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SM Energy Co 10-Q 2014

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Graphic
  6. Graphic
SM-3.31.2014-10Q



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

FORM 10-Q

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

For the quarterly period ended March 31, 2014
Commission File Number 001-31539
SM ENERGY COMPANY
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction
of incorporation or organization)
 
41-0518430
(I.R.S. Employer
Identification No.)

1775 Sherman Street, Suite 1200, Denver, Colorado
(Address of principal executive offices)
 
80203
(Zip Code)

(303) 861-8140
(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 þ No o

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer þ
 
Accelerated filer o
 
 
 
Non-accelerated filer o  
(Do not check if a smaller reporting company)
 
Smaller reporting company o

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

As of April 23, 2014, the registrant had 67,058,145 shares of common stock, $0.01 par value, outstanding.



1


SM ENERGY COMPANY
INDEX
PAGE
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2


PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SM ENERGY COMPANY AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
(in thousands, except share amounts)
 
March 31,
2014
 
December 31,
2013
 ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
236,435

 
$
282,248

Accounts receivable
307,784

 
318,371

Derivative asset
7,450

 
21,559

Deferred income taxes
11,227

 
10,749

Prepaid expenses and other
14,446

 
14,574

Total current assets
577,342

 
647,501

 
 
 
 
Property and equipment (successful efforts method):
 
 
 
Proved oil and gas properties
5,875,541

 
5,637,462

Less - accumulated depletion, depreciation, and amortization
(2,722,287
)
 
(2,583,698
)
Unproved oil and gas properties
287,607

 
271,100

Wells in progress
277,879

 
279,654

Oil and gas properties held for sale net of accumulated depletion, depreciation and amortization of $31,766 in 2014 and $7,390 in 2013
42,276

 
19,072

Other property and equipment, net of accumulated depreciation of $31,013 in 2014 and $28,775 in 2013
243,680

 
236,202

Total property and equipment, net
4,004,696

 
3,859,792

 
 
 
 
Noncurrent assets:
 
 
 
Derivative asset
13,886

 
30,951

Restricted cash
23,753

 
96,713

Other noncurrent assets
69,334

 
70,208

Total other noncurrent assets
106,973

 
197,872

Total Assets
$
4,689,011

 
$
4,705,165

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable and accrued expenses
$
443,395

 
$
606,751

Derivative liability
60,684

 
26,380

Other current liabilities
11,200

 
6,000

Total current liabilities
515,279

 
639,131

 
 
 
 
Noncurrent liabilities:
 
 
 
Revolving credit facility

 

Senior Notes (note 5)
1,600,000

 
1,600,000

Asset retirement obligation
115,889

 
115,659

Asset retirement obligation associated with oil and gas properties held for sale
4,526

 
3,033

Net Profits Plan liability
55,209

 
56,985

Deferred income taxes
688,994

 
650,125

Derivative liability
7,885

 
4,640

Other noncurrent liabilities
25,810

 
28,771

Total noncurrent liabilities
2,498,313

 
2,459,213

 
 
 
 
Commitments and contingencies (note 6)


 


 
 
 
 
Stockholders’ equity:
 
 
 
Common stock, $0.01 par value - authorized: 200,000,000 shares; issued: 67,078,853 shares in 2014 and 2013; outstanding, net of treasury shares: 67,056,441 shares in 2014 and 2013
671

 
671

Additional paid-in capital
264,064

 
257,720

Treasury stock, at cost: 22,412 shares in 2014 and 2013
(823
)
 
(823
)
Retained earnings
1,416,923

 
1,354,669

Accumulated other comprehensive loss
(5,416
)
 
(5,416
)
Total stockholders’ equity
1,675,419

 
1,606,821

Total Liabilities and Stockholders’ Equity
$
4,689,011

 
$
4,705,165

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

3


SM ENERGY COMPANY AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(in thousands, except per share amounts)

 
For the Three Months Ended March 31,
 
2014
 
2013
Operating revenues:
 
 
 
Oil, gas, and NGL production revenue
$
623,109


$
469,575

Other operating revenues
9,611


14,605

Total operating revenues
632,720


484,180







Operating expenses:





Oil, gas, and NGL production expense
163,709


125,633

Depletion, depreciation, amortization, and asset retirement obligation liability accretion
177,215


198,709

Exploration
21,335

 
15,398

Impairment of properties
2,801

 
21,521

General and administrative
35,051

 
32,280

Change in Net Profits Plan liability
(1,776
)

(1,925
)
Derivative loss
97,662

 
30,572

Other operating expense
8,089


15,794

Total operating expenses
504,086


437,982







Income from operations
128,634


46,198







Non-operating income (expense):





Interest income
26


12

Interest expense
(24,190
)

(19,101
)






Income before income taxes
104,470


27,109

Income tax expense
(38,863
)

(10,382
)






Net income
$
65,607


$
16,727







Basic weighted-average common shares outstanding
67,056


66,211







Diluted weighted-average common shares outstanding
68,126


67,521







Basic net income per common share
$
0.98


$
0.25







Diluted net income per common share
$
0.96


$
0.25







Dividends per common share
$
0.05


$
0.05


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

4


SM ENERGY COMPANY AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
(in thousands)
 
For the Three Months Ended March 31,
 
 
2014
 
2013
 
 
 
 
Net income
$
65,607

 
$
16,727

Other comprehensive income (loss), net of tax:
 
 
 
Reclassification to earnings (1)

 
61

Pension liability adjustment

 
(3
)
Total other comprehensive income, net of tax

 
58

Total comprehensive income
$
65,607

 
$
16,785

(1) Reclassification from accumulated other comprehensive income (loss) (AOCIL) related to de-designated hedges. As of December 31, 2013,
all commodity derivative contracts that had been designated as cash flow hedges were settled and reclassified into earnings from AOCIL.


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

5


SM ENERGY COMPANY AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(in thousands)

 
For the Three Months Ended March 31,
 
2014
 
2013
Cash flows from operating activities:
 
 
 
Net income
$
65,607

 
$
16,727

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
(Gain) loss on divestiture activity
(2,958
)
 
574

Depletion, depreciation, amortization, and asset retirement obligation liability accretion
177,215

 
198,709

Exploratory dry hole expense

 
159

Impairment of properties
2,801

 
21,521

Stock-based compensation expense
6,344

 
8,113

Change in Net Profits Plan liability
(1,776
)
 
(1,925
)
Derivative loss
97,662

 
30,572

Derivative cash settlement (loss) gain
(28,940
)
 
11,792

Amortization of deferred financing costs
1,477

 
1,077

Deferred income taxes
38,374

 
10,280

Plugging and abandonment
(1,325
)
 
(1,378
)
Other
(3,103
)
 
1,836

Changes in current assets and liabilities:
 
 
 
Accounts receivable
9,347

 
(22,164
)
Prepaid expenses and other
885

 
605

Accounts payable and accrued expenses
(61,882
)
 
5,794

Net cash provided by operating activities
299,728

 
282,292

 
 
 
 
Cash flows from investing activities:
 
 
 
Net proceeds from sale of oil and gas properties
1,979

 
4,307

Capital expenditures
(351,739
)
 
(381,185
)
Other
4,227

 
(2,025
)
Net cash used in investing activities
(345,533
)
 
(378,903
)
 
 
 
 
Cash flows from financing activities:
 
 
 
Proceeds from credit facility

 
223,500

Repayment of credit facility

 
(133,500
)
Other
(8
)
 
772

Net cash provided by (used in) financing activities
(8
)
 
90,772

 
 
 
 
Net change in cash and cash equivalents
(45,813
)
 
(5,839
)
Cash and cash equivalents at beginning of period
282,248

 
5,926

Cash and cash equivalents at end of period
$
236,435

 
$
87

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

6


SM ENERGY COMPANY AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (Continued)

Supplemental schedule of additional cash flow information and non-cash investing and financing activities:
 
For the Three Months Ended March 31,
 
2014
 
2013
 
(in thousands)
Cash paid for interest, net of capitalized interest
$
(37,851
)
 
$
(24,721
)
 
 
 
 
Net cash refunded for income taxes
$
14

 
$
165


Dividends of approximately $3.4 million were declared by the Company’s Board of Directors, but not paid, as of March 31, 2014. Dividends of approximately $3.3 million were declared by the Company’s Board of Directors, but not paid, as of March 31, 2013.

