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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

x

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

 

For the quarterly period ended September 30, 2013

 

OR

 

o

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

 

Commission file number: 1-35372

 

Sanchez Energy Corporation

(Exact name of registrant as specified in its charter)

 

Delaware

 

45-3090102

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer
Identification No.)

 

1111 Bagby Street, Suite 1800
Houston, Texas

 

77002

(Address of principal executive offices)

 

(Zip Code)

 

(713) 783-8000
(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x  No o

 

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

 

Large accelerated filer o

 

Accelerated filer x

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

 

Number of shares of registrant’s common stock, par value $0.01 per share, outstanding as of November 6, 2013: 46,359,613.

 

 

 



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We are an “emerging growth company” as defined under the Jumpstart Our Business Startups Act of 2012, commonly referred to as the “JOBS Act”.  We will remain an “emerging growth company” for up to five years from the date of the completion of our initial public offering (the “IPO”) on December 19, 2011, or until the earlier of (1) the last day of the fiscal year in which our total annual gross revenues exceed $1 billion, (2) the date that we become a “large accelerated filer” as defined in Rule 12b-2 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which would occur if the market value of our common equity that is held by non-affiliates is $700 million or more as of the last business day of our most recently completed second fiscal quarter or (3) the date on which we have issued more than $1 billion in non-convertible debt during the preceding three year period.

 

As an “emerging growth company”, we may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies” including, but not limited to:

 

·                  not being required to comply with the auditor attestation requirements related to our internal control over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act;

 

·                  reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements; and

 

·                  exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved.

 

In addition, Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933, as amended (the “Securities Act”), for complying with new or revised accounting standards. Under this provision, an “emerging growth company” can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to avail ourselves of this exemption from new or revised accounting standards and, therefore, we will not be subject to new or revised accounting standards at the same time as other public companies that are not emerging growth companies.

 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.  All statements, other than statements of historical facts, included in this Quarterly Report on Form 10-Q that address activities, events or developments that we expect, believe or anticipate will or may occur in the future are forward-looking statements, including statements relating to successfully closing our announced acquisitions, the anticipated benefits of our acquisitions, any planned takeover of operations, future down-spacing and movement to pad drilling to further reduce costs and to produce additional upside potential and other aspects of any proposed acquisitions.  These statements are based on certain assumptions we made based on management’s experience, perception of historical trends and technical analyses, current conditions, anticipated future developments and other factors believed to be appropriate and reasonable by management.  When used in this Quarterly Report on Form 10-Q, words such as “will,” “potential,” “believe,” “estimate,” “intend,” “expect,” “may,” “should,” “anticipate,” “could,” “plan,” “predict,” “project,” “profile,” “model,” “strategy,” “future” or their negatives or the statements that include these words, are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words.  In particular, statements, express or implied, concerning our future operating results and returns or our ability to replace or increase reserves, increase production, or generate income or cash flows are forward-looking statements.  Forward-looking statements are not guarantees of performance.  Such statements are subject to a number of assumptions, risks and uncertainties, many of which are beyond our control.  Although we believe that the expectations reflected in our forward-looking statements are reasonable and are based on reasonable assumptions, no assurance can be given that these assumptions are accurate or that any of these expectations will be achieved (in full or at all) or will prove to have been correct.  Important factors that could cause our actual results to differ materially from the expectations reflected in the forward looking statements include, among others:

 

·                  our ability to successfully execute our business and financial strategies;

 

·                  our ability to replace the reserves we produce through drilling and property acquisitions;

 

·                  the realized benefits of the acquisition of SN Marquis LLC (“Marquis LLC”), the acreage acquired in the Tuscaloosa Marine Shale (the “TMS transactions”), the acquisition of assets from Hess Corporation (“Hess”, and such acquisition transaction, the “Cotulla acquisition’’) and liabilities assumed in connection therewith, and the acquisition of the Wycross properties and other assets and liabilities assumed in connection therewith (the “Wycross acquisition”);

 

·                  the extent to which our drilling plans are successful in economically developing our acreage in, and to produce reserves and achieve anticipated production levels from, our existing and future projects;

 

·                  the accuracy of reserve estimates, which by their nature involve the exercise of professional judgment and may therefore be imprecise;

 

·                  the extent to which we can optimize reserve recovery and economically develop our plays utilizing horizontal and vertical drilling, advanced completion technologies and hydraulic fracturing;

 

·                  our ability to successfully execute our hedging strategy and the resulting realized prices therefrom;

 

·                  competition in the oil and natural gas exploration and production industry for employees and other personnel, equipment, materials and services and, related thereto, the availability and cost of employees and other personnel, equipment, materials and services;

 

·                  our ability to access the credit and capital markets to obtain financing on terms we deem acceptable, if at all, and to otherwise satisfy our capital expenditure requirements;

 

·                  the availability, proximity and capacity of, and costs associated with, gathering, processing, compression and transportation facilities;

 

·                  the timing and extent of changes in prices for, and demand for, crude oil and condensate, natural gas liquids (“NGLs”), natural gas and related commodities;

 

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·                  our ability to compete with other companies in the oil and natural gas industry;

 

·                  the impact of, and changes in, government policies, laws and regulations, including tax laws and regulations, environmental laws and regulations relating to air emissions, waste disposal, hydraulic fracturing and access to and use of water, laws and regulations imposing conditions and restrictions on drilling and completion operations and laws and regulations with respect to derivatives and hedging activities;

 

·                  developments in oil-producing and natural gas-producing countries;

 

·                  our ability to effectively integrate acquired crude oil and natural gas properties into our operations, fully identify existing and potential problems with respect to such properties and accurately estimate reserves, production and costs with respect to such properties;

 

·                  the extent to which our crude oil and natural gas properties operated by others are operated successfully and economically;

 

·                  the use of competing energy sources and the development of alternative energy sources;

 

·                  the extent to which we incur uninsured losses and liabilities or losses and liabilities in excess of our insurance coverage; and

 

·                  the other factors described under “Part I, Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Part II, Item 1A. Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q and in our other public filings with the Securities and Exchange Commission (the “SEC”).

 

In light of these risks, uncertainties and assumptions, the events anticipated by our forward-looking statements may not occur, and, if any of such events do, we may not have correctly anticipated the timing of their occurrence or the extent of their impact on our actual results.  Accordingly, you should not place any undue reliance on any of our forward-looking statements.  Any forward-looking statement speaks only as of the date on which such statement is made, and we undertake no obligation to correct or update any forward-looking statement, whether as a result of new information, future events or otherwise, except as required by applicable law.

 

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Sanchez Energy Corporation

Form 10-Q

For the Quarterly Period Ended September 30, 2013

 

Table of Contents

 

 

PART I

 

 

 

 

Item 1.

Unaudited Financial Statements

 

 

 

 

 

Condensed Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012

6

 

 

 

 

Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2013 and 2012

7

 

 

 

 

Condensed Consolidated Statement of Stockholders’ Equity for the Nine Months Ended September 30, 2013

8

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2013 and 2012

9

 

 

 

 

Notes to the Condensed Consolidated Financial Statements

10

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

30

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

47

 

 

 

Item 4.

Controls and Procedures

49

 

 

 

PART II

 

 

 

 

Item 1.

Legal Proceedings

50

 

 

 

Item 1A.

Risk Factors

50

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

52

 

 

 

Item 3.

Defaults Upon Senior Securities

52

 

 

 

Item 4.

Mine Safety Disclosures

53

 

 

 

Item 5.

Other Information

53

 

 

 

Item 6.

Exhibits

54

 

 

 

SIGNATURES

57

 

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PART I — FINANCIAL INFORMATION

 

Item 1. Unaudited Financial Statements

 

Sanchez Energy Corporation

Condensed Consolidated Balance Sheets (Unaudited)

(in thousands, except share amounts)

 

 

 

September 30,

 

December 31,

 

 

 

2013

 

2012

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

479,999

 

$

50,347

 

Investments

 

10,000

 

11,591

 

Oil and natural gas receivables

 

36,565

 

10,435

 

Joint interest billing receivables

 

3,452

 

 

Fair value of derivative instruments

 

40

 

2,145

 

Deferred tax asset

 

7,520

 

 

Other current assets

 

739

 

438

 

Total current assets

 

538,315

 

74,956

 

Oil and natural gas properties, at cost, using the full cost method:

 

 

 

 

 

Unproved oil and natural gas properties

 

268,556

 

138,937

 

Proved oil and natural gas properties

 

868,284

 

232,523

 

Total oil and natural gas properties

 

1,136,840

 

371,460

 

Less: Accumulated depreciation, depletion, amortization and impairment

 

(98,729

)

(22,605

)

Total oil and natural gas properties, net

 

1,038,111

 

348,855

 

 

 

 

 

 

 

Other assets:

 

 

 

 

 

Debt issuance costs, net

 

19,869

 

2,595

 

Fair value of derivative instruments

 

423

 

 

Other assets

 

2,575

 

168

 

 

 

 

 

 

 

Total assets

 

$

1,599,293

 

$

426,574

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

26,779

 

$

 

Accounts payable - related entities

 

782

 

13,454

 

Other payables

 

2,973

 

 

Accrued liabilities

 

110,084

 

44,828

 

Dividends payable

 

5,485

 

 

Fair value of derivative instruments

 

7,033

 

1,003

 

Total current liabilities

 

153,136

 

59,285

 

Long term debt, net of discount

 

593,032

 

 

Asset retirement obligations

 

3,507

 

546

 

Deferred tax liability

 

3,852

 

 

Other non-current liabilities

 

478

 

 

Total liabilities

 

754,005

 

59,831

 

 

 

 

 

 

 

Commitments and contingencies (Note 16)

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock ($0.01 par value, 15,000,000 shares authorized; 3,000,000 shares of 4.875% Cumulative Perpetual Convertible, Series A, issued and outstanding as of each of September 30, 2013 and December 31, 2012, respectively; 4,500,000 and zero shares of 6.500% Cumulative Perpetual Convertible, Series B, issued and outstanding as of September 30, 2013 and December 31, 2012, respectively)

 

75

 

30

 

Common stock ($0.01 par value, 150,000,000 shares authorized; 46,350,513 and 33,762,400 shares issued and outstanding as of September 30, 2013 and December 31, 2012, respectively)

 

464

 

338

 

Additional paid-in capital

 

863,805

 

385,086

 

Accumulated deficit

 

(19,056

)

(18,711

)

Total stockholders’ equity

 

845,288

 

366,743

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

1,599,293

 

$

426,574

 

 

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

 

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Sanchez Energy Corporation

Condensed Consolidated Statements of Operations (Unaudited)

(in thousands, except per share amounts)

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

REVENUES:

