ITEM 3. LEGAL PROCEEDINGS
Other than acting pursuant to the Management Agreement as it relates to the management and operations of the oil and natural gas properties owned by Operating LLC, the Company is not a party to any material pending legal proceedings. With respect to certain claims of the Company against Enron Corp. relating to the oil and natural gas properties contributed to Holding LLC, a representative of the Company has been appointed to the official committee of unsecured creditors in the Enron bankruptcy proceeding.
The Company's Joint Plan became effective August 4, 2000 and the Bankruptcy Court issued a final decree effective December 13, 2001 closing the case.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On October 5, 2001, an annual meeting of the shareholders of the Company was held.
At the meeting two proposals were voted upon and the following sets forth the number of votes that were cast for and against the proposals and the number of abstentions and broker no votes on the proposals:
(i) Proposal to elect five nominees as directors of the Company to serve until the next annual meeting of shareholders:
NAME OF DIRECTOR
(ii) Proposal to ratify the selection of KPMG LLP as the Company's independent auditors for the current fiscal year ended December 31, 2001.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
The Company's common stock currently trades on the OTC Bulletin Board. Effective October 19, 2000, the Company's common stock began trading under the symbol "NEGI". The following table sets forth, for the periods indicated, the high and low closing sales prices as reported on the OTC Bulletin Board. The prices for periods prior to confirmation of the Joint Plan have been adjusted to reflect a 7-for-1 reverse stock split. The quotations represent prices between dealers in securities and may not include retail mark-up, mark-down, or commission and may not represent actual transactions.
On March 25, 2002, the latest practicable date for providing price information, the last quoted price for the Company's common stock was $.38.
HOLDERS
As of March 25, 2002, the Company had approximately 7,500 record holders of its shares of common stock, including multiple nominee holders for an undetermined number of beneficial owners.
DIVIDENDS ON COMMON STOCK
The Company has never paid cash dividends on its common stock and does not expect to declare cash dividends in the foreseeable future. The terms of the Company's credit facility with Arnos do not permit dividends on the common stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected historical financial and operating data with respect to the Company as of and for each of the five years in the period ended December 31, 2001. The financial data was derived from the historical financial statements of the Company. This information is not necessarily indicative of the Company's future performance. The financial data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and the related notes thereto of the Company included elsewhere herein.
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(1) Reflects the revenues, results of operations, and production subsequent to the dates of acquisitions of various oil and natural gas properties that affect the comparability of the data presented.
(2) The results of operations for the year ended December 31, 1997 included a writedown of oil and natural gas properties of approximately $46.4 million ($37.5 million, net of deferred income taxes) in accordance with the full cost method of accounting. The results of operations for the year ended December 31, 1998, include writedowns of oil and natural gas properties of approximately $148.4 million in accordance with the full cost method of accounting.
(3) Accrual of interest on the Company's senior notes was discontinued during the Bankruptcy Proceeding. Approximately $17.7 million and $10.5 million of additional interest expense would have been recognized by the Company during 1999 and 2000, respectively, if not for the discontinuation of the interest accrual.
(4) EBITDA is earnings (including interest income and excluding accretion of Investment in NEG Holding LLC, discontinued operations, extraordinary items, charges resulting from changes in accounting and significant nonrecurring revenues and expenses and reorganization items) before interest expense,
income taxes, depletion, depreciation and amortization, and the provision for impairment of oil and natural gas properties. EBITDA is not a measure of cash flow as determined by generally accepted accounting principles. The Company has included information concerning EBITDA because EBITDA is a measure used by certain investors in determining the Company's historical ability to service its indebtedness. However, this measure may not be comparable to similarly titled measures of other companies. EBITDA should not be considered as an alternative to, or more meaningful than, net income or cash flows as determined in accordance with generally accepted accounting principles as an indicator of the Company's operating performance or liquidity.
(5) For the purposes of calculating the ratio of earnings to, or deficiency of earnings over, fixed charges, earnings consist of income before extraordinary items and income taxes plus fixed charges, excluding capitalized interest. Fixed charges consist of interest expense, capitalized interest, the interest component of rent expense, and amortization of debt premium, discount and financing costs. The deficiency of earnings over fixed charges for the years ended December 31, 1997 and 1998, were approximately $44.2 million, and $167.9 million, respectively.
(6) Due to the discontinuance of the accrual of interest on the Company's unsecured senior notes during the Bankruptcy proceeding, these measurements are not meaningful for the years ended December 31, 1999 and December 31, 2000 and have not been presented.
(7) Due to the Chapter 11 proceedings, these measurements are not meaningful for the year ended December 31, 1999 and have not been presented. See Notes 1, 5 and 6 of Notes to Consolidated Financial Statements.
(8) The principal and interest outstanding under the senior notes and credit facility was classified as current at December 31, 1998. Due to the Chapter 11 proceedings, this measurement is not meaningful as of December 31, 1999 and has not been presented. See Note 6 of Notes to Consolidated Financial Statements.
(9) Excludes the effects of the full cost ceiling writedowns discussed in Note 2 above.