As of March 31, 2014, and 2013, $200.5 million and $202.8 million, respectively, of accrued capital expenditures were included in accounts payable and accrued expenses in the Company’s condensed consolidated balance sheets. These oil and gas property additions are reflected in cash used in investing activities in the periods during which the payables are settled.


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

7


SM ENERGY COMPANY AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

Note 1 - The Company and Business

SM Energy Company (“SM Energy” or the “Company”) is an independent energy company engaged in the acquisition, exploration, development, and production of crude oil and condensate, natural gas, and natural gas liquids (also respectively referred to as “oil,” “gas,” and “NGLs” throughout this report) in onshore North America, with a current focus on oil and liquids-rich resource plays.

Note 2 - Basis of Presentation, Significant Accounting Policies, and Recently Issued Accounting Standards

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of SM Energy have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and the instructions to Form 10-Q and Regulation S-X. They do not include all information and notes required by GAAP for complete financial statements. However, except as disclosed herein, there has been no material change in the information disclosed in the notes to consolidated financial statements included in SM Energy’s Annual Report on Form 10-K for the year ended December 31, 2013 (the “2013 Form 10-K”). In the opinion of management, all adjustments, consisting of normal recurring accruals considered necessary for a fair presentation of interim financial information, have been included. Operating results for the periods presented are not necessarily indicative of expected results for the full year. In connection with the preparation of its unaudited condensed consolidated financial statements, the Company evaluated events subsequent to the balance sheet date of March 31, 2014, through the filing date of this report.

Significant Accounting Policies

The significant accounting policies followed by the Company are set forth in Note 1 to the Company’s consolidated financial statements in its 2013 Form 10-K, and are supplemented by the notes to the unaudited condensed consolidated financial statements in this report. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the 2013 Form 10-K.

Recently Issued Accounting Standards

In April 2014, the Financial Accounting Standards Board issued new authoritative accounting guidance related to the recognition and presentation of discontinued operations in the financial statements. The guidance is aimed at reducing the frequency of disposals reported as discontinued operations by focusing on strategic shifts that have or will have a major effect on an entity’s operations and financial results. This authoritative accounting guidance is effective for interim and annual periods beginning after December 15, 2014, and is to be applied prospectively. The Company is currently evaluating the provisions of this authoritative guidance and assessing its impact, but does not currently believe it will have a material effect on the Company's financial statements or disclosures.
    
There are no other new significant accounting standards applicable to the Company that have been issued but not yet adopted by the Company as of March 31, 2014.

Note 3 – Acquisitions, Divestitures, and Assets Held for Sale
Acquisitions

Subsequent to March 31, 2014, the Company entered into separate agreements to acquire acreage in its Rocky Mountain region for total cash consideration of approximately $100.0 million plus approximately 7,000 net acres. These agreements are expected to close during the second quarter 2014 and are subject to standard closing conditions and normal closing and post-closing adjustments. No assurance can be given that the Company will successfully close any of these acquisitions.


8


Assets Held for Sale

Assets are classified as held for sale when the Company commits to a plan to sell the assets and there is reasonable certainty the sale will take place within one year. Upon classification as held for sale, long-lived assets are no longer depreciated or depleted, and a measurement for impairment is performed to identify and expense any excess of carrying value over fair value less estimated costs to sell. Subsequent decreases to the estimated fair value less the costs to sell will impact the measurement of assets held for sale.

As of March 31, 2014, the accompanying condensed consolidated balance sheets (“accompanying balance sheets”) present $42.3 million of oil and gas properties held for sale, net of accumulated depletion, depreciation, and amortization expense. A corresponding asset retirement obligation liability of $4.5 million is separately presented. The assets held for sale include the Company’s Marcellus shale assets located in Pennsylvania and other non-strategic assets in the Company’s Rocky Mountain region, all of which are recorded at the lesser of their carrying values or their respective fair value less estimated costs to sell. When write-downs to fair value less estimated costs to sell occur, they are reflected in gain (loss) on divestiture activity, which is included within the other operating revenues line item in the accompanying condensed consolidated statements of operations (“accompanying statements of operations”).

The Company determined that these planned asset sales do not qualify for discontinued operations accounting under financial statement presentation authoritative guidance.

Note 4 - Income Taxes

Income tax expense for the three months ended March 31, 2014, and 2013, differs from the amounts that would be provided by applying the statutory United States federal income tax rate to income before income taxes primarily due to the effect of state income taxes, changes in valuation allowances, percentage depletion, research and development (“R&D”) credits, and other permanent differences. The quarterly rate can also be impacted by the proportional effects of forecasted net income as of each period end presented.

The provision for income taxes consists of the following:

 
For the Three Months Ended March 31,
 
2014
 
2013
 
(in thousands)
Current portion of income tax expense:
 
 
 
Federal
$

 
$

State
489

 
102

Deferred portion of income tax expense
38,374

 
10,280

Total income tax expense
$
38,863

 
$
10,382

 
37.2
%
 
38.3
%


9


On a year-to-date basis, a change in the Company’s effective tax rate between reported periods will generally reflect differences in its estimated highest marginal state tax rate due to changes in the composition of income from Company activities among various state tax jurisdictions. Cumulative effects of state rate changes are reflected in the period legislation is enacted. The decrease in the effective rate from 2013 primarily reflects temporary and permanent changes in the mix of highest marginal state tax rates, the effects of valuation allowance adjustments, the state tax rate effect divestitures have between years, drilling activities, and changes in the effects of other permanent differences.

The Company and its subsidiaries file federal income tax returns and various state income tax returns. With certain exceptions, the Company is no longer subject to United States federal or state income tax examinations by tax authorities for years before 2007. Federal tax law allowing for the calculation of an R&D credit was enacted in 2013, which allowed the credit for the 2012 and 2013 tax years. However, the Company has not yet commissioned a study to calculate the credit for these tax years. The table above excludes the impact for any credit that would be allowed in 2013. The Internal Revenue Service (“IRS”) initiated an audit in the first quarter of 2012 related to R&D tax credits claimed by the Company for the 2007 through 2010 tax years. On April 23, 2013, the IRS issued a Notice of Proposed Adjustment disallowing $4.6 million of R&D tax credits claimed for open tax years during the audit period. The Company maintains it is entitled to the claimed credits and is pursuing its appeal.

On September 13, 2013, the United States Department of the Treasury and IRS issued the final and re-proposed tangible property regulations effective for tax years beginning January 1, 2014. The Company has determined it is materially compliant with the requirements of these regulations.

Note 5 - Long-term Debt

Revolving Credit Facility

The Company’s Fifth Amended and Restated Credit Agreement provides a maximum loan amount of $2.5 billion, current aggregate lender commitments of $1.3 billion, and a maturity date of April 12, 2018.  The borrowing base is subject to regular semi-annual redeterminations and was re-affirmed on March 28, 2014, at $2.2 billion. The borrowing base redetermination process under the credit facility considers the value of the Company’s oil and gas properties and other assets, as determined by the lender group. The next scheduled redetermination date is October 1, 2014. Borrowings under the facility are secured by at least 75 percent of the Company’s proved oil and gas properties. 
 
The Company must comply with certain financial and non-financial covenants under the terms of its credit facility agreement, including the limitation of the Company’s dividends to no more than $50.0 million per year.  The Company was in compliance with all covenants under the credit facility as of March 31, 2014, and through the filing date of this report.

The following table presents the outstanding balance, total amount of letters of credit, and available borrowing capacity under the Company’s credit facility as of April 23, 2014, March 31, 2014, and December 31, 2013:

 
As of April 23, 2014
 
As of March 31, 2014
 
As of December 31, 2013
 
(in thousands)
Credit facility balance
$

 
$

 
$

Letters of credit (1)
$
808

 
$
808

 
$
808

Available borrowing capacity
$
1,299,192

 
$
1,299,192

 
$
1,299,192

____________________________________________
(1) Letters of credit reduce the available borrowing capacity under the credit facility on a dollar-for-dollar basis.