 

 

 

 

 

 

 

 

 

Oil sales

 

$

87,436

 

$

12,308

 

$

171,635

 

$

25,858

 

Natural gas liquids sales

 

3,190

 

3

 

6,166

 

10

 

Natural gas sales

 

3,574

 

182

 

6,520

 

594

 

Total revenues

 

94,200

 

12,493

 

184,321

 

26,462

 

 

 

 

 

 

 

 

 

 

 

OPERATING COSTS AND EXPENSES:

 

 

 

 

 

 

 

 

 

Oil and natural gas production expenses

 

11,026

 

610

 

21,098

 

2,015

 

Production and ad valorem taxes

 

5,531

 

613

 

10,942

 

1,569

 

Depreciation, depletion, amortization and accretion

 

38,372

 

4,580

 

76,368

 

9,291

 

General and administrative (inclusive of stock-based compensation expense of $6,657 and $836, respectively, for the three months ended September 30, 2013 and 2012, and $14,369 and $24,800, respectively, for the nine months ended September 30, 2013 and 2012)

 

15,195

 

2,844

 

35,564

 

31,451

 

 

 

 

 

 

 

 

 

 

 

Total operating costs and expenses

 

70,124

 

8,647

 

143,972

 

44,326

 

 

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

24,076

 

3,846

 

40,349

 

(17,864

)

 

 

 

 

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

 

 

 

 

Interest and other income

 

32

 

12

 

104

 

31

 

Interest expense

 

(9,460

)

 

(17,613

)

 

Realized and unrealized gains (losses) on derivative instruments

 

(14,436

)

(2,191

)

(13,812

)

809

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income taxes

 

212

 

1,667

 

9,028

 

(17,024

)

 

 

 

 

 

 

 

 

 

 

Income tax benefit

 

3,668

 

 

3,668

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

3,880

 

1,667

 

12,696

 

(17,024

)

 

 

 

 

 

 

 

 

 

 

Less:

 

 

 

 

 

 

 

 

 

Preferred stock dividends

 

(5,485

)

(264

)

(13,041

)

(264

)

Net income allocable to participating securities

 

 

(21

)

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) attributable to common stockholders

 

$

(1,605

)

$

1,382

 

$

(345

)

$

(17,288

)

 

 

 

 

 

 

 

 

 

 

Net income (loss) per common share - basic and diluted

 

$

(0.05

)

$

0.04

 

$

(0.01

)

$

(0.52

)

 

 

 

 

 

 

 

 

 

 

Weighted average number of shares used to calculate net income (loss) attributable to common stockholders - basic and diluted

 

34,737

 

33,000

 

33,651

 

33,000

 

 

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

 

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Sanchez Energy Corporation

Condensed Consolidated Statement of Stockholders’ Equity for the Nine Months Ended September 30, 2013 (Unaudited)

(in thousands)

 

 

 

Series A

 

Series B

 

 

 

 

 

Additional

 

 

 

Total

 

 

 

Preferred Stock

 

Preferred Stock

 

Common Stock

 

Paid-in

 

Accumulated

 

Stockholders’

 

 

 

Shares

 

Amount

 

Shares

 

Amount

 

Shares

 

Amount

 

Capital

 

Deficit

 

Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE, December 31, 2012

 

3,000

 

$

30

 

 

$

 

33,762

 

$

338

 

$

385,086

 

$

(18,711

)

$

366,743

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Common shares issued, net of offering costs of $12,422

 

 

 

 

 

11,040

 

111

 

241,387

 

 

241,498

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Issuance of Series B Preferred Stock, net of offering costs of $8,439

 

 

 

4,500

 

45

 

 

 

216,516

 

 

216,561

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Preferred stock dividends

 

 

 

 

 

 

 

 

(13,041

)

(13,041

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Purchase of oil and natural gas properties for common stock

 

 

 

 

 

343

 

3

 

7,517

 

 

7,520

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Restricted stock awards, net of forfeitures

 

 

 

 

 

1,257

 

13

 

(13

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Purchases of common stock

 

 

 

 

 

(52

)

(1

)

(1,057

)

 

(1,058

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock-based compensation

 

 

 

 

 

 

 

14,369

 

 

14,369

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

 

 

12,696

 

12,696

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE, September 30, 2013

 

3,000

 

$

30

 

4,500

 

$

45

 

46,350

 

$

464

 

$

863,805

 

$

(19,056

)

$

845,288

 

 

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

 

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Sanchez Energy Corporation

Condensed Consolidated Statements of Cash Flows (Unaudited)

(in thousands)

 

 

 

Nine Months Ended September 30,

 

 

 

2013

 

2012

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income (loss)

 

$

12,696

 

$

(17,024

)

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

 

 

 

 

 

Depreciation, depletion, amortization and accretion

 

76,368

 

9,291

 

Stock-based compensation

 

14,369

 

24,800

 

Unrealized losses (gains) on derivative instruments

 

6,820

 

(1,594

)

Amortization of deferred financing costs and debt discount

 

5,862

 

 

Deferred taxes

 

(3,668

)

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(29,903

)

(3,114

)

Other current assets

 

(301

)

(214

)

Price risk management activities, net

 

3,484

 

(618

)

Accounts payable

 

8,427

 

 

Accounts payable - related entities

 

(12,672

)

13,402

 

Other payables

 

829

 

 

Accrued liabilities

 

26,413

 

1,266

 

Net cash provided by operating activities

 

108,724

 

26,195

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Payments for oil and natural gas properties

 

(295,670

)

(88,798

)

Payments for other property and equipment

 

(1,665

)

 

Acquisitions of oil and natural gas properties

 

(402,669

)

 

Purchases of investments

 

(10,000

)

(11,583

)

Sale of investments

 

11,591

 

 

Net cash used in investing activities

 

(698,413

)

(100,381

)

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Proceeds from borrowings

 

236,000

 

 

Repayment of borrowings

 

(236,000

)

 

Issuance of senior notes, net of discount

 

593,000

 

 

Issuance of common stock

 

253,920

 

 

 

Issuance of preferred stock

 

225,000

 

150,000

 

Payments for stock offering costs

 

(20,861

)

(5,488

)

Financing costs

 

(23,104

)

 

Preferred dividends paid

 

(7,556

)

 

Purchase of common stock

 

(1,058

)

 

Net cash provided by financing activities

 

1,019,341

 

144,512

 

 

 

 

 

 

 

Increase in cash and cash equivalents

 

429,652

 

70,326

 

Cash and cash equivalents, beginning of period

 

50,347

 

63,041

 

Cash and cash equivalents, end of period

 

$

479,999

 

$

133,367

 

 

 

 

 

 

 

NON-CASH INVESTING AND FINANCING ACTIVITIES:

 

 

 

 

 

Asset retirement obligations

 

$

2,833

 

$

205

 

Change in accrued capital expenditures

 

38,842

 

23,207

 

Capital expenditures in accounts payable

 

18,352

 

 

Deferred premium liabilities

 

718

 

563

 

Purchase of oil and natural gas properties in exchange for common stock

 

7,520

 

 

Accrued preferred stock dividends

 

5,485

 

 

SUPPLEMENTAL DISCLOSURE:

 

 

 

 

 

Cash paid for interest

 

$

2,020

 

$

 

 

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

 

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Note 1.   Organization

 

Sanchez Energy Corporation (together with its consolidated subsidiaries, the “Company,” “we,” “our,” “us” or similar terms) is an independent exploration and production company focused on the acquisition, exploration, and development of unconventional oil and natural gas resources onshore along the U.S. Gulf Coast, primarily in the Eagle Ford Shale in South Texas. As of September 30, 2013, the Company had accumulated acreage in the Eagle Ford Shale in Gonzales, Zavala, Frio, Fayette, Lavaca, Atascosa, Webb, DeWitt, Dimmit and LaSalle Counties of South Texas.  In August 2013, the Company added undeveloped acreage targeting the Tuscaloosa Marine Shale (“TMS”) located in Southwest Mississippi and Southeast Louisiana.  In addition, the Company has some minor property interests located in the Haynesville Shale in north central Louisiana.

 

The Company was formed in August 2011 to acquire, explore and develop unconventional oil and natural gas assets.  On December 19, 2011, the Company completed its IPO of 10.0 million shares of common stock, par value $0.01 per share, at a price to the public of $22.00 per share and received net proceeds of approximately $203.3 million in cash (net of expenses and underwriting discounts and commissions).

 

In connection with its IPO, on December 19, 2011, the Company entered into a contribution, conveyance and assumption agreement whereby Sanchez Energy Partners I, LP (“SEP I”), an affiliate of the Company, contributed to the Company 100% of the limited liability company interests in SEP Holdings III, LLC (“SEP Holdings III”), which owns interests in unconventional oil and natural gas assets consisting of undeveloped leasehold, proved oil and natural gas reserves and related equipment and other assets (the “SEP I Assets”) in exchange for approximately 22.1 million shares of the Company’s common stock and $50.0 million in cash.  The acquisition of oil and natural gas properties from SEP I was a transaction among entities under common control and, accordingly, the Company recorded the assets and liabilities acquired at their historical carrying values and presented the historical operations of the SEP I Assets on a retrospective basis for all periods prior to the IPO presented in its financial statements.  In addition, the $50.0 million payment was reflected as a distribution to SEP I in the financial statements.

 

Also in connection with its IPO, the Company entered into a contribution agreement whereby it acquired 100% of the limited liability company interests in Marquis LLC, which owns evaluated and unevaluated properties in Fayette, Lavaca, Atascosa, Webb and DeWitt Counties of South Texas (the “Marquis Assets”) in exchange for 909,091 shares of the Company’s common stock, valued at $20.0 million, and approximately $89.0 million in cash from the proceeds of the IPO. The acquisition was accounted for as a purchase of assets and recorded at cost at the acquisition date.

 

Also in connection with its IPO, on December 19, 2011, the Company entered into a services agreement and other related agreements with Sanchez Oil & Gas Corporation (“SOG” and together with its affiliates (excluding the Company but including SEP I) collectively referred to as members of the “Sanchez Group”), an affiliate of the Company, pursuant to which SOG (directly or through its subsidiaries) agreed to provide the Company with the services and data that the Company believes are necessary to manage, operate and grow its business, and the Company agreed to reimburse SOG for all direct and indirect costs incurred on its behalf.

 

On June 19, 2012 and September 17, 2012, SEP I distributed substantially all of the approximately 22.1 million shares of the Company’s common stock that SEP I owned to the partners of SEP I (the “Distribution”).  The 21,932,659 shares of common stock distributed to SEP I’s partners constituted 66.5% of the then issued and outstanding shares of the Company’s common stock.  The Distribution was a return on SEP I’s partners’ capital contributions to SEP I, thus no consideration was paid to SEP I for the shares of the Company’s common stock distributed.  Since June 19, 2012, the Company has not been under common control with SEP I.

