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Epsilon Energy Ltd. - Quarter Report: 2023 March (Form 10-Q)

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, 2023

  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.)

500 Dallas Street, Suite 1250

Houston, Texas 77002

(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 9, 2023, there were 22,926,444 Common Shares outstanding.

Table of Contents

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

1.

Description of Business

9

2.

Basis of Preparation

9

Interim Financial Statements

9

Principles of Consolidation

9

Use of Estimates

9

Reclassification

9

Recently Issued Accounting Standards

9

3.

Cash, Cash Equivalents, and Restricted Cash

10

4.

Short Term Investments

10

5.

Property and Equipment

11

Property Impairment

11

6.

Revolving Line of Credit

11

7.

Shareholders’ Equity

12

8.

Revenue Recognition

16

9.

Income Taxes

17

10.

Commitments and Contingencies

17

Litigation

17

11.

Leases

18

12.

Net Income Per Share

19

13.

Operating Segments

20

14.

Commodity Risk Management Activities

22

Commodity Price Risks

22

Commodity Derivative Contracts

22

15.

Asset Retirement Obligations

23

16.

Fair Value Measurements

23

17.

Current Expected Credit Loss

24

18.

Subsequent Events

24

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

25

Overview

25

Business Strategy

25

Operational Highlights

25

Non-GAAP Financial Measures-Adjusted EBITDA

26

Net Operating Revenues

27

Operating Costs

28

Depletion, Depreciation, Amortization and Accretion

28

Table of Contents

General and Administrative

29

Loss on Derivative Contracts

29

Capital Resources and Liquidity

29

Cash Flow

29

Credit Agreement

30

Repurchase Transactions

30

Derivative Transactions

31

Contractual Obligations

31

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

31

Gathering System Revenue Risk

31

Interest Rate Risk

32

Derivative Contracts

32

ITEM 4. CONTROLS AND PROCEDURES

32

Disclosure Controls and Procedures

32

Changes in Internal Control Over Financial Reporting

32

Inherent Limitations on Effectiveness of Controls

32

PART II OTHER INFORMATION

33

ITEM 1. LEGAL PROCEEDINGS

33

ITEM 1A. RISK FACTORS

33

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

33

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, 2022, 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, 2022. Our Annual Report on Form 10-K for the year ended December 31, 2022 is available on our website at www.epsilonenergyltd.com.

4

Table of Contents

PART I-FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Balance Sheets

    

March 31, 

    

December 31, 

2023

2022

ASSETS

Current assets

Cash and cash equivalents

$

19,110,225

$

45,236,584

Accounts receivable

4,805,320

7,201,386

Short term investments

30,138,743

Fair value of derivatives

1,927,450

1,222,090

Prepaid income taxes

1,140,094

Other current assets

496,731

632,154

Operating lease right-of-use assets

31,383

Total current assets

56,478,469

55,463,691

Non-current assets

Property and equipment:

Oil and gas properties, successful efforts method

Proved properties

149,323,372

148,326,265

Unproved properties

18,275,226

18,169,157

Accumulated depletion, depreciation, amortization and impairment

(109,194,701)

(107,729,293)

Total oil and gas properties, net

58,403,897

58,766,129

Gathering system

42,660,626

42,639,001

Accumulated depletion, depreciation, amortization and impairment

(34,778,321)

(34,500,740)

Total gathering system, net

7,882,305

8,138,261

Land

637,764

637,764

Buildings and other property and equipment, net

318,805

286,035

Total property and equipment, net

67,242,771

67,828,189

Other assets:

Operating lease right-of-use assets, long term

532,013

Restricted cash

571,324

570,363

Total non-current assets

68,346,108

68,398,552

Total assets

$

124,824,577

$

123,862,243

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities

Accounts payable trade

$

1,900,847

$

1,695,353

Gathering fees payable

867,533

935,012

Royalties payable

1,898,177

2,223,043

Income taxes payable

196,131

Accrued capital expenditures

348,135

41,694

Accrued compensation

233,172

598,351

Other accrued liabilities

257,788

690,655

Operating lease liabilities

2,756

35,299

Total current liabilities

5,704,539

6,219,407

Non-current liabilities

Asset retirement obligations

2,801,056

2,780,237

Deferred income taxes

10,605,286

10,617,394

Operating lease liabilities, long term

541,396

Total non-current liabilities

13,947,738

13,397,631

Total liabilities

19,652,277

19,617,038

Commitments and contingencies (Note 10)

Shareholders' equity

Preferred shares, no par value, unlimited shares authorized, none issued or outstanding

Common shares, no par value, unlimited shares authorized and 22,926,444 shares issued and 22,879,224 shares outstanding at March 31, 2023 and 23,117,144 issued and outstanding at December 31, 2022

122,789,659

123,904,965

Treasury shares, at cost, 47,220 at March 31, 2023 and 0 at December 31, 2022

(252,119)

Additional paid-in capital

10,035,977

9,856,229

Accumulated deficit

(37,173,168)

(39,290,540)

Accumulated other comprehensive income

9,771,951

9,774,551

Total shareholders' equity

105,172,300

104,245,205

Total liabilities and shareholders' equity

$

124,824,577

$

123,862,243

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

5

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EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income

Three months ended March 31, 

    

2023

    

2022

Revenues from contracts with customers:

Gas, oil, NGL, and condensate revenue

$

6,969,581

$

11,479,325

Gas gathering and compression revenue

2,386,695

2,120,773

Total revenue

9,356,276

13,600,098

Operating costs and expenses:

Lease operating expenses

1,404,279

1,405,490

Gathering system operating expenses

651,341

524,375

Development geological and geophysical expenses

2,386

Depletion, depreciation, amortization, and accretion

1,773,006

1,389,219

General and administrative expenses:

Stock based compensation expense

179,748

142,302

Other general and administrative expenses

2,023,773

1,171,132

Total operating costs and expenses

6,032,147

4,634,904

Operating income

3,324,129

8,965,194

Other income (expense):

Interest income

490,762

15,221

Interest expense

(28,437)

(15,319)

