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EARTHSTONE ENERGY INC - Quarter Report: 2011 June (Form 10-Q)

este_10q.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

þ
 
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Quarterly Period Ended June 30, 2011

o
 
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
Commission file number: 0-7914
 
(Exact Name of Registrant as Specified in its Charter)

Delaware
 
84-0592823
(State of Incorporation or Organization)  
(I.R.S. Employer Identification No.)
     
633 17th Street, Suite 1645, Denver, Colorado
 
80202-3625
(Address of principal executive office)  
(Zip Code)
     
 
(303) 296-3076
(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 the filing requirements for the past 90 days.
Yes þ   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 þ   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.
 
Large accelerated filer o Accelerated filer  o
       
Non-accelerated filer o Smaller reporting company þ
(Do not check if a smaller reporting company)       

Check whether the issuer is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No þ

Shares of common stock outstanding on August 12, 2011: 1,712,912
 


 
 

 
EARTHSTONE ENERGY, INC.
FORM 10-Q
 
INDEX

 
PART I. FINANCIAL INFORMATION
 
Page
 
         
Item 1.
Financial Statements
    5  
           
 
    Condensed Consolidated Balance Sheets: June 30, 2011 (Unaudited) and March 31, 2011
    5  
           
 
    Condensed Consolidated Statements of Operations: Three Months Ended June 30, 2011 and 2010 (Unaudited)
    7  
           
 
    Condensed Consolidated Statements of Cash Flows: Three Months Ended June 30, 2011 and 2010 (Unaudited)
    8  
           
 
    Notes to Unaudited Condensed Consolidated Financial Statements: June 30, 2011 (Unaudited)
    9  
           
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
    13  
           
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
    18  
           
Item 4.
Controls and Procedures
    18  
           
 
PART II. OTHER INFORMATION
       
           
Item 1.
Legal Proceedings
    19  
           
Item 1A.
Risk Factors
    19  
           
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
    19  
           
Item 3.
Defaults Upon Senior Securities
    19  
           
Item 4.
Submission of Matters to a Vote of Security Holders
    19  
           
Item 5.
Other Information
    19  
           
Item 6.
Exhibits
    19  
           
 
Signatures
    20  
 
 
2

 

FORWARD-LOOKING STATEMENTS

This Current Report on Form 10-Q, including information incorporated herein by reference, contains forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995.  These statements are subject to risks and uncertainties and are based on the beliefs and assumptions of management and information currently available to management.  The use of any statements containing the words "anticipate," "intend," "believe," "estimate," "project," "expect," "predict," "plan," "should," "likely," "may," "will," "continue" or similar expressions are intended to identify such statements.  All statements other than statements of historical facts that address activities that we intend, expect or anticipate will or may occur in the future are forward-looking statements.  All forward-looking statements should be evaluated with the understanding of their inherent uncertainty.  Forward-looking statements relate to, among other things:
 
our strategies, either existing or anticipated;
our future financial position, including anticipated liquidity; 
our ability to satisfy obligations from cash generated from operations;
amounts and nature of future capital expenditures;
acquisitions and other business opportunities;
operating costs and other expenses;
wells expected to be drilled, other anticipated exploration efforts and the expenses associated therewith;
our asset retirement obligation;
estimates of proved oil and natural gas reserves, deferred tax assets, and depletion rates;
our ability to meet additional acreage, seismic and/or drilling cost requirements arising from acquisition opportunities;
other estimates and assumptions we use in our accounting policies; and
future share repurchases.
   
Factors that could cause actual results to differ materially from our expectations include, among others, such things as:
   
oil and natural gas prices;
our ability to replace oil and natural gas reserves;
loss of senior management or technical personnel;
inaccuracy in reserve estimates and expected production rates;
exploitation, development and exploration results;
mechanical failure;
the actual costs related to asset retirement obligation, and whether or not those retirements actually occur in the future;
the potential unavailability of drilling rigs and other field equipment and services;
the existence of unanticipated liabilities or problems relating to acquired properties;
factors affecting the nature and timing of our capital expenditures, including the availability of service contractors and equipment;
the willingness and ability of third parties to honor their contractual commitments;
permitting issues;
the nature, extent and duration of workovers;
the impact and costs related to compliance with or changes in laws governing our operations;
environmental liabilities;
acquisitions and other business opportunities (or the lack thereof) that may be pursued by us;
competition for available properties and the effect of such competition on the price of those properties;
general economic, market or business conditions;
weather;
any change in interest rates or inflation;
a lack of available capital and financing;
risk factors consistent with comparable companies within our industry, especially companies  with similar market capitalization and/or employee census; and
other factors, many of which are beyond our control.
 