 

Note 2.   Summary of Significant Accounting Policies

 

The accompanying condensed consolidated financial statements are unaudited and were prepared from the Company’s records.  The condensed consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP” or “U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  The Company derived the condensed consolidated balance sheet as of December 31, 2012 from the audited financial statements filed in its Annual Report on Form 10-K for the fiscal year ended December 31, 2012 (the “2012 Annual Report”).  Because this is an interim period filing presented using a condensed format, it does not include all of the disclosures required by U.S. GAAP.  These condensed consolidated financial statements should be read in connection with the consolidated financial statements and notes thereto included in the 2012 Annual Report, which contains a summary of the Company’s significant accounting policies and other disclosures.  In the opinion of management, these financial statements include the adjustments and accruals, all of which are of a normal recurring nature, which are necessary for a fair presentation of the results for the interim periods.  These interim results are not necessarily indicative of results to be expected for the entire year.

 

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As of September 30, 2013, the Company’s significant accounting policies are consistent with those discussed in Note 2 in the notes to the Company’s consolidated financial statements contained in its 2012 Annual Report, as supplemented by the significant accounting policy set forth below.

 

Our acquisitions, except those acquisitions made between entities under common control, are accounted for under the acquisition method of accounting in accordance with ASC Topic 805, “Business Combinations” (“ASC Topic 805”). An acquisition may result in the recognition of a gain or goodwill based on the measurement of the fair value of the assets acquired at the acquisition date as compared to the fair value of consideration transferred, adjusted for purchase price adjustments. Any such gain or any loss resulting from the impairment of goodwill is recognized in current period earnings and classified in operating costs and expenses in the accompanying condensed consolidated statements of operations. The initial accounting for acquisitions may not be complete and adjustments to provisional amounts, or recognition of additional assets acquired or liabilities assumed, may occur as more detailed analyses are completed and additional information is obtained about the facts and circumstances that existed as of the acquisition dates. The results of operations of the properties acquired in our acquisitions have been included in the condensed consolidated financial statements since the closing dates of the acquisitions.

 

Basis of Presentation

 

The acquisition of oil and natural gas properties from SEP I was a transaction among entities under common control and accordingly, the Company recorded the assets and liabilities acquired at their historical carrying values and has presented the historical accounts of the SEP I Assets on a retrospective basis for all periods prior to the IPO presented in the consolidated financial statements.

 

SOG is a private oil and gas company engaged in the exploration for and development of oil and natural gas. SOG has historically acted as the operator of a significant portion of SEP I’s oil and natural gas properties. SOG provided all employee, management, and administrative support to SEP I and, for periods prior to December 19, 2011, a proportionate share of SOG’s general and administrative costs were allocated to the SEP I Assets. The costs of these services associated with the SEP I Assets were allocated to the SEP I Assets primarily based on the ratio of capital expenditures between the entities to which SOG provides services and the SEP I Assets. However, other factors, such as time spent on general management services and producing property activities, were also considered in the allocation of these costs. Management believes such allocations were reasonable; however, they may not be indicative of the actual expense that would have been incurred had the SEP I Assets been operated as an independent company for periods prior to December 19, 2011. On December 19, 2011, SOG began providing similar types of services to the Company under the services agreement as described below (Note 11).

 

Principles of Consolidation

 

The Company’s condensed consolidated financial statements include the accounts of the Company and its subsidiaries.  All intercompany balances and transactions have been eliminated.

 

Use of Estimates

 

The condensed consolidated financial statements are prepared in conformity with U.S. GAAP, which 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 oil and natural gas reserves and related cash flow estimates used in the depletion and impairment of oil and natural gas properties, fair value accounting for acquisitions, the evaluation of unproved properties for impairment, the fair value of commodity derivative contracts and asset retirement obligations, accrued oil and natural gas revenues and expenses and the allocation of general and administrative expenses. Actual results could differ materially from those estimates.

 

Reclassifications

 

Certain reclassifications have been made to the 2012 condensed consolidated financial statements to conform to the 2013 presentation.  These reclassifications were not material to the accompanying condensed consolidated financial statements.

 

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Note 3. Acquisitions

 

Our acquisitions, except those acquisitions made between entities under common control, are accounted for under the acquisition method of accounting in accordance with ASC Topic 805, “Business Combinations” (“ASC Topic 805”). An acquisition may result in the recognition of a gain or goodwill based on the measurement of the fair value of the assets acquired at the acquisition date as compared to the fair value of consideration transferred, adjusted for purchase price adjustments. Any such gain or any loss resulting from the impairment of goodwill is recognized in current period earnings and classified in operating costs and expenses in the accompanying condensed consolidated statements of operations. The initial accounting for acquisitions may not be complete and adjustments to provisional amounts, or recognition of additional assets acquired or liabilities assumed, may occur as more detailed analyses are completed and additional information is obtained about the facts and circumstances that existed as of the acquisition dates. The results of operations of the properties acquired in our acquisitions have been included in the condensed consolidated financial statements since the closing dates of the acquisitions.

 

Tuscaloosa Marine Shale (“TMS”) Asset Purchase

 

In August 2013, the Company completed its acquisition of assets, which consisted of undeveloped acreage in Mississippi and Louisiana covering the emerging TMS trend, from three sellers (two third parties and one related party of the Company) for total consideration of approximately $70 million in cash and the issuance of 342,760 common shares of the Company, valued at approximately $7.5 million.  The total consideration provided to SR Acquisition I, LLC (together with its parent company Sanchez Resources, LLC, where applicable, “SR”), an affiliate of the Company, was $14.4 million, and included $0.9 million in customary closing adjustments.  The acquisitions were accounted for as the purchase of assets at cost at the acquisition date.

 

Pursuant to the terms of the agreements, the Company established an Area of Mutual Interest (“AMI”) with SR in the TMS.  As part of the transactions, the Company acquired all of the working interests in the AMI owned by the third party plus a portion of SR’s working interests, resulting in the Company owning an undivided 50% working interest across the AMI through the TMS. The Company has further committed, as a part of the total consideration, to carry SR for its 50% working interest in an initial 3 gross (1.5 net) TMS wells to be drilled within the AMI and, at the Company’s election, it may carry SR in an additional 3 gross (1.5 net) TMS wells if it desires to participate in additional drilling within the AMI.

 

Cotulla Acquisition

 

On May 31, 2013, the Company completed the Cotulla acquisition for an aggregate adjusted purchase price of $281.6 million.  The effective date of the transaction was March 1, 2013.

 

The purchase price was funded with borrowings under the Company’s First Lien Credit Agreement, cash on hand, and proceeds from the Company’s private placement of the Series B Convertible Preferred Stock. The preliminary purchase price allocation for the Cotulla acquisition has been finalized except for the settlement of certain post-closing adjustments with the seller.  The total purchase price was allocated to the assets purchased and liabilities assumed in the Cotulla acquisition based upon fair values on the date of acquisition as follows (in thousands):

 

Proved oil and natural gas properties

 

$

265,468

 

Unproved properties

 

16,745

 

Other assets acquired

 

856

 

Fair value of assets acquired

 

283,069

 

 

 

 

 

Asset retirement obligations

 

(1,138

)

Other liabilities assumed

 

(351

)

 

 

 

 

Fair value of net assets acquired

 

$

281,580

 

 

The following unaudited pro forma combined results for each of the three and nine months ended September 30, 2013 and 2012 reflect the consolidated results of operations of the Company as if the Cotulla acquisition and related financings had occurred on January 1, 2012.  The pro forma information includes adjustments primarily for revenues and expenses from the acquired properties, depreciation, depletion, amortization and accretion, interest expense and debt issuance cost amortization for acquisition debt, and stock dividends for the issuance of preferred stock.

 

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The unaudited pro forma combined financial statements give effect to the events set forth below:

 

·                  The Cotulla acquisition completed May 31, 2013.

 

·                  The increase in borrowings under the First Lien Credit Agreement to finance a portion of the acquisition, and the related adjustments to interest expense.

 

·                  Issuance of Series B Convertible Preferred Stock and related adjustments to preferred dividends (in thousands, except per share amounts):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

Revenues

 

$

94,200

 

$

42,228

 

$

237,926

 

$

96,819

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) attributable to common stockholders

 

$

(1,669

)

$

(2,747

)

$

407

 

$

(23,127

)

 

 

 

 

 

 

 

 

 

 

Net income (loss) per common share, basic and diluted

 

$

(0.05

)

$

(0.08

)

$

0.01

 

$

(0.70

)

 

The unaudited pro forma combined financial information is for informational purposes only and is not intended to represent or to be indicative of the combined results of operations that the Company would have reported had the Cotulla acquisition been completed as of the dates set forth in this unaudited pro forma combined financial information and should not be taken as indicative of the Company’s future combined results of operations. The actual results may differ significantly from that reflected in the unaudited pro forma combined financial information for a number of reasons, including, but not limited to, differences in assumptions used to prepare the unaudited pro forma combined financial information and actual results.

 

The amounts of revenue and revenues in excess of direct operating expenses included in the Company’s condensed consolidated statements of operations for the Cotulla acquisition are shown in the table that follows.  Direct operating expenses include lease operating expenses and production and ad valorem taxes (in thousands):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30, 2013

 

September 30, 2013

 

Revenues

 

$

40,267

 

$

48,741

 

 

 

 

 

 

 

Excess of revenues over direct operating expenses

 

$

29,890

 

$

34,819

 

 

Note 4. Cash and Cash Equivalents

 

As of September 30, 2013 and December 31, 2012, cash and cash equivalents consisted of the following (in thousands):

 

 

 

September 30,

 

December 31,

 

 

 

2013

 

2012

 

Cash at banks

 

$

309,826

 

$

5,265

 

Money market funds

 

170,173

 

82

 

Commercial paper (1)

 

 

45,000

 

Total cash and cash equivalents

 

$

479,999

 

$

50,347

 

 


(1) These securities matured three months or less from date of purchase.

 

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Note 5. Investments

 

At September 30, 2013, the Company held certain investments in marketable securities as a means of temporarily investing the proceeds from its offering of the Senior Notes (defined below).  The Company classified these securities as held-to-maturity investments on the condensed consolidated balance sheet.  At December 31, 2012, the Company held certain investments in marketable securities as a means of temporarily investing the proceeds from its Series A Convertible Preferred Stock offering until the funds were needed for operating purposes.  At the time of acquisition, the Company classified these securities as “available-for-sale” due primarily to the Company’s potential liquidity requirements that could result in these securities being sold prior to maturity.