Gain (loss) on derivative contracts

1,068,660

(971,904)

Other income (expense)

1,635

(5,406)

Other income (expense), net

1,532,620

(977,408)

Net income before income tax expense

4,856,749

7,987,786

Income tax expense

1,326,922

2,181,898

NET INCOME

$

3,529,827

$

5,805,888

Currency translation adjustments

(2,600)

5,402

NET COMPREHENSIVE INCOME

$

3,527,227

$

5,811,290

Net income per share, basic

$

0.15

$

0.25

Net income per share, diluted

$

0.15

$

0.24

Weighted average number of shares outstanding, basic

22,990,893

23,677,842

Weighted average number of shares outstanding, diluted

23,027,684

23,862,428

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

6

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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, 2023

23,117,144

$

123,904,965

$

$

9,856,229

$

9,774,551

$

(39,290,540)

$

104,245,205

Net income

3,529,827

3,529,827

Dividends paid

(1,412,455)

(1,412,455)

Stock-based compensation expense

179,748

179,748

Buyback of common shares

(237,920)

(1,367,425)

(1,367,425)

Retirement of treasury shares

(190,700)

(1,115,306)

190,700

1,115,306

Other comprehensive loss

(2,600)

(2,600)

Balance at March 31, 2023

22,926,444

$

122,789,659

(47,220)

$

(252,119)

$

10,035,977

$

9,771,951

$

(37,173,168)

$

105,172,300

    

  

  

  

  

  

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 paid

(1,483,027)

(1,483,027)

Stock-based compensation expense

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

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

7

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EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Cash Flows

Three months ended March 31, 

    

2023

    

2022

Cash flows from operating activities:

Net income

$

3,529,827

$

5,805,888

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

Depletion, depreciation, amortization, and accretion

1,773,006

1,389,219

(Gain) loss on derivative contracts

(1,068,660)

971,904

Settlement received (paid) on derivative contracts

363,300

(1,211,728)

Settlement of asset retirement obligation

(73,998)

Stock-based compensation expense

179,748

142,302

Deferred income tax expense (benefit)

(12,108)

22,686

Changes in assets and liabilities:

Accounts receivable

2,396,066

(1,871,330)

Other assets and liabilities

143,646

104,177

Accounts payable, royalties payable and other accrued liabilities

(1,062,898)

267,058

Income taxes payable

1,336,225

2,157,292

Net cash provided by operating activities

7,578,152

7,703,470

Cash flows from investing activities:

Additions to unproved oil and gas properties

(106,069)

(92,600)

Additions to proved oil and gas properties

(621,132)

(2,771,925)

(Additions) disposals to gathering system properties

(12,423)

3,612

Additions to land, buildings and property and equipment

(42,703)

Purchases of short term investments

(30,138,743)

Net cash used in investing activities

(30,921,070)

(2,860,913)

Cash flows from financing activities:

Buyback of common shares

(1,367,425)

Exercise of stock options

209,312

Dividends paid

(1,412,455)

(1,483,027)

Net cash used in financing activities

(2,779,880)

(1,273,715)

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

(2,600)

5,402

(Decrease) increase in cash, cash equivalents, and restricted cash

(26,125,398)

3,574,244

Cash, cash equivalents, and restricted cash, beginning of period

45,806,947

27,065,423

Cash, cash equivalents, and restricted cash, end of period

$

19,681,549

$

30,639,667

Supplemental cash flow disclosures:

Interest paid

$

17,216

$

17,501

Non-cash investing activities:

Change in proved properties accrued in accounts payable and accrued liabilities

$

375,242

$

(253,632)

Change in gathering system accrued in accounts payable and accrued liabilities

$

9,201

$

19,005

Asset retirement obligation asset additions and adjustments

$

736

$

6,684

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

8

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

1. Description of Business

Epsilon Energy Ltd. (the “Company” or “Epsilon” or “we”) was incorporated under the laws of the Province of Alberta, Canada on March 14, 2005. On October 24, 2007, the Company became a publicly traded entity trading on the Toronto Stock Exchange (“TSX”) in Canada. On February 14, 2019, Epsilon’s registration statement on Form 10 was declared effective by the United States Securities and Exchange Commission and on February 19, 2019, we 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. Epsilon is a North American on-shore focused independent natural gas and oil company engaged in the acquisition, development, gathering and production of natural gas and oil reserves.

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 statement 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, 2022. 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.

Reclassification

The consolidated financial statements for the prior periods include certain reclassifications that were made to conform to the current period presentation. Such reclassifications have no impact on previously reported consolidated financial position, results of operations or cash flows.

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

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

9

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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

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 removes all recognition thresholds and requires 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. Epsilon has adopted ASU 2016-13 as of January 1, 2023. There was no impact from the adoption of this ASU.

In 2020, the FASB issued ASU 2020-04, Facilitation of the Effects of Reference Rate Reform on Financial Reporting, which, for a limited period of time, adds ASC 848 to the Codification providing entities with certain practical expedients and exceptions from applying modification accounting if certain criteria are met. The amendments are designed to reduce operational challenges that entities will face in applying modification accounting to all contracts that will be revised due to reference rate reform. The guidance in ASC 848 was triggered by the pending discontinuation of certain benchmark reference rates and, in some cases, their replacement by new rates that are more observable or transaction-based and, therefore, less susceptible to manipulation, than certain interest-rate benchmark reference rates commonly used today, including the London Interbank Offered Rate (LIBOR). This process of reference rate reform will require entities to modify certain contracts by removing the discontinued rates and including new rates. Epsilon has adopted ASU 2020-04 as of January 1, 2023.

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.

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, 2023 and December, 31 2022:

    

March 31, 

    

December 31,

2023

2022

Cash and cash equivalents

$

19,110,225

$

45,236,584

Restricted cash included in other assets

571,324

570,363

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

$

19,681,549

$

45,806,947

4. Short Term Investments

Short term investments are highly liquid investments with original maturities between three and twelve months. The Company’s short term investments consist of US Treasury Notes. These investments are classified as held-to-maturity and are carried at amortized cost with the intent to be held to maturity. Interest on these investments is presented as interest income in the Consolidated Statements of Operations and Comprehensive Income.

