Epsilon Energy Ltd. - Quarter Report: 2022 March (Form 10-Q)

Three months ended March 31,

Net income available to shareholders

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2022

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

For the transition period from to

Commission file number: 001-38770

EPSILON ENERGY LTD.

(Exact name of registrant as specified in its charter)


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

16945 Northchase Drive, Suite 1610

Houston, Texas 77060

(281) 670-0002

(Address of principal executive offices including zip code and

telephone number, including area code)

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


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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ⌧ No ◻

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

Yes⌧ No ◻

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

Large accelerated filer ◻

Accelerated filer ◻

Non-accelerated filer ⌧

Smaller reporting company ☒

Emerging growth company ☒

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

Yes ☐ No ⌧

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

Yes ☐ No ⌧

As of May 10, 2022, there were 23,773,203 Common Shares outstanding.

Table of Contents


Contents

FORWARD-LOOKING STATEMENTS		4
PART I-FINANCIAL INFORMATION		5
ITEM 1. FINANCIAL STATEMENTS		5
Unaudited Condensed Consolidated Balance Sheets		5
Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income (Loss)		6
Unaudited Condensed Consolidated Statements of Changes in Shareholders’ Equity		7
Unaudited Condensed Consolidated Statements of Cash Flows		8
Notes to the Unaudited Condensed Consolidated Financial Statements		9
1.	Description of Business	9
2.	Basis of Preparation	9
	Interim Financial Statements	9
	Principles of Consolidation	9
	Use of Estimates	9
	Recently Issued Accounting Standards	9
3.	Cash, Cash Equivalents, and Restricted Cash	10
4.	Property and Equipment	11
	Property Impairment	11
5.	Revolving Line of Credit	11
6.	Shareholders’ Equity	12
7.	Revenue Recognition	16
8.	Income Taxes	17
9.	Commitments and Contingencies	18
	Litigation	18
10.	Net Income Per Share	18
11.	Operating Segments	19
12.	Risk Management Activities	21
	Commodity Price Risks	21
	Commodity Derivative Contracts	21
13.	Asset Retirement Obligations	22
14.	Fair Value Measurements	22
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		24
	Overview	24
	Business Strategy	24
	Operational Highlights	25
	Non-GAAP Financial Measures-Adjusted EBITDA	26
	Net Operating Revenues	27
	Operating Costs	28
	Depletion, Depreciation, Amortization and Accretion (“DD&A”)	28
	General and Administrative	29
	Interest Expense	29
	(Loss) Gain on Commodity Contracts	29
	Other Income (Expense)	30
	Capital Resources and Liquidity	30

Table of Contents

	Cash Flow	30
	Credit Agreement	30
	Derivative Transactions	31
	Contractual Obligations	32
	Off-Balance Sheet Arrangements	32
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		32
	Gathering System Revenue Risk	32
	Interest Rate Risk	32
	Derivative Contracts	33
ITEM 4. CONTROLS AND PROCEDURES		33
	Disclosure Controls and Procedures	33
	Changes in Internal Control Over Financial Reporting	33
	Inherent Limitations on Effectiveness of Controls	33
PART II OTHER INFORMATION		33
ITEM 1. LEGAL PROCEEDINGS		33
ITEM 1A. RISK FACTORS		34
ITEM 2. UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS		34
ITEM 3. DEFAULTS UPON SENIOR SECURITIES		34
ITEM 4. MINE SAFETY DISCLOSURES		34
ITEM 5. OTHER INFORMATION		34
ITEM 6. EXHIBITS		35
SIGNATURES		35

Table of Contents

FORWARD-LOOKING STATEMENTS

Certain statements contained in this report constitute forward-looking statements. The use of any of the words ‘‘anticipate,’’ ‘‘continue,’’ ‘‘estimate,’’ ‘‘expect,’’ ‘‘may,’’ ‘‘will,’’ ‘‘project,’’ ‘‘should,’’ ‘‘believe,’’ and similar expressions and statements relating to matters that are not historical facts constitute ‘‘forward looking information’’ within the meaning of applicable securities laws. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results or events to differ materially from those anticipated. Such forward-looking statements are based on reasonable assumptions, but no assurance can be given that these expectations will prove to be correct and the forward-looking statements included in this report should not be unduly relied upon. These statements are made only as of the date of this report. All statements that address operating performance, events or developments that we expect or anticipate will occur in the future — including statements relating to natural gas and oil production rates, commodity prices for crude oil or natural gas, supply and demand for natural gas and oil; the estimated quantity of natural gas and oil reserves, including reserve life; future development and production costs, and statements expressing general views about future operating results — are forward-looking statements. Management believes that these forward-looking statements are reasonable as and when made. However, caution should be taken not to place undue reliance on any such forward-looking statements because such statements speak only as of the date when made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In addition, forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our present expectations or projections. These risks and uncertainties include, but are not limited to, those described in our Annual Report on Form 10-K for the year ended December 31, 2021, and those described from time to time in our future reports filed with the Securities and Exchange Commission. You should consider carefully the statements under Item 1A. Risk Factors included in our Annual Report on Form 10-K for the year ended December 31, 2021. Our Annual Report on Form 10-K for the year ended December 31, 2021 is available on our website at www.epsilonenergyltd.com.

Table of Contents

PART I-FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Balance Sheets


	March 31,		December 31,
	2022		2021
ASSETS
Current assets
Cash and cash equivalents	$	30,070,813	$	26,497,305
Accounts receivable		6,468,261		4,596,931
Other current assets		465,694		569,870
Total current assets		37,004,768		31,664,106
Non-current assets
Property and equipment:
Oil and gas properties, successful efforts method
Proved properties		140,557,389		138,032,413
Unproved properties		21,793,526		21,700,926
Accumulated depletion, depreciation, amortization and impairment		(103,558,669)		(102,480,972)
Total oil and gas properties, net		58,792,246		57,252,367
Gathering system		42,490,479		42,475,086
Accumulated depletion, depreciation, amortization and impairment		(33,727,110)		(33,443,949)
Total gathering system, net		8,763,369		9,031,137
Land		637,764		637,764
Buildings and other property and equipment, net		300,318		309,102
Total property and equipment, net		68,493,697		67,230,370
Other assets:
Restricted cash		568,854		568,118
Total non-current assets		69,062,551		67,798,488
Total assets	$	106,067,319	$	99,462,594

LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities
Accounts payable trade	$	1,820,112	$	1,189,905
Gathering fees payable		843,523		963,546
Royalties payable		1,956,002		1,853,508
Income taxes payable		3,255,717		1,098,425
Accrued capital expenditures		732,523		1,016,830
Other accrued liabilities		802,188		1,098,127
Fair value of derivatives		—		239,824
Asset retirement obligations		11,209		85,207
Total current liabilities		9,421,274		7,545,372
Non-current liabilities
Asset retirement obligations		2,774,709		2,748,449
Deferred income taxes		9,928,126		9,905,440
Total non-current liabilities		12,702,835		12,653,889
Total liabilities		22,124,109		20,199,261
Commitments and contingencies (Note 9)
Shareholders' equity
Common shares, no par value, unlimited shares authorized and 23,706,953 issued and outstanding at March 31, 2022 and 24,202,218 issued and 23,668,203 shares outstanding at December 31, 2021.		129,602,044		131,815,739
Treasury shares, 0 at March 31, 2022 and 534,015 at December 31, 2021		—		(2,423,007)
Additional paid-in capital		8,977,505		8,835,203
Accumulated deficit		(64,460,346)		(68,783,207)
Accumulated other comprehensive income		9,824,007		9,818,605
Total shareholders' equity		83,943,210		79,263,333
Total liabilities and shareholders' equity	$	106,067,319	$	99,462,594

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

Table of Contents

EPSILON ENERGY LTD.

