Coterra Energy Inc. - Quarter Report: 2012 March (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

 

For the quarterly period ended March 31, 2012

 

 

Commission file number 1-10447

 

 

CABOT OIL & GAS CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

Three Memorial City Plaza

840 Gessner Road, Suite 1400, Houston, Texas 77024

(Address of principal executive offices including ZIP code)

 

(281) 589-4600

(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 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. (Check one):

 

 

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

 

As of April 23, 2012, there were 209,830,719 shares of Common Stock, Par Value $.10 Per Share, outstanding.

CABOT OIL & GAS CORPORATION

 

INDEX TO FINANCIAL STATEMENTS

 

	Page
Part I. Financial Information
Item 1.      Financial Statements
Condensed Consolidated Balance Sheet at March 31, 2012 and December 31, 2011	3
Condensed Consolidated Statement of Operations for the Three Months Ended March 31, 2012 and 2011	4
Condensed Consolidated Statement of Comprehensive Income for the Three Months Ended March 31, 2012 and 2011	5
Condensed Consolidated Statement of Cash Flows for the Three Months Ended March 31, 2012 and 2011	6
Notes to the Condensed Consolidated Financial Statements	7
Report of Independent Registered Public Accounting Firm on Review of Interim Financial Information	20
Item 2.      Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
Item 3.      Quantitative and Qualitative Disclosures about Market Risk	28
Item 4.      Controls and Procedures	30
Part II. Other Information
Item 1.      Legal Proceedings	31
Item 1A.   Risk Factors	31
Item 2.      Unregistered Sales of Equity Securities and Use of Proceeds	31
Item 6.      Exhibits	32
Signatures	33

 

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PART I. FINANCIAL INFORMATION

 

ITEM  1.                           Financial Statements

 

CABOT OIL & GAS CORPORATION

 

CONDENSED CONSOLIDATED BALANCE SHEET (Unaudited)

 

		March 31,			December 31,
(In thousands, except share amounts)		2012			2011
ASSETS
Current Assets
Cash and Cash Equivalents		$	32,328		$	29,911
Accounts Receivable, Net		95,120			114,381
Income Taxes Receivable		—			1,388
Inventories		12,230			21,278
Derivative Instruments		196,683			174,263
Other Current Assets		3,366			4,579
Total Current Assets		339,727			345,800
Properties and Equipment, Net (Successful Efforts Method)		4,011,203			3,934,584
Derivative Instruments		22,259			21,249
Other Assets		29,605			29,860
		$	4,402,794		$	4,331,493
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Accounts Payable		$	213,188		$	217,294
Income Taxes Payable		799			—
Deferred Income Taxes		61,871			55,132
Accrued Liabilities		46,296			70,918
Total Current Liabilities		322,154			343,344
Postretirement Benefits		39,591			38,708
Long-Term Debt		1,012,000			950,000
Deferred Income Taxes		814,189			802,592
Asset Retirement Obligation		61,284			60,142
Other Liabilities		28,620			31,939
Total Liabilities		2,277,838			2,226,725
Commitments and Contingencies
Stockholders’ Equity
Common Stock:
Authorized — 240,000,000 Shares of $0.10 Par Value in 2012 and 2011 Issued—209,829,748 Shares and 209,019,458 Shares in 2012 and 2011, respectively		20,983			20,902
Additional Paid-in Capital		716,965			724,377
Retained Earnings		1,272,432			1,258,291
Accumulated Other Comprehensive Income		117,925			104,547
Less Treasury Stock, at Cost:
404,400 Shares in 2012 and 2011, respectively		(3,349		)	(3,349		)
Total Stockholders’ Equity		2,124,956			2,104,768
		$	4,402,794		$	4,331,493

 

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

 

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CABOT OIL & GAS CORPORATION

 

CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS (Unaudited)

 

		Three Months Ended
		March 31,
(In thousands, except per share amounts)		2012			2011
OPERATING REVENUES
Natural Gas		$	206,782		$	170,098
Brokered Natural Gas		13,444			18,408
Crude Oil and Condensate		49,981			18,592
Other		1,929			1,928
		272,136			209,026
OPERATING EXPENSES
Brokered Natural Gas Cost		11,872			15,362
Direct Operations		27,320			27,007
Transportation and Gathering		30,258			12,868
Taxes Other Than Income		18,583			8,151
Exploration		4,001			6,308
Depreciation, Depletion and Amortization		110,357			77,124
General and Administrative		22,549			24,299
		224,940			171,119
Gain / (Loss) on Sale of Assets		(535		)	(1,517		)
INCOME FROM OPERATIONS		46,661			36,390
Interest Expense and Other		16,917			17,367
Income Before Income Taxes		29,744			19,023
Income Tax Expense		11,426			6,137
NET INCOME		$	18,318		$	12,886
Earnings Per Share
Basic		$	0.09		$	0.06
Diluted		$	0.09		$	0.06
Weighted-Average Shares Outstanding
Basic		209,128			208,288
Diluted		210,813			210,640
Dividends per common share		$	0.02		$	0.02