As of March 31, 2023, there was $30.1 million in short term investments, $29.9 million of adjusted cost basis and $0.2 million in unrecognized gains.

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

5.  Property and Equipment

The following table summarizes the Company’s property and equipment as of March 31, 2023 and December 31, 2022:

    

March 31, 

    

December 31, 

2023

2022

Property and equipment:

Oil and gas properties, successful efforts method

Proved properties

$

149,323,372

$

148,326,265

Unproved properties

18,275,226

18,169,157

Accumulated depletion, depreciation, amortization and impairment

(109,194,701)

(107,729,293)

Total oil and gas properties, net

58,403,897

58,766,129

Gathering system

42,660,626

42,639,001

Accumulated depletion, depreciation, amortization and impairment

(34,778,321)

(34,500,740)

Total gathering system, net

7,882,305

8,138,261

Land

637,764

637,764

Buildings and other property and equipment, net

318,805

286,035

Total property and equipment, net

$

67,242,771

$

67,828,189

Property Impairment

We perform a quantitative impairment test 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 compare 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. Additionally, if an exploratory well is determined not to have found proved reserves, the costs incurred, net of any salvage value, should be charged to expense.

During the three months ended March 31, 2023 and 2022, no impairment was recorded.

6. Revolving Line of Credit

The Company has a senior secured credit facility which includes a total commitment of up to $100 million. The effective borrowing base is $30 million, which is subject to semi-annual redetermination. There are currently no borrowings under the facility. If we decide to access the facility, depending on the level of borrowing, we might need to increase our hedging activity. Hedging requirements were amended to be between 0%-62.5% of the 24-month projected production volumes, based on percentage utilization on the facility. 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) the Prime Rate, or b) the sum of the Federal Funds Rate plus 0.5%, plus an applicable margin (0.25%-1.25%, based on percentage utilization on the facility). The facility matures on March 1, 2024.

On February 10, 2023, Epsilon Energy USA entered into the Ninth Amendment of the Credit Agreement. The borrowing base was increased to $30 million. Per ASC 848, Facilitation of the Effects of Reference Rate Reform on Financial Reporting, LIBOR was removed as a reference option in the calculation of interest. Hedging requirements were amended to be between 0%-62.5% of the 24-month projected production volumes, based on percentage utilization on the facility. Also, cash distributions to the parent company (Epsilon Energy Ltd.) were allowed if the facility is < 80% utilized and the leverage ratio (total debt / income adjusted for interest, taxes and non-cash amounts) is less than 2 to 1.

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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 to 1 (income adjusted for interest, taxes and non-cash amounts / cash interest expense)
Current ratio greater than 1 to 1 (current assets / current liabilities)
Leverage ratio less than 3.5 to 1 (total debt / income adjusted for interest, taxes and non-cash amounts)

We were in compliance with the financial covenants of the agreement as of March 31, 2023.

7. 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

On March 9, 2023, the Board of Directors authorized a new share repurchase program of up to 2,292,644 common shares, representing 10% of the outstanding common shares of Epsilon, for an aggregate purchase price of not more than US $15.0 million. The program is pursuant to a normal course issuer bid and will be conducted in accordance with Rule 10b-18 under the Exchange Act. The program commenced on March 27, 2023 and will end on March 26, 2024, unless the maximum amount of common shares is purchased before then or Epsilon provides earlier notice of termination. During the three months ended March 31, 2023, we repurchased 47,220 common shares at an average price of $5.32 per share (excluding commissions).

Commencing on March 8, 2022, we implemented a plan to repurchase our issued and outstanding common shares and to return capital to our shareholders. We used cash on hand to fund these repurchases. During the year ended December 31, 2022, we repurchased 982,500 common shares of the maximum of 1,183,410 authorized for repurchase and spent $6,234,879 under the plan. The repurchased stock had an average price of $6.32 per share (excluding commissions) and was subsequently retired during the year ended December 31, 2022.

Under the same plan, in 2023, we repurchased and retired 190,700 common shares at an average price of $5.82 per share (excluding commissions) before the plan terminated on March 7, 2023.

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table contains activity relating to our acquisition of equity securities during the three months ended March 31, 2023:

    

Maximum number

of shares

Total number

Average price

remaining to be

of shares

paid per

purchased under

    

purchased

share

    

the program

Beginning of normal-course issuer bid, March 8, 2022 (1)

1,183,410

January 2023

125,200

$

5.96

February 2023

65,500

$

5.63

Total as of March 7, 2023

190,700

$

5.82

10,210

Beginning of normal-course issuer bid, March 27, 2023 (2)

2,292,644

March 2023

47,220

$

5.32

Total as of March 31, 2023

47,220

$

5.32

2,245,424

(1)Epsilon repurchased these shares under its 2022-2023 share repurchase program that commenced on March 8, 2022 and terminated on March 7, 2023, as described above.
(2)Epsilon repurchased these shares under its 2023-2024 share repurchase program that commenced on March 27, 2023, as described above.

(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.

Restricted Stock Awards

For the three months ended March 31, 2023, no shares of Restricted Stock were awarded to the Company’s board of directors and employees. For the year ended December 31, 2022, 289,231 common shares of Restricted Stock with a weighted average market price at the grant date of $6.28 were awarded to the Company’s officers, employees, and board of directors. These shares vest over a three or four-year period, with an equal number of 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.

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table summarizes Restricted Stock activity for the three months ended March 31, 2023, and the year ended December 31, 2022:

Three months ended

Year ended

March 31, 2023

December 31, 2022

Number of

Weighted

Number of

Weighted

Restricted

Average

Restricted

Average

Shares

Remaining Life

Shares

Remaining Life

    

Outstanding

    

(years)

    

Outstanding

    

(years)

Balance non-vested Restricted Stock at beginning of period

298,210

1.74

166,002

1.38

Granted

289,231

1.86

Vested

(157,023)

Balance non-vested Restricted Stock at end of period

298,210

1.49

298,210

1.74

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, 2023 and 2022 was $165,064 and $95,112, respectively.