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


	Three months ended March 31,
	2022		2021
Revenues from contracts with customers:
Gas, oil, NGL, and condensate revenue	$	11,479,325	$	6,439,155
Gas gathering and compression revenue		2,120,773		2,002,157
Total revenue		13,600,098		8,441,312

Operating costs and expenses:
Lease operating expenses		1,770,654		1,594,188
Gathering system operating expenses		159,211		190,947
Development geological and geophysical expenses		2,386		11,539
Depletion, depreciation, amortization, and accretion		1,389,219		1,682,860
General and administrative expenses:
Stock based compensation expense		142,302		202,499
Other general and administrative expenses		1,171,132		1,327,161
Total operating costs and expenses		4,634,904		5,009,194
Operating income		8,965,194		3,432,118

Other income (expense):
Interest income		15,221		7,813
Interest expense		(15,319)		(27,073)
(Loss) gain on derivative contracts		(971,904)		465,341
Other (expense) income		(5,406)		1,941
Other (expense) income, net		(977,408)		448,022

Net income before income tax expense		7,987,786		3,880,140
Income tax expense		2,181,898		1,144,573
NET INCOME	$	5,805,888	$	2,735,567
Currency translation adjustments		5,402		242
NET COMPREHENSIVE INCOME	$	5,811,290	$	2,735,809

Net income per share, basic	$	0.25	$	0.11
Net income per share, diluted	$	0.24	$	0.11
Weighted average number of shares outstanding, basic		23,677,842		23,947,222
Weighted average number of shares outstanding, diluted		23,862,428		24,030,104

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

Table of Contents

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Changes in Shareholders’ Equity


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


									Accumulated
									Other				Total
	Common Shares Issued			Treasury Shares			Additional		Comprehensive		Accumulated		Shareholders'
	Shares	Amount		Shares	Amount		paid-in Capital		Income		Deficit		Equity
Balance at January 1, 2021	23,985,799	$	131,730,401	—	$	—	$	7,879,119	$	9,820,647	$	(80,410,724)	$	69,019,443
Net income	—		—	—		—		—		—		2,735,567		2,735,567
Stock-based compensation expenses	—		—	—		—		202,499		—		—		202,499
Buyback of common shares	—		—	(123,200)		(492,479)		—		—		—		(492,479)
Other comprehensive income	—		—	—		—		—		242		—		242
Balance at March 31, 2021	23,985,799		131,730,401	(123,200)		(492,479)		8,081,618		9,820,889		(77,675,157)	$	71,465,272

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

Table of Contents

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Cash Flows


	Three months ended March 31,
	2022		2021
Cash flows from operating activities:
Net income	$	5,805,888	$	2,735,567
Adjustments to reconcile net income to net cash provided by operating activities:
Depletion, depreciation, amortization, and accretion		1,389,219		1,682,860
Plug and abandon of proved properties		(73,998)		—
Loss (gain) on derivative contracts		971,904		(465,341)
Settlement (paid) received on derivative contracts		(1,211,728)		64,200
Settlement of asset retirement obligation		—		(3,483)
Stock-based compensation expense		142,302		202,499
Deferred income tax expense		22,686		805,359
Changes in assets and liabilities:
Accounts receivable		(1,871,330)		454,740
Prepaid income taxes and other current assets		104,177		161,374
Accounts payable, royalties payable and other accrued liabilities		267,058		(349,705)
Income taxes payable		2,157,292		336,798
Net cash provided by operating activities		7,703,470		5,624,868
Cash flows from investing activities:
Additions to unproved oil and gas properties		(92,600)		(23,702)
Additions to proved oil and gas properties		(2,771,925)		(481,021)
Additions to gathering system properties		3,612		(40,963)
Additions to land, buildings and property and equipment		—		(5,745)
Prepaid drilling costs		—		156
Net cash used in investing activities		(2,860,913)		(551,275)
Cash flows from financing activities:
Buyback of common shares		—		(492,479)
Exercise of stock options		209,312		—
Dividends		(1,483,027)		—
Net cash used in financing activities		(1,273,715)		(492,479)
Effect of currency rates on cash, cash equivalents and restricted cash		5,402		242
Increase in cash, cash equivalents and restricted cash		3,574,244		4,581,356
Cash, cash equivalents and restricted cash, beginning of period		27,065,423		13,836,771
Cash, cash equivalents and restricted cash, end of period	$	30,639,667	$	18,418,127

Supplemental cash flow disclosures:
Interest paid	$	17,501	$	29,562

Non-cash investing activities:
Change in unproved properties accrued in accounts payable and accrued liabilities	$	—	$	(65,000)
Change in proved properties accrued in accounts payable and accrued liabilities	$	(253,632)	$	468,972
Change in gathering system accrued in accounts payable and accrued liabilities	$	19,005	$	(27,679)
Asset retirement obligation asset additions and adjustments	$	6,684	$	(21,554)

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

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

1. Description of Business

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

2. Basis of Preparation

Interim Financial Statements

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the appropriate rules and regulations of the SEC. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. All adjustments which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the interim periods presented have been included. The interim financial information and notes hereto should be read in conjunction with the Company’s consolidated financial statements as of and for the year ended December 31, 2021. The results of operations for interim periods are not necessarily indicative of results to be expected for a full fiscal year.

Principles of Consolidation

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

Use of Estimates

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

Recently Issued Accounting Standards

The Company, an emerging growth company (“EGC”), has elected to take advantage of the benefits of the extended transition period provided for in Section 7(a)(2)(B) of the Securities Act, for complying with new or revised accounting standards which allows the Company to defer adoption of certain accounting standards until those standards would otherwise apply to private companies.

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

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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

In June 2016 the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which removes the thresholds that companies apply to measure credit losses on financial instruments measured at amortized cost, such as loans, receivables, and held-to-maturity debt securities. Under current U.S. GAAP, companies generally recognize credit losses when it is probable that the loss has been incurred. The revised guidance will remove all recognition thresholds and will require companies to recognize an allowance for credit losses for the difference between the amortized cost basis of a financial instrument and the amount of amortized cost that the Company expects to collect over the instrument’s contractual life. ASU 2016-13 is effective for fiscal years beginning after December 15, 2022, and interim periods within those fiscal years, and must be applied retrospectively. Early adoption is permitted. Epsilon will adopt ASU 2016-13 as of January 1, 2023.