 
3

 
 
Furthermore, forward-looking statements are made based on our current assessment available at the time. Subsequently obtained information concerning the merits of any property, as well as changes in estimated exploration and development costs and ownership interest, may result in revisions to our expectations and intentions and, thus, we may alter our plans regarding any exploration and development activities.

Although we believe that the expectations reflected in such forward-looking statements are reasonable, those expectations may prove to be incorrect.  As with comparable companies within our industry, there are numerous factors that could cause actual results to differ materially from our expectations.  All forward-looking statements speak only as of the date made.  All subsequent written and oral forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by these cautionary statements.  Except as required by law, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made or to reflect the occurrence of anticipated or unanticipated events or circumstances.

 
4

 

PART I – FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
 
Earthstone Energy, Inc.
Condensed Consolidated Balance Sheets
Page 1 of 2

   
June 30,
   
March 31,
 
   
2011
   
2011
 
   
(Unaudited)
       
ASSETS
           
Current assets:
           
     Cash and cash equivalents
 
$
3,549,000
   
$
4,051,000
 
     Accounts receivable:
               
          Oil and gas sales
   
1,810,000
     
1,674,000
 
          Joint interest and other receivables, net of allowance of $93,000
   
329,000
     
329,000
 
     Other current assets
   
1,073,000
     
539,000
 
                 
Total current assets
   
6,761,000
     
6,593,000
 
                 
Oil and gas property, full cost method:
               
     Proved property
   
35,674,000
     
35,379,000
 
     Unproved property
   
3,931,000
     
3,112,000
 
     Accumulated depletion and impairment
   
(24,898,000
)    
(24,713,000
                 
     Net oil and gas property
   
14,707,000
     
13,778,000
 
                 
Support equipment and other non-current assets, net of accumulated depreciation of $384,000 and $377,000, respectively
   
502,000
     
471,000
 
                 
Total non-current assets
   
15,209,000
     
14,249,000
 
Total assets
 
$
21,970,000
   
$
20,842,000
 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

 
5

 

Earthstone Energy, Inc.
Condensed Consolidated Balance Sheets
Page 2 of 2

   
June 30,
   
March 31,
 
   
2011
   
2011
 
   
(Unaudited)
       
LIABILITIES AND SHAREHOLDERS’ EQUITY
           
Current liabilities:
           
     Accounts payable
 
$
378,000
   
$
496,000
 
     Accrued liabilities
   
1,504,000
     
1,167,000
 
                 
Total current liabilities
   
1,882,000
     
1,663,000
 
                 
Long-term liabilities:
               
     Deferred tax liability
   
2,502,000
     
2,319,000
 
     Asset retirement obligation
   
1,834,000
     
1,795,000
 
                 
Total long-term liabilities
   
4,336,000
     
4,114,000
 
                 
Total liabilities
   
6,218,000
     
5,777,000
 
                 
Shareholders’ Equity:
               
     Preferred shares, $0.001 par value, 600,000 authorized and none issued or outstanding
   
     
 
     Common shares, $0.001 par value, 6,400,000 shares authorized and 1,788,000 and 1,782,000 shares issued, respectively
   
18,000
     
18,000
 
     Additional paid-in capital
   
23,042,000
     
23,020,000
 
     Treasury stock, at cost, 76,000 shares
   
(373,000
)    
(373,000
)
     Accumulated deficit
   
(6,935,000
   
(7,600,000
)
                 
Total shareholders’ equity
   
15,752,000
     
15,065,000
 
Total liabilities and shareholders’ equity
 
$
21,970,000
   
$
20,842,000
 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

 
6

 

Earthstone Energy, Inc.
Condensed Consolidated Statements of Operations
(Unaudited)
  
     
Three Months Ended
 
     
June 30,
 
     
2011
     
2010
 
                 
Revenues:
               
     Oil and gas sales
 
$
2,480,000
   
$
1,763,000
 
     Well service and water disposal revenue
   
45,000
     
1,000
 
                 
Total revenues
   
2,525,000
     
1,764,000
 
                 
Expenses:
               
     Oil and gas production
   
795,000
     
506,000
 
     Production tax
   
138,000
     
126,000
 
     Well service and water disposal
   
6,000
     
3,000
 
     Depletion and depreciation
   
196,000
     
259,000
 
     Accretion of asset retirement obligation
   
41,000
     
40,000
 
     General and administrative
   
442,000
     
386,000
 
                 
Total expenses
   
1,618,000
     
1,320,000
 
                 
Income from operations
   
907,000
     
444,000
 
                 
Other income (expense):
               
     Interest and other income
   
7,000
     
3,000
 
     Interest and other expenses
   
(3,000
)    
 ―
 
                 
Total other income (expense)
   