At March 31, 2023, the Company had unrecognized stock-based compensation related to these shares of $1,503,501 to be recognized over a weighted average period of 1.4 years (at December 31, 2022: $1,668,564 over 1.55 years).

Performance Share Unit Awards (“PSU”)

For the three months ended March 31, 2023, no PSUs vested and were issued. For the year ended December 31, 2022, a total of 135,667 common shares vested and were issued. The Company grants PSUs, which are paid in stock, to certain key employees. 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 at the discretion of the Compensation Committee of the Board of Directors.

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table summarizes PSUs for the three months ended March 31, 2023 and the year ended December 31, 2022:

Three months ended

Year ended

March 31, 2023

December 31, 2022

Number of

Weighted

Number of

Weighted

Performance

Average

Performance

Average

Shares

Remaining Life

Shares

Remaining Life

    

Outstanding

    

(years)

    

Outstanding

    

(years)

Balance non-vested PSUs at beginning of period

15,833

1.00

151,500

3.84

Vested

(135,667)

Balance non-vested PSUs at end of period

15,833

0.75

15,833

1.00

Stock compensation expense for the granted PSUs is recognized over the vesting period. Stock compensation expense recognized during the three months ended March 31, 2023 and 2022 related to PSUs was $14,684 and $47,190, respectively.

At March 31, 2023, the Company had unrecognized stock-based compensation related to these shares of $44,053 to be recognized over a weighted average period of 0.50 years (at December 31, 2022: $63,328 over 0.63 years).

Stock Options

As of March 31, 2023, the Company had outstanding stock options covering 70,000 Common Shares at an overall average exercise price of $5.03 per Common Share to directors, officers, and employees of the Company and its subsidiaries. These 70,000 options have a weighted average expected remaining term of approximately 0.80 years.

The following table summarizes stock option activity for the three months ended March 31, 2023 and the year ended December 31, 2022:

Three months ended

Year ended

March 31, 2023

December 31, 2022

Weighted

Weighted

Number of

Average

Number of

Average

Options

Exercise

Options

Exercise

Exercise price in US$

    

Outstanding

    

Price

    

Outstanding

    

Price (1)

Balance at beginning of period

70,000

$

5.03

218,750

$

5.28

Exercised

$

(138,750)

$

5.38

Expired/Forfeited

$

(10,000)

$

5.51

Balance at period-end

70,000

$

5.03

70,000

$

5.03

Exercisable at period-end

70,000

$

5.03

70,000

$

5.03

At March 31, 2023, the Company had unrecognized stock-based compensation, related to these options, of nil (at December 31, 2022: nil). The aggregate intrinsic value at March 31, 2023 was $21,700 (at December 31, 2022: $112,000).

During the three months ended March 31, 2023 and the year ended December 31, 2022, the Company awarded no stock options.

(d) Dividends

On March 3, 2023, the Board declared quarterly dividends of $0.0625 per common share (annualized $0.25 per common share) totaling in aggregate an amount of approximately $1.41 million that was paid on March 31, 2023.

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

8. Revenue Recognition

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

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 points 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, 2023 and 2022.

Three Months Ended March 31, 

    

2023

    

2022

Operating revenue

Natural gas

$

6,256,178

$

10,703,084

Natural gas liquids

196,295

314,428

Oil and condensate

517,108

461,813

Gathering and compression fees

2,386,695

2,120,773

Total operating revenue

$

9,356,276

$

13,600,098

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 generally 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.

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 GGS is received two months after gathering and compression has occurred. As a result, the Company must estimate the amount of production that was gathered 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 Credit Losses

The Company records an allowance for credit losses on a case-by-case basis once there is evidence that collection is not probable. For the three months ended March 31, 2023, there were no accounts for which collection was not probable.

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table details accounts receivable as of March 31, 2023 and December 31, 2022.

    

March 31, 

    

December 31, 

2023

2022

Accounts receivable

Natural gas and oil sales

$

2,593,604

$

5,696,419

Joint interest billing

17,476

20,454

Gathering and compression fees

1,765,871

1,483,956

Other

428,369

557

Total accounts receivable

$

4,805,320

$

7,201,386

9. Income Taxes

Income tax provisions for the three months ended March 31, 2023 and 2022 are as follows:

Three months ended March 31, 

    

2023

    

2022

Current:

Federal

$

960,508

$

1,466,896

State

378,522

692,316

Total current income tax expense

1,339,030

2,159,212

Deferred:

Federal

(17,278)

22,015

State

5,170

671

Total deferred tax expense

(12,108)

22,686

Income tax expense

$

1,326,922

$

2,181,898

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 no uncertain income tax positions. The Company's tax returns are open to audit under the statute of limitations for the years ending December 31, 2019 through December 31, 2022. 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, 2023 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.

10. Commitments and Contingencies

The Company enters into commitments for capital expenditures in advance of the expenditures being made. As of March 31, 2023, the Company had commitments of $0.2 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 Northeast Pennsylvania, as required under both the settlement agreement and JOAs.

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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 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 briefing schedule was set and briefing closed October 14, 2022.  Oral argument was held in January 2023.  A decision on the appeal is not expected until mid-2023.

Epsilon re-filed a complaint against Chesapeake in the Middle District on May 9, 2022.  Epsilon generally asserts 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 but not based on specific well proposals.  Chesapeake filed a motion to stay pending a decision on the Third Circuit appeal, which was granted.  The matter is stayed pending a decision from the Third Circuit.  