(10) Operating data is included only through August 31, 2001 when the oil and natural gas assets were contributed to NEG Holding LLC.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the Company's Financial Statements and "Selected Financial Data" and respective notes thereto, included elsewhere herein. The information below should not be construed to imply that the results discussed herein will necessarily continue into the future or that any conclusion reached herein will necessarily be indicative of actual operating results in the future. Such discussion only represents the best present assessment by management of the Company.
On February 11, 1999, the United States Bankruptcy Court for the Northern District of Texas, Dallas Division ("Bankruptcy Court") entered an involuntary petition placing the Company under protection of the Bankruptcy Court pursuant to Title 11, Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Proceeding"). On July 24, 2000 the Bankruptcy Court entered a subsequent order confirming a Plan of Reorganization (the "Plan of Reorganization") jointly proposed by the Company and the official committee of unsecured creditors, which Plan of Reorganization became effective on August 4, 2000. The Bankruptcy Court issued a Final Decree closing the case effective December 13, 2001. Accordingly, the Company has effectively settled all matters relating to the Bankruptcy Proceeding.
As mandated by the Plan of Reorganization and the Bankruptcy Court, NEG Holding LLC ("Holding LLC"), a Delaware limited liability company, was formed in August 2000. In exchange for an initial 50% membership interest in Holding LLC, on September 12, 2001, but effective as of May 1, 2001, the Company contributed to Holding LLC all of its operating assets and oil and natural gas properties excluding cash of $4.3 million. In exchange for its initial 50% membership interest in Holding LLC, Gascon Partners, an entity owned or controlled by Carl C. Icahn, the Company's largest stockholder ("Gascon"), contributed its sole membership interest in Shana National LLC, an oil and natural gas producing company, and cash, including a $10.9 million Revolving Note issued to Arnos Corp., an entity owned or controlled by Carl C. Icahn, the Company's largest stockholder ("Arnos"), evidencing the borrowings under the Company's revolving credit facility. In connection with the foregoing, Holding LLC initially owns 100% of the membership interest in NEG Operating LLC ("Operating LLC"), a Delaware limited liability company. All of the oil and natural gas assets contributed by the Company and all of the oil and natural gas assets associated with Gascon's contribution to Holding LLC were transferred from Holding LLC to Operating LLC on September 12, 2001, but effective as of May 1, 2001.
Pursuant to the Holding LLC Operating Agreement, the Company is to receive guaranteed payments, in addition to a priority distribution amount of $202.2 million before Gascon receives any monies. It is anticipated that the priority distribution amount of $202.2 million will be used by the Company to pay off the Company's indebtedness (currently held by entities owned or controlled by Carl C. Icahn). The priority distribution is to be made on or before November 1, 2006. Guaranteed payments are to be paid on a semi annual basis, based on 10.75% of the outstanding priority distribution amount. After the payments to the Company, Gascon is to receive distributions equivalent to the priority distribution amount and guaranteed payments plus other amounts as defined in the NEG Holding LLC Operating Agreement referred herein. Following the above distributions to the Company and Gascon, additional distributions, if any, are to be made in accordance with their respective capital accounts. Because of the substantial uncertainty that the Company will receive any distributions above the priority and guaranteed payment amounts, the Company accounts for its investment in Holding LLC as a preferred investment whereby guaranteed payment amounts received and receipts of the priority distribution amount are recorded as reductions in the investment and income is recognized from accretion of the investment up to the priority distribution amount, including the guaranteed payments (based on the interest method), and the residual interest attributable to Holding LLC will be valued at zero. Cash receipts, if any, from the residual interest will be reported in income as earned.
The Holding LLC Operating Agreement entered into on September 12, 2001, contains a provision that allows Gascon at any time, in its sole discretion, to redeem the Company's membership interest in Holding LLC at a price equal to the fair market value of such interest determined as if Holding LLC had sold all of its assets for fair market value and liquidated. Since all of the Company's operating assets and oil and natural gas properties have been contributed to Holding LLC, as noted above, following such a redemption, the Company's principal assets would consist solely of its cash balances. In the event that such redemption right is
exercised by Gascon and there follows a liquidation and distribution of the proceeds, the Company may be obligated to use the proceeds that it would receive for its redeemed membership interest to pay outstanding indebtedness and operating expenses before the distribution of any portion of such proceeds to the Company's shareholders. Following the payment of the Company's indebtedness (currently held by entities owned or controlled by Carl C. Icahn) and its operating expenses, there is a substantial risk that there will be no proceeds remaining for distribution to the Company's shareholders. It is the present intention of Holding LLC to continue to conduct oil and natural gas drilling and development activities in the ordinary course of business and to seek additional reserves.
