RESERVE PETROLEUM CO - Quarter Report: 2018 June (Form 10-Q)

PART I – FINANCIAL INFORMATION

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THE RESERVE PETROLEUM COMPANY

NOTES TO FINANCIAL STATEMENTS

June 30, 2018

(Unaudited)

This discussion and analysis should be read with reference to a similar discussion in the 2017 Form 10-K, as well as the financial statements included in this Form 10-Q.

Forward-Looking Statements

This discussion and analysis includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements give the Company’s current expectations of future events. They include statements regarding the drilling of oil and gas wells, the production that may be obtained from oil and gas wells, cash flow and anticipated liquidity and expected future expenses.

Although management believes the expectations in these and other forward-looking statements are reasonable, we can give no assurance they will prove to have been correct. They can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Factors that would cause actual results to differ materially from expected results are described under “Forward-Looking Statements” on page 8 of the 2017 Form 10-K.

We caution you not to place undue reliance on these forward-looking statements, which speak only as of the date of this Form 10-Q, and we undertake no obligation to update this information. You are urged to carefully review and consider the disclosures made in this and our other reports filed with the Securities and Exchange Commission that attempt to advise interested parties of the risks and factors that may affect our business.

Financial Conditions and Results of Operations

Liquidity and Capital Resources

Please refer to the Balance Sheets and the Condensed Statements of Cash Flows in this Form 10-Q to supplement the following discussion. In the first half of 2018, the Company continued to fund its business activity through the use of internal sources of cash. The Company had net cash provided by operations of $1,739,237 and cash provided by the maturities of available-for-sale securities of $16,371,544. Additional cash of $578,430 was provided by property dispositions and $14,995 from tax refunds for total cash provided of $18,704,206. The Company utilized cash for the purchase of available-for-sale securities of $16,415,010, property additions of $838,104, other investment activity of $53,086 and financing activities of $824,888 for total cash applied of $18,131,088. Cash and cash equivalents increased $573,118 (12%) to $5,340,928.

Discussion of Significant Changes in Working Capital. In addition to the changes in cash and cash equivalents discussed above, there were other changes in working capital line items from December 31, 2017. A discussion of these items follows.

Accounts receivable increased $347,258 (42%) to $1,177,082 from $829,824 due to increased oil prices and volumes.

Refundable income taxes decreased $107,433 (33%) to $219,397 from $326,830 due mostly to the second quarter 2018 current income tax provision of $92,438.

Accounts payable increased $83,379 (35%) to $318,386 from $235,007 due to an increase in the drilling and exploration activity in the quarter ended June 30, 2018 compared to the year ended December 31, 2017.

Other current liabilities increased $25,000 (99%) to $50,243 from $25,243 due to ad valorem tax accruals. Ad valorem (property) taxes are primarily for Texas properties and are accrued for the first three quarters each year to be paid in the fourth quarter.

Discussion of Significant Changes in the Condensed Statements of Cash Flows. As noted in the first paragraph above, net cash provided by operating activities was $1,739,237 in 2018, a decrease of $95,124 (5%) from the comparable period in 2017. The decrease was primarily due to decreased income from Other Investments. For more information see “Operating Revenues” and “Other Income” below.

Cash applied to the purchase of property additions in 2018 was $838,104, a decrease of $687,364 (45%) from cash applied in 2017 of $1,525,468. In both 2018 and 2017, cash applied to property additions was mostly related to oil and gas exploration and development activity. See the subheading “Exploration Costs” in the “Results of Operations” section below for additional information.

Conclusion. Management is unaware of any additional material trends, demands, commitments, events or uncertainties, which would impact liquidity and capital resources to the extent that the discussion presented in the 2017 Form 10-K would not be representative of the Company’s current position.

Material Changes in Results of Operations Six Months Ended June 30, 2018, Compared with Six Months Ended June 30, 2017

Net income increased $1,191,168 (258%) to net income of $1,653,281 in 2018 from a $462,113 net income in 2017. Net income per share, basic and diluted, increased $7.56 to $10.49 per share in 2018 from $2.93 per share in 2017.

A discussion of revenue from oil and gas sales and other significant line items in the statements of operations follows.