11. Leases

Under ASC 842, Leases, the Company recognized an operating lease related to its corporate office as of March 31, 2023 summarized in the following table:

    

March 31, 

    

December 31,

2023

2022

Asset

Operating lease right-of-use assets

$

-

$

31,383

Operating lease right-of-use assets, long term

532,013

-

Total operating lease right-of-use assets

$

532,013

$

31,383

Liabilities

Operating lease liabilities

$

2,756

$

35,299

Operating lease liabilities, long term

541,396

-

Total operating lease liabilities

$

544,152

$

35,299

Operating lease costs

$

35,233

$

32,097

Cash paid for amounts included in the measurement of lease liabilities

Operating cash flows from operating leases

$

27,010

$

106,798

Weighted average remaining lease term (years) - operating lease

3.39

0.33

Weighted average discount rate (annualized) - operating lease

8.25%

8.09%

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The Company had one office lease that expired in April 2023.  On March 1, 2023, the Company commenced a new office lease with a 70 month lease term and future lease payments estimated to be approximately $0.85 million. There are no other pending leases, and no lease arrangements in which the Company is the lessor. Lease expense for operating leases was $0.04 million and $0.03 million as of March 31, 2023 and December 31, 2022, respectively. This lease expense is presented in other general and administrative expenses in the consolidated statements of operations and comprehensive income.

Future minimum lease payments as of March 31, 2023 are as follows:

Operating Leases

2023

$

2024

134,750

2025

173,550

2026

177,021

2027

180,492

Thereafter

183,963

Total minimum lease payments

849,776

Less: imputed interest

(305,624)

Present value of future minimum lease payments

544,152

Less: current obligations under leases

(2,756)

Long-term lease obligations

$

541,396

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

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

Three months ended March 31, 

    

2023

    

2022

Net income

$

3,529,827

$

5,805,888

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

Three months ended March 31, 

    

2023

    

2022

Basic weighted-average number of shares outstanding

22,990,893

23,677,842

Dilutive stock options

8,512

16,728

Unvested time-based restricted shares

 

21,415

 

65,395

Unvested performance-based restricted shares

 

6,864

 

102,463

Diluted weighted average shares outstanding

 

23,027,684

 

23,862,428

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

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

Three months ended March 31, 

    

2023

    

2022

Anti-dilutive options

61,488

163,272

Anti-dilutive unvested time-based restricted shares

276,795

100,607

Anti-dilutive unvested performance-based restricted shares

8,969

49,037

Total Anti-dilutive shares

 

347,252

 

312,916

13. 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 income (loss) as shown in the table below. Interest income and expense, and income taxes are managed separately on a group basis. As of March 31, 2023, general and administrative costs and interest income were moved to the Corporate segment because they are entirely comprised of corporate expenses and are not allocated to the Upstream and Gas Gathering segments. To be consistent with this current presentation, the general administrative costs of $1.3 million and interest income of $0.02 million for the three months ended March 31, 2022 has been reclassed as well.

The Company’s reportable segments are as follows:

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

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Segment activity as of, and for the three months ended March 31, 2023 and 2022 is as follows:

    

Upstream

    

Gas Gathering

    

Corporate

    

Elimination

    

Consolidated

For the three months ended March 31, 2023

Operating revenue

Natural gas

$

6,256,178

$

$

$

$

6,256,178

Natural gas liquids

196,295

196,295

Oil and condensate

517,108

517,108

Gathering and compression fees

2,750,503

(363,808)

2,386,695

Total operating revenue (1)

6,969,581

2,750,503

(363,808)

9,356,276

Operating costs

Operating costs

1,768,087

651,371

2,203,491

(363,808)

4,259,141

Depletion, depreciation, amortization and accretion

1,493,755

279,251

1,773,006

Operating income

3,707,739

1,819,881

(2,203,491)

3,324,129

Other income (expense)

Interest income

490,762

490,762

Interest expense

(28,437)

(28,437)

Gain (loss) on derivative contracts

1,068,660

1,068,660

Other (expense) income

652

983

1,635

Other income (expense), net

1,040,875

491,745

1,532,620

Net income before income tax expense

$

4,748,614

$

1,819,881

$

(1,711,746)

$

$

4,856,749

Capital expenditures (2)

$

1,145,146

$

21,624

$

$

$

1,166,770

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

Operating costs

Operating costs

1,773,040

524,375

1,313,434

(365,164)

3,245,685

Depletion, depreciation, amortization and accretion

1,104,497

284,722

1,389,219

Operating income

8,601,788

1,676,840

(1,313,434)

8,965,194

Other income (expense)

Interest income

15,221

15,221

Interest expense

(15,319)

(15,319)

Gain (loss) on derivative contracts

(971,904)

(971,904)

Other (expense) income

(5,406)

(5,406)

Other income (expense), net

(987,223)

9,815

(977,408)

Net income before income tax expense

$

7,614,565

$

1,676,840

$

(1,303,619)

$

$

7,987,786

Capital expenditures (2)

$

2,610,894

$

15,393

$

$

$

2,626,287

(1)Segment operating revenue represents revenues generated from the operations of the segment. Inter-segment sales during the three months ended March 31, 2023 and 2022 have been eliminated upon consolidation. For the three months ended March 31, 2023, Epsilon sold natural gas to 27 unique customers. The three customers over 10% comprised 13%, 12%, and 11% of total revenue. 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.
(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.

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

14. 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 derivative 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 oil and natural gas 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.

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, 2023, Epsilon recognized gains on commodity derivative contracts of $1,068,660. This amount included cash received on settlements on these contracts of $363,300. For the three months ended March 31, 2022, Epsilon recognized losses on commodity derivative contracts of $971,904. This amount included cash paid on settlements on these contracts of $1,211,728.

Commodity Derivative Contracts

At March 31, 2023, the Company had outstanding NYMEX HH swaps totaling 0.92 Bcf and Tennessee Z4 basis swaps totaling 0.92 Bcf outstanding.