4,000
     
3,000
 
                 
Income before income tax
   
911,000
     
447,000
 
                 
Current income tax expense
   
63,000
     
68,000
 
Deferred income tax expense
   
183,000
     
           1,000
 
                 
Total income tax expense
   
246,000
     
69,000
 
                 
Net income
 
$
665,000
   
$
378,000
 
                 
Per share amounts:
               
     Basic
 
$
0.39
   
$
0.22
 
     Diluted
 
$
0.39
   
$
0.22
 
                 
Weighted average common shares outstanding:
               
     Basic
   
1,712,744
     
1,686,767
 
     Diluted
   
1,712,744
     
1,686,767
 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

 
7

 

Earthstone Energy, Inc.
Condensed Consolidated Statements of Cash Flows
(Unaudited)

     
Three Months Ended
 
     
June 30,
 
     
2011
     
2010
 
                 
Cash flows from operating activities:
               
     Net income
 
$
  665,000
   
$
  378,000
 
     Adjustments to reconcile net income to net cash provided by operating activities:
               
        Depletion and depreciation
   
      196,000
     
      259,000
 
        Deferred tax expense
   
             183,000
     
             1,000
 
        Accretion of asset retirement obligation
   
       41,000
     
       40,000
 
        Payments on asset retirement obligation
   
       
     
       170,000
 
        Share-based compensation
   
           22,000
     
           20,000
 
     Change in:
               
        Accounts receivable, net
   
(136,000
)    
181,000
 
        Other current assets
   
        2,000
     
        139,000
 
        Accounts payable, accrued and other liabilities
   
          (96,000
)    
          345,000
 
                 
Net cash provided by operating activities
   
     877,000
     
     1,193,000
 
                 
Cash flows from investing activities:
               
     Oil and gas property
   
     (1,337,000
)    
     (1,074,000
)
     Support equipment and other non-current assets
   
            (42,000
)    
            (1,000
)
                 
Net cash used in investing activities
   
        (1,379,000
)    
        (1,075,000
)
                 
Cash flows from financing activities:
               
     Purchase of treasury shares
   
          
     
          (51,000
                 
Net cash used in financing activities
   
         
     
         (51,000
)
                 
Cash and cash equivalents:
               
Net (decrease) increase in cash and cash equivalents
   
(502,000
)    
           67,000
 
Cash and cash equivalents, beginning of year
   
     4,051,000
     
     4,905,000
 
                 
Cash and cash equivalents, end of period
 
$
      3,549,000
   
$
      4,972,000
 
                 
Supplemental disclosure of cash flow information:
               
     Cash paid for interest
 
$
   
$
 
     Cash paid for income tax
 
$
           
   
$
           90,000
 
Non-cash:
               
     Increase in oil and gas property due to asset retirement obligation
 
$
        
   
$
        202,000
 
     Accrued capital expenditures
 
$
439,000
   
$
633,000
 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

 
8

 

Earthstone Energy, Inc.
Notes to Unaudited Condensed Consolidated Financial Statements
June 30, 2011

1. Basis of Presentation

The accompanying interim financial statements of Earthstone Energy, Inc. (formerly Basic Earth Science Systems, Inc. sometimes referred to as “the Company” “we” “our” or “us”) are unaudited.  However, in the opinion of management, the interim data includes any applicable adjustments necessary for a fair presentation of the financial and operational results for the interim period according to generally accepted accounting principles in the United States of America (“U.S. GAAP”).

At the directive of the Securities and Exchange Commission to use “plain English” in public filings, the Company will use such terms as “we,” “our,” “us” or “the Company” in place of Earthstone Energy, Inc. and its wholly-owned subsidiary.  When such terms are used in this manner throughout the notes to the condensed consolidated financial statements, they are in reference only to the corporation, Earthstone Energy, Inc. and its subsidiaries, and are not used in reference to the Board of Directors, corporate officers, management, or any individual employee or group of employees.

The financial statements included herein have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such rules and regulations.  We believe the disclosures made are adequate to make the information not misleading and suggest that these financial statements be read in conjunction with the financial statements and related notes thereto included in our Annual Report on Form 10-K for the year ended March 31, 2011 and Quarterly Reports on Forms 10-Q for the quarters ended December 31, 2010, September 30, 2010 and June 30, 2010.

For the three months ended June 30, 2011, we determined that there were no subsequent events to recognize or disclose in these condensed consolidated financial statements which would either impact the results reflected in this report or the Company’s results going forward.

The results of operations for the three months ended June 30, 2011, are not necessarily indicative of the operating results that may be expected for the year ending March 31, 2012.

Reclassifications. Certain amounts for the comparable three month period in the prior year were reclassified to conform to current presentation.  Such reclassifications had no effect on previously reported net income, accumulated deficit, net assets or total shareholders' equity.