The management and operation of Operating LLC is being undertaken by the Company pursuant to a Management Agreement (the "Management Agreement") which the Company has entered into with Operating LLC. However, neither the Company's officers nor directors will control the strategic direction of Operating LLC's oil and natural gas business, including oil and natural gas drilling and capital investments, which shall be controlled by the managing member of Holding LLC (currently Gascon). The Management Agreement provides that the Company will manage Operating LLC's oil and natural gas assets and business until the earlier of November 1, 2006, or such time as Operating LLC no longer owns any of the managed oil and natural gas properties. The Company's employees will conduct the day-to-day operations of Operating LLC's oil and natural gas properties, and all costs and expenses incurred in the operation of the oil and natural gas properties shall be borne by Operating LLC; although the Management Agreement provides that the salary of the Company's Chief Executive Officer shall be 70% attributable to the managed oil and natural gas properties, and the salaries of each of the General Counsel and Chief Financial Officer shall be 20% attributable to the managed oil and natural gas properties. In exchange for the Company's management services, Operating LLC shall pay the Company a management fee equal to 115% of the actual direct and indirect administrative and reasonable overhead costs incurred by the Company in operating the oil and natural gas properties, which either the Company or Operating LLC may seek to change within the range of 110%-115% as such change is warranted; however, the parties have agreed to consult with each other to ensure that such administrative and reasonable overhead costs attributable to the managed properties are properly reflected in the management fee paid to the Company. In addition, Operating LLC has agreed to indemnify the Company to the extent it incurs any liabilities in connection with its operation of the assets and properties of Operating LLC, except to the extent of its gross negligence, or misconduct. The Company recorded $2.7 million as a management fee for the four month period ended December 31, 2001.
As a result of the foregoing transactions and as mandated by the Plan of Reorganization, the Company is a holding company of which (i) the principal assets are its remaining cash balances, accounts receivable from affiliates, deferred tax asset and its initial 50% membership interest in Holding LLC, and (ii) the principal liabilities are the $10.9 million outstanding under its existing $25 million revolving credit facility with Arnos and its 10 3/4% senior notes and Reinstated Interest (defined below). None of the Company's employees have been transferred to Holding LLC or Operating LLC.
Pursuant to the Plan of Reorganization, as of December 31, 2000 the Company reinstated $45.8 million of interest expense on the senior notes ("Reinstated Interest"). This Reinstated Interest consisted of $10.5 million of prepetition interest and $35.3 million of interest expense that did not accrue during the pendancy of the Bankruptcy Proceeding pursuant to Bankruptcy Court rules and regulations. Accordingly, interest will accrue at 10.75% on the revised obligation amount at December 31, 2000 of $210.8 million pursuant to terms of the senior notes indenture. The Reinstated Interest plus interest accrued thereon becomes due in installments beginning in April 2003. The Company will continue to pay the semi-annual interest on the original senior note face amount of $165 million. The senior note balance is $148.6 million as of December 31, 2001. (See Note 6 to the Consolidated Financial Statements).
In August 2001, the Company redeemed both $16.4 million of principal outstanding under the senior note obligations and $4.8 million of Reinstated Interest for $10.5 million. The Company paid two Arnos affiliates approximately $.4 million in current interest on the redeemed senior note obligations at the date of redemption related to interest owed from the last semi-annual interest payment date of May 1, 2001 to the date of redemption. As this was a partial redemption of the senior notes, it has been accounted for as a modification of terms that changes the amounts of future cash payments. Accordingly, the excess of redeemed principal and
interest over the redemption payment of $10.5 million will be amortized as a reduction to interest expense over the remaining life of the bonds. In connection with this transaction, the Company borrowed $10.9 million under its existing credit facility with Arnos.
Although the Company is highly leveraged following confirmation of the Plan of Reorganization, the Company expects that availability under its existing credit facility, expected cash flows from guaranteed payments, priority distributions and management fees will be sufficient to fund its operations and debt service. However, no assurances can be given that Holding LLC will generate sufficient cash flows to make these payments and in that event, the Company would not be able to meet its obligations.
RESULTS OF OPERATIONS
On September 12, 2001 the Company contributed all its operating assets and oil and natural gas properties, excluding cash of $4.3 million to Holding LLC, in exchange for an initial 50% membership interest ("LLC Contribution"). For tax and valuation purposes the effective date is May 1, 2001, however, for financial reporting purposes the transaction is as of September 1, 2001. Operations from September 1 to September 12 were not significant. The Company recorded eight months of oil and natural gas operations and four months of accretion of the preferred investment and management fees. In the future, the Company will only recognize income from accretion of the preferred investment and management fees.
OVERVIEW OF PRODUCTION, SALES AND UNIT ECONOMICS
The following table sets forth certain information regarding the production volumes, oil and natural gas sales, average sales prices, and unit economics per Mcfe for revenues and costs and expenses related to the Company's oil and natural gas production for the periods indicated.
YEAR ENDED DECEMBER 31, 2001, COMPARED WITH YEAR ENDED DECEMBER 31, 2000
Revenues. Total revenues decreased by $5.3 million (10.4%) to $45.7 million for 2001 from $51.0 million in 2000. The decrease in revenues is due to the decrease in overall production and the LLC Contribution. Average natural gas prices increased $1.01 per Mcf to $4.92 per Mcf for 2001 from $3.91 for 2000, and
average oil prices decreased $1.54 per barrel to $27.70 per barrel for 2001 from $29.24 for 2000. The Company recorded $9.8 million in accretion of investment in Holding LLC and management fees of $2.7 million in 2001.