Operating Revenues. Revenues from oil and gas sales increased $924,479 (29%) to $4,136,471 in 2018 from $3,211,992 in 2017. The $924,479 increase is due to an increase in crude oil sales of $1,022,691 and an increase in miscellaneous oil and gas product sales of $33,249, partially offset by a decrease in natural gas sales of $131,461.

The $1,022,691 (55%) increase in oil sales to $2,870,389 in 2018 from $1,847,698 in 2017 was the net result of an increase in the volume sold and an increase in the average price per barrel (Bbl). The volume of oil sold increased 6,254 Bbls to 46,849 Bbls in 2018, resulting in a positive volume variance of $284,682. This volume increase was the net result of an increase of 11,724 Bbls for production that began after June 30, 2017, offset by a decline of 5,470 Bbls from older properties. The average price per Bbl increased $15.75 to $61.27 per Bbl in 2018, resulting in a positive price variance of $738,009.

The $131,461 (10%) decrease in gas sales to $1,130,774 in 2018 from $1,262,235 in 2017 was the result of a decrease in the volume sold and a decrease in the average price per thousand cubic feet (MCF). The volume of gas sold decreased 812 MCF to 424,579 MCF from 425,391 MCF in 2017, for a negative volume variance of $2,412. The decrease in gas volumes sold was the net result of approximately 9,355 MCF of production declines from older wells, partially offset by production of approximately 8,543 MCF from wells that first produced after June 30, 2017. The average price per MCF decreased $0.31 to $2.66 per MCF from $2.97 per MCF in 2017, resulting in a negative price variance of $129,049.

Sales from the Robertson County, Texas royalty interest properties provided approximately 34% of the Company’s first half 2018 gas sales volumes for 2018 and 23% of the first half gas sales volumes for 2017. See discussion on page 11 of the 2017 Form 10-K under the subheading “Operating Revenues” for more information about these properties. Sales from Arkansas working interest properties provided approximately 10% of the Company’s first half 2018 gas sales volumes and about 12% of the first half 2017 gas sales volumes.

For both oil and gas sales, the price change was mostly the result of a change in the spot market prices upon which most of the Company’s oil and gas sales are based. These spot market prices have had significant fluctuations in the past and these fluctuations are expected to continue.

Sales of miscellaneous oil and gas products were $135,308 in 2018 compared to $102,059 in 2017.

The Company received lease bonuses of $225,795 in the first half of 2018 for leases on its owned minerals with none in 2017. In 2018, most of the bonuses were for leases on owned minerals in Texas.

Operating Costs and Expenses. Operating costs and expenses decreased $143,063 (4%) to $3,181,272 in 2018 from $3,324,335 in 2017. Material line item changes are discussed and analyzed in the following paragraphs.

Production costs increased $158,458 (15%) in 2018 to $1,219,259 from $1,060,801 in 2017. This increase was primarily the result of an increase of $180,055 in lease operating expenses offset by a decrease of $21,597 in handling expenses.

Exploration costs decreased $386,962 (74%) to $135,185 in 2018 from $522,147 in 2017. Dry hole and other costs decreased $491,435 to $2,665 in 2018 from $494,100 in 2017. Geological and geophysical expense increased $104,473 to $132,520 in 2018 from $28,047 in 2017.

The following is a summary as of July 31, 2018, updating both exploration and development activity from December 31, 2017, for the period ended June 30, 2018.

The Company will participate with 12% and 8% working interests in the drilling of two development wells on a Woods County, Oklahoma prospect starting in July 2018. Prepaid costs for the period were $33,600.

The Company participated with its 8.4% working interest in the drilling of an exploratory well on a Thomas County, Kansas prospect. The well was completed as a dry hole. No additional drilling is planned on the prospect. Dry hole costs for the period were $14,970 and an impairment expense of $19,258 was taken against the leasehold.

The Company participated with its 10.5% working interest in the drilling of an exploratory well on a Thomas County, Kansas prospect. The well was completed as a dry hole. No additional drilling is planned on the prospect. Dry hole costs for the period were $19,949 and an impairment expense of $684 was taken against the leasehold.

The Company participated with its 18% working interest in the drilling of two step-out wells (one a re-entry) on a Kiowa County, Kansas prospect. Both wells were completed as commercial oil and gas producers. Actual costs of $119,493 for the period were offset by prepaid costs from 2017 for a net capitalized amount of $0.