Fair Value Measurements.  The Company’s financial instruments consist of cash and cash equivalents, trade receivables, trade payables and accrued liabilities, all of which are considered to be representative of their fair market value, due to the short-term and highly liquid nature of these instruments.

Use of Estimates.  The preparation of financial statements in conformity with U.S. GAAP requires estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  These estimates and assumptions concern matters that are inherently uncertain.  Estimates and assumptions are revised periodically and the effects of revisions are reflected in the financial statements in the period it is determined to be necessary.  Actual results could differ from those estimates.

Commitments.  The Company is committed to a total of $281,000 plus maintenance fees for a five-year lease term ending April 30, 2013 on a 4,000 square foot office space located in downtown Denver, Colorado.  The Company does not have any off-balance sheet financing transactions, arrangements or obligations.
 
Recent Accounting Pronouncements. Various accounting pronouncements have been recently issued, most of which represented technical corrections to the accounting literature or were applicable to specific industries, and are not expected to have a material effect on our financial position, results of operations, or cash flows.
 
 
9

 
 
2. Other Current Assets

   
June 30,
2011
   
March 31,
2011
 
   
(Unaudited)
       
             
Lease and well equipment inventory
  $ 399,000     $ 399,000  
Drilling and completion cost prepayments
    552,000       24,000  
Prepaid insurance premiums
    37,000       16,000  
Prepaid income taxes
    18,000       81,000  
Other current assets
    67,000       19,000  
                 
 Total other current assets
  $ 1,073,000     $ 539,000  

3. Accrued Liabilities

   
June 30,
   
March 31,
 
    2011  
 
2011  
   
(Unaudited)
 
 
   
                 
Revenue and production taxes payable
 
$
395,000
 
 
$
340,000
 
Accrued compensation
   
283,000
 
 
 
223,000
 
Accrued operations payable
   
526,000
 
 
 
239,000
 
Accrued income tax payable and other
   
171,000
     
238,000
 
Short term asset retirement obligation
   
129,000
 
 
 
127,000
 
                 
 Total accrued liabilities
 
$
1,504,000
 
 
$
1,167,000
 
 
 
10

 

4. Income Tax

The provision for income tax for the three months ended June 30, 2011 and 2010 is comprised of:

   
Three Months Ended
June 30,
 
   
2011
   
2010
 
   
(Unaudited)
   
(Unaudited)
 
             
Current:
           
     Federal
 
$
56,000
   
$
61,000
 
     State
   
7,000
     
7,000
 
 Total current income tax expense
   
63,000
     
68,000
 
                 
Deferred:
               
     Federal
   
170,000
     
1,000
 
     State
   
13,000
     
 
Total deferred income tax expense
   
183,000
     
1,000
 
                 
Income tax expense
 
$
246,000
   
$
69,000
 
 
A reconciliation between the income tax provision at the statutory rate on income tax and the income tax provision for the three months ended June 30, 2011 and 2010 follows:

   
Three Months Ended
June 30,
 
   
2011
   
2010
 
   
(Unaudited)
   
(Unaudited)
 
                 
Federal tax at statutory rate
 
$
310,000
   
$
152,000
 
State taxes, net of federal benefit
   
17,000
     
7,000
 
Excess percentage depletion
   
(83,000
)    
(59,000
)
Other adjustments, net
   
2,000
     
(31,000
)
                 
Income tax expense
 
$
246,000
   
$
69,000
 
Effective tax rate expressed as a percentage of income before income tax
   
27.0
%
   
15.4
%

The overall effective tax rate expressed as a percentage of book income before income tax for the three months ended June 30, 2011, as compared to the same period in 2010, was higher due to the Company having larger deductions for statutory depletion and deferred tax assets from the amounts originally estimated on the prior year tax provision.

Net income tax payments were nil and $90,000 for the three months ended June 30, 2011 and 2010, respectively.
 
 
11

 

Net deferred tax assets and liabilities as of June 30, 2011 and March 31, 2011 were comprised of:

   
June 30,
   
March 31,
 
   
2011
   
2011
 
   
(Unaudited)
       
             
Deferred tax assets:
           
Allowance for doubtful accounts
 
$
34,000
   
$
34,000
 
Asset retirement obligation
   
718,000
     
703,000
 
Statutory depletion carry-forward
   
1,091,000
     
1,110,000
 
                 
Gross deferred tax assets
   
1,843,000
     
1,847,000
 
                 
Other accruals
   
86,000
     
69,000
 
Depletion, depreciation and intangible drilling costs
   
(4,430,000
)    
(4,235,000
                 
Gross deferred tax liabilities
   
(4,344,000
)    
(4,166,000
)
                 
Deferred tax liabilities, net
 
$
(2,501,000
)  
$
(2,319,000
)

Projections of future income taxes and their timing require significant estimates with respect to future operating results.  Accordingly, deferred tax assets and liabilities are continually re-evaluated and numerous estimates are revised over time.  As such, deferred taxes may change significantly as more information and data is gathered with respect to such events as changes in commodity prices, their effect on the estimate of oil and gas reserves and the depletion of these long-lived reserves.