 

The Company’s investments as of September 30, 2013 and December 31, 2012 consisted of the following (in thousands):

 

 

 

September 30,

 

December 31,

 

 

 

2013

 

2012

 

Commercial paper

 

$

 

$

7,500

 

Corporate notes and bonds

 

10,000

 

4,091

 

Total investments

 

$

10,000

 

$

11,591

 

 

The Company’s investments as of September 30, 2013 consisted of held-to-maturity securities, and accordingly are to be measured at their amortized cost basis on the condensed consolidated balance sheet.  The Company purchased its existing investments at an immaterial discount and therefore has not reflected that discount or the subsequent amortization separately in the condensed consolidated financial statements.  As of September 30, 2013, we recorded a $0.1 million loss on the sale of investments during the period.  There were no gains or losses recorded on investments held as of September 30, 2013 and December 31, 2012 due to the fact that the fair value of these investments approximated the costs paid for these securities.

 

Note 6.  Oil and Natural Gas Properties

 

 

The Company’s oil and natural gas properties are accounted for using the full cost method of accounting.  All direct costs and certain indirect costs associated with the acquisition, exploration and development of oil and natural gas properties are capitalized. Once evaluated, these costs, as well as the estimated costs to retire the assets, are included in the amortization base and amortized to depletion expense using the units-of-production method.  Depletion is calculated based on estimated proved oil and natural gas reserves.  Proceeds from the sale or disposition of oil and natural gas properties are applied to reduce net capitalized costs unless the sale or disposition causes a significant change in the relationship between costs and the estimated quantity of proved reserves.

 

Capitalized costs (net of accumulated depreciation, depletion and amortization and deferred income taxes) of proved oil and natural gas properties are subject to a full cost ceiling limitation.  The ceiling limits these costs to an amount equal to the present value, discounted at 10%, of estimated future net cash flows from estimated proved reserves less estimated future operating and development costs, abandonment costs (net of salvage value) and estimated related future income taxes.  In accordance with SEC rules, the oil and natural gas prices used to calculate the full cost ceiling are the 12-month average prices, calculated as the unweighted arithmetic average of the first-day-of-the-month price for each month within the 12-month period prior to the end of the reporting period, unless prices are defined by contractual arrangements. Prices are adjusted for “basis” or location differentials.  Prices are held constant over the life of the reserves.  If unamortized costs capitalized within the cost pool exceed the ceiling, the excess is charged to expense and separately disclosed during the period in which the excess occurs. Amounts thus required to be written off are not reinstated for any subsequent increase in the cost center ceiling.  No impairment expense was recorded for the three and nine month periods ended September 30, 2013 or 2012.

 

Investments in unproved properties and major development projects are capitalized and excluded from the amortization base until proved reserves associated with the projects can be determined or until impairment occurs.  Once the assessment of unproved properties is complete and when major development projects are evaluated, the costs previously excluded from amortization are transferred to the full cost pool subject to periodic amortization.  The Company assesses the carrying value of its unproved properties that are not subject to amortization for impairment periodically.  If the results of an assessment indicate that the properties are impaired, the amount of the asset impaired is added to the full cost pool subject to both periodic amortization and the ceiling test.

 

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Note 7. Long-Term Debt

 

Long-term debt at September 30, 2013 consisted of $600 million principal amount under the 7.75% Senior Notes (as defined below), including the Additional Notes (as defined below) which were issued at a discount to face value of $7.0 million, maturing on June 15, 2021.  The Company did not have any long-term debt outstanding at December 31, 2012.

 

Credit Facility

 

Previous Credit Agreements:  On November 16, 2012, we and our subsidiaries, SEP Holdings III and Marquis LLC (collectively referred to with us as the “Original Borrowers”), entered into the Previous First Lien Credit Agreement, dated as of November 15, 2012, among the Original Borrowers, as borrowers, Capital One, National Association, as administrative agent, sole lead arranger and sole book runner, and each of the other lenders party thereto. The Previous First Lien Credit Agreement provided for a $250 million revolving credit facility which was to mature November 16, 2015 and was secured by a senior lien on substantially all of the assets of the Original Borrowers. The borrowing base under the Previous First Lien Credit Agreement, initially set at $27.5 million, was increased to $95 million on February 21, 2013.

 

Also on November 16, 2012, we entered into the Second Lien Term Credit Agreement (the “Second Lien Term Credit Agreement”), dated as of November 15, 2012, among the Original Borrowers, as borrowers, Macquarie Bank Limited, as administrative agent, sole lead arranger and sole book runner, and the other lenders party thereto. The Second Lien Term Credit Agreement provided for a $250 million term loan facility which was to mature May 16, 2016 and was secured by a lien on substantially all of the assets of the Original Borrowers that was junior to the liens on such assets under the Previous First Lien Credit Agreement. The Second Lien Term Credit Agreement provided for an initial commitment of $50 million, subject to customary conditions, with the remaining commitments subject to the approval of the lenders and other customary conditions.  We borrowed $50 million under the Second Lien Term Credit Agreement in January 2013.

 

In connection with the purchase and sale agreement to purchase the Cotulla assets (Note 3), the Company entered into commitment letters for $325 million in debt financing and issued the Series B Convertible Preferred Stock.  The $325 million in debt financing contemplated by the commitment letters consisted of an amendment and restatement of the Company’s Previous First Lien Credit Agreement to increase the borrowing base from $95 million to $175 million and a $150 million bridge loan credit facility.  Availability of the debt financing was conditioned upon, and was intended to be available concurrently with, the closing of the Cotulla acquisition and was subject to the satisfaction of various customary closing conditions, including the execution and delivery of definitive documents. On May 30, 2013, the Company borrowed $90 million under its Previous First Lien Credit Agreement.  The Company did not enter into a definitive agreement for the bridge loan credit facility and it was never activated.

 

Current Credit Agreement:  On May 31, 2013, the Original Borrowers and a new subsidiary of the Company, SN Cotulla Assets, LLC (“SN Cotulla”) (collectively, the “Borrowers”) entered into the First Lien Credit Agreement with Royal Bank of Canada as the administrative agent, Capital One, National Association as the syndication agent and RBC Capital Markets as sole lead arranger and sole book runner and each of the other lenders party thereto.

 

The First Lien Credit Agreement amended and restated the Previous First Lien Credit Agreement in its entirety to renew, extend and rearrange the debt outstanding under the Previous First Lien Credit Agreement (but not to repay or pay off such debt) and to, among other things, (i) replace Capital One with Royal Bank of Canada as administrative agent and issuing bank, (ii) increase the maximum credit amount to $500 million, (iii) increase the borrowing base to $175 million, and (iv) make certain other amendments.   The Borrowers’ obligations under the First Lien Credit Agreement are secured by a first priority lien on substantially all of their assets and the assets of the Company’s existing and future subsidiaries not designated as “unrestricted subsidiaries,” including a first priority lien on all ownership interests in existing and future subsidiaries. Availability under the First Lien Credit Agreement is at all times subject to customary conditions and the then applicable borrowing base, which was initially set at $175 million and is subject to periodic redetermination. The borrowing base was also subject to reduction by 25% of the amount of the increase in the Borrowers’ net debt (taking into consideration any required repayment of debt) resulting from the issuance of certain debt, including pursuant to the issuance of the Senior Notes (as defined below). The borrowing base can be redetermined up or down by the lenders based on, among other things, their evaluation of the Company’s oil and natural gas reserves.  All borrowings under the First Lien Credit Agreement bear interest, at the option of the Borrowers, either at an alternate base rate or a eurodollar rate.  The alternate base rate of interest is equal to the sum of (a) the greatest of (i) the administrative agent’s U.S. “prime rate”, (ii) the federal funds effective rate plus ½ of 1% and (iii) the one-month LIBO Rate multiplied by the statutory reserve rate, plus 1% and (b) the applicable margin.  The eurodollar rate of interest is equal to the sum of (x) the LIBO Rate for the applicable interest period multiplied by the statutory reserve rate and (y) the applicable margin.  The applicable margin varies from 1.00% to 1.75% for alternate base rate borrowings and from 2.00% to 2.75% for

 

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eurodollar borrowings, depending on the utilization of the borrowing base.  Furthermore, the Borrowers are required to pay a commitment fee on the unused committed amount at a rate varying from 0.375% to 0.50% per annum, depending on the utilization of the borrowing base. Additionally, the First Lien Credit Agreement provides for the issuance of letters of credit, limited in the aggregate to the lesser of $20 million and the total availability thereunder. As of September 30, 2013, there were no letters of credit outstanding.

 

The First Lien Credit Agreement contains various affirmative and negative covenants and events of default that limit the Borrowers’ ability to, among other things, incur indebtedness, make restricted payments, grant liens, consolidate or merge, dispose of certain assets, make certain investments, engage in transactions with affiliates and hedge transactions and make certain acquisitions. Furthermore, the First Lien Credit Agreement contains financial covenants that require the Borrowers to satisfy certain specified financial ratios, including (i) current assets to current liabilities of at least 1.0 to 1.0 and (ii) net debt to consolidated EBITDA of not greater than 4.0 to 1.0. Upon an event of default, the administrative agent may, at its election or at the direction of lenders holding, as applicable, at least 50% of (i) the maximum committed amounts (if no borrowings or letters of credit are outstanding) or (ii) the outstanding borrowings and letter of credit exposure (if borrowings or letters of credit are outstanding) thereunder, accelerate the amounts due under the First Lien Credit Agreement. The obligations under the First Lien Credit Facility are guaranteed by all of the Company’s existing and future subsidiaries not designated as ‘‘unrestricted subsidiaries.” As of September 30, 2013, the Company was in compliance with the covenants of the First Lien Credit Agreement.

 

On May 31, 2013, the Borrowers entered into several conforming and technical amendments to the Second Lien Term Credit Agreement.  Pursuant to its terms, the First Lien Credit Agreement matures on May 31, 2018.  However, the First Lien Credit Agreement would mature on November 16, 2015 if the Second Lien Term Credit Agreement were not repaid in full on or before November 16, 2015.  On May 31, 2013, the Company borrowed $96 million under its First Lien Credit Agreement.  The Company used proceeds from this borrowing to repay the $90 million outstanding under the Previous First Lien Credit Agreement.  On June 13, 2013, the Company used proceeds from its Senior Notes (as defined below) offering described below to repay the $96 million outstanding under the First Lien Credit Agreement and the $50 million outstanding under the Second Lien Term Credit Agreement.  The Second Lien Term Credit Agreement was retired with no further availability.  On July 3, 2013, Macquarie Bank Limited novated its rights and obligations under hedging agreements with the Company to Société Générale, a lender under the First Lien Credit Agreement.  The borrowing base on the First Lien Credit Agreement was increased to $175 million as a result of the redetermination conducted by the banks based upon the Company’s June 30, 2013 updated reserves and remains $175 million as of September 30, 2013. The next redetermination of the borrowing base was scheduled to occur on or before October 1, 2013 and that process is currently underway, with other redeterminations scheduled to occur quarterly through July 1, 2014 and then semi-annually thereafter on April 1 and October 1 of each year.