10


Senior Notes
The Senior Notes line on the accompanying balance sheets represents the outstanding principal amount of the 6.625% Senior Notes due 2019 (the “2019 Notes”), the 6.50% Senior Notes due 2021 (the “2021 Notes”), the 6.50% Senior Notes due 2023 (the “2023 Notes”), and the 5.0% Senior Notes due 2024 (the “2024 Notes” and collectively with the 2019 Notes, 2021 Notes, and 2023 Notes, the “Senior Notes”), as shown in the table below:
 
As of March 31, 2014
 
As of December 31, 2013
 
(in thousands)
2019 Notes
$
350,000

 
$
350,000

2021 Notes
350,000

 
350,000

2023 Notes
400,000

 
400,000

2024 Notes
500,000

 
500,000

Total Senior Notes
$
1,600,000

 
$
1,600,000


The Senior Notes are unsecured senior obligations and rank equal in right of payment with all of the Company’s existing and any future unsecured senior debt, and are senior in right of payment to any future subordinated debt. There are no subsidiary guarantors of the Senior Notes.  The Company is subject to certain covenants under the respective indentures governing the Senior Notes that limit the Company’s ability to incur additional indebtedness, issue preferred stock, and make restricted payments, including dividends; provided, however, that the first $6.5 million of dividends paid each year are not restricted by these covenants. The Company was in compliance with all covenants under its Senior Notes as of March 31, 2014, and through the filing date of this report.
5.0% Senior Notes Due 2024
On May 20, 2013, the Company issued $500.0 million in aggregate principal amount of 2024 Notes. The 2024 Notes were issued at par and mature on January 15, 2024. Please refer to Note 5 - Long-term Debt in the Company’s 2013 Form 10-K for additional discussion of the terms of these notes.
On May 20, 2013, the Company entered into a registration rights agreement that provides holders of the 2024 Notes certain registration rights under the Securities Act of 1933, as amended (the “Securities Act”). Pursuant to the registration rights agreement, the Company filed an exchange offer registration statement with the Securities and Exchange Commission (“SEC”) on March 4, 2014, offering to exchange the 2024 Notes for substantially identical notes that are registered under the Securities Act. If the registration statement is not declared effective by the SEC on or before May 20, 2014, or if the shelf registration statement, if required, is not declared effective within the time periods specified in the registration rights agreement, the Company has agreed to pay additional interest with respect to the 2024 Notes in an amount not to exceed one percent of the principal amount of the 2024 Notes until the exchange offer is completed or the shelf registration statement is declared effective.

Note 6 - Commitments and Contingencies

Commitments

During the first quarter of 2014, and through the filing date of this report, the Company entered into drilling rig contracts with varying terms extending through 2016. The total commitments for these contracts is $52.7 million.

Contingencies

The Company is subject to litigation and claims arising in the ordinary course of business. The Company accrues for such items when a liability is both probable and the amount can be reasonably estimated. In the opinion of management, the results of such pending litigation and claims will not have a material effect on the results of operations, the financial position, or the cash flows of the Company.

On April 16, 2014, the Company agreed to settle its previously disclosed litigation against Endeavour Operating Corporation (“Endeavour”). The Company, its working interest partners, and Endeavour agreed to release all claims and dismiss the lawsuit in exchange for certain cash payments and other consideration paid to the Company and its working interest partners by Endeavour.


11


On January 27, 2011, Chieftain Royalty Company (“Chieftain”) filed a Class Action Petition against the Company in the District Court of Beaver County, Oklahoma, claiming damages related to royalty valuation on all of the Company’s Oklahoma wells. These claims include breach of contract, breach of fiduciary duty, fraud, unjust enrichment, tortious breach of contract, conspiracy, and conversion, based generally on asserted improper deduction of post-production costs. The Company removed this lawsuit to the United States District Court for the Western District of Oklahoma on February 22, 2011. The Company responded to the petition and denied the allegations. The district court did not rule on Chieftain’s motion to certify the putative class, and stayed all proceedings until the United States Court of Appeals for the Tenth Circuit issued its rulings on class certification in two similar royalty class action lawsuits. On July 9, 2013, the Tenth Circuit issued its opinions, reversing the trial courts’ grant of class certification and remanding the matters to the trial courts for those cases. The district court presiding over the Company’s case subsequently lifted its stay, and the Company expects Chieftain to file a new motion for class certification in the first half of 2015.

This case involves complex legal issues and uncertainties; a potentially large class of plaintiffs, and a large number of related producing properties, lease agreements and wells; and an alleged class period commencing in 1988 and spanning the entire producing life of the wells. Because the proceedings are in the early stages, with discovery yet to be completed, the Company is unable to estimate what impact, if any, the action will have on its financial condition, results of operations, or cash flows. The Company is still evaluating the claims, but believes that it has properly paid royalties under Oklahoma law and has and will continue to vigorously defend this case. On December 30, 2013, the Company sold a substantial portion of the assets that are subject to this matter and the buyer assumed any such liabilities related to such properties.

Note 7 - Compensation Plans

Cash Bonus Plan

During the first quarters of 2014 and 2013, the Company paid $41.7 million and $16.0 million, respectively, for cash bonuses earned during the 2013 and 2012 performance years, respectively. The general and administrative (“G&A”) expense and exploration expense line items in the accompanying statements of operations include $6.6 million and $5.6 million of accrued cash bonus plan expense for the three months ended March 31, 2014, and 2013, respectively, related to the respective performance years.

Non-qualified Deferred Compensation Plan

In January 2014, the Company established a non-qualified deferred compensation (“NQDC”) plan intended to provide plan participants with the ability to plan for income tax events and the opportunity to receive a benefit for matching contributions in excess of Internal Revenue Code (“IRC”) limits applicable to the Company’s 401(k) plan. The NQDC plan is designed to allow participants to defer a portion of base salary and cash bonuses paid pursuant to the Company’s cash bonus plan. Each year, participating employees may elect to defer (i) between 0% and 50% of their base salary, and (ii) between 0% and 100% of the cash bonus paid pursuant to the cash bonus plan. The NQDC plan requires the Company to make contributions for each eligible employee equal to 100% of the deferred amount for such employee, limited to 6% of such employee’s base salary and cash bonus. Each eligible employee’s interest in the contributions the Company makes will vest 40% after the second year of such employee’s service to the Company, and 20% per year thereafter. A participant’s account will be distributed based upon the participant’s payment election made at the time of deferral. A participant may elect to have distributions made in lump sum or in annual installments ranging for a period from 1 to 10 years. Participants in the NQDC plan are currently limited to the Company’s officers and directors.

Restricted Stock Units Under the Equity Incentive Compensation Plan

The Company grants restricted stock units (“RSUs”) as part of its equity compensation program. Each RSU represents a right to one share of the Company’s common stock to be delivered upon settlement of the award at the end of the specified vesting period. Expense associated with RSUs is recognized as G&A expense and exploration expense over the vesting period of the award.

Total expense recorded for RSUs for the three months ended March 31, 2014, and 2013, was $2.8 million and $3.0 million, respectively. As of March 31, 2014, there was $15.9 million of total unrecognized compensation expense related to unvested RSU awards, which is being amortized through 2016. There have been no material changes to the outstanding and non-vested RSUs during the three months ended March 31, 2014.


12


Performance Stock Units Under the Equity Incentive Compensation Plan

The Company grants performance share units (“PSUs”) as part of its equity compensation program. The number of shares of the Company’s common stock issued to settle PSUs ranges from 0% to 200% of the number of PSUs awarded and is determined based on the Company’s performance over a three-year measurement period. The performance criteria for the PSUs are based on a combination of the Company’s annualized total shareholder return (“TSR”) for the measurement period and the relative measure of the Company’s TSR compared with the annualized TSRs of a group of peer companies for the measurement period. Expense associated with PSUs is recognized as G&A expense and exploration expense over the vesting period of the award.

Total expense recorded for PSUs for the three months ended March 31, 2014, and 2013, was $3.2 million and $4.7 million, respectively. As of March 31, 2014, there was $14.9 million of total unrecognized compensation expense related to unvested PSU awards, which is being amortized through 2016. There have been no material changes to the outstanding and non-vested PSUs during the three months ended March 31, 2014.