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

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

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

3. Cash, Cash Equivalents, and Restricted Cash

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

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

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table provides a reconciliation of cash, cash equivalents and restricted cash reported in the Consolidated Balance Sheets to the total of the amounts in the Consolidated Statements of Cash Flows as of March 31, 2022 and December, 31 2021:


	March 31,		December 31,
	2022		2021
Cash and cash equivalents	$	30,070,813	$	26,497,305
Restricted cash included in other assets		568,854		568,118
Cash, cash equivalents and restricted cash in the statement of cash flows	$	30,639,667	$	27,065,423

4. Property and Equipment

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


	March 31,		December 31,
	2022		2021
Property and equipment:
Oil and gas properties, successful efforts method
Proved properties	$	140,557,389	$	138,032,413
Unproved properties		21,793,526		21,700,926
Accumulated depletion, depreciation, amortization and impairment		(103,558,669)		(102,480,972)
Total oil and gas properties, net		58,792,246		57,252,367
Gathering system		42,490,479		42,475,086
Accumulated depletion, depreciation, amortization and impairment		(33,727,110)		(33,443,949)
Total gathering system, net		8,763,369		9,031,137
Land		637,764		637,764
Buildings and other property and equipment, net		300,318		309,102
Total property and equipment, net	$	68,493,697	$	67,230,370

Property Impairment

Epsilon performs a quantitative impairment test quarterly or whenever events or changes in circumstances indicate that an asset group's carrying amount may not be recoverable, over proved properties using the published NYMEX forward prices, timing, methods and other assumptions consistent with historical periods. When indicators of impairment are present, GAAP requires that the Company first compares expected future undiscounted cash flows by asset group to their respective carrying values. If the carrying amount exceeds the estimated undiscounted future cash flows, a reduction of the carrying amount of the oil and natural gas properties to their estimated fair values is required, which is determined based on discounted cash flow techniques using significant assumptions including projected revenues, future commodity prices, and a market-specific weighted average cost of capital which are affected by expectations about future market and economic conditions. During the three months ended March 31, 2022 and 2021, no impairment was required.

5. Revolving Line of Credit

The Company has a senior secured revolving credit facility (“Facility”) which includes a total commitment of up to $100 million. The current borrowing base is $14 million, which is subject to semi-annual redetermination. There are currently no borrowings under the Facility. If Epsilon decided to access the Facility, depending on the level of borrowing, the Company might need to increase its hedging activity. Borrowings from the Facility may be used for the acquisition and development of oil and gas properties, investments in cash flow generating assets complimentary to the production of oil and gas, and for letters of credit and other general corporate purposes. Upon each advance, interest is charged at the highest of a) rate of LIBOR plus an applicable margin (2.75%-3.75% based on the percent of the line of credit utilized), b) the Prime Rate, or c) the sum of the Federal Funds Rate plus 0.5%.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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

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

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

● Interest coverage ratio greater than 3 based on income adjusted for interest, taxes and non-cash amounts.

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

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

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

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

Balance at

March 31,

December 31,

Current

Interest Rate

2022

2021

Borrowing Base

3 mo.

Revolving line of credit

—

14,000,000

LIBOR + 3.25%⁽¹⁾

(1)

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

6. Shareholders’ Equity

(a)Authorized shares

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

(b)Purchases of Equity Shares

Normal Course Issuer Bid

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

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

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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

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

(c)Equity Incentive Plan

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

The 2020 Plan provides for incentive compensation in the form of stock options, stock appreciation rights, restricted stock and stock units, performance shares and units, other stock-based awards and cash-based awards. Under the 2020 Plan, Epsilon will be authorized to issue up to 2,000,000 Common Shares. As of December 31, 2021, the Company granted, after the Compensation Committee approved the terms, target formulas, and peer group applicable to the performance incentive awards, 20,834 common shares and 48,000 time-based restricted shares to the CEO and the board of directors.

Restricted Stock Awards

For the three months ended March 31, 2022, no shares of Restricted Stock were awarded. For the year ended December 31, 2021, 48,000 common shares of Restricted Stock with a weighted average market price at the grant date of $5.04 were awarded to the Company’s board of directors. These shares vest over a three-year period, with one-third of the shares being issued per period on the anniversary of the award resolution. The vesting of the shares is contingent on the individuals’ continued employment or service. The Company determined the fair value of the granted Restricted Stock-based on the market price of the common shares of the Company on the date of grant.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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


	Three months ended		Year ended
	March 31, 2022		December 31, 2021
		Weighted		Weighted
	Number of	Average	Number of	Average
	Shares	Remaining Life	Shares	Remaining Life
	Outstanding	(years)	Outstanding	(years)
Balance non-vested Restricted Stock at beginning of period	166,002	1.38	290,070	1.60
Granted	—	—	48,000	3.00
Vested	—	—	(137,668)	—
Forfeited	—	—	(34,400)	—
Balance non-vested Restricted Stock at end of period	166,002	1.13	166,002	1.38

Stock compensation expense for the granted Restricted Stock is recognized over the vesting period. Stock compensation expense recognized during the three months ended March 31, 2022 and 2021 was $95,112 and $137,206, respectively.

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

Performance Share Unit Awards (“PSU”)

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

●

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

●

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

●

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

●

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

The number of shares ultimately issued under these awards can range from zero to 200% of target award amounts.

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

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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

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

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


	Three months ended		Year ended
	March 31, 2022		December 31, 2021
		Weighted		Weighted
	Number of	Average	Number of	Average
	Shares	Remaining Life	Shares	Remaining Life
	Outstanding	(years)	Outstanding	(years)
Balance non-vested PSUs at beginning of period	151,500	0.75	193,167	1.60
Granted	—	—	20,834	—
Vested	—	—	(62,501)	—
Balance non-vested PSUs at end of period	151,500	0.72	151,500	0.75

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

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

Stock Options

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

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


	Three months ended			Year ended
	March 31, 2022			December 31, 2021
		Weighted				Weighted
	Number of	Average		Number of		Average
	Options	Exercise		Options		Exercise
Exercise price in US$	Outstanding	Price⁽¹⁾		Outstanding		Price⁽¹⁾
Balance at beginning of period	218,750	$	5.28		245,000	$	5.27
Exercised	(38,750)	$	5.40		(16,250)	$	5.25
Expired/Forfeited	—				(10,000)	$	5.50
Balance at period-end	180,000	$	5.25		218,750	$	5.28

Exercisable at period-end	180,000	$	5.25		218,750	$	5.28

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

(1)

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

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

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

(d) Dividends

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

7. Revenue Recognition

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

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

The following table details revenue for the three months ended March 31, 2022 and 2021.


	Three Months Ended March 31,
	2022		2021
Operating revenue
Natural gas	$	10,703,084	$	6,332,099
Natural gas liquids		314,428		45,621
Oil and condensate		461,813		61,435
Gathering and compression fees		2,120,773		2,002,157
Total operating revenue	$	13,600,098	$	8,441,312

Product Sales Revenue

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

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

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Gas Gathering and Compression Revenue

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

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

Allowance for Doubtful Accounts

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

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


	March 31,		December 31,
	2022		2021
Accounts receivable
Natural gas and oil sales	$	4,702,314	$	2,996,344
Joint interest billing		96,459		60,134
Gathering and compression fees		1,545,035		1,539,976
Other		124,453		477
Total accounts receivable	$	6,468,261	$	4,596,931

8. Income Taxes

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


	Three months ended March 31,
	2022		2021
Current:
Federal	$	1,466,896	$	155,370
State		692,316		183,844
Total current income tax expense		2,159,212		339,214
Deferred:
Federal		22,015		663,202
State		671		142,157
Total deferred tax expense		22,686		805,359
Income tax expense	$	2,181,898	$	1,144,573

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

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

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

open to audit under the statute of limitations for the years ending December 31, 2018 through December 31, 2021. To the extent we utilize net operating losses generated in earlier years, such earlier years may also be subject to audit.