 

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

 

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CABOT OIL & GAS CORPORATION

 

CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (Unaudited)

 

		Three Months Ended
		March 31,
(In thousands)		2012					2011
Net Income				$	18,318				$	12,886
Other Comprehensive Income / (Loss), net of taxes:
Reclassification Adjustment for Settled Contracts, net of taxes of $21,600 and $5,008, respectively				(34,070		)			(8,171		)
Changes in Fair Value of Hedge Positions, net of taxes of $(27,523) and $(4,778), respectively				43,205					7,795
Defined Benefit Pension and Postretirement Plans:
Amortization of Net Obligation at Transition, net of taxes of $0 and $(59), respectively		—					99
Amortization of Prior Service Cost, net of taxes of $(43) and $(118), respectively		68					199
Amortization of Net Loss, net of taxes of $(2,647) and $(1,194), respectively		4,175		4,243			2,009		2,307
Foreign Currency Translation Adjustment, net of taxes of $0 and $0, respectively				—					(2		)
Total Other Comprehensive Income / (Loss)				13,378					1,929
Comprehensive Income / (Loss)				$	31,696				$	14,815

 

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

 

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CABOT OIL & GAS CORPORATION

 

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (Unaudited)

 

		Three Months Ended
		March 31,
(In thousands)		2012			2011
CASH FLOWS FROM OPERATING ACTIVITIES
Net Income		$	18,318		$	12,886
Adjustments to Reconcile Net Income to Cash Provided by Operating Activities:
Depreciation, Depletion and Amortization		110,357			77,124
Deferred Income Tax Expense		9,724			6,543
(Gain) / Loss on Sale of Assets		535			1,517
Exploration Expense		49			493
Unrealized (Gain) / Loss on Derivative Instruments		(42		)	(17		)
Amortization of Debt Issuance Costs		1,064			1,120
Stock-Based Compensation, Pension and Other		(1,470		)	12,614
Changes in Assets and Liabilities:
Accounts Receivable, Net		19,261			3,902
Income Taxes		2,187			(24,202		)
Inventories		9,048			8,861
Other Current Assets		518			1,014
Accounts Payable and Accrued Liabilities		(38,149		)	(9,615		)
Other Assets and Liabilities		380			(1,027		)
Net Cash Provided by Operating Activities		131,780			91,213
CASH FLOWS FROM INVESTING ACTIVITIES
Capital Expenditures		(188,547		)	(203,169		)
Proceeds from Sale of Assets		1,280			5,043
Net Cash Used in Investing Activities		(187,267		)	(198,126		)
CASH FLOWS FROM FINANCING ACTIVITIES
Borrowings from Debt		90,000			110,000
Repayments of Debt		(28,000		)	(30,000		)
Dividends Paid		(4,177		)	(3,122		)
Other		81			(1,018		)
Net Cash Provided by Financing Activities		57,904			75,860
Net Increase / (Decrease) in Cash and Cash Equivalents		2,417			(31,053		)
Cash and Cash Equivalents, Beginning of Period		29,911			55,949
Cash and Cash Equivalents, End of Period		$	32,328		$	24,896

 

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

 

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CABOT OIL & GAS CORPORATION

 

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

1. FINANCIAL STATEMENT PRESENTATION

 

During interim periods, Cabot Oil & Gas Corporation (the Company) follows the same accounting policies disclosed in its Annual Report on Form 10-K for the year ended December 31, 2011 (Form 10-K) filed with the Securities and Exchange Commission (SEC). The interim financial statements should be read in conjunction with the notes to the consolidated financial statements and information presented in the Form 10-K. In management’s opinion, the accompanying interim condensed consolidated financial statements contain all material adjustments, consisting only of normal recurring adjustments, necessary for a fair statement. The results for any interim period are not necessarily indicative of the expected results for the entire year.

 

Certain reclassifications have been made to prior year statements to conform with current year presentation. These reclassifications have no impact on previously reported net income.

 

On January 3, 2012, the Board of Directors declared a 2-for-1 split of the Company’s common stock in the form of a stock dividend. The stock dividend was distributed on January 25, 2012 to shareholders of record as of January 17, 2012. All common stock accounts and per share data have been retroactively adjusted to give effect to the 2-for-1 split of the Company’s common stock.