Stock Option Grants Under the Equity Incentive Compensation Plan

As of March 31, 2014, there were 39,088 stock option awards outstanding at a weighted average exercise price of $20.87 with an aggregate intrinsic value of $2.0 million. There was no unrecognized compensation expense as of March 31, 2014, and no changes in these awards occurred during the quarter.
Net Profits Interest Bonus Plan

Cash payments made or accrued under the Company’s Net Profits Interest Bonus Plan (“Net Profits Plan”) that have been recorded as either G&A expense or exploration expense are presented in the table below:

 
For the Three Months Ended March 31,
 
2014
 
2013
 
(in thousands)
General and administrative expense
$
2,978

 
$
3,786

Exploration expense
288

 
374

Total
$
3,266

 
$
4,160

    
The Company records changes in the present value of estimated future payments under the Net Profits Plan as a separate line item in the accompanying statements of operations. The change in the estimated liability is recorded as a non-cash expense or benefit in the current period and is not allocated to G&A expense or exploration expense because it is associated with the future net cash flows from oil and gas properties in the respective pools rather than results being realized through current period production. If the Company allocated the change in liability to these specific functional line items, based on the current allocation of actual distributions made by the Company, such expenses or benefits would predominately be allocated to G&A expense. Over time, less of the amount distributed relates to prospective exploration efforts as more of the amount distributed is paid to employees that have terminated employment and do not provide ongoing exploration support to the Company.

Note 8 - Pension Benefits

Pension Plans

The Company has a non-contributory pension plan covering substantially all employees who meet age and service requirements (the “Qualified Pension Plan”). The Company also has a supplemental non-contributory pension plan covering certain management employees (the “Nonqualified Pension Plan” and together with the Qualified Pension Plan, the “Pension Plans”).


13


Components of Net Periodic Benefit Cost for the Pension Plans

The following table presents the components of the net periodic benefit cost for the Pension Plans:
 
For the Three Months Ended March 31,
 
2014
 
2013
 
(in thousands)
Service cost
$
1,573

 
$
1,232

Interest cost
407

 
345

Expected return on plan assets that reduces periodic pension costs
(385
)
 
(286
)
Amortization of prior service costs
4

 
4

Amortization of net actuarial loss
306

 
197

Net periodic benefit cost
$
1,905

 
$
1,492


Prior service costs are amortized on a straight-line basis over the average remaining service period of active participants. Gains and losses in excess of 10 percent of the greater of the benefit obligation and the market-related value of assets are amortized over the average remaining service period of active participants.

Contributions

The Company contributed $5.3 million to the Pension Plans during the three month period ended March 31, 2014.



14


Note 9 - Earnings per Share

Basic net income per common share is calculated by dividing net income available to common stockholders by the basic weighted-average common shares outstanding for the respective period. The Company’s earnings per share calculations reflect the impact of any repurchases of shares of common stock made by the Company.

Diluted net income per common share is calculated by dividing adjusted net income by the diluted weighted-average common shares outstanding, which includes the effect of potentially dilutive securities. Potentially dilutive securities for this calculation consist of in-the-money outstanding stock options, unvested RSUs, and contingent PSUs. The treasury stock method is used to measure the dilutive impact of unvested RSUs, contingent PSUs, and in-the-money stock options.

PSUs represent the right to receive, upon settlement of the PSUs after completion of the three-year performance period, a number of shares of the Company’s common stock that may range from 0% to 200% of the number of PSUs granted on the award date. The number of potentially dilutive shares related to PSUs is based on the number of shares, if any, that would be issuable at the end of the respective reporting period, assuming that date was the end of the contingency period applicable to such PSUs. For additional discussion on PSUs, please refer to Note 7 - Compensation Plans under the heading Performance Stock Units Under the Equity Incentive Compensation Plan.

The following table sets forth the calculations of basic and diluted earnings per share:
 
For the Three Months Ended March 31,
 
2014
 
2013
 
(in thousands, except per share amounts)
Net income
$
65,607

 
$
16,727

Basic weighted-average common shares outstanding
67,056

 
66,211

Add: dilutive effect of stock options, unvested RSUs, and contingent PSUs
1,070

 
1,310

Diluted weighted-average common shares outstanding
68,126

 
67,521

Basic net income per common share
$
0.98

 
$
0.25

Diluted net income per common share
$
0.96

 
$
0.25


Note 10 - Derivative Financial Instruments

Summary of Oil, Gas, and NGL Derivative Contracts in Place
    
The Company has entered into various commodity derivative contracts to mitigate a portion of its exposure to potentially adverse market changes in commodity prices and the associated impact on cash flows. All contracts are entered into for other-than-trading purposes. The Company’s derivative contracts include swap and costless collar arrangements for oil, gas, and NGLs.
    
As of March 31, 2014, and through the filing date of this report, the Company has commodity derivative contracts outstanding through the second quarter of 2018 for a total of 17.0 million Bbls of oil production, 216.6 million MMBtu of gas production, and 2.9 million Bbls of NGL production.

In a typical commodity swap agreement, if the agreed upon published third-party index price is lower than the swap fixed price, the Company receives the difference between the index price and the agreed upon swap fixed price. If the index price is higher than the swap fixed price, the Company pays the difference.  For collar agreements, the Company receives the difference between an agreed upon index and the floor price if the index price is below the floor price.  The Company pays the difference between the agreed upon ceiling price and the index price if the index price is above the ceiling price.  No amounts are paid or received if the index price is between the floor and ceiling prices.

15



The following tables summarize the approximate volumes and average contract prices of contracts the Company had in place as of March 31, 2014, and through the filing date of this report:

Oil Contracts

Oil Swaps


Contract Period
 
NYMEX WTI Volumes
 
Weighted-Average
 Contract Price
 
 
(Bbls)
 
(per Bbl)
Second quarter 2014
 
2,373,000

 
$
94.95

Third quarter 2014
 
1,533,000

 
$
96.04

Fourth quarter 2014
 
1,353,000

 
$
94.88

2015
 
3,308,000

 
$
89.34

2016
 
2,704,000

 
$
85.19

All oil swaps
 
11,271,000

 
 

Oil Collars
Contract Period
 
NYMEX WTI
 Volumes
 
Weighted-
Average Floor
 Price
 
Weighted-
Average Ceiling
 Price
 
 
(Bbls)
 
(per Bbl)
 
(per Bbl)
Second quarter 2014
 
431,000

 
$
85.00

 
$
102.50

Third quarter 2014
 
973,000

 
$
85.00

 
$
102.58

Fourth quarter 2014
 
923,000

 
$
85.00

 
$
102.63

2015
 
3,366,000

 
$
85.00

 
$
94.25

All oil collars
 
5,693,000

 
 
 
 

Gas Contracts

Gas Swaps
Contract Period
 
Volumes
 
Weighted-Average
 Contract Price
 
 
(MMBtu)
 
(per MMBtu)
Second quarter 2014
 
23,758,000

 
$
3.98

Third quarter 2014
 
24,541,000

 
$
4.02

Fourth quarter 2014
 
22,014,000

 
$
4.02

2015
 
57,943,000

 
$
4.04

2016
 
37,472,000

 
$
4.17

2017
 
23,430,000

 
$
4.21

2018
 
10,200,000

 
$
4.31

All gas swaps*
 
199,358,000

 
 

*Gas swaps are comprised of IF El Paso Permian (3%), IF HSC (83%), IF NGPL TXOK (2%), IF NNG Ventura (3%), IF Reliant N/S (8%), and IF CIG N System (1%).

16



Gas Collars
Contract Period
 
Volumes
 
Weighted-
Average Floor
Price
 
Weighted-
Average Ceiling
Price
 
 
(MMBtu)
 
(per MMBtu)
 
(per MMBtu)
Second quarter 2014
 
4,194,000

 
$
4.38

 
$
5.29

2015
 
13,002,000

 
$
3.98

 
$
4.30

All gas collars*
 
17,196,000

 
 
 
 

*Gas collars are comprised of IF El Paso Permian (3%), IF HSC (64%), IF NGPL TXOK (3%), IF NNG Ventura (6%), IF Reliant N/S (16%), and IF TETCO STX (8%).

NGL Contracts

NGL Swaps
Contract Period
 
Volumes
 
Weighted-Average
 Contract Price
 
 
(Bbls)
 
(per Bbl)
Second quarter 2014
 
1,096,000

 
$
58.04

Third quarter 2014
 
960,000

 
$
58.06

Fourth quarter 2014
 
861,000

 
$
58.06

All NGL swaps*
 
2,917,000

 
 

*NGL swaps are comprised of Oil Price Information System (“OPIS”) Mont Belvieu LDH Propane (72%) and OPIS Mont Belvieu NON-LDH Natural Gasoline (28%).