 

From time to time, the agents and lenders under the First Lien Credit Agreement and their affiliates have provided, and may provide in the future, investment banking, commercial lending, hedging and financial advisory services to the Company and its affiliates in the ordinary course of business, for which they have received, or may in the future receive, customary fees and commissions for these transactions.

 

7.75% Senior Notes Due 2021

 

On June 13, 2013, the Company completed a private offering to eligible purchasers of $400 million in aggregate principal amount of the Company’s 7.75% senior notes that will mature on June 15, 2021 (the “Original Notes”).  Interest is payable on each June 15 and December 15, commencing December 15, 2013.  The Company received net proceeds from this offering of approximately $388 million, after deducting initial purchasers’ discounts and estimated offering expenses, which the Company used to repay all of the approximately $96 million in borrowings outstanding under its First Lien Credit Agreement and to retire the Second Lien Term Credit Agreement by repaying in full the $50 million in borrowings outstanding.  The Original Notes are the senior unsecured obligations of the Company and are guaranteed on a joint and several senior unsecured basis by, with certain exceptions, substantially all of the Company’s existing and future subsidiaries.   The borrowing base under the Company’s First Lien Credit Agreement was reduced to $87.5 million upon issuance of the Original Notes, and was later increased to $175 million, all of which is available for future revolver borrowings as of September 30, 2013.

 

On September 18, 2013, the Company issued an additional $200 million in aggregate principal amount of its 7.750% senior notes due 2021 (the “Additional Notes” and, together with the Original Notes, the “Senior Notes”) in a private offering to eligible purchasers at a price to the purchasers of 96.5% of the Additional Notes.  The Company received net proceeds from this offering of approximately $188.8 million, after deducting the initial purchasers’ discounts and estimated offering expenses of approximately $4.2

 

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million.  The Company also received cash for accrued interest from June 13, 2013 through the date of issuance of $4.1 million.  The Additional Notes were issued under the same indenture as the Original Notes, and are therefore treated as a single class of debt securities under the indenture.  The Company used the net proceeds from the offering to partially fund the acquisition of Wycross properties (the “Wycross acquisition”), completed in October 2013, and intends to use the remaining proceeds to fund a portion of the 2013 capital budget, a portion of the preliminary 2014 capital budget, and for general corporate purposes.

 

The Senior Notes are the senior unsecured obligations of the Company and rank equally in right of payment with all of the Company’s existing and future senior unsecured indebtedness. The Senior Notes rank senior in right of payment to the Company’s future subordinated indebtedness. The Senior Notes are effectively junior in right of payment to all of the Company’s existing and future secured debt (including under the First Lien Credit Agreement) to the extent of the value of the assets securing such debt. The Senior Notes are fully and unconditionally guaranteed on a joint and several senior unsecured basis by the subsidiary guarantors party to the indenture governing the Senior Notes (collectively, the “Subsidiary Guarantors”). To the extent set forth in the indenture governing the Senior Notes, certain subsidiaries of the Company will be required to fully and unconditionally guarantee the Senior Notes on a joint and several senior unsecured basis in the future.

 

The indenture governing the Senior Notes, among other things, restricts the Company’s ability and the ability of the Company’s restricted subsidiaries to: (i) incur additional indebtedness or issue preferred stock; (ii) pay dividends or make other distributions; (iii) make other restricted payments and investments; (iv) create liens on their assets; (v) incur restrictions on the ability of restricted subsidiaries to pay dividends or make certain other payments; (vi) sell assets, including capital stock of restricted subsidiaries; (vii) merge or consolidate with other entities; and (viii) enter into transactions with affiliates.

 

The Company has the option to redeem all or a portion of the Senior Notes, at any time on or after June 15, 2017 at the applicable redemption prices specified in the indenture plus accrued and unpaid interest. The Company may also redeem the Senior Notes, in whole or in part, at a redemption price equal to 100% of their principal amount plus a make whole premium, together with accrued and unpaid interest and additional interest, if any, to the redemption date, at any time prior to June 15, 2017. In addition, the Company may redeem up to 35% of the Senior Notes prior to June 15, 2016 under certain circumstances with the net cash proceeds from certain equity offerings at the redemption price specified in the indenture. The Company may also be required to repurchase the Senior Notes upon a change of control.

 

Note 8.  Derivative Instruments

 

To reduce the impact of fluctuations in oil and natural gas prices on the Company’s revenues, or to protect the economics of property acquisitions, the Company periodically enters into derivative contracts with respect to a portion of its projected oil and natural gas production through various transactions that fix or, through options, modify the future prices to be realized. These transactions may include price swaps whereby the Company will receive a fixed price for its production and pay a variable market price to the contract counterparty. Additionally, the Company may enter into collars, whereby it receives the excess, if any, of the fixed floor over the floating rate or pays the excess, if any, of the floating rate over the fixed ceiling price. In addition, the Company enters into option transactions, such as puts or put spreads, as a way to manage its exposure to fluctuating prices. These hedging activities are intended to support oil and natural gas prices at targeted levels and to manage exposure to oil and natural gas price fluctuations. It is never the Company’s intention to enter into derivative contracts for speculative trading purposes.

 

Under Accounting Standards Codification (“ASC”) Topic 815, “Derivatives and Hedging,” all derivative instruments are recorded on the condensed consolidated balance sheets at fair value as either short-term or long-term assets or liabilities based on their anticipated settlement date. The Company will net derivative assets and liabilities for counterparties where it has a legal right of offset.  Changes in the derivatives’ fair values are recognized currently in earnings unless specific hedge accounting criteria are met.  The Company has elected not to designate its current derivative contracts as hedges.  Therefore, changes in the fair value of these instruments are recognized in earnings and included as realized and unrealized gains (losses) on derivative instruments in the condensed consolidated statements of operations.

 

As of September 30, 2013, the Company had the following crude oil swaps, options, and put spreads covering anticipated future production as indicated below:

 

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Derivative

 

 

 

 

 

 

 

Contract Period

 

Instrument

 

Barrels

 

Purchased

 

Sold

 

October 1, 2013 - December 31, 2013

 

Put Spread

 

92,000

 

$

95.00

 

$

75.00

 

October 1, 2013 - December 31, 2013

 

Swap

 

46,000

 

$

97.10

 

n/a

 

October 1, 2013 - December 31, 2013

 

Swap

 

92,000

 

$

88.90

 

n/a

 

October 1, 2013 - December 31, 2013

 

Put Spread

 

92,000

 

$

90.00

 

$

75.00

 

October 1, 2013 - December 31, 2013

 

Swap

 

69,000

 

$

94.50

 

n/a

 

October 1, 2013 - December 31, 2013

 

Swap

 

69,000

 

$

95.25

 

n/a

 

October 1, 2013 - December 31, 2013

 

Swap

 

92,000

 

$

96.80

 

n/a

 

October 1, 2013 - December 31, 2013

 

Swap

 

46,000

 

$

103.69

 

n/a

 

October 1, 2013 - December 31, 2013

 

Swap

 

46,000

 

$

103.70

 

n/a

 

January 1, 2014 - December 31, 2014

 

Swap

 

273,750

 

$

91.35

 

n/a

 

January 1, 2014 - December 31, 2014

 

Swap

 

273,750

 

$

92.45

 

n/a

 

January 1, 2014 - December 31, 2014

 

Swap

 

273,750

 

$

92.00

 

n/a

 

January 1, 2014 - June 30, 2014

 

Swap

 

90,500

 

$

97.19

 

n/a

 

January 1, 2014 - December 31, 2014

 

Swap

 

365,000

 

$

95.45

 

n/a

 

January 1, 2014 - December 31, 2014

 

Asian Option

 

365,000

 

$

90.00

 

$

99.10

 

July 1, 2014 - December 31, 2014

 

Put Spread

 

184,000

 

$

90.00

 

$

75.00

 

 

As of September 30, 2013, the Company had the following three-way crude oil collar contracts that combine a long and short put with a short call as indicated below:

 

Contract Period

 

Barrels

 

Short Put

 

Long Put

 

Short Call

 

Pricing Index

 

January 1, 2014 - December 31, 2014

 

547,500

 

$

65.00

 

$

85.00

 

$

102.25

 

NYMEX West Texas Intermediate crude

 

January 1, 2014 - December 31, 2014

 

365,000

 

$

75.00

 

$

95.00

 

$

107.50

 

Louisiana light sweet crude

 

 

The Company deferred the payment of premiums associated with certain of its oil derivative instruments.  At September 30, 2013, the balance of deferred payments totaled approximately $1.2 million. These premiums are being paid to the counterparty with each monthly settlement beginning July 2013.