Our effective tax rate will typically differ from the statutory federal rate primarily as a result of state income taxes and the valuation allowance against the Canadian net operating loss. The effective tax rate for the three months ended March 31, 2022 was higher than the statutory federal rate as a result of the state income taxes and the valuation allowance against the Canadian net operating loss.

9. Commitments and Contingencies

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


Year ended
December 31,	Payments
2022	$	140,189
2023		62,444
	$	202,633

The Company enters into commitments for capital expenditures in advance of the expenditures being made. As of March 31, 2022, the Company had commitments of $1.03 million for capital expenditures.

Litigation

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

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

Epsilon filed a notice of appeal on February 15, 2022 challenging both the motion to dismiss and motion for reconsideration decisions. Chesapeake filed a cross-appeal on March 1, 2022. A court-mandated mediation was set for June 9, 2022. A briefing schedule has not yet been set, and accordingly, a decision on the appeal is not expected until early to mid-2023.

Epsilon re-filed a complaint against Chesapeake in the Middle District on May 9, 2022. Epsilon generally asserts the similar claims as in the previous suit, pursuing declaratory judgment claims regarding Chesapeake’s obligation to Epsilon to cooperate with Epsilon’s efforts in the Auburn Development and regarding Chesapeake’s obstruction of Epsilon’s efforts with the Pennsylvania Department of Environmental Protection permitting process. Chesapeake’s response to the complaint is expected in June 2022.

10. Net Income Per Share

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

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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

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

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


	Three months ended March 31,
	2022	2021
Basic weighted-average number of shares outstanding	23,677,842	23,947,222
Dilutive stock options	16,728	—
Unvested time-based restricted shares	65,395	29,034
Unvested performance-based restricted shares	102,463	53,848
Diluted weighted average shares outstanding	23,862,428	24,030,104

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


	Three months ended March 31,
	2022	2021
Anti-dilutive options	163,272	245,000
Anti-dilutive unvested time-based restricted shares	100,607	239,036
Anti-dilutive unvested performance-based restricted shares	49,037	139,319
Total Anti-dilutive shares	312,916	623,355

11. Operating Segments

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

The Company’s reportable segments are as follows:

The Upstream segment activities include acquisition, development and production of oil, natural gas, and other liquid reserves on properties within the United States;

The Gas Gathering segment partners with two other companies to operate a natural gas gathering system; and

The Corporate segment activities include corporate listing and governance functions of the Company.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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


	Upstream		Gas Gathering		Corporate			Elimination		Consolidated
As of and for the three months ended March 31, 2022
Operating revenue
Natural gas	$	10,703,084	$	—	$	—		$	—	$	10,703,084
Natural gas liquids		314,428		—		—			—		314,428
Oil and condensate		461,813		—		—			—		461,813
Gathering and compression fees		—		2,485,937		—			(365,164)		2,120,773
Total operating revenue ⁽¹⁾	$	11,479,325	$	2,485,937	$	—		$	(365,164)	$	13,600,098

Net earnings (loss) for the period	$	8,601,788	$	1,676,840	$	(4,472,740)	⁽³⁾	$	—	$	5,805,888
Operating costs		1,770,654		524,375		—			(365,164)		1,929,865
Development geological and geophysical expenses		2,386		—		—			—		2,386
Depletion, depreciation, amortization and accretion		1,104,497		284,722		—			—		1,389,219

Segment assets	$	92,693,843	$	13,171,557	$	394,750		$	—	$	106,260,149
Capital expenditures ⁽²⁾		2,610,894		15,393		—			—		2,626,287
Proved properties (net)		36,998,720		—		—			—		36,998,720
Unproved properties (net)		21,793,526		—		—			—		21,793,526
Gathering system (net)		—		8,763,369		—			—		8,763,369
Lease right-of-use-asset		—		—		—			—		—
Other property and equipment (net)		938,082		—		—			—		938,082

As of and for the three months ended March 31, 2021
Operating revenue
Natural gas	$	6,332,099	$	—	$	—		$	—	$	6,332,099
Natural gas liquids		45,621		—		—			—		45,621
Oil and condensate		61,435		—		—			—		61,435
Gathering and compression fees		—		2,386,588		—			(384,431)		2,002,157
Total operating revenue⁽¹⁾	$	6,439,155	$	2,386,588	$	—		$	(384,431)	$	8,441,312

Net earnings (loss) for the period	$	3,531,142	$	1,430,636	$	(2,226,211)	⁽³⁾	$	—	$	2,735,567
Operating costs		1,594,188		575,378		—			(384,431)		1,785,135
Development geological and geophysical expenses		11,539		—		—			—		11,539
Depletion, depreciation, amortization and accretion		1,302,286		380,574		—			—		1,682,860

Segment assets	$	76,473,690	$	13,674,102	$	54,567		$	—	$	90,202,359
Capital expenditures ⁽²⁾		979,440		13,284		—			—		992,724
Proved properties (net)		35,361,937		—		—			—		35,361,937
Unproved properties (net)		21,510,765		—		—			—		21,510,765
Gathering system (net)		—		9,735,190		—			—		9,735,190
Other property and equipment (net)		973,219		—		—			—		973,219

(1)

Segment operating revenue represents revenues generated from the operations of the segment. Inter-segment sales during the three months ended March 31, 2022 and 2021 have been eliminated upon consolidation. For the three months ended March 31, 2022, Epsilon sold natural gas to 12 unique customers. The three customers over 10% comprised 37%, 13%, and 12% of total revenue. For the three months ended March 31, 2021, Epsilon sold natural gas to 18 unique customers. The one customer over 10% comprised 54% of total revenue.

(2)

Capital expenditures for the Upstream segment consist primarily of the acquisition of properties, and the drilling and completing of wells while Gas Gathering consists of expenditures relating to the expansion and completion of the gathering and compression facility.

(3)

Segment reporting for net earnings for the period does not include non-monetary compensation, general and administrative expense, interest income, interest expense, both gains and (losses) on derivative contracts, or income tax amounts as they are managed on a group basis and are instead included in the corporate column for reconciliation purposes.

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

12. Commodity Risk Management Activities

Commodity Price Risks

Epsilon engages in price risk management activities from time to time. These activities are intended to manage Epsilon’s exposure to fluctuations in commodity prices for natural gas by securing fixed price contracts for a portion of expected sales volumes.

Inherent in the Company’s fixed price contracts, are certain business risks, including market risk and credit risk. Market risk is the risk that the price of natural gas and oil will change, either favorably or unfavorably, in response to changing market conditions. Credit risk is the risk of loss from nonperformance by the Company’s counterparty to a contract. The Company does not currently require collateral from any of its counterparties nor does its counterparties require collateral from the Company. Additionally, there is a risk that gas prices could fall to a level low enough to affect the volumes flowing through the gathering system.

The Company enters into certain commodity derivative instruments to mitigate commodity price risk associated with a portion of its future natural gas production and related cash flows. The natural gas revenues and cash flows are affected by changes in commodity product prices, which are volatile and cannot be accurately predicted. The objective for holding these commodity derivatives is to protect the operating revenues and cash flows related to a portion of the future natural gas sales from the risk of significant declines in commodity prices, which helps ensure the Company’s ability to fund the capital budget.