Derivative Assets and Liabilities Fair Value

The Company’s commodity derivatives are measured at fair value and are included in the accompanying balance sheets as derivative assets and liabilities. The fair value of the commodity derivative contracts was a net liability of $47.2 million and net asset of $21.5 million at March 31, 2014, and December 31, 2013, respectively.

The following tables detail the fair value of derivatives recorded in the accompanying balance sheets, by category:

 
As of March 31, 2014
 
Derivative Assets
 
Derivative Liabilities
 
Balance Sheet
 Classification
 
Fair Value
 
Balance Sheet
 Classification
 
Fair Value
 
(in thousands)
Commodity contracts
Current assets
 
$
7,450

 
Current liabilities
 
$
60,684

Commodity contracts
Noncurrent assets
 
13,886

 
Noncurrent liabilities
 
7,885

Derivatives not designated as hedging instruments
 
 
$
21,336

 
 
 
$
68,569


 
As of December 31, 2013
 
Derivative Assets
 
Derivative Liabilities
 
Balance Sheet
 Classification
 
Fair Value
 
Balance Sheet
 Classification
 
Fair Value
 
(in thousands)
Commodity contracts
Current assets
 
$
21,559

 
Current liabilities
 
$
26,380

Commodity contracts
Noncurrent assets
 
30,951

 
Noncurrent liabilities
 
4,640

Derivatives not designated as hedging instruments
 
 
$
52,510

 
 
 
$
31,020


17



Offsetting of Derivative Assets and Liabilities

As of March 31, 2014, and December 31, 2013, all derivative instruments held by the Company were subject to enforceable master netting arrangements held by various financial institutions. In general, the terms of the Company’s agreements provide for offsetting of amounts payable or receivable between it and the counterparty, at the election of both parties, for settlements that occur on the same date and in the same currency. The Company’s agreements also provide that in the event of an early termination, the counterparties have the right to offset amounts owed or owing under that and any other agreement with the same counterparty. The Company’s accounting policy is to not offset these positions in its accompanying balance sheets.
 
The following table provides a reconciliation between the gross assets and liabilities reflected on the accompanying balance sheets and the potential effects of master netting arrangements on the fair value of the Company’s derivative contracts:

 
 
Derivative Assets
 
Derivative Liabilities
 
 
As of
 
As of
Offsetting of Derivative Assets and Liabilities
 
March 31, 2014
 
December 31, 2013
 
March 31, 2014
 
December 31, 2013
 
 
(in thousands)
Gross amounts presented in the accompanying balance sheets
 
$
21,336

 
$
52,510

 
$
(68,569
)
 
$
(31,020
)
Amounts not offset in the accompanying balance sheets
 
(21,336
)
 
(30,652
)
 
21,336

 
30,652

Net amounts
 
$

 
$
21,858

 
$
(47,233
)
 
$
(368
)
    
The following table summarizes the components of the derivative loss presented in the accompanying statements of operations:

 
For the Three Months Ended March 31,
 
2014
 
2013
 
(in thousands)
Derivative cash settlement loss (gain):
 
 
 
Oil contracts
$
6,758

 
$
277

Gas contracts
13,404

 
(9,824
)
NGL contracts
8,778

 
(2,245
)
Total derivative cash settlement loss (gain) (1)
28,940


(11,792
)
 
 
 
 
Derivative loss (gain):
 
 
 
Oil contracts
25,192

 
3,789

Gas contracts
46,057

 
40,069

NGL contracts
(2,527
)
 
(1,494
)
Total derivative loss (2)
$
97,662


$
30,572

____________________________________________
(1) 
Total derivative cash settlement loss (gain) is reported in the derivative cash settlement (loss) gain line item on the condensed consolidated statements of cash flows within net cash provided by operating activities.
(2) 
Total derivative loss is reported in the derivative loss line item on the condensed consolidated statements of cash flows within cash provided by operating activities.

Credit Related Contingent Features

As of March 31, 2014, and through the filing date of this report, all of the Company’s derivative counterparties were members of the Company’s credit facility lender group. The Company’s obligations under its derivative contracts are secured by liens on at least 75 percent of the Company’s proved oil and gas properties.


18


Note 11 - Fair Value Measurements

The Company follows fair value measurement authoritative accounting guidance for all assets and liabilities measured at fair value. That authoritative accounting guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date. Market or observable inputs are the preferred sources of values, followed by assumptions based on hypothetical transactions in the absence of market inputs. The fair value hierarchy for grouping these assets and liabilities is based on the significance level of the following inputs:
Level 1 – quoted prices in active markets for identical assets or liabilities
Level 2 – quoted prices in active markets for similar assets or liabilities, quoted prices for identical or similar instruments in markets that are not active, and model-derived valuations whose inputs are observable or whose significant value drivers are observable
Level 3 – significant inputs to the valuation model are unobservable
The following is a listing of the Company’s assets and liabilities that are measured at fair value and their classification within the fair value hierarchy as of March 31, 2014:

 
Level 1
 
Level 2
 
Level 3
 
(in thousands)
Assets:
 
 
 
 
 
Derivatives (1)
$

 
$
21,336

 
$

Liabilities:
 
 
 
 
 
Derivatives (1)
$

 
$
68,569

 
$

Net Profits Plan (1)
$

 
$

 
$
55,209

____________________________________________
(1) This represents a financial asset or liability that is measured at fair value on a recurring basis.

The following is a listing of the Company’s assets and liabilities that are measured at fair value and their classification within the fair value hierarchy as of December 31, 2013:

 
Level 1
 
Level 2
 
Level 3
 
(in thousands)
Assets:
 
 
 
 
 
Derivatives (1)
$

 
$
52,510

 
$

Proved oil and gas properties (2)
$

 
$

 
$
62,178

Unproved oil and gas properties (2)
$

 
$

 
$
3,280

Oil and gas properties held for sale (2)
$

 
$

 
$
650

Liabilities:
 
 
 
 
 
Derivatives (1)
$

 
$
31,020

 
$

Net Profits Plan (1)
$

 
$

 
$
56,985

____________________________________________
(1) This represents a financial asset or liability that is measured at fair value on a recurring basis.
(2) This represents a non-financial asset or liability that is measured at fair value on a nonrecurring basis.

Both financial and non-financial assets and liabilities are categorized within the above fair value hierarchy based on the lowest level of input that is significant to the fair value measurement. The following is a description of the valuation methodologies used by the Company as well as the general classification of such instruments pursuant to the above fair value hierarchy.


19


Derivatives

The Company uses Level 2 inputs to measure the fair value of oil, gas, and NGL commodity derivatives. Fair values are based upon interpolated data. The Company derives internal valuation estimates taking into consideration the counterparties’ credit ratings, the Company’s credit rating, and the time value of money. These valuations are then compared to the respective counterparties’ mark-to-market statements. These factors result in an estimated exit-price that management believes provides a reasonable and consistent methodology for valuing derivative instruments. The derivative instruments utilized by the Company are not considered by management to be complex, structured, or illiquid. The oil, gas, and NGL commodity derivative markets are highly active.

Generally, market quotes assume that all counterparties have near zero, or low, default rates and have equal credit quality. However, an adjustment may be necessary to reflect the credit quality of a specific counterparty to determine the fair value of the instrument. The Company monitors the credit ratings of its counterparties and may require counterparties to post collateral if their ratings deteriorate. In some instances the Company will attempt to novate the trade to a more stable counterparty.

Valuation adjustments are necessary to reflect the effect of the Company’s credit quality on the fair value of any liability position with a counterparty. This adjustment takes into account any credit enhancements, such as collateral margin that the Company may have posted with a counterparty, as well as any letters of credit between the parties. The methodology to determine this adjustment is consistent with how the Company evaluates counterparty credit risk, taking into account the Company’s credit rating, current credit facility margins, and any change in such margins since the last measurement date. All of the Company’s derivative counterparties are members of the Company’s credit facility lender group.

The methods described above may result in a fair value estimate that may not be indicative of net realizable value or may not be reflective of future fair values and cash flows. While the Company believes that the valuation methods utilized are appropriate and consistent with authoritative accounting guidance and with other marketplace participants, the Company recognizes that third parties may use different methodologies or assumptions to determine the fair value of certain financial instruments that could result in a different estimate of fair value at the reporting date.