 

With respect to the unaudited financial information of the Company as of March 31, 2012 and for the three months ended March 31, 2012 and 2011, PricewaterhouseCoopers LLP reported that they have applied limited procedures in accordance with professional standards for a review of such information. However, their separate report dated April 27, 2012 appearing herein states that they did not audit and they do not express an opinion on that unaudited financial information. Accordingly, the degree of reliance on their report on such information should be restricted in light of the limited nature of the review procedures applied. PricewaterhouseCoopers LLP is not subject to the liability provisions of Section 11 of the Securities Act of 1933 for their report on the unaudited financial information because that report is not a “report” or a “part” of the registration statement prepared or certified by PricewaterhouseCoopers LLP within the meaning of Sections 7 and 11 of the Act.

 

Recent Accounting Pronouncements

 

In May 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The amendments in this update generally represent clarifications of Topic 820, but also include some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This update results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRS. The amendments are effective for interim and annual periods beginning after December 15, 2011 and are to be applied prospectively. This update did not have any impact on the Company’s consolidated financial position, results of operations or cash flows.

 

In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income.” This update was amended in December 2011 by ASU No. 2011-12, “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” This update defers only those changes in update 2011-05 that relate to the presentation of reclassification adjustments. All other requirements in update 2011-05 are not affected by this update, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements.  ASU No. 2011-05 and 2011-12 are effective for fiscal years (including interim periods) beginning after December 15, 2011. The Company has elected to present two separate but consecutive financial statements. These updates did not have any impact on the Company’s consolidated financial position, results of operations or cash flows.

 

In December 2011, the FASB issued ASU No. 2011-11, “Disclosures about Offsetting Assets and Liabilities.” The amendments in this update require enhanced disclosures around financial instruments and derivative instruments that are either (1) offset in accordance with either Accounting Standards Codification (ASC) 210-20-45 or ASC 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with either ASC 210-20-45 or ASC 815-10-45. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The amendments are effective during interim and annual periods beginning on or after January 1, 2013. The

 

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Company does not expect this guidance to have any impact on its consolidated financial position, results of operations or cash flows.

 

2. PROPERTIES AND EQUIPMENT, NET

 

Properties and equipment, net are comprised of the following:

 

		March 31,			December 31,
(In thousands)		2012			2011
Proved Oil and Gas Properties		$	5,185,986		$	5,006,846
Unproved Oil and Gas Properties			483,846			478,942
Gathering and Pipeline Systems		238,281			238,660
Land, Building and Other Equipment		81,350			80,908
		5,989,463			5,805,356
Accumulated Depreciation, Depletion and Amortization		(1,978,260		)	(1,870,772		)
		$	4,011,203		$	3,934,584

 

At March 31, 2012, the Company did not have any projects that had exploratory well costs that were capitalized for a period of greater than one year after drilling.

 

Haynesville/Bossier Shale Joint Venture

 

During the first three months of 2011, the Company entered into a participation agreement with a third party related to certain of its Haynesville and Bossier shale leaseholds in east Texas. Under the terms of the participation agreement, the third party agreed to fund 100% of the cost to drill and complete certain Haynesville and Bossier shale wells in the related leaseholds over a multi-year period in exchange for a 75% working interest in the leaseholds. During the first quarter of 2011, the Company received a reimbursement of drilling costs incurred of approximately $5.9 million associated with wells that had commenced drilling prior to the execution of the participation agreement.

 

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3. ADDITIONAL BALANCE SHEET INFORMATION

 

Certain balance sheet amounts are comprised of the following:

 