Fair Value of Derivative 
Assets

    

March 31, 

    

December 31, 

2023

2022

Current

 

  

 

  

NYMEX Henry Hub swap

 

$

2,373,200

$

1,219,865

Tennessee Z4 basis swap

 

181,775

 

$

2,373,200

$

1,401,640

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Fair Value of Derivative
 Liabilities

    

March 31, 

    

December 31, 

2023

2022

Current

 

  

 

  

Tennessee Z4 basis swap

 

$

(445,750)

$

(179,550)

 

$

(445,750)

$

(179,550)

Net Fair Value of Derivatives

 

$

1,927,450

$

1,222,090

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

Three months ended March 31, 

    

2023

    

2022

Fair value of asset (liability), beginning of the period

$

1,222,090

$

(239,824)

Gains (losses) on derivative contracts included in earnings

 

1,068,660

 

(971,904)

Settlement of commodity derivative contracts

 

(363,300)

 

1,211,728

Fair value of asset (liability), end of the period

$

1,927,450

$

15. Asset Retirement Obligations

Asset retirement obligations are 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, and the forecast risk free cost of capital. Epsilon has estimated the value of its total asset retirement obligations to be $2.8 million as of March 31, 2023 ($2.8 million at December 31, 2022) based on a total net future undiscounted liability of approximately $7.5 million ($7.4 million at December 31, 2022). Each year we review, and to the extent necessary, revise our asset retirement obligations estimates.

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

Three Months Ended

Year ended

March 31, 

December 31, 

2023

    

2022

Balance beginning of period

$

2,780,237

$

2,833,656

Liabilities acquired

736

12,053

Liabilities disposed of

(25,835)

Wells plugged and abandoned

(118,260)

Accretion

20,083

78,623

Balance end of period

$

2,801,056

$

2,780,237

16. Fair Value Measurements

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

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The methodologies used to determine the fair value of our financial assets and liabilities at March 31, 2023 were the same as those used at December 31, 2022.

Cash and cash equivalents, restricted cash, accounts receivable, and accounts payable 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.

The Company has investments in U.S. Treasury Notes, some of which mature over a period greater than 90 days and are classified as short term investments. The U.S. Treasury Notes are carried at amortized cost. The carrying values are adjusted for accretion of discounts over the remaining life of the investment. The U.S. Treasury Notes are classified within Level 1 of the fair value hierarchy. As of March 31, 2023, there was $30.1 million in short term investments, $29.9 million of adjusted cost basis and $0.2 million in unrecognized gains.

Commodity derivative instruments consist of NYMEX Henry Hub swap and basis swap contracts for natural gas. The Company’s derivative contracts are valued based on a marked to market approach. These assumptions are observable in the 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.

17. Current Expected Credit Loss

Under ASU 326, Financial Instruments – Credit Losses, estimated losses on financial assets are provided through an allowance for credit losses. The majority of our financial assets are invested in U.S. Treasury Notes. We also have accounts receivable which are primarily from purchasers of oil and natural gas, counterparties to our financial instruments, and revenues earned for compression and gathering services. Our oil, gas, and natural gas liquids accounts receivables are generally collected within 30 days after the end of the month. Compression and gathering receivables are generally collected within 60 days after the end of the month. We assess collectability through various procedures, including review of our trade receivable balances by counterparty, assessing economic events and conditions, our historical experience with counterparties, the counterparty’s financial condition and the amount and age of past due accounts. As of the three months ended March 31, 2023, we determined that our allowance for credit loss was nil.

18. Subsequent Events

Effective April 13, 2023, Dewey Energy Holding, LLC divested two operated wells in the State of Oklahoma along with 1,298 net acres of leasehold. Subsequently, Dewey Energy Holdings, LLC now owns 7,228 net acres of leasehold in Oklahoma.

On May 9, 2023, Epsilon entered into definitive agreements to acquire 10% interest in two wellbores (located in Eddy Co, NM) from a private operator. The wells are currently on flow-back. Total capital expenditures (net to Epsilon) are estimated at $2.1 million.

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

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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, 2023 and 2022 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, 2022. 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 areas of operations are the Marcellus shale section of the Appalachian basin in Pennsylvania and the NW Anadarko basin in Oklahoma. In Pennsylvania, we hold 5,098 net acres producing 25 MMcf/d net to our revenue interest. In Oklahoma, we hold 7,228 net acres producing 2.7 MMcfe/d net to our revenue interest.  

In Pennsylvania, the Company owns a 35% interest in the 52 mile Auburn Gas Gathering System (“Auburn GGS") which is operated by a subsidiary of Williams Partners, LP.

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

Business Strategy

The Company is focused on high rate of return capital investments in onshore North American natural gas and oil basins. We are committed to disciplined capital allocation which should include shareholder returns in the form of dividends and share buybacks. We expect that our strong balance sheet and large liquidity position will allow us to opportunistically invest in both our existing project areas and potential new projects.     

 

To date, our investments have been focused in our position in the prolific Marcellus unconventional reservoir in Pennsylvania (“PA”). Our PA assets are supported by our 35% ownership in the Auburn GGS. We have a substantial remaining drillable location inventory within our existing leaseholds.

The Company is actively seeking new opportunities in several other onshore North American natural gas and oil basins.

Three months ended March 31, 2023 Highlights

Operational Highlights

Marcellus Shale – Pennsylvania

During the three months ended March 31, 2023, Epsilon’s realized natural gas price was $2.56 per Mcf compared to $4.47 per Mcf over the same period in 2022, a 43% decrease.

During the three months ended March 31, 2023, Epsilon’s natural gas production was 2.5 Bcf compared to 2.4 Bcf during the same period in 2022, a 0.8% increase.

Gathered and delivered 16.2 Bcf gross (5.7 Bcf net to Epsilon’s interest) during the three months ended March 31, 2023, or 180 MMcf/d through the Auburn Gas Gathering System.

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

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Anadarko, NW Stack Trend – Oklahoma

During the three months ended March 31, 2023, Epsilon’s realized price for all Oklahoma production was $6.44 per Mcfe compared to $7.71 per Mcfe over the same period in 2022, a 17% decrease.  

Total production for the three months ended March 31, 2023 included natural gas, natural gas liquids, and oil and condensate and was 0.17 Bcfe, as compared to 0.17 Bcfe during the same period in 2022.

At March 31, 2023, the Company had 1 gross (.11 net) well waiting on completion.