The Company participated with its 14% working interest in the drilling of two injection wells on a Hansford County, Texas waterflood unit. One well has been completed and is injecting water and the other missed the reservoir and was plugged. There are three other injection wells and two producing wells in the unit. Actual costs of $185,887 for the period were offset by $103,936 of prepaid costs from 2017 for a net capitalized amount of $81,951.

The Company is participating with its 14% interest in the reworking of previously acquired 3-D seismic and in the acquisition of additional leasehold on a Creek County, Oklahoma prospect. Capitalized costs for the period were $12,843 and seismic costs were $3,266.

The Company owns a 35% interest in 16,472.55 net acres of leasehold on a Crockett and Val Verde Counties, Texas prospect. The Company is participating in the development of the prospect and is currently engaged in efforts to sell a portion of its interest.

The Company owns a 12.25% interest in 4,882.5 net acres of leasehold on a Crockett County, Texas prospect. An exploratory well was drilled on the prospect in 2017. A completion attempt of the well was unsuccessful and it is likely to be plugged. Capitalized costs for the period were $2,925 and an impairment expense of $25,146 was taken against the well.

The Company is participating with a 13% interest in a 3-D seismic prospect covering approximately 35,000 acres in San Patricio County, Texas. A 3-D seismic survey of the prospect area has been completed and analysis of the data is ongoing. Nine prospects have already been identified and lease acquisition is in progress. An exploratory well will be drilled starting in August 2018. Capitalized costs for the period were $15,588 and seismic costs were $107,752.

The Company participated with its 10.5% working interest in the completion of an exploratory well that was drilled in 2017 on a Lea County, New Mexico prospect. The well is a marginal oil producer. Capitalized costs for the period were $64,804 and an impairment expense of $265,818 was taken against the well.

The Company participated with its 7% working interest in the drilling of an exploratory well on a Summit County, Utah prospect. The well has been completed as a commercial gas and gas condensate producer and is awaiting pipeline connection. Capitalized costs for the period were $718,458.

The Company is participating with its 11.2% working interest in workovers on a group of wells that were purchased in 2017 on a Tyler County, Texas prospect. The workovers performed so far have been successful in significantly increasing production and others are planned. Capitalized costs for the period were negligible as most of the work was charged to expense.

The Company participated with its 8.33% working interest in the drilling of a horizontal well in a Harding County, South Dakota producing unit. A completion is in progress. The unit is being developed for waterflooding. Capitalized costs for the period were $350,764.

Other Income, Net. This line item increased $109,919 (18%) to $707,443 in 2018 from $597,524 in 2017. See Note 2 to the accompanying financial statements for the analysis of the various components of this line item. Components with significant changes are discussed in the following paragraphs.

Gains on trading securities in 2018 were $14,945 compared to gains of $64,875 in 2017, a decrease of $49,930. In 2018, the Company had realized gains of $59,657 and unrealized losses of $(44,712) from adjusting the securities to estimated fair market value. In 2017, the Company had unrealized gains of $99,488 and realized losses of $(34,613).

Gain on asset sales increased $543,054 from the sale of leasehold rights along with associated wells and gathering system in Major County, Oklahoma.

Other Income decreased $422,293 (95%) to $24,448 in 2018 from $446,741 in 2017. The decrease was mostly due to $428,000 less in other investment income in 2018 compared to 2017.

Income Tax Provision/(Benefit). Income tax provision increased $212,088 to $235,156 in 2018 from $23,068 in 2017. Of the 2018 income tax provision, the estimated current tax expense was $92,438 and the estimated deferred tax expense was $142,718. Of the 2017 income tax provision, the estimated current tax expense was $78,269 and the estimated deferred tax benefit was $(55,201). See Note 4 to the accompanying financial statements for additional information on income taxes.

Material Changes in Results of Operations Three Months Ended June 30, 2018, Compared with Three Months Ended June 30, 2017

Net income increased $1,448,069 to $1,382,688 in 2018 from net loss of $(65,381) in 2017. The material changes in the results of operations, which caused the increase in net income, are discussed below.

Operating Revenues. Revenues from crude oil and natural gas sales increased $926,675 (57%) to $2,557,191 in 2018 from $1,630,516 in 2017. This was due to increases in crude oil sales of $950,605 and sales of miscellaneous products of $25,260, offset by a decrease in natural gas sales of $49,190.

