September 30, 2012		899,519		$	13.16

 

Unrecognized expense as of September 30, 2012 for all outstanding restricted stock awards was $10.2 million and will be recognized over a weighted average period of 2.6 years. Outstanding restricted stock awards had zero intrinsic value at September 30, 2012.

 

At September 30, 2012, 5,663,916 shares remain available for issuance under the terms of the 2012 LTIP.

 

The following table summarizes share-based compensation costs (after amounts capitalized to oil and gas properties)recognized as expense by the Company for the periods presented (in thousands):

 

 

For the three and nine months ended September 30, 2012, the Company capitalized $0.1 million of qualifying share-based compensation costs to oil and gas properties.

 

10. Income Taxes

 

Prior to its corporate reorganization (See Note 1), the Company was a limited liability company and not subject to federal income tax or state income tax (in most states). Accordingly, no provision for federal or state income taxes was recorded prior to the corporate reorganization as the Company’s equity holders were responsible for income tax on the Company’s profits. In connection with the closing of the Company’s initial public offering, the Company merged into a corporation and became subject to federal and state income taxes. The Company’s book and tax basis in assets and liabilities differed at the time of the corporate reorganization due

 

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