Refer to Note 10 - Derivative Financial Instruments for more information regarding the Company’s derivative instruments.

Net Profits Plan

The Net Profits Plan is a standalone liability for which there is no available market price, principal market, or market participants. The inputs available for this instrument are unobservable and are therefore classified as Level 3 inputs. The Company employs the income approach, which converts expected future cash flow amounts to a single present value amount. This technique uses the estimate of future cash payments, expectations of possible variations in the amount and/or timing of cash flows, the risk premium, and nonperformance risk to calculate the fair value. There is a direct correlation between realized oil, gas, and NGL commodity prices driving net cash flows and the Net Profits Plan liability. Generally, higher commodity prices result in a larger Net Profits Plan liability and lower commodity prices result in a smaller Net Profits Plan liability.

The Company records the estimated fair value of the long-term liability for estimated future payments under the Net Profits Plan based on the discounted value of estimated future payments associated with each individual pool. The calculation of this liability is a significant management estimate. A discount rate of 12 percent is used to calculate this liability and is intended to represent the Company’s best estimate of the present value of expected future payments under the Net Profits Plan.

The Company’s estimate of its liability is highly dependent on commodity prices, cost assumptions, discount rates, and overall market conditions. The Company regularly assesses the current market environment.  The Net Profits Plan liability is determined using price assumptions of five one-year strip prices with the fifth year’s pricing then carried out indefinitely. The average price is adjusted for realized price differentials and to include the effects of the forecasted production covered by derivatives contracts in the relevant periods.  The non-cash expense associated with this significant management estimate is highly volatile from period to period due to fluctuations that occur in the oil, gas, and NGL commodity markets.

If the commodity prices used in the calculation changed by five percent, the liability recorded at March 31, 2014, would differ by approximately $5 million. A one percent increase or decrease in the discount rate would result in a change of approximately $2 million. Actual cash payments to be made to participants in future periods are dependent on realized actual production, realized commodity prices, and costs associated with the properties in each individual pool of the Net Profits Plan. Consequently, actual cash payments are inherently different from the amounts estimated.


20


No published market quotes exist on which to base the Company’s estimate of fair value of its Net Profits Plan liability. As such, the recorded fair value is based entirely on management estimates that are described within this footnote. While some inputs to the Company’s calculation of fair value on the Net Profits Plan’s future payments are from published sources, others, such as the discount rate and the expected future cash flows, are derived from the Company’s own calculations and estimates.
    
The following table reflects the activity for the Company’s Net Profits Plan liability measured at fair value using Level 3 inputs:
 
For the Three Months Ended March 31, 2014
 
(in thousands)
Beginning balance
$
56,985

Net increase in liability (1)
1,707

Net settlements (1) (2)
(3,483
)
Transfers in (out) of Level 3

Ending balance
$
55,209


____________________________________________
(1) 
Net changes in the Company’s Net Profits Plan liability are shown in the Change in Net Profits Plan liability line item of the accompanying statements of operations.
(2) 
Settlements represent cash payments made or accrued under the Net Profits Plan. The Company accrued or made cash payments under the Net Profits Plan of $217,000 relating to divestiture proceeds for the three months ended March 31, 2014.

Long-term Debt
The following table reflects the fair value of the Senior Notes measured using Level 1 inputs based on quoted secondary market trading prices. The Senior Notes were not presented at fair value on the accompanying balance sheets as of March 31, 2014, or December 31, 2013, as they are recorded at historical value.

 
As of March 31, 2014
 
As of December 31, 2013
 
(in thousands)
2019 Notes
$
375,375

 
$
374,290

2021 Notes
$
376,250

 
$
373,625

2023 Notes
$
428,760

 
$
422,000

2024 Notes
$
488,440

 
$
475,315


As of March 31, 2014, the Company had no floating-rate debt outstanding.

Proved and Unproved Oil and Gas Properties

Proved oil and gas property costs are evaluated for impairment and reduced to fair value when there is an indication that the carrying costs may not be recoverable. The Company uses Level 3 inputs and the income valuation technique, which converts future amounts to a single present value amount, to measure the fair value of proved properties through an application of discount rates and price forecasts selected by the Company’s management. The calculation of the discount rate is based on the best information available and was estimated to be 12 percent as of March 31, 2014, and December 31, 2013. The Company believes that the discount rate is representative of current market conditions and takes into account estimates of future cash payments, expectations of possible variations in the amount and/or timing of cash flows, the risk premium, and nonperformance risk. The prices for oil and gas are forecasted based on New York Mercantile Exchange (“NYMEX”) strip pricing, adjusted for basis differentials, for the first five years, after which a flat terminal price is used for each commodity stream. The prices for NGLs are forecasted using OPIS Mont Belvieu pricing, for as long as the market is actively trading, after which a flat terminal price is used. Future operating costs are also adjusted as deemed appropriate for these estimates. Proved properties classified as held for sale are valued using a market approach, based on an estimated selling price, as evidenced by the most current bid prices received from third parties. If an estimated selling price is not available, the Company utilizes the income valuation technique discussed above.


21


Unproved oil and gas property costs are evaluated for impairment and reduced to fair value when there is an indication that the carrying costs may not be recoverable.  To measure the fair value of unproved properties, the Company uses a market approach, which takes into account the following significant assumptions: future development plans, risk weighted potential resource recovery, and estimated reserve values. Unproved properties classified as held for sale are valued using a market approach, based on an estimated selling price, as evidenced by the most current bid prices received from third parties. If an estimated selling price is not available, the Company estimates acreage value based on the price received for similar acreage in recent transactions by the Company or other market participants in the principal market.
Acquisitions of proved and unproved properties are measured at fair value as of the acquisition date using an income valuation technique similar to the Company’s approach in measuring the fair value of proved and unproved properties, as discussed above. Due to the unobservable characteristics of the inputs, the fair value of acquired properties are considered Level 3 within the fair value hierarchy.

Asset Retirement Obligations

The Company utilizes the income valuation technique to determine the fair value of the asset retirement obligation liability at the point of inception by applying a credit-adjusted risk-free rate, which takes into account the Company’s credit risk, the time value of money, and the current economic state, to the undiscounted expected abandonment cash flows. Given the unobservable nature of the inputs, the initial measurement of the asset retirement obligation liability is deemed to use Level 3 inputs. There were no asset retirement obligations recorded at fair value in the accompanying balance sheets at March 31, 2014, or December 31, 2013.

22


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

This discussion and analysis contains forward-looking statements. Refer to Cautionary Information about Forward-Looking Statements at the end of this item for an explanation of these types of statements.

Overview of the Company, Highlights, and Outlook

General Overview

We are an independent energy company engaged in the acquisition, exploration, development, and production of oil, gas, and NGLs in onshore North America. Our assets include leading positions in the Eagle Ford shale and Bakken/Three Forks resource plays, oil-focused plays in the Permian Basin, and positions in emerging plays in East Texas and the Powder River Basin in Wyoming. We have built a portfolio of onshore properties in the contiguous United States primarily through early entry into existing and emerging resource plays. This portfolio is comprised of properties with established production and reserves, prospective drilling opportunities, and unconventional resource prospects. We believe our strategy provides for stable and predictable production and reserves growth. Furthermore, by entering these plays early, we believe we can capture larger resource potential at a lower cost.

Our principal business strategy is to focus on the early capture of resource plays in order to create and then enhance value for our stockholders while maintaining a strong balance sheet. We strive to leverage industry-leading exploration and leasehold acquisition teams to quickly acquire and test new resource play concepts at a reasonable cost. Once we have identified potential value through these efforts, our goal is to develop such potential through top-tier operational and project execution, and as appropriate, high-grade our portfolio by selectively divesting assets. We regularly examine our portfolio for opportunities to improve the quality of our asset base in order to optimize our returns and preserve our financial strength.

In the first quarter of 2014, we had the following financial and operational results:

Average net daily production for the three months ended March 31, 2014, was 40.6 MBbls of oil, 394.9 MMcf of gas, and 32.1 MBbls of NGLs, for a quarterly equivalent daily production rate of 138.6 MBOE, compared with 115.0 MBOE for the same period in 2013. Please see additional discussion below under the caption Production Results.