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, 2023 and 2022, 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, 

 

2023

 

2022

Net income

$

3,529,827

$

5,805,888

Add Back:

Interest (income) expense, net

(462,325)

98

Income tax expense

1,326,922

2,181,898

Depreciation, depletion, amortization, and accretion

1,773,006

1,389,219

Stock based compensation expense

179,748

142,302

Gain on derivative contracts net of cash received or paid on settlement

(705,360)

(239,824)

Foreign currency translation loss

(983)

5,402

Adjusted EBITDA

$

5,640,835

$

9,284,983

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

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Results of Operations

Net Operating Revenues

For the three months ended March 31, 2023 revenues decreased $4.2 million, or 31%, to $9.4 million from $13.6 million during the same period of 2022.

Revenue and volume statistics for the three months ended March 31, 2023 and 2022 were as follows:

Three months ended

March 31, 

    

2023

    

2022

Revenues

Pennsylvania

Natural gas revenue

$

5,852,725

$

10,131,015

Volume (MMcf)

 

2,286

 

2,265

Avg. Price ($/Mcf)

$

2.56

$

4.47

Gathering system revenue

$

2,386,695

$

2,120,773

Total PA Revenues

$

8,239,420

$

12,251,788

Oklahoma

Natural gas revenue

$

403,453

$

572,069

Volume (MMcf)

 

96

 

86

Avg. Price ($/Mcf)

$

4.20

$

6.68

Natural liquids revenue

$

196,295

$

314,428

Volume (MBO)

 

6.1

 

9.8

Avg. Price ($/Bbl)

$

32.29

$

32.19

Oil and condensate revenue

$

517,108

$

461,813

Volume (MBO)

 

6.8

 

5.1

Avg. Price ($/Bbl)

$

76.15

$

90.62

Total OK Revenues

$

1,116,856

$

1,348,310

Total Revenues

$

9,356,276

$

13,600,098

Upstream natural gas revenue for the three months ended March 31, 2023 decreased by $4.4 million, or 42%, over the same period in 2022. A decrease of $4.6 million was due to lower natural gas prices partially offset by an increase of $0.2 million due to higher sales volumes.

Upstream natural gas liquids revenue for the three months ended March 31, 2023 decreased by $0.1 million, or 38% over the same period in 2022.  This was a result of decreased NGL production.

Upstream oil and condensate revenue for the three months ended March 31, 2023 increased by $0.1 million, or 12% over the same period in 2022.  An increase of $0.2 million was due to higher volumes offset by a decrease of $0.1 million due to lower prices.

Gathering system revenue for the three months ended March 31, 2023 increased by $0.3 million, or 13% over the same period in 2022. This was the result of anchor shipper volumes, which pay the full gathering rate, increasing from 62% to 88% of total throughput. Revenues derived from transporting and compressing our production, which have been eliminated from gathering system revenues amounted to $0.4 million for each of the three months ended March 31, 2023 and 2022.

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

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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, 2023 and 2022:

Three months ended March 31, 

    

2023

    

2022

Lease operating costs

$

1,404,279

$

1,405,490

Gathering system operating costs

651,341

524,375

$

2,055,620

$

1,929,865

Upstream operating costs—Total $/Mcfe

0.57

0.58

Gathering system operating costs $/Mcf

0.18

0.12

Operating costs include the effects of elimination entries to remove the gathering fees paid to Epsilon’s ownership in the gathering system.

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. For the three months ended March 31, 2023 and 2022, upstream operating costs remained consistent.

Gathering system operating costs consist primarily of rental payments for the natural gas fueled compression units and overhead fees due to the system’s operator. For the three months ended March 31, 2023, gathering system operating costs increased by $0.1 million, or 24% from the same period in 2022. This increase is due to a higher mix of anchor shipper volumes and a CPI-U adjusted increase to the G&A fee on these volumes.

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

Three months ended March 31, 

    

2023

    

2022

Depletion, depreciation, amortization and accretion

$

1,773,006

$

1,389,219

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 amounts pertaining to our office furniture and fixtures, leasehold improvements, 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 costs.

For the three months ended March 31, 2023, DD&A expense was generally consistent compared to the same period in 2022, increasing by $0.2 million, or 12%.

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

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General and Administrative (“G&A”)

Three months ended March 31, 

    

2023

    

2022

General and administrative

$

2,203,521

$

1,313,434

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 granted and restricted shares of stock granted and the related non-cash compensation.

G&A expenses increased by $0.9 million, or 68%, during the three months ended March 31, 2023 from 2022. This was primarily due to $0.4 million in compensation associated with management transition, $0.1 million in legal fees related to the complaint filed against Chesapeake, $0.2 million in other service fees, and $0.2 million in other miscellaneous G&A.

Loss on Derivative Contracts

Three months ended March 31, 

    

2023

    

2022

Gain (loss) on derivative contracts

$

1,068,660

$

(971,904)

For the three months ended March 31, 2023 and 2022, Epsilon was entered into NYMEX Henry Hub (“HH”) Natural Gas Futures swaps and Tennessee basis swap derivative contracts for the purpose of hedging its physical natural gas sales revenue. During the three months ended March 31, 2023, we received net cash settlements of $363,300. During the three months ended March 31, 2022, we paid net cash settlements of $1,211,728.

For the three months ended March 31, 2023, realized gains on derivative contracts increased as the NYMEX Henry Hub Natural Gas Futures prices decreased further from the prices at which the Company sold the Henry Hub swaps. As of March 31, 2023, the Company had no derivative contracts beyond December 31, 2023.

Capital Resources and Liquidity

Cash Flow

The primary source of cash for Epsilon during the three months ended March 31, 2023 and 2022 was funds generated from operations. The primary uses of cash for the three months ended March 31, 2023 were development of natural gas properties, investment in U.S. Treasury Notes, the repurchase of shares of common stock, and the distribution of dividends. The primary uses of cash for the three months ended March 31, 2022 were development of natural gas properties and the distribution of dividends.

At March 31, 2023, we had a working capital surplus of $50.8 million, an increase of $1.6 million over the $49.2 million surplus at December 31, 2022. 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 the next twelve months and beyond.

Three months ended March 31, 2023 compared to 2022

During the three months ended March 31, 2023, $7.6 million was provided by the Company’s operating activities, compared to $7.7 million provided during the same period in 2022, a $0.1 million, and 2% decrease.