In 2001, the Company produced 428 Mbbls of oil, a decrease of 46.4% compared to 799 Mbbls in 2000, and the Company produced 4,333 Mmcf of natural gas in 2001, a decrease of 38.8% from 7,081 Mmcf in the same period of 2000. The decrease in production is due to the LLC Contribution and natural decline in production.
Costs and Expenses. Lease operating expenses decreased $1.8 million (31.6%) to $3.9 million for 2001 from $5.7 million in 2000 primarily due to the LLC Contribution. Lease operating expenses per Mcfe increased to $.56 for 2001 from $.48 for 2000 due to the decline in overall production.
Production taxes decreased $1.2 million (41.4%) to $1.7 million for 2001 compared to $2.9 million for 2000. This decrease is the direct result of the decline in overall production and revenue in 2001 and the LLC Contribution.
Depreciation, depletion and amortization ("DD&A") decreased $4.8 million (43.6%) to $6.2 million for 2001 compared to $11.0 million for 2000. This decrease in DD&A is due to the decline in overall production and the LLC Contribution.
General and administrative costs increased $1.4 million (31.1%) to $5.9 million for 2001 compared to $4.5 million for 2000. This increase is the result of the LLC Contribution and the resulting change in the Company's recording of general and administrative costs. Effective September 1, 2001, the Company no longer offsets general and administrative costs by field employee costs or lease management income, but is reimbursed a management fee for these and other costs of 115% of general and administrative costs as defined in the Management Agreement. As discussed in Note 2 to the consolidated financial statements, prior to September 2001, the Company capitalized internal general and administrative costs that can be directly identified with acquisition, development and exploration activities. The Company's capitalized general and administrative expenses totaled $.6 million and $.5 million for the years ended December 31, 2000 and 2001, respectively.
Other Income and Expenses. The $11.5 million increase in interest expense to $21.2 million for 2001 from $9.7 million for 2000 was due primarily to interest expense on the senior notes that began accruing upon confirmation of the Plan of Reorganization. The Company accrued interest on the revised senior note obligation amount at December 31, 2000 of $210.8 million through July 31, 2001. In August 2001, the Company redeemed both $16.4 million of principal outstanding under the senior note obligations and $4.8 million of Reinstated Interest for $10.5 million. Approximately $10.5 million additional interest expense would have been recognized by the Company for 2000 if not for the discontinuation of the interest accrual on the Company's senior notes during the Bankruptcy Proceeding pursuant to Bankruptcy Court rules and regulations. The weighted average interest rate for 2001 was 10.6% compared to 10.4% for the same period in 2000.
Of the $.3 million other expense recognized for the year ended December 31, 2001, $.7 million represents the non-cash decrease in the fair value of the Company's derivative contracts. Of the $1.7 million other income recognized for the year ended December 31, 2000, $.6 million represents the non-cash change in the fair value of the Company's derivative contracts and the remainder represents interest earned on cash accumulated subsequent to confirmation of the Joint Plan.
Reorganization Items. The Company incurred $1.4 million for the year ended December 31, 2000, for professional fees and other expenses associated with the bankruptcy proceeding. The Company earned $1.1 million in interest income on cash accumulating during the bankruptcy proceeding for the year ended December 31, 2000.
Income Taxes. As of December 31, 2001, the Company had consolidated net operating loss carryforwards of approximately $129 million for income tax reporting purposes that expire from 2002 through 2020. Prior to the formation of Holding LLC, the income tax benefit associated with the loss carryforwards had not
been recognized since, in the opinion of management, there was not sufficient positive evidence of future taxable income to justify recognition of a benefit. Upon the formation of Holding LLC, management again evaluated all evidence, both positive and negative, in determining whether a valuation allowance to reduce the carrying value of deferred tax assets was still needed and concluded, based on the projected allocations of taxable income by Holding LLC, the company more likely than not will realize a partial benefit from the loss carryforwards. Accordingly, the Company recorded a deferred tax asset of $31.9 million in September 2001. Ultimate realization of the deferred tax asset is dependent upon, among other factors, the Company's ability to generate sufficient taxable income within the carryforward periods and is subject to change depending on the tax laws in effect in the years in which the carryforwards are used. As a result of the recognition of expected future income tax benefits, subject to additional changes in the valuation allowance, subsequent periods will reflect a full effective tax rate provision.
Extraordinary Loss. The Company recognized a $33.0 million extraordinary loss during 2000 in connection with confirmation of the Joint Plan. The extraordinary loss consists of $35.3 million reinstated interest on the senior notes which was offset by a $2.2 million gain on discharge of other indebtedness pursuant to the Joint Plan.