Net income for the three months ended March 31, 2014, was $65.6 million, or $0.96 per diluted share, compared to net income for the three months ended March 31, 2013, of $16.7 million, or $0.25 per diluted share. Please refer to the Comparison of Financial Results and Trends Between the Three Months Ended March 31, 2014, and 2013 for additional discussion regarding the components of net income.
 
Costs incurred for oil and gas property acquisitions and exploration and development activities for the three months ended March 31, 2014, were $346.7 million, compared with $341.9 million for the same period in 2013. The majority of costs incurred during this period were in our Eagle Ford shale, Bakken/Three Forks, and Permian programs. Please refer to Overview of Liquidity and Capital Resources below for additional discussion on how we expect to fund our capital program.

EBITDAX, a non-GAAP financial measure, for the three months ended March 31, 2014, was $398.9 million, which was in excess of our capital expenditures for the three months ended March 31, 2014. EBITDAX for the three months ended March 31, 2013, was $328.8 million. Please refer to the caption Non-GAAP Financial Measures below for additional discussion, including our definition of EBITDAX and reconciliations of our GAAP net income and net cash provided by operating activities to EBITDAX.

During the first quarter of 2014, our lenders re-affirmed our credit facility’s borrowing base at $2.2 billion, after taking into consideration several divestitures that occurred in late 2013, including the divestiture of our Anadarko Basin assets. Please refer to the caption Credit Facility in the Overview of Liquidity and Capital Resources section below and Note 5 - Long-term Debt in Part I, Item 1 of this report for additional discussion.


23


Oil, Gas, and NGL Prices

Our financial condition and the results of our operations are significantly affected by the prices we receive for our oil, gas, and NGL production, which can fluctuate dramatically. We sell the majority of our gas under contracts using first-of-the-month index pricing, which means gas produced in a given month is sold at the first-of-the-month price regardless of the spot price on the day the gas is produced.  For assets where high BTU gas is sold at the wellhead, we also receive additional value for the high energy content contained in the gas stream. Our NGL production is generally sold using contracts paying us a monthly average of the posted OPIS daily settlement prices, adjusted for processing, transportation, and location differentials. Our oil and condensate are sold using contracts paying us various industry posted prices, most commonly NYMEX West Texas Intermediate (“WTI”). We are paid the average of the daily settlement price for the respective posted prices for the period in which the product is sold, adjusted for quality, transportation, American Petroleum Institute (“API”) gravity, and location differentials. Substantially all of our oil production in our South Texas & Gulf Coast region is condensate. When we refer to realized oil, gas, and NGL prices below, the disclosed price represents the average price for the respective period, unless otherwise indicated.

The following table summarizes commodity price data, as well as the effects of derivative cash settlements as further discussed under the caption Derivative Activity below, for the first quarter of 2014, as well as the fourth and first quarters of 2013:

 
For the Three Months Ended
 
March 31, 2014
 
December 31, 2013
 
March 31, 2013
Crude Oil (per Bbl):
 
 
 
 
 
Average NYMEX price
$
98.65

 
$
97.56

 
$
94.30

Realized price
$
88.96

 
$
86.48

 
$
91.67

Effects of derivative cash settlements
$
(1.85
)
 
$
(0.36
)
 
$
(0.37
)
 
 
 
 
 
 
Natural Gas:
 
 
 
 
 
Average NYMEX price (per MMBtu)
$
5.16

 
$
3.84

 
$
3.48

Realized price (per Mcf)
$
5.22

 
$
3.98

 
$
3.57

Effects of derivative cash settlements (per Mcf)
$
(0.38
)
 
$
0.29

 
$
0.33

 
 
 
 
 
 
Natural Gas Liquids (per Bbl):
 
 
 
 
 
Average OPIS price
$
45.61

 
$
43.13

 
$
40.61

Realized price
$
38.79

 
$
38.63

 
$
36.65

Effects of derivative cash settlements
$
(3.03
)
 
$
(0.29
)
 
$
1.15

____________________________________________
Note: Average OPIS prices per barrel of NGL, historical or strip, are based on a product mix of 37% Ethane, 32% Propane, 6% Isobutane, 11% Normal Butane, and 14% Natural Gasoline for all periods presented. This product mix represents the industry standard composite barrel and does not necessarily represent our product mix for NGL production. Realized prices reflect our actual product mix.
    
While quoted NYMEX oil and gas and OPIS NGL prices are generally used as a basis for comparison within our industry, the prices we receive are affected by quality, energy content, location, and transportation differentials for these products. 

We expect future prices for oil, gas, and NGLs to be volatile.  In addition to supply and demand fundamentals, as a global commodity, the price of oil will continue to be impacted by real or perceived geopolitical risks in oil producing regions of the world, particularly the Middle East. The relative strength of the U.S. dollar compared to other currencies could affect the price of oil. The supply of NGLs in the United States is expected to continue to grow in the near term as a result of the number of industry participants targeting projects that produce these products. If demand does not keep pace with anticipated growth in NGL supply, prices could be negatively impacted. The prices of several NGL products correlate to the price of oil and accordingly are likely to directionally follow that market. Gas prices have been under sustained downward pressure due to high levels of supply in recent years, although cold weather during recent winter months provided a near term increase in pricing. Longer term, we think there remains a large amount of productive supply, particularly in the Northeast United States, which we anticipate will exert downward pressure on natural gas pricing. The following table below summarizes 12-month strip prices for NYMEX WTI oil, NYMEX Henry Hub gas, and OPIS NGLs (same product mix as discussed under the table above) as of April 23, 2014, and March 31, 2014:


24


 
As of April 23, 2014
 
As of March 31, 2014
NYMEX WTI oil (per Bbl)
$
97.24

 
$
96.72

NYMEX Henry Hub gas (per MMBtu)
$
4.76

 
$
4.46

OPIS NGLs (per Bbl)
$
41.75

 
$
40.61


Derivative Activity
We use financial derivative instruments as part of our financial risk management program. We have a financial risk management policy governing our use of derivatives.  The amount of our production covered by derivatives is driven by the amount of debt on our balance sheet and the level of capital commitments and long-term obligations we have in place.  With our current derivative contracts, we believe we have established a base cash flow stream for our future operations and have partially reduced our exposure to volatility in commodity prices.  Our use of costless collars for a portion of our derivatives allows us to participate in some of the upward movements in oil, gas, and NGL prices while also setting a price floor for a portion of our production. Please refer to Note 10 - Derivative Financial Instruments in Part I, Item 1 of this report for additional information regarding our oil, gas, and NGL derivatives.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) included provisions requiring over-the-counter derivative transactions to be cleared through clearinghouses and traded on exchanges. On July 10, 2012, the Commodity Futures Trading Commission (“CFTC”) and the SEC adopted final joint rules under Title VII of the Dodd-Frank Act, which define certain terms that determine what types of transactions will be subject to regulation under the Dodd-Frank Act swap rules. The issuance of these final rules also triggers compliance dates for a number of other final Dodd-Frank Act rules, including new rules proposed by the CFTC governing margin requirements for uncleared swaps entered into by non-bank swap entities, and new rules proposed by U.S. banking regulators regarding margin requirements for uncleared swaps entered into by bank swap entities. The ultimate effect of these new rules on our business and any additional regulations is currently uncertain. Under CFTC rules we believe our derivative activity qualifies for the non-financial, commercial end-user exception, which exempts derivatives intended to hedge or mitigate commercial risk entered into by entities predominantly engaged in non-financial activity from the mandatory swap clearing requirement. However, we are not certain whether the provisions of the final rules and regulations will exempt us from the requirements to post margin in connection with commodity price risk management activities. Final rules and regulations on major provisions of the legislation, such as new margin requirements, are to be established through regulatory rulemaking. Although we cannot predict the ultimate outcome of these rulemakings, new rules and regulations in this area may result in increased costs and cash collateral requirements for the types of derivative instruments we use to manage our financial risks related to volatility in oil, gas, and NGL commodity prices.