 

Balance Sheet Presentation

 

The Company’s derivatives are presented on a net basis as “Fair value of derivative instruments” on the condensed consolidated balance sheets.  The following table summarizes the gross fair values of derivative instruments, presenting the impact of offsetting the derivative assets and liabilities on the Company’s condensed consolidated balance sheets for the periods indicated (in thousands):

 

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Table of Contents

 

 

 

September 30, 2013

 

 

 

 

 

Gross Amounts

 

Net Amounts

 

 

 

 

 

Offset in the

 

Presented in

 

 

 

Gross Amount

 

Condensed

 

the Condensed

 

 

 

of Recognized

 

Consolidated

 

Consolidated

 

 

 

Assets

 

Balance Sheets

 

Balance Sheets

 

Offsetting Derivative Assets:

 

 

 

 

 

 

 

Current asset

 

$

3,396

 

$

(3,356

)

$

40

 

Long-term asset

 

1,860

 

(1,437

)

423

 

Total asset

 

$

5,256

 

$

(4,793

)

$

463

 

 

 

 

 

 

 

 

 

Offsetting Derivative Liabilities:

 

 

 

 

 

 

 

Current liability

 

$

(10,389

)

$

3,356

 

$

(7,033

)

Long-term liability

 

(1,915

)

1,437

 

(478

)

Total liability

 

$

(12,304

)

$

4,793

 

$

(7,511

)

 

 

 

December 31, 2012

 

 

 

 

 

Gross Amounts

 

Net Amounts

 

 

 

 

 

Offset in the

 

Presented in

 

 

 

Gross Amount

 

Condensed

 

the Condensed

 

 

 

of Recognized

 

Consolidated

 

Consolidated

 

 

 

Assets

 

Balance Sheets

 

Balance Sheets

 

Offsetting Derivative Assets:

 

 

 

 

 

 

 

Current asset

 

$

37,012

 

$

(34,867

)

$

2,145

 

Long-term asset

 

 

 

 

Total asset

 

$

37,012

 

$

(34,867

)

$

2,145

 

 

 

 

 

 

 

 

 

Offsetting Derivative Liabilities:

 

 

 

 

 

 

 

Current liability

 

$

(34,867

)

$

34,867

 

$

 

Long-term liability

 

 

 

 

Total liability

 

$

(34,867

)

$

34,867

 

$

 

 

Gain (Loss) on Derivatives

 

Gains and losses on derivatives are reported on the condensed consolidated statements of operations as “Realized and unrealized gains (losses) on derivative instruments.”  Realized gains (losses) represent amounts related to the settlement of derivative instruments or the expiration of contracts.  Unrealized gains (losses) represent the change in fair value of the derivative instruments to be settled in the future and are non-cash items which fluctuate in value as commodity prices change.  The following summarizes the Company’s realized and unrealized gains (losses) on derivative instruments for the three and nine months ended September 30, 2013 and 2012 (in thousands):

 

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Table of Contents

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

 

 

 

 

 

 

 

 

 

 

Realized losses on derivative instruments

 

$

(5,531

)

$

(87

)

$

(6,992

)

$

(785

)

Unrealized gains (losses) on derivative instruments

 

(8,905

)

(2,104

)

(6,820

)

1,594

 

Total realized and unrealized gains (losses) on derivative instruments

 

$

(14,436

)

$

(2,191

)

$

(13,812

)

$

809

 

 

Note 9.         Fair Value of Financial Instruments

 

Measurements of fair value of derivative instruments are classified according to the fair value hierarchy, which prioritizes the inputs to the valuation techniques used to measure fair value. Fair value is the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are classified and disclosed in one of the following categories:

 

Level 1: Measured based on unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. Active markets are considered those in which transactions for the assets or liabilities occur in sufficient frequency and volume to provide pricing information on an ongoing basis.

 

Level 2: Measured based on quoted prices in markets that are not active, or inputs which are observable, either directly or indirectly, for substantially the full term of the asset or liability. This category includes those derivative instruments that can be valued using observable market data. Substantially all of these inputs are observable in the marketplace throughout the term of the derivative instrument, can be derived from observable data, or supported by observable levels at which transactions are executed in the marketplace.

 

Level 3: Measured based on prices or valuation models that require inputs that are both significant to the fair value measurement and less observable from objective sources (i.e. supported by little or no market activity). The valuation models used to value derivatives associated with the Company’s oil and natural gas production are primarily industry standard models that consider various inputs including: (a) quoted forward prices for commodities, (b) time value, and (c) current market and contractual prices for the underlying instruments, as well as other relevant economic measures. Although third party quotes are utilized to assess the reasonableness of the prices and valuation techniques, there is not sufficient corroborating evidence to support classifying these assets and liabilities as Level 2.

 

Financial assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. Management’s assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect the valuation of the fair value of assets and liabilities and their placement within the fair value hierarchy levels.

 

Fair Value on a Recurring Basis

 

The following tables set forth, by level within the fair value hierarchy, the Company’s financial assets and liabilities that were accounted for or disclosed at fair value on a recurring basis as of September 30, 2013 and December 31, 2012 (in thousands):

 

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As of September 30, 2013

 

 

 

Active Market

 

 

 

 

 

 

 

 

 

for Identical

 

Observable

 

Unobservable

 

Total

 

 

 

Assets

 

Inputs

 

Inputs

 

Carrying

 

 

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

Value

 

Cash and cash equivalents:

 

 

 

 

 

 

 

 

 

Money market funds

 

$

170,173

 

$

 

$

 

$

170,173

 

Investments:

 

 

 

 

 

 

 

 

 

Corporate notes and bonds

 

 

10,000

 

 

10,000

 

Oil derivative instruments:

 

 

 

 

 

 

 

 

 

Swaps

 

 

(5,245

)

 

(5,245

)

Three-way collars

 

 

 

(138

)

(138

)

Asian Options

 

 

 

(32

)

(32

)

Puts

 

 

 

(414

)

(414

)

Debt:

 

 

 

 

 

 

 

 

 

Senior Notes

 

 

586,500

 

 

586,500

 

Total

 

$

170,173

 

$

591,255

 

$

(584

)

$

760,844

 

 

 

 

As of December 31, 2012

 

 

 

Active Market

 

 

 

 

 

 

 

 

 

for Identical

 

Observable

 

Unobservable

 

Total

 

 

 

Assets

 

Inputs

 

Inputs

 

Carrying

 

 

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

Value

 

Cash and cash equivalents:

 

 

 

 

 

 

 

 

 

Commercial paper

 

$

 

$

45,000

 

$

 

$

45,000

 

Money market funds

 

82

 

 

 

82

 

Investments:

 

 

 

 

 

 

 

 

 

Commercial paper

 

 

7,500

 

 

7,500

 

Corporate notes and bonds

 

 

4,091

 

 

4,091

 

Oil derivative instruments:

 

 

 

 

 

 

 

 

 

Swaps

 

 

(870

)

 

(870

)

Puts

 

 

 

3,015

 

3,015

 

Total

 

$

82

 

$

55,721

 

$

3,015

 

$

58,818

 

 

The Level 1 instruments presented in the table above consist of money market funds included in cash and cash equivalents on the Company’s condensed consolidated balance sheets at September 30, 2013 and December 31, 2012. The Company’s money market funds represent cash equivalents backed by the assets of high-quality banks and financial institutions.  The Company identified the money market funds as Level 1 instruments due to the fact that the money market funds have daily liquidity, quoted prices for the underlying investments can be obtained and there are active markets for the underlying investments.

 

The Level 2 instruments presented in the table above include commercial paper and corporate notes and bonds included in cash and cash equivalents and investments on the Company’s condensed consolidated balance sheet at September 30, 2013 and December 31, 2012.  The Company identified the commercial paper and corporate notes and bonds as Level 2 instruments due to the fact that although the assets do not have regular market pricing, their fair value can be readily determined based on other data values

 

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or market prices. These asset values can be closely approximated using simple models and extrapolation methods using known, observable prices as parameters.

 

The Company uses a market approach to determine fair value of its Senior Notes using observable market data, which results in a Level 2 fair value measurement.  The estimated fair value of the Company’s Senior Notes was $586.5 million at September 30, 2013.

 

The Company’s oil derivative instruments, which consist of oil swaps, options, and puts, are classified as either Level 2 or Level 3 in the table above.  The fair value of the Company’s derivatives is based on third-party pricing models which utilize inputs that are either readily available in the public market, such as oil forward curves, or can be corroborated from active markets of broker quotes.  These values are then compared to the values given by the Company’s counterparties for reasonableness.  Since oil swaps do not include optionality and therefore generally have no unobservable inputs, they are classified as Level 2.  The Company’s oil puts, Asian options and three-way collars include some level of unobservable input, such as volatility curves, and are therefore classified as Level 3.   Derivative instruments are also subject to the risk that counterparties will be unable to meet their obligations. Such non-performance risk is considered in the valuation of the Company’s derivative instruments, but to date has not had a material impact on estimates of fair values. Significant changes in the quoted forward prices for commodities and changes in market volatility generally lead to corresponding changes in the fair value measurement of the Company’s oil derivative instruments.

 

The fair values of the Company’s oil derivative instruments classified as Level 3 at September 30, 2013 and December 31, 2012 were ($0.6) million and $3.0 million, respectively.  The significant unobservable inputs for Level 3 contracts include unpublished forward prices of oil, market volatility and credit risk of counterparties.  Changes in these inputs will impact the fair value measurement of the Company’s derivative contracts.

 

The following table sets forth a reconciliation of changes in the fair value of the Company’s oil derivative instruments classified as Level 3 in the fair value hierarchy (in thousands):

 

 

 

Significant Unobservable Inputs

 

 

 

(Level 3)

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

Beginning balance

 

$

3,003

 

$

7,369

 

$

3,015

 

$

1,461

 

Realized and unrealized gains (losses) included in earnings

 

(4,305

)

(2,191

)

(4,154

)

809

 

Settlements

 

 

(962

)

(163

)

(1,190

)

Purchase of derivative contracts

 

718

 

 

718

 

2,952

 

Buy out of derivative contracts

 

 

 

 

184

 

Ending balance

 

$

(584

)

$

4,216

 

$

(584

)

$

4,216

 

 

 

 

 

 

 

 

 

 

 

Change in unrealized gains (losses) included in earnings related to derivatives still held as of September 30, 2013 and 2012

 

$

(3,338

)

$

(1,994

)

$

(2,445

)

$

1,523

 

 

Fair Value on a Non-Recurring Basis

 

The Company follows the provisions of ASC 820-10 for nonfinancial assets and liabilities measured at fair value on a non-recurring basis.  Fair-value measurements of assets acquired and liabilities assumed are based on inputs that are not observable in the market and thus represent Level 3 inputs. The fair value of acquired properties is based on market and cost approaches. Our purchase price allocation for the Cotulla acquisition is presented in Note 3.  Liabilities assumed include asset retirement obligations existing at the date of acquisition.  The asset retirement obligation estimates are derived from historical costs as well as management’s expectation of future cost environments.  As there is no corroborating market activity to support the assumptions, the Company has

 

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designated these liabilities as Level 3.  A reconciliation of the beginning and ending balances of the Company’s asset retirement obligations is presented in Note 10.

 

Note 10.  Asset Retirement Obligations

 

Asset retirement obligations represent the present value of the estimated cash flows expected to be incurred to plug, abandon and remediate producing properties, excluding salvage values, at the end of their productive lives in accordance with applicable laws. The significant unobservable inputs to this fair value measurement include estimates of plugging, abandonment and remediation costs, well life, inflation and credit-adjusted risk-free rate. The inputs are calculated based on historical data as well as current estimates. When the liability is initially recorded, the carrying amount of the related long-lived asset is increased. Over time, accretion of the liability is recognized each period, and the capitalized cost is amortized over the useful life of the related asset. Upon settlement of the liability, any gain or loss is treated as an adjustment to the full cost pool.