		March 31,			December 31,
(In thousands)		2012			2011
ACCOUNTS RECEIVABLE, NET
Trade Accounts		$	91,742		$	111,306
Joint Interest Accounts		3,840			5,417
Other Accounts		778			1,003
		96,360			117,726
Allowance for Doubtful Accounts		(1,240		)	(3,345		)
		$	95,120		$	114,381
INVENTORIES
Natural Gas in Storage		$	3,854		$	13,513
Tubular Goods and Well Equipment		7,539			7,146
Other		837			619
		$	12,230		$	21,278
OTHER CURRENT ASSETS
Prepaid Balances		1,371			2,290
Restricted Cash		1,907			2,234
Other		88			55
		$	3,366		$	4,579
OTHER ASSETS
Rabbi Trust Deferred Compensation Plan		$	11,644		$	10,838
Debt Issuance Cost		16,616			17,680
Other Accounts		1,345			1,342
		$	29,605		$	29,860
ACCOUNTS PAYABLE
Trade Accounts		$	14,052		$	18,253
Natural Gas Purchases		1,966			3,012
Royalty and Other Owners		39,574			48,113
Accrued Capital Costs		136,860			138,122
Taxes Other Than Income		11,847			2,076
Drilling Advances		385			1,489
Wellhead Gas Imbalances		2,351			2,312
Other Accounts		6,153			3,917
		$	213,188		$	217,294
ACCRUED LIABILITIES
Employee Benefits		$	5,858		$	26,035
Pension and Postretirement Benefits		5,917			6,331
Taxes Other Than Income		11,562			12,297
Interest Payable		14,875			24,701
Derivative Contracts		6,538			385
Other Accounts		1,546			1,169
		$	46,296		$	70,918
OTHER LIABILITIES
Rabbi Trust Deferred Compensation Plan		$	19,183		$	20,187
Derivative Contracts		1,481			—
Other Accounts		7,956			11,752
		$	28,620		$	31,939

 

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4. LONG-TERM DEBT

 

The Company’s debt consisted of the following:

 

(In thousands)		March 31, 2012			December 31, 2011
Long-Term Debt
7.33% Weighted-Average Fixed Rate Notes		$	95,000		$	95,000
6.51% Weighted-Average Fixed Rate Notes		425,000			425,000
9.78% Notes		67,000			67,000
5.58% Weighted-Average Fixed Rate Notes		175,000			175,000
Credit Facility		250,000			188,000
		$	1,012,000		$	950,000

 

At March 31, 2012, the Company had $250.0 million of borrowings outstanding under its revolving credit facility at a weighted-average interest rate of 3.6% and $649.0 million available for future borrowings.

 

5. EARNINGS PER COMMON SHARE

 

Basic EPS is computed by dividing net income (the numerator) by the weighted-average number of common shares outstanding for the period (the denominator). Diluted EPS is similarly calculated except that the denominator is increased using the treasury stock method to reflect the potential dilution that could occur if outstanding stock options and stock appreciation rights were exercised and stock awards were vested at the end of the applicable period.

 

The following is a calculation of basic and diluted weighted-average shares outstanding:

 

		Three Months Ended
		March 31,
(In thousands)		2012		2011
Weighted-Average Shares - Basic		209,128		208,288
Dilution Effect of Stock Options, Stock Appreciation Rights and Stock Awards at End of Period		1,685		2,352
Weighted-Average Shares - Diluted		210,813		210,640
Weighted-Average Stock Awards and Shares Excluded from Diluted Earnings per Share due to the Anti-Dilutive Effect		82		708

 

6. COMMITMENTS AND CONTINGENCIES

 

Constitution Pipeline Company, LLC

 

In February 2012, the Company entered into a Precedent Agreement with Constitution Pipeline Company, LLC (Constitution), at the time a wholly owned subsidiary of Williams Partners L.P., to develop and construct a 120 mile large diameter pipeline to transport its production in northeast Pennsylvania to both the New England and New York markets.  Under the terms of the Precedent Agreement, the Company will have transportation rights for up to approximately 500,000 Mcf per day of capacity on the newly constructed pipeline and the right to acquire a 25% equity interest in the project, subject to regulatory approval and certain terms and conditions to be determined.

 

In April 2012, the Company entered into an Amended and Restated Limited Liability Company Agreement (LLC Agreement) with Constitution. Under the terms of the LLC Agreement, the Company agreed to invest approximately $187 million in exchange for a 25% equity interest, subject to a contribution cap of $250 million.  The investment, which is expected to occur over the next three years, will fund the development and construction of the pipeline and related facilities.

 

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Legal Matters

 

Preferential Purchase Right Litigation

 

In September 2005, the Company and Linn Energy, LLC were sued by Power Gas Marketing & Transmission, Inc. in the Court of Common Pleas of Indiana County, Pennsylvania. The lawsuit seeks unspecified damages arising out of the Company’s 2003 sale of oil and gas properties located in Indiana County, Pennsylvania, to Linn Energy, LLC. The plaintiff alleges breach of a preferential purchase right regarding those properties contained in a 1969 joint operating agreement, to which the plaintiff was a party. The Company initially obtained judgment as a matter of law as to all claims in a decision by the trial court dated February 2007. Plaintiff appealed the ruling to the Pennsylvania Superior Court, where the ruling in favor of the Company was reversed and remanded to the trial court in March 2008. The Company appealed the Superior Court ruling to the Pennsylvania Supreme Court, but in December 2008 that Court declined to review. Effective July 2008, Linn Energy, LLC sold the subject properties to XTO Energy, Inc., giving rise to a second lawsuit for unspecified damages filed in September 2009 by EXCO—North Coast Energy, Inc., as successor in interest to Power Gas Marketing & Transmission, Inc., against the Company, Linn Energy, LLC and XTO Energy, Inc. The second lawsuit has been consolidated into the first lawsuit. A bench trial on the merits, should one be necessary, has been set for early June 2012.