Net Loss. Net loss of $14.4 million was recognized for 2000, compared with a net income of $37.3 million for the comparable 2001 period. Results for 2000 (i) include $1.4 million, relating to the Bankruptcy Proceeding and (ii) include $1.1 million in interest income on cash accumulating during the Bankruptcy Proceeding and (iii) includes a $33.0 million extraordinary loss in connection with the confirmation of the Joint Plan. Results for 2001 include income of $.2 million related to the Bankruptcy Proceeding and a $31.9 million benefit from income taxes as a result of the LLC Contribution and $1.3 million in deferred income tax expense. Excluding the effects of the above items, a net income of $18.9 million would have been recognized for 2000 compared to net income of $6.5 million for the same period in 2001.
YEAR ENDED DECEMBER 31, 2000, COMPARED WITH YEAR ENDED DECEMBER 31, 1999
Revenues. Total revenues increased by $11.7 million (29.8%) to $51.0 million for 2000 from $39.3 million in 1999. The increase in revenues is due to the increase in oil and natural gas prices from the same period in 1999, offset in part by a decline in overall production. Average natural gas prices increased $1.83 per Mcf to $3.91 per Mcf for 2000 from $2.08 for 1999, and average oil prices increased $11.62 per barrel to $29.24 per barrel for 2000 from $17.62 for 1999. The increase in average prices increased 2000 revenues by approximately $22.2 million compared to 1999.
In 2000, the Company produced 799 Mbbls of oil, a decrease of 29.6% compared to 1,135 Mbbls in 1999, and the Company produced 7,081 Mmcf of natural gas in 2000, a decrease of 23.6% from 9,266 Mmcf in the same period of 1999. The decline in production is primarily due to natural production declines combined with the loss of production from non-strategic properties sold at an oil and natural gas auction in December 1999. During the Bankruptcy Proceeding, the Company's ability to offset natural production declines through drilling and exploration was limited due to the Bankruptcy Court restrictions. However, the Company has emerged from Chapter 11 and is operating its business in the ordinary course and initiated drilling activity in 2000.
Costs and Expenses. Lease operating expenses decreased $.4 million (6.6%) to $5.7 million for 2000 from $6.1 million in 1999 primarily due to the Company's efforts to reduce and control these costs. The decline is also, in part, due to the sale of oil and natural gas properties in the December 1999 auction. Lease operating expenses per Mcfe increased to $.48 for 2000 from $.38 for 1999 due to the decline in overall production.
Production taxes increased $.8 million (38.1%) to $2.9 million for 2000 compared to $2.1 million for 1999. This increase is the direct result of the increased oil and natural gas revenue in 2000 combined with certain non-recurring severance tax refunds received during 1999.
Depreciation, depletion and amortization ("DD&A") decreased $4.9 million (30.8%) to $11.0 million for 2000 compared to $15.9 million for 1999. This decrease in DD&A is due to the decrease in production combined with the slight decrease in the depletion rate per Mcfe from $.91 in 1999 to $.88 for 2000.
General and administrative costs increased $.4 million (9.8%) to $4.5 million for 2000 compared to $4.1 million for 1999. This increase is primarily due to the fact that capitalized internal costs decreased during the Bankruptcy proceeding. As discussed in Note 2 to the consolidated financial statements, the Company capitalizes internal general and administrative costs that can be directly identified with acquisition, development and exploration activities. The Company's capitalized general and administrative expenses totaled $.8 million and $.6 million for the years ended December 31, 1999 and 2000, respectively.
Other Income and Expenses. The increase of $7.8 million in interest expense to $9.7 million for 2000 from $1.9 million for 1999 was primarily due to the accrual of interest expense on the senior notes subsequent to the effective date of the Joint Plan. Approximately $10.5 million and $17.7 million additional interest expense would have been recognized by the Company if not for discontinuance of the interest accrual on the senior notes during the Bankruptcy Proceeding in 2000 and 1999, respectively. The average balance of debt outstanding during 2000 and 1999 was $190.0 million. The weighted average interest rate for 2000 was 10.4% for interest accrued compared to 8.2% for 1999. The increase in the weighted average interest rate is due to the accrual of interest on the senior notes subsequent to the effective date of the Joint Plan.
Of the $1.7 million other income recognized for the year ended December 31, 2000, $580,500 represents the noncash change in the fair value of the Company's derivative contract and the remainder represents interest earned on cash accumulated subsequent to confirmation of the Joint Plan.
Reorganization Items. The Company incurred $4.7 million and $1.4 million for the years ended December 31, 1999 and 2000, respectively, for professional fees and other expenses associated with the bankruptcy proceeding. The Company earned $.8 million and $1.1 million in interest income on cash accumulating during the bankruptcy proceeding for the years ended December 31, 1999 and 2000, respectively. In addition, the Company wrote off a total of $3.2 million of unamortized debt issuance costs and premiums related to the senior notes due to the Bankruptcy Proceeding in 1999.
Extraordinary Loss. The Company recognized a $33.0 million extraordinary loss during 2000 in connection with confirmation of the Joint Plan. The extraordinary loss consists of $35.3 million reinstated interest on the senior notes which was offset by a $2.2 million gain on discharge of indebtedness pursuant to the Joint Plan.