First Quarter 2014 Highlights and Outlook for the Remainder of 2014

Operational Activities. We expect our 2014 capital budget to be $1.9 billion, of which approximately $1.7 billion will be deployed on drilling and completion activities. We expect that approximately 85 percent of our drilling budget will be spent on our Eagle Ford shale, Bakken/Three Forks and Permian shale programs. For the first quarter of 2014, our EBITDAX of $398.9 million exceeded our capital expenditures.
During the first quarter of 2014, in our operated Eagle Ford shale program in South Texas we operated four drilling rigs supported by two frac spreads. We were primarily focused on pad drilling in the northern portion of our acreage position where there is a higher liquids contribution to our product mix. Our program for 2014 focuses on improving well design and completion to enhance well performance and capital efficiency. We believe we have secured the requisite services, such as gas pipeline takeaway capacity and drilling and completion services, to support our current development plans.
In our outside operated Eagle Ford program, the operator ran 10 drilling rigs during the first quarter of 2014. We were carried for substantially all of our drilling and completion costs pursuant to our Acquisition and Development Agreement with Mitsui E&P Texas LP (“Mitsui”), an indirect subsidiary of Mitsui & Co., Ltd. (the “Acquisition and Development Agreement”). We expect the remaining carry will be realized during the second quarter of 2014. We plan to invest approximately $250 million of un-carried drilling and completion capital in this program in 2014, based on our assumptions regarding the operator’s level of activity in 2014.

We have an ongoing exploration program to acquire leasehold and test concepts in new plays. In 2014, we are focused on an emerging new venture play in East Texas where we have approximately 215,000 net acres and plan to continue leasing. We currently have three rigs running in the play and we expect to conduct tests of intervals of interest, including the Eagle Ford shale and Woodbine formation, during the remainder of the year.

25


In our Bakken/Three Forks program, we operated three drilling rigs during the first quarter of 2014 focusing on infill drilling of our Raven/Bear Den and Gooseneck prospects in the North Dakota portion of the Williston Basin. We plan to monitor the results of various well and completion designs and down-spacing tests of both our operated and non-operated properties throughout 2014. Additionally, we plan to test the Bakken interval on our Gooseneck and Stateline acreage during the year.
We have another emerging new venture play in the Powder River Basin in Wyoming. During the first quarter of 2014, we added a second drilling rig in the basin and expect to move to three rigs by the end of the second quarter to accelerate the delineation of the Powder River Basin play area. We expect to continue our leasing efforts in the Powder River Basin. Subsequent to March 31, 2014, we entered into separate agreements to acquire acreage in the Powder River Basin for total cash consideration of approximately $100.0 million plus approximately 7,000 net acres. These agreements are expected to close during the second quarter 2014 and are subject to standard closing conditions and normal closing and post-closing adjustments. No assurance can be given that we will successfully close any of these acquisitions.
In our Permian program, we operated two drilling rigs during the first quarter of 2014 focused on horizontal testing and development of the Wolfcamp B interval in our Sweetie Peck prospect. During 2014, we also plan to test the Wolfcamp D and lower Spraberry intervals in our Buffalo prospect. We have approximately 130,000 net acres in the Permian region.
In December 2013, we closed the sale of our Anadarko Basin assets in the Mid-Continent region, which included our interest in the Granite Wash interval. During the first quarter of 2014, we operated one drilling rig in this region.

Please refer to Overview of Liquidity and Capital Resources below for additional discussion regarding how we intend to fund our 2014 capital program.
Production Results. The table below provides a regional breakdown of our production for the first quarter of 2014:
 
South Texas & Gulf Coast
 
Rocky Mountain
 
Permian
 
Mid-Continent
 
Total (1)
 
 
 
 
 
 
 
 
 
 
Oil (MMBbl)
1.6

 
1.6

 
0.4

 

 
3.7

Gas (Bcf)
28.3

 
1.5

 
1.0

 
4.7

 
35.5

NGLs (MMBbl)
2.9

 

 

 

 
2.9

Equivalent (MMBOE)
9.1

 
1.9

 
0.6

 
0.8

 
12.5

Avg. daily equivalents (MBOE/d)
101.6

 
21.0

 
6.8

 
9.2

 
138.6

Relative percentage
73
%
 
15
%
 
5
%
 
7
%
 
100
%
____________________________________________
(1) Totals may not add due to rounding.

Our production in the first quarter of 2014 was primarily driven by the continued development of our operated and non-operated Eagle Ford shale programs in our South Texas & Gulf Coast region. Please refer to Comparison of Financial Results and Trends Between the Three Months Ended March 31, 2014, and 2013 below for additional discussion on production.


26


Financial Results of Operations and Additional Comparative Data

The table below provides information regarding selected production and financial information for the quarter ended March 31, 2014, and the immediately preceding three quarters. Additional details of per BOE costs are presented later in this section.

 
For the Three Months Ended
 
March 31,
 
December 31,
 
September 30,
 
June 30,
 
2014
 
2013
 
2013
 
2013
 
(in millions, except for production data)
Production (MMBOE)
12.5

 
13.2

 
12.8

 
12.0

Oil, gas, and NGL production revenue
$
623.1

 
$
593.7

 
$
601.8

 
$
534.5

Lease operating expense
$
57.0

 
$
61.1

 
$
61.0

 
$
56.2

Transportation costs
$
79.2

 
$
75.0

 
$
68.8

 
$
67.0

Production taxes
$
27.5

 
$
26.7

 
$
29.1

 
$
26.5

Depletion, depreciation, amortization, and asset retirement obligation liability accretion
$
177.2

 
$
202.6

 
$
195.8

 
$
225.7

Exploration
$
21.3

 
$
21.8

 
$
16.3

 
$
20.7

General and administrative
$
35.1

 
$
48.0

 
$
33.9

 
$
35.4

Net income
$
65.6

 
$
7.0

 
$
70.7

 
$
76.5


Selected Performance Metrics:

 
For the Three Months Ended
 
March 31,
 
December 31,
 
September 30,
 
June 30,
 
2014
 
2013
 
2013
 
2013
Average net daily production equivalent (MBOE/d)
138.6

 
143.8

 
138.8

 
131.8

Lease operating expense (per BOE)
$
4.58

 
$
4.62

 
$
4.77

 
$
4.69

Transportation costs (per BOE)
$
6.35

 
$
5.67

 
$
5.38

 
$
5.59

Production taxes as a percent of oil, gas, and NGL production revenue
4.4
%
 
4.5
%
 
4.8
%
 
5.0
%
Depletion, depreciation, amortization, and asset retirement obligation liability accretion (per BOE)
$
14.21

 
$
15.31

 
$
15.33

 
$
18.82

General and administrative (per BOE)
$
2.81

 
$
3.63

 
$
2.66

 
$
2.95

____________________________________________
Note: Amounts may not recalculate due to rounding.

27


A three-month overview of selected production and financial information, including trends:
 
For the Three Months Ended March 31,
 
Amount Change Between Periods
 
Percent Change Between Periods
 
2014
 
2013
 
Net production volumes (1)
 
 
 
 
 
 
 
Oil (MMBbl)
3.7

 
3.1

 
0.5

 
17
 %
Gas (Bcf)
35.5

 
32.2

 
3.3

 
10
 %
NGLs (MMBbl)
2.9

 
1.8

 
1.1

 
57
 %
Equivalent (MMBOE)
12.5

 
10.3

 
2.1

 
21
 %
Average net daily production (1)
 
 
 
 
 
 
 
Oil (MBbl per day)
40.6

 
34.8

 
5.8

 
17
 %
Gas (MMcf per day)
394.9

 
358.2

 
36.7

 
10
 %
NGLs (MBbl per day)
32.1

 
20.5

 
11.7

 
57
 %
Equivalent (MBOE per day)
138.6

 
115.0

 
23.6

 
21
 %
Oil, gas, & NGL production revenue (in millions)
 
 
 
 
 
 
Oil production revenue
$
325.3

 
$
287.1

 
$
38.2

 
13
 %
Gas production revenue
185.6

 
115.0

 
70.6

 
61
 %
NGL production revenue
112.2

 
67.5

 
44.7

 
66
 %
Total
$
623.1

 
$
469.6

 
$
153.5

 
33
 %
Oil, gas, & NGL production expense (in millions)
 
 
 
 
 
 
Lease operating expense
$
57.0

 
$
54.7

 
$
2.3

 
4
 %
Transportation costs
79.2

 
47.4

 
31.8

 
67
 %
Production taxes
27.5

 
23.5

 
4.0

 
17
 %
Total
$
163.7

 
$
125.6

 
$
38.1

 
30
 %
Realized price