The Company used $30.9 million and $2.9 million of cash for investing activities during the three months ended March 31, 2023 and 2022, respectively. The Company invested $30,1 million in U.S Treasury Notes and $0.8 million on leasehold and development costs targeting increasing production in Pennsylvania and Oklahoma.

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

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The Company used $2.8 million of cash for financing activities during the three months ended March 31, 2023.  This was spent primarily on dividend payments and the repurchase of shares of common stock. The Company used $1.3 million of cash for financing activities during the three months ended March 31, 2022. This cash was spent on dividend payments.

Credit Agreement

The Company has a senior secured credit facility which includes a total commitment of up to $100 million. The effective borrowing base is $30 million, which is subject to semi-annual redetermination. There are currently no borrowings under the facility. If we decide to access the facility, depending on the level of borrowing, we might need to increase our hedging activity. Hedging requirements were amended to be between 0%-62.5% of the 24-month projected production volumes, based on percentage utilization on the facility. 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) the Prime Rate, or b) the sum of the Federal Funds Rate plus 0.5%, plus an applicable margin (0.25%-1.25%, based on percentage utilization on the facility). The facility matures on March 1, 2024.

On February 10, 2023, Epsilon Energy USA entered into the Ninth Amendment of the Credit Agreement. The borrowing base was increased to $30 million. Per ASC 848, Facilitation of the Effects of Reference Rate Reform on Financial Reporting, LIBOR was removed as a reference option in the calculation of interest. Hedging requirements were amended to be between 0%-62.5% of the 24-month projected production volumes, based on percentage utilization on the facility. Also, cash distributions to the parent company (Epsilon Energy Ltd.) were allowed if the facility is < 80% utilized and the leverage ratio (total debt / income adjusted for interest, taxes and non-cash amounts) is less than 2 to 1.

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 to 1 (income adjusted for interest, taxes and non-cash amounts / cash interest expense)
Current ratio greater than 1 to 1 (current assets / current liabilities)
Leverage ratio less than 3.5 to 1 (total debt / income adjusted for interest, taxes and non-cash amounts)

We were in compliance with the financial covenants of the agreement as of March 31, 2023 and expect to be in compliance for the next 12 months. We currently have no borrowings under the facility.

Repurchase Transactions

On March 9, 2023, the Board of Directors authorized a new share repurchase program of up to 2,292,644 common shares, representing 10% of the outstanding common shares of Epsilon, for an aggregate purchase price of not more than US $15.0 million. The program is pursuant to a normal course issuer bid and will be conducted in accordance with Rule 10b-18 under the Exchange Act. The program commenced on March 27, 2023 and will end on March 26, 2024, unless the maximum amount of common shares is purchased before then or Epsilon provides earlier notice of termination. During the three months ended March 31, 2023, we repurchased 47,220 common shares at an average price of $5.32 per share (excluding commissions).

Commencing on March 8, 2022, we implemented a plan to repurchase our issued and outstanding common shares and to return capital to our shareholders. We used cash on hand to fund these repurchases. During the year ended December 31, 2022, we repurchased 982,500 common shares of the maximum of 1,183,410 authorized for repurchase and spent

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

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$6,234,879 under the plan. The repurchased stock had an average price of $6.32 per share (excluding commissions) and was subsequently retired during the year ended December 31, 2022.

Under the same plan, in 2023, we repurchased and retired 190,700 common shares at an average price of $5.82 per share (excluding commissions) before the plan terminated on March 7, 2023.

Derivative Transactions

The Company has entered into hedging arrangements to reduce the impact of natural gas price volatility on operations. By reducing 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.

At March 31, 2023, Epsilon’s outstanding natural gas commodity contracts consisted of the following:

Weighted Average Price ($/MMbtu)

Volume

Basis

Fair Value of Asset

Derivative Type

    

(MMbtu)

    

 Swaps 

    

Differential

    

March 31, 2023

2023

NYMEX Henry Hub swap

 

920,000

$

5.21

$

 

$

2,373,200

Tennessee Z4 basis swap

 

920,000

$

$

(1.25)

 

(445,750)

 

1,840,000

$

1,927,450

Contractual Obligations

The Company enters into commitments for capital expenditures in advance of the expenditures being made. As of March 31, 2023, the Company had short term commitments of $0.2 million for capital expenditures and long term commitments of $7.4 million for asset retirement obligations.

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.

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.

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

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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, 2023 and 2022, the outstanding principal balance under the credit agreement was nil.

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, 2023 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, 2023 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.

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

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PART II OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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 Northeast 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 briefing schedule was set and briefing closed October 14, 2022.  Oral argument was held in January 2023.  A decision on the appeal is not expected until mid-2023.

Epsilon re-filed a complaint against Chesapeake in the Middle District on May 9, 2022.  Epsilon generally asserts 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 but not based on specific well proposals.  Chesapeake filed a motion to stay pending a decision on the Third Circuit appeal, which was granted.  The matter is stayed pending a decision from the Third Circuit.

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, 2022.

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

(c) Purchases of Equity Securities by Epsilon Energy Ltd.

The following table contains information about our acquisition of equity securities during the three months ended March 31, 2023.

    

Maximum number

of shares

Total number

Average price

remaining to be

of shares

paid per

purchased under

    

purchased

share

    

the program

Beginning of normal-course issuer bid, March 8, 2022 (1)

1,183,410

January 2023

125,200

$

5.96

February 2023

65,500

$

5.63

Total as of March 7, 2023

190,700

$

5.82

10,210

Beginning of normal-course issuer bid, March 27, 2023 (2)

2,292,644

March 2023

47,220

$

5.32

Total as of March 31, 2023

47,220

$

5.32

2,245,424

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

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(1)Epsilon repurchased these shares under its 2022-2023 share repurchase program that commenced on March 8, 2022 and terminated on March 7, 2023.
(2)Epsilon repurchased these shares under its 2023-2024 share repurchase program that commenced on March 27, 2023.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

Not applicable.

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

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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 10, 2023

By:

/s/ J. Andrew Williamson

J. Andrew Williamson

Chief Financial Officer (Principal Financial Officer and Duly Authorized Officer)

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