Net Loss. Net income of $2.0 million was recognized for 1999, compared with a net loss of $14.4 million for the comparable 2000 period. Results for 1999 and 2000 (i) include expenses of $7.9 million and $1.4 million, respectively, relating to the Bankruptcy Proceeding and (ii) include $.8 million and $1.1 million in interest income on cash accumulating during the Bankruptcy Proceeding. The year ended December 31, 1999 excludes $17.7 million in additional interest expense on the senior notes not accrued during the Bankruptcy Proceeding pursuant to Bankruptcy Court rules and regulations. The year ended December 31, 2000 includes a $33.0 million extraordinary loss in connection with the confirmation of the Joint Plan. Excluding the effects of the above items, a net loss of $8.6 million would have been recognized for 1999 compared to net income of $18.9 million for the same period in 2000.
LIQUIDITY AND CAPITAL RESOURCES
YEAR ENDED DECEMBER 31, 2001, COMPARED WITH YEAR ENDED DECEMBER 31, 2000
Net cash provided by operating activities was $11.5 million for the year ended December 31, 2001, compared to $23.8 million for the same period in 2000. The decrease in cash flow from operating activities is primarily due to decreased income from operations before non-cash charges, resulting from additional interest expense due to the revised obligation amount of the senior notes. (See Note 6 of the Consolidated Financial Statements).
Net cash used by investing activities was $27.2 million for 2001 compared with $11.7 million for 2000. The cash used by investing activities for 2001 increased due to the Company's resumption of its drilling activities at the end of 2000 and during 2001.
Net cash used in financing activities in 2001 was $24.6 million compared to net cash provided by financing activities of $2.0 million in 2000. The net cash used in financing activities in 2001 consisted of repayment of the outstanding borrowing of $25 million under the credit facility. In August 2001, the Company borrowed $10.9 under its existing credit facility with Arnos in order to redeem $16.4 million of principal outstanding under the senior note obligations and $4.8 million of Reinstated Interest for $10.5 million. The net cash provided by financing activities during 2000 consisted of the $2.0 million paid by Arnos, in accordance with the Joint Plan, to purchase additional common stock such that, together with its affiliates, it would own 49.9% of the outstanding common stock of the Company.
The Company's working capital surplus at December 31, 2001 was $1.7 million compared to a working capital surplus at December 31, 2000 of $19.8 million. The decrease in working capital was due primarily to increased drilling activities and the LLC Contribution.
The following table is a summary of contractual obligations as of December 31, 2001.
YEAR ENDED DECEMBER 31, 2000, COMPARED WITH YEAR ENDED DECEMBER 31, 1999
Net cash provided by operating activities was $23.8 million for the year ended December 31, 2000, compared to $27.7 million for the same period in 1999. Although income from operations significantly increased from 1999, cash flow from operating activities decreased as approximately $4.8 million of the increase in net income is attributable to a decline in non-cash depletion expense and the Company began making interest payments on its senior notes upon confirmation of the Joint Plan.
Net cash used by investing activities was $11.7 million for 2000 compared with $1.0 million for 1999. The cash used by investing activities for 2000 increased due to the Company's resumption of its drilling activities during 2000.
Net cash provided by financing activities in 2000 was $2.0 million. The net cash provided by financing activities during 2000 consisted of the $2.0 million paid by Arnos, in accordance with the Joint Plan, to purchase additional common stock such that, together with its affiliates, it would own 49.9% of the outstanding common stock of the Company. There was no cash provided by financing activities in 1999.
The Company's working capital surplus at December 31, 2000 was $19.8 million compared to a working capital deficit at December 31, 1999 of $11.1 million. The increase in working capital was due primarily to the increase in cash and cash equivalents and the reclassification of the prepetition accrued interest to long-term.
FUTURE CAPITAL AND FINANCING REQUIREMENTS
The Company currently has $10.9 million outstanding under its existing $25 million credit facility with Arnos. The credit facility will remain in place under existing terms until new terms are agreed upon between the Company and Arnos. The Company was in violation of the credit facility's minimum interest coverage ratio at June 30, 2001 and September 30, 2001, however, the Company obtained a default waiver from Arnos through December 31, 2001 with respect to this violation and an extension of the maturity date of the credit facility through December 31, 2001. Arnos continues to be the holder of the credit facility; however, the $10.9 million note currently outstanding under the credit facility was contributed to Holding LLC as part of
Gascon's contribution to Holding LLC on September 12, 2001. The Company anticipates repayment of this amount through the priority distribution from Holding LLC. In December 2001, the maturity date of the credit facility was extended to December 31, 2003 and a waiver of compliance was given with respect to any and all covenant violations.
Although the Company is highly leveraged following confirmation of the Plan of Reorganization, the Company expects that availability under its existing credit facility, expected cash flows from guaranteed payments, priority distributions and management fees will be sufficient to fund its operations and debt service. However, no assurances can be given that Holding LLC will generate sufficient cash flows to make these payments and in that event, the Company would not be able to meet its obligations.