 

The changes in the asset retirement obligation for the nine months ended September 30, 2013 and 2012 were as follows (in thousands):

 

 

 

2013

 

2012

 

Abandonment liability as of January 1,

 

$

546

 

$

83

 

Liabilities incurred during period

 

727

 

205

 

Acquisitions

 

1,138

 

 

Revisions

 

968

 

 

Accretion expense

 

128

 

9

 

Abandonment liability as of September 30,

 

$

3,507

 

$

297

 

 

During the first quarter of 2013, the Company reviewed its asset retirement obligation estimates. A quote was obtained from a third party that indicated anticipated costs for future abandonment had increased from previous estimates.  As a result, the Company increased its estimates of future asset retirement obligations by $1.0 million to reflect anticipated increased costs for plugging and abandonment.

 

Note 11.   Related Party Transactions

 

SOG, headquartered in Houston, Texas, is a private full service oil and natural gas company engaged in the exploration and development of oil and natural gas primarily in the South Texas and onshore Gulf Coast areas on behalf of its affiliates.   The Company refers to SOG, SEP I, and their affiliates (but excluding the Company) collectively as the “Sanchez Group.”

 

The Company does not have any employees.  On December 19, 2011 it entered into a services agreement with SOG pursuant to which specified employees of SOG provide certain services with respect to the Company’s business under the direction, supervision and control of SOG. Pursuant to this arrangement, SOG performs centralized corporate functions for the Company, such as general and administrative services, geological, geophysical and reserve engineering, lease and land administration, marketing, accounting, operational services, information technology services, compliance, insurance maintenance and management of outside professionals. The Company compensates SOG for the services at a price equal to SOG’s cost of providing such services, including all direct costs and indirect administrative and overhead costs (including the allocable portion of salary, bonus, incentive compensation and other amounts paid to persons that provide the services on SOG’s behalf) allocated in accordance with SOG’s regular and consistent accounting practices, including for any such costs arising from amounts paid directly by other members of the Sanchez Group on SOG’s behalf or borrowed by SOG from other members of the Sanchez Group, in each case, in connection with the performance by SOG of services on the Company’s behalf. The Company also reimburses SOG for sales, use or other taxes, or other fees or assessments imposed by law in connection with the provision of services to the Company (other than income, franchise or margin taxes measured by SOG’s net income or margin and other than any gross receipts or other privilege taxes imposed on SOG) and for any costs and expenses arising from or related to the engagement or retention of third party service providers.

 

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Table of Contents

 

The initial term of the services agreement is five years. The term will automatically extend for additional 12-month periods unless either party provides 180 days written notice otherwise prior to the expiration of the applicable 12-month period. Either party may terminate the agreement at any time upon 180 days written notice.

 

In connection with the services agreement, SOG also entered into a licensing agreement with the Company pursuant to which it granted to the Company a license to the unrestricted use of proprietary seismic, geological and geophysical information related to the Company’s properties owned by SOG, and all such information related to the Company’s properties not otherwise licensed to the Company will be interpreted and used by SOG for the Company’s benefit under the services agreement. In addition, SOG entered into a contract operating agreement with the Company under which SOG agreed to develop, manage and operate the Company’s properties or engage a responsible unaffiliated industry operator and joint owner for such development, management and operation.  No costs, fees or other expenses are payable by the Company under these agreements. The licensing agreement and contract operating agreement will terminate concurrently with the termination or expiration of the services agreement.

 

Prior to entering into the services agreement, SOG incurred general and administrative expenses that were allocated to the Company based on the ratio of capital expenditures between the entities to which SOG provided services and the SEP I Assets.  Other factors, such as time spent on general management services and producing property activities, were also considered in the allocation of these costs.  Beginning December 19, 2011, the costs were allocated to the Company according to the terms of the services agreement.  Salaries and associated benefit costs of SOG employees are allocated to the Company based on the actual time spent by the professional staff on the properties and business activities of the Company. General and administrative costs, such as office rent, utilities, supplies, and other overhead costs, are allocated to the Company based on a fixed percentage that is reviewed quarterly and adjusted, if needed, based on the activity levels of services provided to the Company. General and administrative costs that are specifically incurred by or for the specific benefit of the Company are charged directly to the Company.  Expenses allocated to the Company for general and administrative expenses for the three and nine months ended September 30, 2013 and 2012 are as follows (in thousands):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

 

 

 

 

 

 

 

 

 

 

Administrative fees

 

$

4,638

 

$

1,341

 

$

10,540

 

$

3,586

 

Third-party expenses

 

2,287

 

667

 

4,571

 

3,065

 

Total included in general and administrative expenses

 

$

6,925

 

$

2,008

 

$

15,111

 

$

6,651

 

 

As of September 30, 2013 and December 31, 2012, the Company had a net payable to SOG and other members of the Sanchez Group of $0.8 million and $13.5 million, respectively, which is reflected as “Accounts payable — related entities” in the condensed consolidated balance sheets.  This amount consists primarily of obligations for general and administrative costs due to SOG and revenue payable to affiliated entities.

 

In August 2013, the Company completed its acquisition of undeveloped acreage in the TMS trend from two third parties, and one related party of the Company, SR.  The total consideration paid to SR was approximately $14.4 million, and included $0.9 million in customary closing adjustments.  Because the transactions included a related party, our audit committee, which is comprised entirely of independent directors, reviewed and approved these transactions.  In connection with the approval of these transactions, our audit committee received a fairness opinion from an independent financial advisor selected by the committee.

 

Note 12. Accrued Liabilities

 

The following information summarizes accrued liabilities as of September 30, 2013 and December 31, 2012 (in thousands):

 

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Table of Contents

 

 

 

September 30,

 

December 31,

 

 

 

2013

 

2012

 

Capital expenditures

 

$

82,402

 

$

43,560

 

General and administrative costs

 

3,401

 

268

 

Production taxes

 

1,942

 

471

 

Ad valorem taxes

 

2,153

 

114

 

Lease operating expenses

 

6,365

 

415

 

Interest payable

 

13,821

 

 

Total accrued liabilities

 

$

110,084

 

$

44,828

 

 

Note 13. Stockholders’ Equity

 

Common Stock Offerings - On December 19, 2011, the Company completed its IPO of 10.0 million shares of common stock, par value $0.01 per share, at a price to the public of $22.00 per share.  The Company received net proceeds of approximately $203.3 million from the sale of the shares of common stock (net of expenses and underwriting discounts and commissions).

 

On September 18, 2013, the Company completed a public offering of 11,040,000 shares of common stock (including 1,440,000 shares purchased pursuant to the full exercise of the underwriters’ overallotment option), at an issue price of $23.00 per share.  The Company received net proceeds from this offering of approximately $241.5 million, after deducting underwriters’ fees and offering expenses of approximately $12.4 million.  The Company used the net proceeds from the offering to partially fund the Wycross acquisition, completed in October 2013, and intends to use the remaining proceeds to fund a portion of the 2013 capital budget, a portion of the preliminary 2014 capital budget, and for general corporate purposes.

 

Series A Convertible Preferred Stock Offering - On September 17, 2012, the Company completed a private placement of 3,000,000 shares of Series A Convertible Preferred Stock, which were sold to a group of qualified institutional buyers pursuant to the Rule 144A exemption from registration under the Securities Act. The issue price of each share of the Series A Convertible Preferred Stock was $50.00. The Company received net proceeds from the private placement of approximately $144.5 million, after deducting initial purchasers’ discounts and commissions and offering costs payable by the Company of approximately $5.5 million.

 

Pursuant to the Certificate of Designations for the Series A Convertible Preferred Stock, each share of Series A Convertible Preferred Stock is convertible at any time at the option of the holder thereof at an initial conversion rate of 2.3250 shares of common stock per share of Series A Convertible Preferred Stock (which is equal to an initial conversion price of approximately $21.51 per share of common stock) and is subject to specified adjustments. Based on the initial conversion price, approximately 6,975,000 shares of common stock would be issuable upon conversion of all of the outstanding shares of the Series A Convertible Preferred Stock.

 

The annual dividend on each share of Series A Convertible Preferred Stock is 4.875% on the liquidation preference of $50 per share and is payable quarterly, in arrears, on each January 1, April 1, July 1 and October 1, commencing on January 1, 2013, when, as and if declared by the Company’s Board of Directors (the “Board”). No dividends were accrued or accumulated prior to September 17, 2012. The Company may, at its option, pay dividends in cash and, subject to certain conditions, common stock or any combination thereof.  As of September 30, 2013, there were $1.8 million in accrued dividends that had been declared but had not yet been paid.

 

Except as required by law or the Company’s Amended and Restated Certificate of Incorporation, holders of the Series A Convertible Preferred Stock will have no voting rights unless dividends fall into arrears for six or more quarterly periods (whether or not consecutive). In that event and until such arrearage is paid in full, the holders of the Series A Convertible Preferred Stock and the holders of the Series B Convertible Preferred Stock, voting as a single class, will be entitled to elect two directors and the number of directors on the Company’s Board will increase by that same number.

 

At any time on or after October 5, 2017, the Company may at its option cause all outstanding shares of the Series A Convertible Preferred Stock to be automatically converted into common stock at the then-prevailing conversion price, if, among other conditions, the closing sale price (as defined) of the Company’s common stock equals or exceeds 130% of the then-prevailing conversion price for a specified period prior to the conversion.

 

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If a holder elects to convert shares of Series A Convertible Preferred Stock upon the occurrence of certain specified fundamental changes, the Company will be obligated to deliver an additional number of shares above the applicable conversion rate to compensate the holder for lost option time value of the shares of Series A Convertible Preferred Stock as a result of the fundamental change.

 

Series B Convertible Preferred Stock Offering - On March 26, 2013, the Company completed a private placement of 4,500,000 shares of Series B Convertible Preferred Stock, which were sold in a private offering to eligible purchasers. The issue price of each share of the Series B Convertible Preferred Stock was $50.00. The Company received net proceeds from the private placement of approximately $216.6 million, after deducting placement agent’s fees and offering costs payable by the Company of approximately $8.4 million.

 

Pursuant to the Certificate of Designations for the Series B Convertible Preferred Stock, each share of Series B Convertible Preferred Stock is convertible at any time at the option of the holder thereof at an initial conversion rate of 2.3370 shares of common stock per share of Series B Convertible Preferred Stock (which is equal to an initial conversion price of approximately $21.40 per share of common stock) and is subject to specified adjustments. Based on the initial conversion price, approximately 10,516,500 shares of common stock would be issuable upon conversion of all of the outstanding shares of the Series B Convertible Preferred Stock.

 

The annual dividend on each share of Series B Convertible Preferred Stock is 6.500% on the liquidation preference of $50 per share and is payable quarterly, in arrears, on each January 1, April 1, July 1 and October 1, commencing on July 1, 2013, when, as and if declared by the Company’s Board. No dividends were accrued or accumulated prior to March 27, 2013. The Company may, at its option, pay dividends in cash and, subject to certain conditions, common stock or any combination thereof.  As of September 30, 2013, there were $3.7 million in accrued dividends that had been declared but had not yet been paid.