Epsilon has historically elected not to designate any of its financial commodity derivative contracts as accounting hedges and, accordingly, accounts for these financial commodity derivative contracts using the mark-to-market accounting method. Under this accounting method, changes in the fair value of outstanding financial instruments are recognized as gains or losses in the period of change and are recorded as loss (gain) on derivative contracts on the condensed consolidated statements of operations and comprehensive income (loss). The related cash flow impact is reflected in cash flows from operating activities. During the three months ended March 31, 2022, Epsilon recognized losses on commodity derivative contracts of $971,904. This amount included settlements on these contracts of $1,211,728. For the three months ended March 31, 2021, Epsilon recognized gains on commodity derivative contracts of $465,341. This amount included cash received on settlements on these contracts of $64,200.

Commodity Derivative Contracts

At March 31, 2022, the Company had no outstanding commodity derivative contracts. At December 31, 2021, the Company had two outstanding natural gas commodity two-way costless collar contracts.


	Fair Value of Derivative Assets
	March 31,		December 31,
	2022		2021
Current
Two-way costless collar	$	—	$	13,312
	$	—	$	13,312

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements


	Fair Value of Derivative Liabilities
	March 31,		December 31,
	2022		2021
Current
Two-way costless collar	$	—	$	(253,136)
	$	—	$	(253,136)


Net Fair Value of Derivatives	$	—	$	(239,824)

The following table presents the changes in the fair value of Epsilon’s commodity derivatives for the periods indicated:


	Three months ended March 31,
	2022		2021
Fair value of asset (liability), beginning of the period	$	(239,824)	$	—
Gains (losses) on derivative contracts included in earnings		(971,904)		465,342
Settlement of commodity derivative contracts		1,211,728		(64,201)
Fair value of asset, end of the period	$	—	$	401,141

13. Asset Retirement Obligations

Asset retirement obligations were estimated by management based on Epsilon’s net ownership interest in all wells and the gathering system, estimated costs to reclaim and abandon such assets and the estimated timing of the costs to be incurred in future periods.

The following tables summarize the changes in asset retirement obligations for the periods indicated:


	Three Months Ended		Year ended
		March 31,		December 31,
	2022		2021
Balance beginning of period	$	2,833,656	$	3,150,243
Liabilities acquired (disposed of)		6,684		(374,337)
Wells plugged and abandoned		(73,998)		(31,945)
Change in estimates		—		(8,299)
Accretion		19,576		97,994
Balance end of period	$	2,785,918	$	2,833,656

14. Fair Value Measurements

The methodologies used to determine the fair value of our financial assets and liabilities at March 31, 2022 were the same as those used at December 31, 2021.

Cash and cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities are carried at cost, which approximates their fair value because of the short-term maturity of these instruments. The Company’s revolving line of credit has a recorded value that approximates its fair value since its variable interest rate is tied to current market rates and the applicable margins represent market rates.

Commodity derivative instruments consist of two-way costless collar and basis swap contracts for natural gas. The Company’s derivative contracts are valued based on an income approach. The model considers various assumptions, such as quoted forward prices for commodities, time value and volatility factors. These assumptions are observable in the

Table of Contents

Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

marketplace throughout the full term of the contract, can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace, and are therefore designated as Level 2 within the valuation hierarchy. The Company utilizes its counterparties’ valuations to assess the reasonableness of its own valuations.

Table of Contents

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

The following discussion is intended to assist in the understanding of trends and significant changes in or results of operations and the financial condition of Epsilon Energy Ltd. and its subsidiaries for the periods presented. The following discussion and analysis should be read in conjunction with our unaudited consolidated financial statements and notes thereto presented in this report, including the unaudited condensed consolidated financial statements as of March 31, 2022 and 2021 and for the three months then ended together with accompanying notes, as well as our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2021. The following discussion contains “forward-looking statements” that reflect our future plans, estimates, beliefs, and expected performance. Actual results and the timing of events may differ materially from those contained in these forward- looking statements due to a number of factors. See “Part II. Item 1A. Risk Factors” and “Forward-Looking Statements.”

Overview

Epsilon Energy Ltd. (the “Company”) is a North American onshore focused independent natural gas and oil company engaged in the acquisition, development, gathering and production of natural gas and oil reserves. Our primary area of operation is Pennsylvania. Additionally, we initiated a small appraisal program on our leases in the NW Anadarko basin of Oklahoma producing oil, natural gas, and natural gas liquids. Our assets are concentrated in areas with known hydrocarbon resources, which are conducive to multi-well, repeatable drilling programs.

Substantially all of the production from our Pennsylvania acreage (4,597 net) is dedicated to the Auburn Gas Gathering System, or the Auburn GGS, located in Susquehanna County, Pennsylvania for a 15 year term expiring in 2026 under an operating agreement whereby the Auburn GGS owners receive a fixed percentage rate of return on the total capital invested in the construction of the system. Epsilon owns a 35% interest in the system which is operated by a subsidiary of Williams Partners, LP. In the three months ended March 31, 2022, Epsilon paid $0.37 million to the Auburn GGS to gather and treat our 2.3 Bcf, of natural gas production in Pennsylvania ($0.38 million to the Auburn GGS to gather and treat our 2.4 Bcf of natural gas in the three months ended March 31, 2021).

Epsilon realized net income of $5.8 million for the three months ended March 31, 2022, as compared to net income of $2.7 million for the three months ended March 31, 2021.

Our common shares trade on the NASDAQ Global Market under the ticker symbol “EPSN.”

Business Strategy

Our business strategy is to manage the cash flow generated from our producing leasehold and midstream assets in a manner where the risked capital allocation provides attractive rates of return. Our remaining inventory of drillable locations within existing leasehold is sufficient to maintain this cash flow for several years at capital expenditure levels well within the yearly cash flow generated from these assets. In addition, we seek to identify attractive onshore natural gas and oil properties in the United States, to acquire leasehold interests and to develop our leasehold interests with the goal of deploying capital to earn attractive rates of return.

The core Marcellus Shale is one of the most attractive dry gas resources in the United States and has attracted significant development capital. Well productivity has improved dramatically for many years due to improving techniques in drilling and completing wells, resulting in increasing initial production rates and gas recoveries. The resulting supply of natural gas at times stresses the transportation infrastructure of the Northeast US and exacerbates the local price discount to Henry Hub. In many other basins throughout the US, the increase in natural gas production had historically outpaced demand. Over the past couple of years, this over supply condition has become more balanced and demand growth from increased LNG exports and pipeline exports to Mexico have provided attractive markets improving the prices for natural gas.

The operating environment remains challenging in Northeast Pennsylvania. We implemented a number of initiatives to enhance the value of our core assets in the Marcellus including a comprehensive review of well spacing and completion productivity for both the Lower and Upper Marcellus, and we are working with our well operators to increase

Table of Contents

operating efficiency. In addition, we continue to work closely with our gathering system partners in order to optimize the operating conditions, enhance operational safety, and to preserve and grow the long-term value of our gathering system assets.

The major producers in the Appalachian region are under pressure from capital markets to demonstrate capital discipline and control costs. Several major producers have announced reduced capital programs to balance the supply-demand for the commodity. Accordingly, we expect local production during 2022 to be flat compared to 2021. Our target is to maintain our current production level or grow modestly, but only if natural gas price levels are sufficient and the capital deployed can achieve our internal hurdle rate of return.