In August 2001, the Company redeemed both $16.4 million of principal outstanding under the senior note obligations, and $4.8 million of Reinstated Interest for $10.5 million. The Company paid two Arnos affiliates approximately $.4 million in current interest on the redeemed senior note obligations at the date of redemption related to interest owed from the semi-annual interest payment date of May 1, 2001 to the date of redemption. As this was a partial redemption of the senior notes, it was accounted for as a modification of terms that changes the amounts of future cash payments. Accordingly, the excess of redeemed principal and interest over the redemption payment of $10.5 million will be amortized as a reduction to interest expense over the remaining life of the senior note obligations. In connection with this transaction, the Company borrowed $10.9 million under its existing credit facility with Arnos.
FINANCIAL REPORTING IMPACT OF FULL COST METHOD OF ACCOUNTING
Prior to the LLC Contribution, the Company followed the full cost method of accounting for oil and natural gas properties. Under such method, the net book value of such properties, less related deferred income taxes, may not exceed a calculated "ceiling." The ceiling is the estimated after-tax future net revenues from proved oil and natural gas properties, discounted at 10% per year. In calculating future net revenues, prices and costs in effect at the time of the calculation are held constant indefinitely, except for changes which are fixed and determinable by existing contracts. The net book value is compared to the ceiling on a quarterly and yearly basis. The excess, if any, of the net book value above the ceiling is required to be written off as a non-cash expense. The Company had no ceiling limitation writedowns during 1999 or 2000. There will be no additional writedowns in future periods under the full cost method of accounting due to the LLC Contribution in 2001.
CRITICAL ACCOUNTING POLICIES
The Company follows certain significant accounting policies when preparing its consolidated financial statements. A complete summary of these policies is included in Note 1 of Notes to Consolidated Financial Statements.
Certain of the policies require management to make significant and subjective estimates, which are sensitive to deviations of actual results from management's assumptions. In particular, management makes estimates regarding the total amount and timing of guaranteed payments and priority distributions that will actually be received from NEG Holding LLC in determining the amount of accretion income to be recorded; and, estimates of future taxable income in determining the amount of deferred tax assets which are more likely than not be realized.
Under the Holding LLC Operating Agreement, the Company is to receive guaranteed payments in addition to a priority distribution amount of $202.2 million before Gascon receives any monies. The priority distribution is to be made on or before November 1, 2006. Guaranteed payments are to be paid, on a semi-annual basis, based on 10.75% of the outstanding priority distribution amount. After the payments to the Company, Gascon is to receive distributions equivalent to the priority distribution amount and guaranteed payments plus other amounts as defined in the NEG Holding LLC Operating Agreement referred herein. Following the above distributions to the Company and Gascon, additional distributions, if any, are to be made in accordance with their respective capital accounts. Because of the substantial uncertainty that the Company will receive any distributions above the priority and guaranteed payment amounts, the Company accounts for its investment in Holding LLC as a preferred investment whereby guaranteed payment amounts received and
receipts of the priority distribution amount are recorded as reductions in the investment, and income is recognized from accretion of the investment up to the priority distribution amount including the guaranteed payments (based on the interest method) and the residual interest attributable to Holding LLC will be valued at zero. The ability of Holding LLC to make the guaranteed payments and priority distributions may be significantly impacted by the market prices of natural gas and crude oil and the ability of Holding LLC to effectively replace existing natural gas and crude oil reserves. Current estimates could change if future events are different than assumed by management.
Upon the formation of Holding LLC, management again evaluated all evidence, both positive and negative, in determining whether a valuation allowance to reduce the carrying value of deferred tax assets was still needed and concluded, based on the projected allocations of taxable income by Holding LLC, the company more likely than not will realize a partial benefit from the loss carryforwards. Ultimate realization of the deferred tax asset is dependent upon, among other factors, the Company's ability to generate sufficient taxable income within the carryforward periods and is subject to change depending on the tax laws in effect in the years in which the carryforwards are used.
RECENT ACCOUNTING PRONOUNCEMENTS
In July 2001, the Financial Accounting Standards Board (FASB) issued Statements of Financial Accounting Standards No. 141 "Business Combinations" ("SFAS No. 141") and No. 142 "Goodwill and Other Intangible Assets" ("SFAS No. 142"). SFAS No. 141 requires that all business combinations initiated after June 30, 2001, be accounted for under the purchase method and SFAS No. 142 requires that goodwill no longer be amortized to earnings, but instead be reviewed for impairment. As of September 30, 2001, there is no impact to the Company's financial statements as we have not entered into any business combinations and have not acquired goodwill.
Also, the FASB issued Statement of Financial Accounting Standards No. 143 "Accounting for Asset Retirement Obligations" ("SFAS No. 143") which establishes requirements for the accounting of removal-type costs associated with asset retirements. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002, with earlier application encouraged. The Company is currently assessing the impact on its financial statements.
On October 3, 2001, the FASB issued FASB Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144") which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years with earlier application encouraged. The Company is currently assessing the impact on its financial statements.
CHANGES IN PRICES
Oil and natural gas prices are subject to seasonal and other fluctuations that are beyond the Company's ability to control or predict.