 

The Company believes that the plaintiff’s claims lack merit and does not consider a loss related to this matter to be probable; however, due to the inherent uncertainties of litigation a loss is possible. In the event that the Company is found liable, the potential loss is currently estimated to be less than $15 million.

 

Other

 

The Company is also a defendant in various other legal proceedings arising in the normal course of business. All known liabilities are accrued based on management’s best estimate of the potential loss. While the outcome and impact of these legal proceedings on the Company cannot be predicted with certainty, management believes that the resolution of these proceedings will not have a material effect on the Company’s financial position or cash flow; however, operating results could be significantly impacted in reporting periods in which such matters are resolved.

 

Contingency Reserves

 

When deemed necessary, the Company establishes reserves for certain legal proceedings. The establishment of a reserve is based on an estimation process that includes the advice of legal counsel and subjective judgment of management. While management believes these reserves to be adequate, it is reasonably possible that the Company could incur additional losses with respect to those matters in which reserves have been established. The Company believes that any such amount above the amounts accrued is not material to the Condensed Consolidated Financial Statements. Future changes in facts and circumstances could result in the actual liability exceeding the estimated ranges of loss and amounts accrued.

 

Environmental Matters

 

Pennsylvania Department of Environmental Protection

 

On November 4, 2009, the Company and the Pennsylvania Department of Environmental Protection (PaDEP) executed a consent order (Consent Order) addressing a number of environmental issues identified in 2008 and 2009, including alleged releases of drilling mud and other substances, alleged record keeping violations at various wells and alleged natural gas contamination of 13 water supplies in Susquehanna County, Pennsylvania. As part of the settlement, the Company paid an aggregate $120,000 civil penalty with respect to the matters addressed by the Consent Order, which were consolidated at the request of the PaDEP.

 

On April 15, 2010, the Company and the PaDEP executed a modified Consent Order (First Modified Consent Order). The First Modified Consent Order provided that the Company would make available a permanent source of potable water to 14 households, most of which the Company had already been supplying with water. The First Modified Consent Order included the following conditions: (i) the Company would plug and abandon three vertical natural gas wells and would undertake certain remedial measures on a fourth well in a nine square mile area in Susquehanna County; (ii) the Company would complete these actions prior to new natural gas well drilling permits being issued for drilling in Pennsylvania, and prior to initiating hydraulic fracturing of seven wells already drilled in the area of concern; and (iii) the Company would also postpone drilling of new natural gas wells in the area of concern until certain terms of the consent orders were fulfilled. In addition, the First Modified Consent Order included a condition that the Company would take certain other actions if requested by the PaDEP and agreed to by the Company, which could include the plugging and abandonment of up to 10 additional wells. As part of the settlement, the Company paid a $240,000 civil

 

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penalty and the First Modified Consent Order included a provision that the Company would pay an additional $30,000 per month until certain terms under the First Modified Consent Order were satisfied.

 

On July 19, 2010, the Company and the PaDEP executed a Second Modification to Consent Order (Second Modified Consent Order) acknowledging that the Company plugged and abandoned the three vertical natural gas wells and completed work on the fourth natural gas well to the PaDEP’s satisfaction. As a result, the PaDEP agreed to commence the processing and issuance of new well drilling permits outside the area of concern so long as the Company continued to provide temporary potable water and offered to provide gas/water separators to 14 households. No penalties were assessed under the Second Modified Consent Order.

 

As outlined in the Second Modified Consent Order, the Company made offers to provide whole-house water treatment systems to 14 households. On August 5, 2010, the Company filed with the PaDEP its report, prepared by its experts, finding that the Company’s natural gas well drilling and development activities were not the source of methane gas reported to be in the groundwater and water wells in the area of concern.

 

In a September 14, 2010 letter to the Company, the PaDEP rejected the Company’s expert report and stated its determination that the Company’s drilling activities continue to cause the unpermitted discharge of natural gas into the groundwater and continue to affect residential water supplies in the area of concern. The PaDEP directed the Company to plug or take remedial actions at the remaining 10 natural gas wells and to contact the PaDEP to discuss connecting the impacted water supplies into community public water systems.