 

Except as required by law or the Company’s Amended and Restated Certificate of Incorporation, holders of the Series B Convertible Preferred Stock will have no voting rights unless dividends fall into arrears for six or more quarterly periods (whether or not consecutive). In that event and until such arrearage is paid in full, the holders of the Series B Convertible Preferred Stock and the holders of the Series A Convertible Preferred Stock, voting as a single class, will be entitled to elect two directors and the number of directors on the Company’s Board will increase by that same number.

 

At any time on or after April 6, 2018, the Company may at its option cause all outstanding shares of the Series B Convertible Preferred Stock to be automatically converted into common stock at the then-prevailing conversion price, if, among other conditions, the closing sale price (as defined) of the Company’s common stock equals or exceeds 130% of the then-prevailing conversion price for a specified period prior to the conversion.

 

If a holder elects to convert shares of Series B Convertible Preferred Stock upon the occurrence of certain specified fundamental changes, the Company will be obligated to deliver an additional number of shares above the applicable conversion rate to compensate the holder for lost option time value of the shares of Series B Convertible Preferred Stock as a result of the fundamental change.

 

Earnings (Loss) Per Share - The following table shows the computation of basic and diluted net earnings (loss) per share for the three and nine months ended September 30, 2013 and 2012 (in thousands, except per share amounts):

 

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Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

3,880

 

$

1,667

 

$

12,696

 

$

(17,024

)

Less:

 

 

 

 

 

 

 

 

 

Preferred stock dividends

 

(5,485

)

(264

)

(13,041

)

(264

)

Net income allocable to participating securities(1)

 

 

(21

)

 

 

Net income (loss) attributable to common stockholders

 

$

(1,605

)

$

1,382

 

$

(345

)

$

(17,288

)

 

 

 

 

 

 

 

 

 

 

Weighted average number of unrestricted outstanding common shares used to calculate basic net income (loss) per share

 

34,737

 

33,000

 

33,651

 

33,000

 

Dilutive shares (2)(3)(4)

 

 

 

 

 

Denominator for diluted net income (loss) per common share

 

34,737

 

33,000

 

33,651

 

33,000

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per common share - basic and diluted

 

$

(0.05

)

$

0.04

 

$

(0.01

)

$

(0.52

)

 


(1) For the three and nine months ended September 30, 2013, no losses were allocated to participating restricted stock because such securities do not have a contractual obligation to share in the Company’s losses.

(2) The three and nine months ended September 30, 2013 excludes 410,779 and 625,920 shares of weighted average restricted stock and 17,491,500 and 14,141,800 shares of common stock, respectively, resulting from an assumed conversion of the Company’s Series A Convertible Preferred Stock and Series B Convertible Preferred Stock from the calculation of the denominator for diluted earnings per common share as we were in a loss position.

(3) The three months ended September 30, 2012 excludes 71,842 shares of weighted average restricted stock from the calculation of the denominator for diluted earnings per common share as these shares were anti-dilutive. The nine months ended September 30, 2012, excludes 254,757 shares of weighted average restricted stock from the calculation of the denominator for diluted earnings per common share as we were in a loss position.

(4) The three and nine months ended September 30, 2012 exclude 996,429 and 330,931 shares of common stock, respectively, resulting from an assumed conversion of the Company’s Series A Convertible Preferred Stock and Series B Convertible Preferred Stock from the calculation of the denominator for diluted earnings per common share as these shares were anti-dilutive.

 

Note 14. Stock-Based Compensation

 

At the Annual Meeting of Stockholders of the Company held on May 23, 2012, the Company’s stockholders approved the Sanchez Energy Corporation Amended and Restated 2011 Long Term Incentive Plan (the “LTIP”). The Company’s Board had previously approved the amendment of the Sanchez Energy Corporation 2011 Long Term Incentive Plan on April 16, 2012, subject to stockholder approval.

 

The LTIP provides for the award of stock options, stock appreciation rights, restricted stock, phantom stock, other stock-based awards or stock awards, or any combination thereof.  Any director or consultant of the Company or any employee of the Company, a subsidiary of the Company or a Sanchez Group Member (as defined in the LTIP) is eligible to participate in the LTIP. The LTIP provides that the maximum number of shares of the Company’s common stock available for incentive awards shall be no more than 15% of the issued and outstanding shares of common stock.

 

The Company records stock-based compensation expense for awards granted to its directors (for their services as directors) in accordance with the provisions of ASC 718, “Compensation — Stock Compensation.”  Stock-based compensation expense for these awards is based on the grant-date fair value and recognized over the vesting period using the straight-line method. The fair value of restricted stock awards is based on the closing sales price of the Company’s common stock on the grant date.

 

Awards granted to employees of the Sanchez Group (including those employees of the Sanchez Group who also serve as the Company’s officers) and consultants in exchange for services are considered awards to non-employees and the Company records stock-based compensation expense for these awards at fair value in accordance with the provisions of ASC 505-50, “Equity-Based Payments to Non-Employees.”   For awards granted to non-employees, the Company records compensation expenses equal to the fair value of the stock-based award at the measurement date, which is determined to be the earlier of the performance commitment date or the service completion date.  Compensation expense for unvested awards to non-employees is revalued at each period end and is

 

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amortized over the vesting period of the stock-based award.  Stock-based payments are measured based on the fair value of goods or services received or the equity instruments granted, whichever is more determinable.

 

For the restricted stock awards granted to non-employees, stock-based compensation expense is based on fair value remeasured at each reporting period and recognized over the vesting period using the straight-line method.  Compensation expense for these awards will be revalued at each period end until vested.

 

The Company recognized the following stock-based compensation expense for the periods indicated which is reflected as general and administrative expense in the consolidated statements of operations (in thousands):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

Restricted stock awards, directors

 

$

242

 

$

91

 

$

473

 

$

184

 

Restricted stock awards, non-employees

 

6,415

 

745

 

13,896

 

2,308

 

Restricted stock awards, cancelled

 

 

 

 

22,308

 

Total stock-based compensation expense

 

$

6,657

 

$

836

 

$

14,369

 

$

24,800

 

 

Based on the $26.41 per share closing price of the Company’s common stock on September 30, 2013, there was approximately $34.5 million of unrecognized compensation cost related to these non-vested restricted shares outstanding.  The cost is expected to be recognized over an average period of approximately 2.0 years.

 

A summary of the status of the non-vested shares as of September 30, 2013 is presented below (in thousands):

 

 

 

Number of
Non-Vested
Shares

 

Non-vested common stock at January 1,

 

762

 

Granted

 

1,329

 

Vested

 

(185

)

Forfeited

 

(71

)

Non-vested common stock at September 30,

 

1,835

 

 

As of September 30, 2013, approximately 4.7 million shares remain available for future issuance to participants.

 

Note 15. Income Taxes

 

The SEP I Assets contributed by SEP I were historically owned by a limited partnership that is not a taxable entity and is a disregarded entity for federal income tax purposes.  SEP I’s taxable income or loss was allocated to the limited and general partners of SEP I.  With the transfer of the properties to the Company, the SEP I Assets’ operations are now subject to federal and state income taxes.

 

The Company’s estimated annual effective income tax rates are used to allocate expected annual income tax expense to interim periods. The rates are determined based on the ratio of estimated annual income tax expense to estimated annual income before income taxes by taxing jurisdiction, except for discrete items, which are significant, unusual or infrequent items for which income taxes are computed and recorded in the interim period in which the specific transaction occurs. The estimated annual effective income tax rates are applied to the year-to-date income before income taxes by taxing jurisdiction to determine the income tax expense allocated to the interim period. The Company updates its estimated annual effective income tax rate at the end of each quarterly period

 

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considering the geographic mix of income based on the tax jurisdictions in which the Company operates. Actual results that are different from the assumptions used in estimating the annual effective income tax rate will impact future income tax expense. The difference between the statutory federal income taxes calculated using a U.S. federal statutory corporate income tax rate of 35% and the Company’s effective tax rate is summarized as follows (in thousands):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

 

 

 

 

 

 

 

 

 

 

Income tax expense (benefit) at the statutory rate

 

$

74

 

$

584

 

$

3,160

 

$

(5,958

)

Rescission of restricted stock

 

 

 

 

7,808

 

Change in valuation allowance

 

(3,742

)

(584

)

(6,828

)

(1,850

)

Net income tax (benefit)

 

$

(3,668

)

$

 

$

(3,668

)

$

 

 

At September 30, 2013, the Company had estimated net operating loss carryforwards of $348.2 million which begin to expire in 2031.

 

In recording deferred income tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred income tax assets will be realized.  The ultimate realization of deferred income tax assets is dependent upon the generation of future taxable income during the periods in which those deferred income tax assets would be deductible.  The Company believes that after considering all the available objective evidence, both positive and negative, historical and prospective, with greater weight given to historical evidence, management has determined that it is more likely than not that the deferred tax assets will be realized and therefore has released the valuation allowance against its net deferred tax asset in the third quarter of 2013.  The Company will continue to assess the valuation allowance against deferred tax assets considering all available information obtained in future reporting periods.

 

At September 30, 2013, the Company had no material uncertain tax positions.

 

Note 16. Commitments and Contingencies

 

From time to time, the Company may be involved in lawsuits that arise in the normal course of its business. It is the opinion of management and counsel that the outcome of any such lawsuits will not materially affect the financial position and operations of the Company.

 

Note 17.  Subsidiary Guarantors

 

The Company has filed a registration statement on Form S-3 with the SEC, which became effective January 14, 2013 and registered, among other securities, debt securities.  The subsidiaries of the Company (the “Subsidiaries”) are co-registrants with the Company, and the registration statement registers guarantees of debt securities by the Subsidiaries. As of September 30, 2013, the Subsidiaries are 100 percent owned by the Company and any guarantees by the Subsidiaries will be full and unconditional (except for customary release provisions). The Company has no assets or operations independent of the Subsidiaries and there are no significant restrictions upon the ability of the Subsidiaries to distribute funds to the Company. In the event that more than one of the Subsidiaries provide guarantees of any debt securities issued by the Company, such guarantees will constitute joint and several obligations.

 

Note 18. Subsequent Events

 

On October 4, 2013, the Company completed the Wycross acquisition, consisting of operated assets with an average working interest of approximately 60% in net contiguous acres in McMullen County, Texas, with an effective date of July 1, 2013, for approximately $230.1 million, subject to further customary post-closing adjustments.

 

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In October 2013, the Company entered into the following crude oil swap contracts using WTI prices:

 

 

 

Derivative