In the longer term, we believe natural gas prices will remain constructive due to moderating supply from both dry gas regions and associated gas from oil prone basins, and incremental demand from LNG exports, exports to Mexico and further coal to gas switching for domestic electrical power generation. Specifically, LNG export capacity is expected to grow from the current ~ 13 Bcf/d to 17 Bcf/d by 2024 based only on facilities currently commissioning or under construction.

In the Northwest Anadarko basin of Oklahoma, we continue to appraise recent and historical results of the Meramec formation from both our wells and analog wells within the focus area. At March 31, 2022, our initial well continues to outperform the pre-completion type curve expectations in terms of both production-to-date and projections for ultimate recoveries. We completed the first of two previously drilled wells at the end of the quarter and the second well after the quarter end. Early results are encouraging and the Company is evaluating additional Meramec locations within the focus area for further exploitation on an opportunistically prudent timeline.

Three months ended March 31, 2022 Highlights

Operational Highlights

Marcellus Shale – Pennsylvania

● During the three months ended March 31, 2022, Epsilon’s realized natural gas price was $4.55 per Mcf, a 77% increase over the three months ended March 31, 2021.

● During the three months ended March 31, 2022, Epsilon’s natural gas production was 2.4 Bcf, as compared to 2.4 Bcf during the same period in 2021.

●

Gathered and delivered 18.3 Bcf gross (6.4 Bcf net to Epsilon’s interest) during the year, or 201 MMcf/d through the Auburn Gas Gathering System.

●At quarter end, the Company had 1 gross (0.18 net) well waiting on completion.

Anadarko, NW Stack Trend – Oklahoma

● During the three months ended March 31, 2022, Epsilon’s realized price for all Oklahoma production was $7.71 per Mcfe, a 117% increase over the three months ended March 31, 2021.

● Total production for the three months ended March 31, 2022 included natural gas, oil, and other liquids and was 0.17 Bcfe, a 141% increase over the same period in 2021.

●

In the first quarter of 2022, the Company completed 1 gross (.44 net) well. At March 31, 2022, the Company had 1 gross (.11 net) well waiting on completion.

Table of Contents

Non-GAAP Financial Measures-Adjusted EBITDA

Epsilon defines Adjusted EBITDA as earnings before (1) net interest expense, (2) taxes, (3) depreciation, depletion, amortization and accretion expense, (4) impairments of natural gas and oil properties, (5) non-cash stock compensation expense, (6) gain or loss on derivative contracts net of cash received or paid on settlement, and (7) other income. Adjusted EBITDA is not a measure of financial performance as determined under U.S. GAAP and should not be considered in isolation from or as a substitute for net income or cash flow measures prepared in accordance with U.S. GAAP or as a measure of profitability or liquidity.

Additionally, Adjusted EBITDA may not be comparable to other similarly titled measures of other companies. Epsilon has included Adjusted EBITDA as a supplemental disclosure because its management believes that EBITDA provides useful information regarding its ability to service debt and to fund capital expenditures. It further provides investors a helpful measure for comparing operating performance on a normalized or recurring basis with the performance of other companies, without giving effect to certain non-cash expenses and other items. This provides management, investors and analysts with comparative information for evaluating the Company in relation to other natural gas and oil companies providing corresponding non-U.S. GAAP financial measures or that have different financing and capital structures or tax rates. These non-U.S. GAAP financial measures should be considered in addition to, but not as a substitute for, measures for financial performance prepared in accordance with U.S. GAAP.

The table below sets forth a reconciliation of net income to Adjusted EBITDA for the three months ended March 31, 2022 and 2021, which is the most directly comparable measure of financial performance calculated under U.S. GAAP and should be reviewed carefully.


	Three months ended March 31,
	2022		2021
Net income	$	5,805,888	$	2,735,567
Add Back:
Net interest expense		98		19,260
Income tax expense		2,181,898		1,144,573
Depreciation, depletion, amortization, and accretion		1,389,219		1,682,860
Stock based compensation expense		142,302		202,499
Loss on derivative contracts net of cash received or paid on settlement		(239,824)		(401,141)
Foreign currency translation loss		5,402		332
Adjusted EBITDA	$	9,284,983	$	5,383,950

Table of Contents

Results of Operations

Net Operating Revenues

For the three months ended March 31, 2022 revenues increased $5.2 million, or 61%, to $13.6 million from $8.4 million during the same period of 2021.

Revenue and volume statistics for the three months ended March 31, 2022 and 2021 were as follows:


	Three months ended
	March 31,
	2022		2021
Revenues
Natural gas revenue	$	10,703,084	$	6,332,099
Volume (MMcf)		2,351		2,466
Avg. Price ($/Mcf)	$	4.55	$	2.57
PA Exit Rate (MMcfpd)		23.1		32.8
Oil and other liquids revenue	$	776,241	$	107,056
Volume (MBO)		14.9		3.7
Avg. Price ($/Bbl)	$	52.22	$	28.58
Gathering system revenue	$	2,120,773	$	2,002,157
Total Revenues	$	13,600,098	$	8,441,312

We earn gathering system revenue as a 35% owner of the Auburn Gas Gathering system. This revenue consists of fees paid by Anchor Shippers (parties listed in Anchor Shipper Gas Gathering Agreement for Northern Pennsylvania, including Epsilon Midstream, LLC) and third-party customers of the system to transport gas from the wellhead to the compression facility, and then to the delivery meter at the Tennessee Gas Pipeline. For the three months ended March 31, 2022, approximately 76% of the Auburn GGS revenues earned were gathering fees, while 24% were compression fees. Gathering revenues from third-party customers represented approximately 10% of total gathering revenues and third-party compression revenues represented 9% of total compression revenues. For the three months ended March 31, 2021 approximately 81% of the Auburn GGS revenues earned were gathering fees, while 19% were compression fees. Gathering revenues from third-party customers represented approximately 8% of revenues and third-party compression revenues represented 3% of revenues. Revenues derived from Epsilon’s production which have been eliminated from gathering system revenues amounted to $0.37 million and $0.38 million for the three months ended March 31, 2022 and 2021.

Upstream natural gas revenue for the three months ended March 31, 2022 increased by $4.4 million, or 69%, over the same period in 2021. This was primarily a result of higher natural gas prices; however, this was partially offset by lower volumes being produced due to natural decline of the wells.

Upstream oil and other liquids revenue for the three months ended March 31, 2022 increased by $0.7 million, or 625%, over the same period in 2021. This was a result of increased production from new wells in addition to higher prices.

The Company’s share of gathering system revenue increased by $0.1 million, or 6%, during the three months ended March 31, 2022 over the same period in 2021. The Auburn GGS is subject to a cost of service model, whereby the Anchor Shippers dedicate acreage and reserves to the Auburn GGS. In exchange for this dedication, the owners of the Auburn system agree to a fixed rate of return on capital invested which cannot be exceeded. Therefore, rather than being subject to a fixed gathering rate, the Shippers are subject to a fluctuating gathering rate which is redetermined annually in order to produce the contractual return on capital to the Auburn GGS owners. The term of the model is fixed from 2012 to 2026. Each year, actual throughput, revenue, operating expenses and capital are captured in the model, and the remaining years are forecasted. The model then resolves a gathering rate that yields the contractual rate of return. All else being equal, to the extent that throughput is higher or capital is lower than the preceding year’s forecast, the gathering rate will decline.