The Company is subject to U.S. federal income tax and income tax from multiple state jurisdictions.  The tax years remaining subject to examination by tax authorities are the years ended March 31, 2007 through 2011.
 
 
12

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

The following discussion and analysis should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in our Annual Report on Form 10-K for the year ended March 31, 2011, as well as the unaudited condensed consolidated financial statements and related notes and other information appearing in Item 1 of this report.

The preparation of our unaudited condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires us to make estimates and assumptions that affect the reported amounts in our unaudited condensed consolidated financial statements and the accompanying notes including matters arising during the normal course of business.  We apply our best judgment, our knowledge of existing facts and circumstances and our knowledge of actions that we may undertake in the future in determining the estimates that will affect our unaudited condensed consolidated financial statements.  We evaluate our estimates on an ongoing basis using our historical experience, as well as other factors we believe appropriate under the circumstances, such as current economic conditions, and adjust or revise our estimates as circumstances change.  As future events and their effects cannot be determined with precision, actual results may differ from these estimates.
 
As used in this report, unless the context otherwise indicates, references to “we,” “our,” “ours,” and “us” refer to Earthstone Energy, Inc. and its subsidiary collectively.

As an oil and natural gas producer, our revenue, cash flow from operations, other income and profitability, reserve values, access to capital and future rate of growth are substantially dependent upon the prevailing prices of crude oil and natural gas.  Declines in commodity prices will materially and adversely affect our financial condition, liquidity, ability to obtain financing and operating results.  Lower commodity prices may reduce the amount of crude oil and natural gas that we can produce economically.  Prevailing prices for such commodities are subject to wide fluctuation in response to relatively minor changes in supply and demand and a variety of additional factors beyond our control, such as global, political and economic conditions.  Historically, prices received for crude oil and natural gas production have been volatile and unpredictable, and such volatility is expected to continue.  Most of our production is sold at market prices.  Generally, if the commodity indexes fall, the price that we receive for our production will also decline.  Therefore, the amount of revenue that we realize is to a large extent determined by factors beyond our control.

Liquidity and Capital Resources

Liquidity Outlook.  Our primary source of funding is the net cash flow from the sale of our oil and natural gas production.  The profitability and cash flow generated by our operations in any particular accounting period will be directly related to: (a) the volume of oil and gas produced and sold, (b) the average realized prices for oil and gas sold, and (c) lifting costs.  At the current price of oil, we believe the cash generated from operations, along with existing cash balances, should enable us to meet our existing and normal recurring obligations during the next year and beyond.

Overview of our Capital Structure.  We recognize the importance of developing our capital resource base in order to pursue our objectives.  However, subsequent to our last public offering in 1980, debt financing has been the sole source of external funding.  In addition to our routine production-related costs, general and administrative expenses and, when necessary, debt repayment requirements, we require capital to fund our exploratory and development drilling efforts and the acquisition of additional properties as well as the enhancement of held and newly acquired properties.

We have received numerous inquiries regarding the possibility of funding our efforts through equity contributions or debt instruments.  Given strong cash flows, and the relatively modest nature of our current drilling projects, we have thus far declined these overtures.  Our primary concern in this area is the dilution of our existing shareholders.  However, going forward, given that one of the key components of our growth strategy is to expand our oil and natural gas reserve base through drilling and/or acquisitions, if we were presented with a significant opportunity and available cash and bank debt financing were insufficient, it is possible we would consider alternative forms of additional financing.
 
 
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Hedging.  During the three months ended June 30, 2011 and 2010, we did not participate in any hedging activities, nor did we have any open futures or option contracts. 

Working Capital. At June 30, 2011, we had a working capital surplus of $4,879,000 (a current ratio of 3.59:1) compared to a working capital surplus at March 31, 2011 of $4,930,000 (a current ratio of 3.96:1).  The decrease in current ratio is largely a result of the timing between payments made for payables, cash received for revenue, joint interest billings and the timing and use of prepaid balances.

Cash Flow. The amounts presented herein are presented on a cash basis (or GAAP presentation), and as such may not be consistent with the changes in amounts presented on the Condensed Consolidated Balance Sheets under operating activities and investing activities for expenditures on oil and gas property, which are presented on an accrual basis.