 

In a September 28, 2010 reply letter to the PaDEP, the Company disagreed with the PaDEP’s rejection of the Company’s expert report, disagreed that the remaining 10 natural gas wells continue to impact groundwater and affect residential water supplies and disagreed that a community public water system is necessary or feasible. The Company believed that offering installation of a whole-house water treatment system to the 14 households constituted compliance with the Company’s obligations under these consent orders. The Company also asserted its belief that the Consent Order, First Modified Consent Order and Second Modified Consent Order were unlawful and not legally binding or enforceable.

 

On December 15, 2010, the Company entered into a consent order and settlement agreement with the PaDEP (CO&SA), which according to its terms supersedes and/or replaces the Consent Order, the First Modified Consent Order and the Second Modified Consent Order. Under the CO&SA, among other things, the Company agreed to place a total of $4.2 million into escrow accounts for the benefit of each of the identified households, pay $500,000 to the PaDEP to reimburse the PaDEP for its costs, perform remedial measures for two natural gas wells in the area of concern, provide pressure, water quality and water well headspace data to the PaDEP and offer water treatment to the households. The CO&SA settled all outstanding issues and claims that are known and that could have been brought against the Company by the PaDEP relating to the natural gas wells in the affected area and the Consent Order, the First Modified Consent Order and the Second Modified Consent Order. It also allows the Company to seek to begin hydraulic fracturing and to commence drilling new wells in the affected areas after providing the PaDEP with certain data and information. Under the CO&SA, the Company has no obligation to connect the impacted water supplies to a community public water system.

 

On January 11, 2011, certain of the affected households appealed the CO&SA to the Pennsylvania Environmental Hearing Board (PEHB).

 

The Company is in continuing discussions with the PaDEP to address the results of the Company’s natural gas well test data, water quality sampling and water well headspace screenings. The Company requested PaDEP approval to resume hydraulic fracturing and new natural gas well drilling operations in the affected area, along with a request to cease temporary water deliveries to the affected households. On October 18, 2011, the PaDEP concurred that temporary water deliveries to the property owners are no longer necessary.

 

On November 18, 2011, certain of the affected households appealed to the PEHB the PaDEP’s October 18, 2011 determination that temporary water deliveries were no longer necessary to the property owners and on November 23, 2011 filed a Petition for Supersedeas in the appeal. On December 9, 2011, the PEHB denied the Petition for Supersedeas and consolidated the appeal of the CO&SA with the appeal of the October 18, 2011 determination. A hearing on the consolidated matter is expected to occur in 2012.

 

As of March 31, 2012, the Company has paid $1.3 million in settlement of fines and penalties sought or claimed by the PaDEP related to this matter, paid $2.3 million (through the escrow process) to ten of the affected households and accrued a $1.9 million settlement liability that represents the unpaid escrow balance, which is included in Other Liabilities in the Condensed Consolidated Balance Sheet.

 

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United States Environmental Protection Agency

 

By letter dated January 6, 2012, the United States Environmental Protection Agency (EPA) sent a Required Submission of Information—Dimock Township Drinking Water Contamination letter to the Company pursuant to the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, as amended (CERCLA). The Required Submission of Information requests all documents, water sampling results and any other correspondence related to the Company’s activities in the area of concern. The Company does not agree that the Submission of Information is required; however, the Company is providing information pursuant to the request.

 

7. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

 

The Company periodically enters into commodity derivative instruments to hedge its exposure to price fluctuations on natural gas and crude oil production. The Company’s credit agreement restricts the ability of the Company to enter into commodity hedges other than to hedge or mitigate risks to which the Company has actual or projected exposure or as permitted under the Company’s risk management policies and not subjecting the Company to material speculative risks. All of the Company’s derivatives are used for risk management purposes and are not held for trading purposes. As of March 31, 2012, the Company had 39 derivative contracts open: 23 natural gas price swap arrangements, six natural gas basis swap arrangements, five crude oil swap arrangements and five natural gas collar arrangements. During the first three months of 2012, the Company entered into two new derivative contracts covering anticipated crude oil production for 2012 and 2013.