Table of Contents

Operating Costs

The following table presents total cost and cost per unit of production (Mcfe), including ad valorem, severance, and production taxes for the three months ended March 31, 2022 and 2021:


	Three months ended March 31,
	2022		2021
Lease operating costs	$	1,770,654	$	1,594,188
Gathering system operating costs		159,211		190,947
	$	1,929,865	$	1,785,135

Upstream operating costs—Total $/Mcfe		0.73		0.64
Gathering system operating costs $ / Mcf		0.09		0.10

Upstream operating costs consist of lease operating expenses necessary to extract natural gas and oil, including gathering and treating the natural gas and oil to ready it for sale.

Upstream operating costs for the three months ended March 31, 2022 increased $0.2 million, or 11%, over the same period in 2021. The increase in total cost was primarily due to rising prices for services leading to a $0.9/Mcfe, or 13%, increase, in the cost associated with operating the wells.

Gathering system operating costs consist primarily of rental payments for the natural gas fueled compression units. Other significant gathering system operating costs include chemicals (to prevent corrosion and to reduce water vapor in the gas stream), saltwater disposal, measurement equipment / calibration and general project management.

The gathering system total per unit operating costs reported include the effects of elimination entries to remove the gas gathering fees billed by the gas gathering system operator to Epsilon’s upstream operations, and the volume associated with those fees. The elimination entries amounted to $0.37 million and $0.38 million for the three months ended March 31, 2022 and 2021, respectively (see Note 11, ‘‘Operating Segments,’’ of the Notes to Unaudited Condensed Consolidated Financial Statements).

Gathering system costs (net of intercompany elimination) for the three months ended March 31, 2022 decreased $0.03 million, or 17%, over the same period in 2021. The Company’s share of total gathering system costs decreased $0.02 million, or 5%, for the three months ended March 31, 2022 over 2021. This decrease is primarily due to a decrease in throughput volumes into the gathering system.

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

Natural gas and oil and gathering system assets are depleted and depreciated using the units of production method aggregating properties on a field basis. For leasehold acquisition costs and the cost to acquire proved and unproved properties, the reserve base used to calculate depreciation and depletion is total proved reserves. At this time, the Company has only minimal leasehold acquisition costs. For natural gas and oil development and gathering system costs, the reserve base used to calculate depletion and depreciation is proved developed reserves. A reserve report is prepared as of December 31, each year.

Depreciation expense includes primarily amounts pertaining to our office furniture and fixtures, leasehold improvements, and computer hardware. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, ranging from 3 to 7 years. Also included in depreciation expense is an amount pertaining to buildings owned by the Company. Depreciation for the buildings is calculated using the straight-line method over an estimated useful life of 30 years.

Accretion expense is related to the asset retirement obligations.

Table of Contents

DD&A expense decreased $0.33 million, or 20% for the three months ended March 31, 2022 compared to the same period in 2021. This was primarily due to the increase in reserves reported and a decrease in production volumes. The lower volumes spread over the increased reserves resulted in lower DD&A.

Impairment

Epsilon performs a quantitative impairment test quarterly or whenever events or changes in circumstances indicate that an asset group's carrying amount may not be recoverable, over proved properties using the published NYMEX forward prices, timing, methods and other assumptions consistent with historical periods. When indicators of impairment are present, GAAP requires that the Company first compares expected future undiscounted cash flows by asset group to their respective carrying values. If the carrying amount exceeds the estimated undiscounted future cash flows, a reduction of the carrying amount of the natural gas properties to their estimated fair values is required, which is determined based on discounted cash flow techniques using significant assumptions including projected revenues, future commodity prices, and a market-specific weighted average cost of capital which are affected by expectations about future market and economic conditions.

During the three months ended March 31, 2021 and 2020, no impairment was required.

General and Administrative

G&A expenses consist of general corporate expenses such as compensation, legal, accounting and professional fees, consulting services, travel and other related corporate costs such as stock options and restricted stock granted and the related non-cash compensation.

G&A expenses for the three months ended March 31, 2022 and 2021 decreased $0.2 million or 14%. This was mainly due to the decreased legal fees related to the complaint filed against Chesapeake, and decreased stock-based compensation as a result of no new stock grants.

Interest Expense

Interest expense relates to the commitment fees paid on the revolving line of credit.

Interest expense for the three months ended March 31, 2022 and 2021 decreased $0.01 million, or 43%. The decrease is due to the reduction in the borrowing base on our line of credit during this time.

(Loss) Gain on Derivative Contracts

For the three months ended March 31, 2022 and 2021, Epsilon entered into NYMEX Henry Hub Natural Gas Futures swap, Dominion basis swap, and two-way costless collar derivative contracts for the purpose of hedging its physical natural gas sales revenue. During the three months ended March 31, 2022 we had net cash settlements of

Table of Contents

$1,211,728 on the settlement of contracts. During the three months ended March 31, 2021, we received net cash settlements of $64,200.

For the three months ended March 31, 2022, realized losses on derivative contracts increased primarily due to the rally in NYMEX Henry Hub Natural Gas Futures resulting in an increased liability for the short call portion of the two-way costless collar position. These increases in realized losses were minimally offset by realized gains on Dominion basis swap contracts. As of March 31, 2022, the Company had no derivative contracts.

Other Income (Expense)

For the three months ended March 31, 2022 and 2021, other income consisted primarily of interest income and was consistent over the periods.

Capital Resources and Liquidity

Cash Flow

The primary source of cash for Epsilon during the three months ended March 31, 2022 and 2021 was funds generated from operations. In addition to operations, the primary uses of cash for the three months ended March 31, 2022 were development of natural gas properties and the distribution of dividends. The primary uses of cash for the three months ended March 31, 2021 were development of natural gas properties and the repurchase of shares of common stock.

At March 31, 2022, we had a working capital surplus of $27.6 million, an increase of $3.5 million over the $24.1 million surplus at December 31, 2021. The surplus increased from December 31, 2021 due mainly to the cash that is continually being generated by operations. The Company anticipates its current cash balance, cash flows from operations, and available sources of liquidity to be sufficient to meet its cash requirements for at least the next twelve months.

Three months ended March 31, 2022 compared to 2021

During the three months ended March 31, 2022, $7.7 million was provided by the Company’s operating activities, compared to $5.6 million provided during the same period in 2021, a $2.1 million, and 38% increase. The increase was mainly due to increased cash operations as a result of increased commodity prices, partially offset by the losses created on the hedges as they matured.

The Company used $2.9 million and $0.6 million of cash for investing activities during the three months ended March 31, 2022 and 2021, respectively. This was spent primarily on leasehold and development costs targeting increasing production in Pennsylvania and Oklahoma.

The Company used $1.3 million of cash for financing activities during the three months ended March 31, 2022. This was spent primarily on dividend payments. The Company used $0.5 million of cash for financing activities during the three months ended March 31, 2021. This cash was spent on the repurchase of common shares of the Company.

Credit Agreement

In addition, the Company has a senior secured credit facility which includes a total commitment of up to $100 million. The current effective borrowing base is $14 million, which is subject to semi-annual redetermination. There are currently no borrowings under the facility. If Epsilon decided to access the facility, depending on the level of borrowing, the Company might need to increase its hedging activity. Borrowings from the Facility may be used for the acquisition and development of oil and gas properties, investments in cash flow generating assets complimentary to the production of oil and gas, and for letters of credit and other general corporate purposes. Upon each advance, interest is charged at the highest of a) rate of LIBOR plus an applicable margin (3.25%-4.25% based on the percent of the line of credit utilized) with the minimum being 0.25%, b) the Prime Rate, or c) the sum of the Federal Funds Rate plus 0.5%.