Net cash provided by operating activities was $877,000 for the three months ended June 30, 2011, compared to $1,193,000 for the three months ended June 30, 2010.  Changes in operating cash relate largely to the timing and payment of accounts payable and accrued liabilities, especially pertaining to capital expenditure outlays, in addition to the timing and collection of accounts receivable and the application of prepaid balances.  Non-cash expenses of $259,000 and $320,000 for the three months ended June 30, 2011 and 2010, respectively, were also a factor in deriving net cash flows from operations.
 
Net cash used in investing activities was 28% higher for the three months ended June 30, 2011, at $1,379,000, than $1,075,000 for the three months ended June 30, 2010.  Spending relates primarily to our drilling and completion activities explained in “Capital Expenditures” below.  On an accrual basis, we capitalized $1,115,000 of costs for the three months ended June 30, 2011, compared to $791,000 for the three months ended June 30, 2010.  The timing of payments for these expenditures and those accrued at the respective prior year end is reflected in net cash used in investing activities for the respective three month periods.

Net cash used in financing activities was $51,000 for the three months ended June 30, 2010, and nil for the three months ended June 30, 2011.  Cash used in financing activities during 2010 related to the stock buyback program adopted in October 2008.

Capital Expenditures

The amounts presented herein are presented on an accrual basis, and as such may not be consistent with the amounts presented on the Condensed Consolidated Statement of Cash Flows under investing activities for expenditures on oil and gas property, which are presented on a cash basis.

During the three months ended June 30, 2011, we spent $1,115,000 on various projects.  This compares to $791,000 for the three months ended June 30, 2010.  During the three months ended June 30, 2011, 97% of our capital expenditures were dedicated to drilling and completions, with leasehold and acquisitions requiring only 2% and 1%, respectively, of our capital expenditure funds.  We spent $861,000 (77%) of our funds on developing properties classified as unevaluated at quarter-end.  Of this amount, $665,000 was deployed on four new horizontal Bakken wells, for which drilling reached total depth by quarter-end.  Additionally this quarter, we expended funds to complete the Onstad 22-14 well in Divide Field, Sheridan County, Montana, acquired from an unrelated party in March, which had been shut-in for over three years.  Unrelated to this acquisition, we re-entered an abandoned well, the Onstad 14-11, also in Divide Field, and were in the process of converting it into a salt water disposal well at quarter-end.  Our share of drilling costs during the quarter on the two Onstad wells in which we hold an interest was $101,000.  Of the remaining 23% of capital spending, 15% pertained to planned enhancements on four producing wells purchased in December 2010.  All projects were funded entirely with internally generated cash flow.
 
 
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As of June 30, 2011, we have Authorizations for Expenditure (“AFEs”) totaling $2,459,000 for our share in completion costs of 19 new wells in addition to the cost of workovers on 4 wells in which we share a working interest.  At present cash flow levels, we expect to have sufficient funds available for our share of both the outstanding AFEs and any additional acreage, seismic and/or drilling cost requirements that might arise from our existing opportunities.  We may alter or vary all or part of any planned capital expenditures for reasons including, but not limited to changes in circumstances, unforeseen opportunities, the inability to negotiate favorable acquisition, farmout, joint venture or divestiture terms, commodity prices, lack of cash flow, and lack of additional funding.

Reserves

During the three months ended June 30, 2011, our proved reserves in barrels of oil equivalent (“BOE”) and present value of estimated future cash flows, before income taxes, discounted at 10% (“PV-10”) increased approximately 3% and 10%, respectively from March 31, 2011 from 1,137,064 and $20,032,664, respectively, to 1,169,768 and $22,120,991, respectively.  The increase resulted from the increase in first day of the month prices for July 1, 2010 through June 1, 2011, compared to those for April 1, 2010 through March 1, 2011, in accordance with SEC pricing rules.
 
Contemplated Activities

We are continually evaluating drilling and acquisition opportunities for possible participation.  Typically, at any one time, several opportunities are in various stages of evaluation.  Our policy is to not disclose the specifics of a project or prospect, nor to speculate on such ventures, until such time as those various opportunities are finalized and undertaken.  We caution that the absence of news and/or press releases should not be interpreted as a lack of development or activity.

Divestitures/Abandonments

We neither sold nor plugged any wells during the three months ended June 30, 2011.

Other Commitments

Other than the aforementioned outstanding AFEs, we do not have any other commitments beyond our office lease and software maintenance contracts.  See further detail in the notes to the Condensed Consolidated Financial Statements.