 

As of March 31, 2012, the Company had the following outstanding commodity derivatives:

 

Commodity and Derivative Type		Weighted-Average Contract Price				Volume				Contract Period
Derivatives Designated as Hedging Instruments
Natural Gas Swaps		$5.22		per Mcf		72,129		Mmcf		Apr. 2012 - Dec. 2012
Natural Gas Collars		$6.20 Ceiling/  $5.15 Floor		per Mcf		17,729		Mmcf		Jan. 2013 - Dec. 2013
Crude Oil Swaps		$99.30		per Bbl		1,100		Mbbl		Apr. 2012 - Dec. 2012
Crude Oil Swaps		$100.33		per Bbl		732		Mbbl		Jan. 2013 - Dec. 2013
Derivatives Not Designated as Hedging Instruments
Natural Gas Basis Swaps		$(0.25	)	per Mcf		12,805		Mmcf		Apr. 2012 - Dec. 2012

 

The change in fair value of derivatives designated as hedges that is effective is recorded to Accumulated Other Comprehensive Income / (Loss) in Stockholders’ Equity in the Condensed Consolidated Balance Sheet. The ineffective portion of the change in fair value of derivatives designated as hedges, and the change in fair value of derivatives not designated as hedges, are recorded currently in earnings as a component of Natural Gas Revenue and Crude Oil and Condensate Revenue, as appropriate, in the Condensed Consolidated Statement of Operations.

 

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The following disclosures reflect the impact of derivative instruments on the Company’s condensed consolidated financial statements:

 

Effect of Derivative Instruments on the Condensed Consolidated Balance Sheet

 

				Fair Value Asset (Liability)
(In thousands)		Balance Sheet Location		March 31, 2012			December 31, 2011
Derivatives Designated as Hedging Instruments
Commodity Contracts		Derivative Instruments (current assets)		$	199,071		$	177,389
Commodity Contracts		Accrued Liabilities		(6,538		)	(385		)
Commodity Contracts		Derivative Instruments (non-current assets)		22,259			21,249
Commodity Contracts		Other Liabilities		(1,481		)	—
				213,311			198,253
Derivatives Not Designated as Hedging Instruments
Commodity Contracts		Derivative Instruments (current assets)		(2,388		)	(3,126		)
				$	210,923		$	195,127

 

At March 31, 2012 and December 31, 2011, unrealized gains of $213.3 million ($130.5 million, net of tax) and $198.3 million ($121.3 million, net of tax), respectively, were recorded in Accumulated Other Comprehensive Income / (Loss). Based upon estimates at March 31, 2012, the Company expects to reclassify $117.8 million in after-tax income associated with its commodity hedges from Accumulated Other Comprehensive Income / (Loss) to the Condensed Consolidated Statement of Operations over the next 12 months.

 

Effect of Derivative Instruments on the Condensed Consolidated Statement of Operations

 

		Three Months Ended								Three Months Ended March 31,
		March 31,								2012			2011
		2012			2011			Location of Gain (Loss)		Amount of Gain (Loss)
Derivatives Designated as Hedging Instruments (In thousands)		Amount of Gain (Loss) Recognized in OCI on Derivative (Effective Portion)						Reclassified from Accumulated OCI into Income		Reclassified from Accumulated OCI into Income (Effective Portion)
Commodity Contracts		$	70,728		$	12,573		Natural Gas Revenues		$	56,996		$	13,481
								Crude Oil and Condensate Revenues		(1,326		)	(302		)
										$	55,670		$	13,179

 

For the three months ended March 31, 2012 and 2011, respectively, there was no ineffectiveness recorded in our Condensed Consolidated Statement of Operations related to our derivative instruments.

 

Derivatives Not Designated as Hedging Instruments		Location of Gain (Loss) Recognized		Three Months Ended March 31,
(In thousands)		in Income on Derivative		2012			2011
Commodity Contracts		Natural Gas Revenues		$	42		$	17

 

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Additional Disclosures about Derivative Instruments and Hedging Activities

 

The use of derivative instruments involves the risk that the counterparties will be unable to meet their obligation under the agreement. The Company enters into derivative contracts with multiple counterparties in order to limit its exposure to individual counterparties. The Company also has netting arrangements with all of its counterparties that allow it to offset payables against receivables from separate derivative contracts with that counterparty.

 

The counterparties to the Company’s derivative instruments are also lenders under its credit facility. The Company’s credit facility and derivative instruments contain certain cross default and acceleration provisions that may require immediate payment of its derivative liability in certain situations.

 

8. FAIR VALUE MEASUREMENTS

 

ASC 820, “Fair Value Measurements and Disclosures,” established a formal framework for measuring fair values of assets and liabilities in financial statements that are already required by generally accepted accounting principles (GAAP) to be measured at fair value. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The transaction is based on a hypothetical transaction in the principal or most advantageous market considered from the perspective of the market participant that holds the asset or owes the liability.

 

The Company utilizes market data or assumptions that market participants who are independent, knowledgeable and willing and able to transact would use in pricing the asset or liability, including assumptions about risk and the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated or generally unobservable. The Company attempts to utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The Company is able to classify fair value balances based on the observability of those inputs. ASC 820 establishes formal fair value hierarchy based on the inputs used to measure fair value. The hierarchy gives the highest priority to Level 1 measurements and the lowest priority to Level 3 measurements.