Table of Contents

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

On November 23, 2021, the borrowing base of $14 million was reaffirmed until May 1, 2022, the next periodic redetermination of the borrowing base.

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

● Interest coverage ratio greater than 3 based on income adjusted for interest, taxes and non-cash amounts.

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

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

Epsilon was in compliance with the financial covenants of the agreement as of March 31, 2022 and expect to be in compliance for the next 12 months. We expect to remain in compliance as we currently have no borrowings under the facility and funded all operations for 2021 and all operations through March 31, 2022 out of operating cash flow and cash on hand and expect to continue to do so through 2022.


	Balance at		Balance at
	March 31,		December 31,		Borrowing Base		Interest
	2022		2021		March 31, 2022		Rate
Revolving line of credit	$	—	$	—	$	14,000,000	3 mo. LIBOR + 3.25%

Repurchase Transactions

Derivative Transactions

The Company has entered into hedging arrangements to reduce the impact of natural gas price volatility on operations. By removing the price volatility from a significant portion of natural gas production, the potential effects of changing prices on operating cash flows have been mitigated, but not eliminated. While mitigating the negative effects of falling commodity prices, these derivative contracts also limit the benefits we might otherwise receive from increases in commodity prices.

Table of Contents

Contractual Obligations

The following table summarizes Epsilon’s contractual obligations at March 31, 2022:


	Payments Due by Period
			Less than		1 – 3		Greater than
	Total		1 Year		Years		3 Years
Asset retirement obligations, undiscounted	$	7,511,953	$	11,209	$	—	$	7,500,744
Capital expenditure commitments		1,026,737		1,026,737		—		—
Operating leases		202,633		140,189		62,444		—
Total future commitments	$	8,741,323	$	1,178,135	$	62,444	$	7,500,744

We enter into commitments for capital expenditures in advance of the expenditures being made. At a given point in time, it is estimated that we have committed to capital expenditures equal to approximately one quarter of our capital budget by means of giving the necessary authorizations to the asset operator to incur the expenditures in a future period. Current commitments have been included in the contractual obligations table above.

Based on current natural gas prices and anticipated levels of production, we believe that the estimated net cash generated from operations, together with cash on hand and amounts available under our credit agreement, will be adequate to meet liquidity needs for the next 12 months and beyond, including satisfying our financial obligations and funding our operating and development activities. To that end, subsequent to quarter end, the Company hedged approximately 15% of its anticipated remaining 2022 production through NYMEX costless collars.

Off-Balance Sheet Arrangements

As of March 31, 2022, the Company had no off-balance sheet arrangements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our earnings and cash flow are significantly affected by changes in the market price of commodities. The prices of natural gas and oil can fluctuate widely and are influenced by numerous factors such as demand, production levels, world political and economic events, and the strength of the US dollar relative to other currencies. Should the price of natural gas and oil decline substantially, the value of our assets could fall dramatically, impacting our future operations and exploration and development activities, along with our gas gathering system revenues. In addition, our operations are exposed to market risks in the ordinary course of our business, including interest rate and certain exposure as well as risks relating to changes in the general economic conditions in the United States.

Gathering System Revenue Risk

The Auburn Gas Gathering System lies within the Marcellus Basin with historically high levels of recoverable reserves and low cost of production. We believe that a short-term low commodity price environment will not significantly impact the reserves produced and thus the revenue of our gas gathering system.

Interest Rate Risk

Market risk is estimated as the change in fair value resulting from a hypothetical 100 basis point change in the interest rate on the outstanding balance under our credit agreement. The credit agreement allows us to fix the interest rate for all or a portion of the principal balance for a period up to three months. To the extent that the interest rate is fixed, interest rate changes affect the instrument’s fair market value but do not affect results of operations or cash flows. Conversely, for the portion of the credit agreement that has a floating interest rate, interest rate changes will not affect the fair market value but will affect future results of operations and cash flows.

At March 31, 2022 and 2021, the outstanding principal balance under the credit agreement was nil.

Table of Contents

Derivative Contracts

The Company’s financial results and condition depend on the prices received for natural gas production. Natural gas prices have fluctuated widely and are determined by economic and political factors. Supply and demand factors, including weather, general economic conditions, the ability to transport the gas to other regions, as well as conditions in other natural gas regions, impact prices. Epsilon has established a hedging strategy and may manage the risk associated with changes in commodity prices by entering into various derivative financial instrument agreements and physical contracts. Although these commodity price risk management activities could expose Epsilon to losses or gains, entering into these contracts helps to stabilize cash flows and support the Company’s capital spending program.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

As required by Rule 13a-15(b) under the Exchange Act, we have evaluated, under the supervision and with the participation of our management, including our principal executive officer and our principal financial officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this 10-Q. Our disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed by us in reports that we file under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure and is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. Our principal executive officer and principal financial officer have concluded that our current disclosure controls and procedures were effective as of March 31, 2022 at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

No changes in our internal control over financial reporting occurred during the quarter ended March 31, 2022 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Inherent Limitations on Effectiveness of Controls

Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that of limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, the risk.

PART II OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Table of Contents

issue without prejudice to Epsilon’s right to file a new lawsuit based on new proposals made after the Court’s decision. Epsilon filed a motion for reconsideration of that decision, but the court denied the motion for reconsideration on January 18, 2022.

Epsilon filed a notice of appeal on February 15, 2022 challenging both the motion to dismiss and motion for reconsideration decisions. Chesapeake filed a cross-appeal on March 1, 2022. A court-mandated mediation was set for June 9, 2022. A briefing schedule has not yet been set , and accordingly, a decision on the appeal is not expected until early to mid-2023.

ITEM 1A. RISK FACTORS

There have been no material changes from the risk factors disclosed in Item 1A. Risk Factors of our Annual Report on Form 10-K for the year ended December 31, 2021.

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

For the three months ended March 31, 2022, no shares had been repurchased.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

Not applicable.

Table of Contents

ITEM 6. —EXHIBITS




Exhibit No.		Description of Exhibit

31.1		Sarbanes-Oxley Section 302 certification of Principal Executive Officer.

31.2		Sarbanes-Oxley Section 302 certification of Principal Financial Officer.

32.1		Sarbanes-Oxley Section 906 certification of Principal Executive Officer.

32.2		Sarbanes-Oxley Section 906 certification of Principal Financial Officer.

101.INS		Inline XBRL Instance Document.

101.SCH		Inline XBRL Schema Document.

101.CAL		Inline XBRL Calculation Linkbase Document.

101.DEF		Inline XBRL Definition Linkbase Document.

101.LAB		Inline XBRL Labels Linkbase Document.

101.PRE		Inline XBRL Presentation Linkbase Document.

104		Cover Page Interactive Data File (embedded within the Inline XBRL document)

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


Epsilon Energy Ltd.
(Registrant)

Date: May 11, 2022	By:	/s/ B. Lane Bond
		B. Lane Bond
		Chief Financial Officer (Principal Financial Officer and Duly Authorized Officer)