Impact of Inflation and Pricing

We deal primarily in U.S. dollars.  Inflation has not had a material impact on the Company in recent years because of the relatively low rates of inflation in the United States.  However, the oil and natural gas industry can be cyclical and the demand for production places pressure on the economic stability and pricing within the industry.  Typically, as prices for oil and natural gas increase, associated costs rise.  Conversely, cost declines are likely to lag and may not adjust downward in proportion to declining prices.  Changes in prices impact our revenues, estimates of reserves, assessments of any impairment of oil and natural gas properties, as well as values of properties being acquired or sold.  Price changes have the potential to affect our ability to raise capital, borrow money, and retain personnel.  While we do not presently expect business costs to materially rise, higher prices for oil and natural gas could result in increases in the costs of materials, services and personnel.
 
 
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Results of Operations

The following provides selected financial information and averages for the three months ended June 30, 2011 and 2010.  Certain prior year amounts have been reclassified to conform to current year presentation.
 
     
Three Months Ended
 
     
June 30,
 
     
2011
     
2010
 
Revenue
         
 
   
     Oil
 
$
2,187,000
   
$
1,577,000
 
     Gas
   
293,000
     
186,000
 
Total revenue 1
   
2,480,000
     
1,763,000
 
                 
Total production expense 2
   
933,000
     
632,000
 
                 
Gross profit
 
$
1,547,000
   
$
1,131,000
 
                 
Depletion expense
 
$
185,000
   
$
250,000
 
                 
Sales volume
               
     Oil (Bbls)
   
22,562
     
23,222
 
     Gas (Mcfs) 3
   
31,403
     
23,964
 
                 
Average sales price 4
               
     Oil (per Bbl)
 
$
96.93
   
$
67.91
 
     Gas (per Mcf)
 
$
9.33
   
$
7.76
 
                 
Average per BOE 5
               
     Production expense 3, 4
 
$
33.57
   
$
23.22
 
     Gross profit 4
 
$
55.66
   
$
41.56
 
     Depletion expense 4
 
$
6.66
   
$
9.19
 
 
1
 
Amount does not include water service and disposal revenue.  For the three months ended June 30, 2011, this revenue amount is net of $45,000 in well service and water disposal revenue, which would otherwise total $2,525,000 in revenue, compared to $1,000 in 2010 to total $1,764,000 for the comparable three month period in 2010.
 
2
 
Overall lifting cost (oil and gas production costs, including production taxes and the cost of workovers)
 
3
 
Estimates of volumes are inherent in reported volumes to coincide with revenue accruals as a result of the timing of sales information reporting by third party operators.
 
4
 
Averages calculated based upon non-rounded figures
 
5
 
Per equivalent barrel (6 thousand cubic feet, “Mcf”, of gas is equivalent to 1 barrel, “Bbl”, of oil)
 
 
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Three Months Ended June 30, 2011 Compared to Three Months Ended June 30, 2010

Overview.  Net income for the three months ended June 30, 2011, was $665,000 compared to net income of $378,000 for the three months ended June 30, 2010, a 76% increase.  The increases in sales prices and BOE volumes, offset by an increase in production costs per BOE, accounts for the increase in net income.  An increase in general and administrative (“G&A”) expense partially offset gross profit margin increases resulting in a $287,000 increase in net income for the three months ended June 30, 2011, compared to the three months ended June 30, 2010.

Revenues.  Oil and gas sales revenue increased $610,000 (39%) and $107,000 (58%), respectively, for the three months ended June 30, 2011, compared to the three months ended June 30, 2010, due to increased BOE production and a higher realized price per BOE.

Volumes and Prices.  Oil sales volume declined 3%, from 23,222 barrels for the three months ended June 30, 2010, to 22,562 barrels for the three months ended June 30, 2011.  The 43% increase in average price per barrel positively effected oil revenues.  We recognized an average price per barrel of $96.93 for the three months ended June 30, 2011, compared to $67.91 for the three months ended June 30, 2010.  Gas sales volume rose 31% from 23,964 Mcf (3,994 BOE) for the three months ended June 30, 2010, to 31,403 Mcf (5,234 BOE) for the three months ended June 30, 2011.  The increase in gas revenue reflects a $1.57 increase in the average price per Mcf from $7.76 for the three months ended June 30, 2010, to $9.33 for the three months ended June 30, 2011, coupled with gains in gas production resulting primarily from the recompletion of nine of the existing Codell wells into the J-Sand formation during the last fifteen months.

Production Expense.  Production expense is comprised of the following items:

   
Three Months Ended
June 30,
 
   
 
2011
   
 
2010
 
                 
Lease operating costs
 
$
496,000
   
$
409,000
 
Workover costs
 
 
230,000
     
56,000
 
Production taxes
   
138,000
     
126,000
 
Transportation and other costs
 
 
69,000
     
41,000
 
                 
Total production expense
 
$
933,000
   
$
632,000
 

Oil and gas production expense increased $301,000 (48%) for the three months ended June 30, 2011, over the expense of $632,000 for the three months ended June 30, 2010, partially in connection with the increase in wells, partially due to larger workover operations in the current quarter.