The $950,605 increase in crude oil sales was the net result of an increase in the volume of oil sold of 8,987 Bbls to 30,182 Bbls, for a positive volume variance of $398,124, and an increase in the average price received of $18.31 per Bbl to $62.61, for a positive price variance of $552,481.

The $49,190 decrease in natural gas sales was the net result of a decrease in the volume of gas sold of 2,935 MCF to 225,901 MCF, for a negative volume variance of $8,191, and a decrease in the average price of $0.18 per MCF to $2.61, for a negative price variance of $40,999.

Other operating revenues were $79,932 in 2018 for lease bonuses with none in 2017.

Operating Costs and Expenses. Operating costs and expenses decreased $95,108 (5%) to $1,719,994 in 2018 from $1,815,102 in 2017. Material line item changes are discussed and analyzed in the following paragraphs.

Production costs increased $78,390 (15%) to $612,492 in 2018 from $534,102 in 2017 due to higher lease operating expense and gross production tax.

Exploration costs decreased $315,101 (85%) to $57,540 in 2018 from $372,641 in 2017. Dry hole costs decreased $321,277 to $34,530 in 2018 from $355,807 in 2017. Geological and geophysical expense increased $6,176 to $23,010 in 2018 from $16,834 in 2017.

Depreciation, Depletion, Amortization and Valuation Provision increased $148,638 (31%) to $633,162 in 2018 from $484,524 in 2017. The increase was due primarily to a long lived asset impairment of $321,376 in 2018 versus $88,764 in 2017, offset by decreases in provisions for depletion, depreciation and amortization. See Note 10 – LONG-LIVED ASSETS IMPAIRMENT LOSS on page 30 of the 2017 Form 10-K for a description of the impairment loss calculation.

Other Income, Net. This line item increased $544,581 (755%) to $617,045 in 2018 from $72,194 in 2017. See Note 2 to the accompanying financial statements for an analysis of the components of other income, net. Components with significant changes are discussed in the following paragraphs.

Gain on Asset Sales increased $557,430 to $600,016 in 2018 from $42,586 in 2017. This was mostly due to the sale of leasehold rights in Major County, Oklahoma.

Income Tax Provision/(Benefit). Income taxes increased $198,497 to a tax provision of $151,486 in 2018 from a tax benefit of $(47,011) in 2017. See discussion above in “Item 2.” and Note 4 to the accompanying financial statements for a discussion of the changes in the provision for income taxes.

There were no additional material changes between the quarters, which were not covered in the discussion in “Item 2.” above, for the six months ended June 30, 2018.

Off-Balance Sheet Arrangements

The Company’s off-balance sheet arrangements relate to Broadway Sixty-Eight, Ltd., an Oklahoma limited partnership, Grand Woods Development, LLC, an Oklahoma limited liability company, and QSN Office Park, an Oklahoma limited liability company. The Company does not have actual or effective control of these entities. Management of these entities could at any time make decisions in their own best interest, which could materially affect the Company’s net income or the value of the Company’s investment. For more information about these entities and the related off-balance sheet arrangements, see Note 3 to the accompanying financial statements.

Not applicable.

As defined in Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the "Exchange Act"), the term “disclosure controls and procedures” means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure.

The Company’s Principal Executive Officer and Principal Financial Officer evaluated the effectiveness of the Company’s disclosure controls and procedures. Based on this evaluation, they concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2018.

Internal Control over Financial Reporting

As defined in Rule 13a-15(f) and 15d-15(f) of the Exchange Act, the term "internal control over financial reporting" means a process designed by, or under the supervision of, the issuer's principal executive and principal financial officers, or persons performing similar functions, and effected by the issuer's board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes, in accordance with generally accepted accounting principles and includes those policies and procedures that:

The Company's management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. There were no changes in the Company’s internal control over financial reporting during the quarter ended June 30, 2018 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.

PART II – OTHER INFORMATION

During the quarter ended June 30, 2018, the Company did not have any material legal proceedings brought against it or its properties.

Not applicable.

¹The Company has no formal equity security purchase program or plan. The Company acts as its own transfer agent, and most purchases result from requests made by stockholders receiving small odd lot share quantities as the result of probate transfers.

None.

Not applicable.

None.

The following documents are exhibits to this Form 10-Q. Each document marked by an asterisk is filed electronically herewith.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereto duly authorized.

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