 

The Company has classified its assets and liabilities into these levels depending upon the data relied on to determine the fair values. For further information regarding the fair value hierarchy, refer to Note 13 of the Notes to the Consolidated Financial Statements in the Form 10-K.

 

Non-Financial Assets and Liabilities

 

The Company discloses or recognizes its non-financial assets and liabilities, such as impairments of long-lived assets, at fair value on a nonrecurring basis. As none of the Company’s non-financial assets and liabilities were impaired as of March 31, 2012 and 2011 and no other assets or liabilities were required to be measured at fair value on a non-recurring basis, additional disclosures are not provided.

 

Financial Assets and Liabilities

 

The Company’s financial assets and liabilities are measured at fair value on a recurring basis. The following fair value hierarchy table presents information about the Company’s financial assets and liabilities measured at fair value on a recurring basis:

 

(In thousands)		Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)			Balance as of March 31, 2012
Assets
Rabbi Trust Deferred Compensation Plan		$	11,644		$	—		$	—		$	11,644
Derivative Contracts		—			—			218,942			218,942
Total Assets		$	11,644		$	—		$	218,942		$	230,586
Liabilities
Rabbi Trust Deferred Compensation Plan		$	19,183		$	—		$	—		$	19,183
Derivative Contracts		—			8,019			—			8,019
Total Liabilities		$	19,183		$	8,019		$	—		$	27,202

 

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(In thousands)		Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)			Balance as of December 31, 2011
Assets
Rabbi Trust Deferred Compensation Plan		$	10,838		$	—		$	—		$	10,838
Derivative Contracts		—			—			195,512			195,512
Total Assets		$	10,838		$	—		$	195,512		$	206,350
Liabilities
Rabbi Trust Deferred Compensation Plan		$	20,187		$	—		$	—		$	20,187
Derivative Contracts		—			—			385			385
Total Liabilities		$	20,187		$	—		$	385		$	20,572

 

The Company’s investments associated with its Rabbi Trust Deferred Compensation Plan consist of mutual funds and deferred shares of the Company’s common stock that are publicly traded and for which market prices are readily available.

 

The derivative contracts were measured based on quotes from the Company’s counterparties. Such quotes have been derived using an income approach that considers various inputs including current market and contractual prices for the underlying instruments, quoted forward prices for natural gas and crude oil, basis differentials, volatility factors and interest rates, such as a LIBOR curve for a similar length of time as the derivative contract term as applicable. These estimates are verified using relevant NYMEX futures contracts or are compared to multiple quotes obtained from counterparties for reasonableness. The determination of the fair values presented above also incorporates a credit adjustment for non-performance risk, as required by GAAP. The Company measured the non-performance risk of its counterparties by reviewing credit default swap spreads for the various financial institutions in which it has derivative transactions, while non-performance risk of the Company is evaluated using a market credit spread provided by the Company’s bank.

 

The significant unobservable inputs for Level 3 derivative contracts include basis differentials and volatility factors.  An increase (decrease) in these unobservable inputs would result in an increase (decrease) in fair value, respectively. The Company does not have access to the specific assumptions used in its counterparties’ valuation models. Consequently, additional disclosures regarding significant Level 3 unobservable inputs were not provided.

 

The following table sets forth a reconciliation of changes in the fair value of financial assets and liabilities classified as Level 3 in the fair value hierarchy:

 

		Three Months Ended
		March 31,
(In thousands)		2012			2011
Balance at beginning of period		$	195,127		$	14,746
Total Gains or (Losses) (Realized or Unrealized):
Included in Earnings (1)		57,038			13,197
Included in Other Comprehensive Income		22,692			(606		)
Settlements		(56,300		)	(13,179		)
Transfers In and/or Out of Level 3		385			—
Balance at end of period		$	218,942		$	14,158

 

(1) Unrealized gains of $42 thousand and $17 thousand for the three months ended March 31, 2012 and 2011, respectively, were included in Natural Gas Revenues in the Condensed Consolidated Statement of Operations.

 

There were no transfers between Level 1 and Level 2 measurements for the three months ended March 31, 2012 and 2011.

 

Fair Value of Other Financial Instruments

 

The estimated fair value of financial instruments is the amount at which the instrument could be exchanged currently between willing parties. The carrying amounts reported in the Condensed Consolidated Balance Sheet for cash and cash equivalents, accounts receivable and accounts payable approximate fair value due to the short-term maturities of these instruments.

 

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