Routine lease operating expense (“LOE”), consisting of lease operating costs, transportation and other costs, per BOE was $20.33 for the three months ended June 30, 2011, compared to $16.53 for the three months ended June 30, 2010.  As a percent of oil and gas sales revenue, routine LOE was 22.8% for the three months ended June 30, 2011, compared to 25.5% for the three months ended June 30, 2010.  This decline in proportion to revenue is indicative of certain costs being fixed regardless of production volume and revenue dollars.
 
Production taxes, which are generally a percentage of oil and gas sales revenue, increased nearly 10%, or $12,000, for the three months ended June 30, 2011, compared to the three months ended June 30, 2010.  Production taxes, as a percent of oil and gas sales revenue decreased from 7.1% for the three months ended June 30, 2010, to 5.6% for the three months ended June 30, 2011.  Production taxes are primarily based on the wellhead values of production, though normal fluctuations occur in the percentage between periods based upon the timing of approval of incentive tax credits in Texas, changes in tax rates, changes in the assessed values of oil and gas properties and equipment for purposes of ad valorem taxes, and changes in the proportion of our production from state to state.  Because production tax rates vary across the different states in which we operate, our average production tax rate will vary depending on the quantities produced from each state and the production tax rates in effect for those states.
 
 
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The overall lifting cost (oil and gas production costs, including production taxes as well as workovers) per BOE increased from $23.22 for the three months ended June 30, 2010, to $33.57 for the three months ended June 30, 2011, primarily as a result of workover costs on 20 wells during the three months ended June 30, 2011 compared to work on 13 wells during the three months ended June 30, 2010.

Other Expenses.
Depletion and depreciation decreased $63,000 (24%) for the three months ended June 30, 2011, compared to the three months ended June 30, 2010, as a result of greater overall production volumes, larger reserves, and additions to depletable property during the past twelve months.    

G&A expense increased $56,000 (15%) for the three months ended June 30, 2011, over the expense for the three months ended June 30, 2010.  This rise in costs is comprised primarily of employee-related expenses, which account for $42,000 of the increase due to the increase in number of employees.  Another $10,000 resulted from the cost of adding another member to our Board of Directors.  As total G&A dollars rose, the expense per BOE increased 12% from $14.18 for the three months ended June 30, 2010, to $15.90 for the three months ended June 30, 2011.  Though, as a percent of total revenue, G&A expense decreased from 22% for the three months ended June 30, 2010, to 18% for the three months ended June 30, 2011.

Income Tax.  For the three months ended June 30, 2011, we recorded income tax expense of $246,000 as compared to $69,000 for the three months ended June 30, 2010.  Our effective income tax rate increased from 15.4% for the three months ended June 30, 2010, to 27.0% for the three months ended June 30, 2011.  Our effective income tax rate was higher for the three month period ended June 30, 2011, due to increases in deductions for statutory depletion and deferred tax assets from the amounts originally estimated on the tax provision for the year ended March 31, 2010.

Off Balance Sheet Arrangements

We have no significant off balance sheet transactions, arrangements or obligations.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
As a “smaller reporting company,” we are not required to provide this information.
 
ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures
 
As defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act, the phrase “disclosure controls and procedures” means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms.  Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Interim Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

We conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2011.  This evaluation was conducted under the supervision and with the participation of management, including our Chief Executive Officer and Interim Chief Financial Officer.  Based on this evaluation, our Chief Executive Officer and Interim Chief Financial Officer concluded that, as of June 30, 2011, our disclosure controls and procedures were effective.
Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting during our last fiscal quarter that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 
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PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

None.

ITEM 1A.  RISK FACTORS

As a “smaller reporting company,” we are not required to provide this information.

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

Unregistered Sales of Equity Securities

Not applicable.

Purchases of Equity Securities
 
None.
 
ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

Exhibit No.
 
Document
     
31.1
 
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Ray Singleton, President and Chief Executive Officer).
     
31.2
 
Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Jim Poage, Interim Chief Financial Officer).
     
32.1
 
Certification Pursuant to 18 U.S.C. §1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Ray Singleton, President and Chief Executive Officer).
     
32.2
 
Certification Pursuant to 18 U.S.C. §1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Jim Poage, Interim Chief Financial Officer).
 

 
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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed by the following authorized persons on behalf of Earthstone Energy, Inc.
 
EARTHSTONE ENERGY, INC.  
     
By:
 /s/ Ray Singleton  
  Ray Singleton   
  President and Chief Executive Officer   
     
By:  /s/ Jim Poage  
 
Jim Poage
 
 
Interim Chief Financial Officer 
 
     
  Date: August 12, 2011  
 
 
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