INFLATION
Although certain of the Company's costs and expenses are affected by the level of inflation, inflation has not had a significant effect on the Company's results of operations during the three years ended December 31, 2001.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
In the past, the Company utilized various hedging instruments, principally to control risk related to future oil and natural gas prices. While the use of hedge contracts can limit the downside risk of adverse price movements, it may also limit future gains from favorable movements. The Company addressed market risk by selecting instruments whose value fluctuations correlated strongly with the underlying commodity. Credit risk related to derivative activities was managed by requiring minimum credit standards for counterparties, periodic settlements, and market to market valuations.
No hedge assets, or liabilities have been recorded by the Company as all of the hedges entered into by the Company were contributed to Holding LLC in September 2001. (Note 1)
The Company's exposure to interest rates relates primarily to its borrowings under its credit facility. The Company does not currently use derivatives to manage interest rate risk. Interest is payable on borrowings under the credit facility based on a floating rate. If short-term interest rates average 10% higher in 2002 than they were in 2001, the Company's interest expense would increase by approximately $.1 million. This amount was determined by applying the hypothetical interest rate change to the Company's outstanding borrowings under the credit facility at December 31, 2001.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Financial Statements of the Company required by this Item 8 are included as part of Item 14(a)(1) hereof. These Financial Statements also serve as financial statements required pursuant to Rule 15d-21 and Form 11-K of the Exchange Act for the National Energy Group, Inc. Employee Stock Purchase Plan, as such Plan invests solely in the Company's common stock.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
As discussed in our Form 8-K dated April 26, 2001, the Company replaced Ernst & Young LLP with KPMG LLP as the principle independent auditor for the fiscal year ending December 31, 2001.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item 10 will be provided in the sections entitled "Director Election", "Management" and "Certain Relationships and Related Transactions" in the Company's definitive Proxy Statement for its 2002 Annual Meeting of Shareholders (the "Proxy Statement"), and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item 11 will be provided in the section entitled, "Executive Compensation" in the Company's Proxy Statement, and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item 12 will be provided in the section entitled "Security Ownership of Certain Beneficial Owners and Management" in the Company's Proxy Statement, and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item 13 will be provided in the section entitled "Certain Relationships and Related Transactions" in the Company's Proxy Statement, and is incorporated herein by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report.
1. Financial Statements: See Index to Financial Statements and Financial Statement Schedules on page of this report.
2. Financial Statement Schedules: See Index to Financial Statements and Financial Statement Schedules on page of this report.
3. Exhibits: The following documents are filed as exhibits to this report:
- ---------------
(1) Incorporated by reference to the Company's Current Report on Form 8-K, dated August 29, 1996.
(2) Incorporated by reference to the Company's Registration Statement on Form S-4 (No. 33-38331), dated April 23, 1991.
(3) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996.
(4) Incorporated by reference to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1992.
(5) Incorporated by reference to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1995.
(6) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997.
(7) Incorporated by reference to the Company's Schedule 14A filed April 25, 1997.
(8) Incorporated by reference to the Company's Form S-8 filed December 23, 1997.
(9) Incorporated by reference to the Company's Form S-4 (No. 333-38075), filed October 16, 1997.
(10) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1997.
(11) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998.
(12) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2000.
(13) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2000.
(14) Incorporated by reference to the Company's Annual Report on Form 10-K for the year Ended December 31, 2000.
(15) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2001.
(16) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2001.
(17) Filed herewith.
(b) No reports on Form 8-K were filed during the quarter ended December 31,
GLOSSARY
Wherever used herein, the following terms shall have the meaning specified.
Bbl -- One stock tank barrel, or 42 U.S. gallons liquid volume, used herein in reference to crude oil or other liquid hydrocarbons.
Bcf -- One billion cubic feet.
Bcfe -- One billion cubic feet of Natural Gas Equivalent.
Behind the Pipe -- Hydrocarbons in a potentially producing horizon penetrated by a well bore the production of which has been postponed pending the production of hydrocarbons from another formation penetrated by the well bore. The hydrocarbons are classified as proved but non-producing reserves.
Developed Acreage -- Acres which are allocated or assignable to producing wells or wells capable of production.
Development Well -- A well drilled within the proved area of an oil and natural gas reservoir to the depth of stratigraphic horizon known to be productive.
Dry Well -- A well found to be incapable of producing either oil or natural gas in sufficient quantities to justify completion as an oil or natural gas well.
EBITDA -- Earnings (including interest income and excluding accretion of Investment in NEG Holding LLC, discontinued operations, extraordinary items, charges resulting from changes in accounting and significant nonrecurring revenues and expenses and reorganization items) before interest expense, income taxes, depletion, depreciation and amortization, and the provision for impairment of oil and natural gas properties. EBITDA is not a measure of cash flow as determined by generally accepted accounting principles. EBITDA information has been included in this document because EBITDA is a measure used by certain investors in determining historical ability to service indebtedness. EBITDA should not be considered as an alternative to, or more meaningful than, net income or cash flows as determined in accordance with generally accepted accounting principles as an indicator of operating performance or liquidity.
Exploratory Well -- A well drilled to find and produce oil or natural gas in an unproved area, to find a new reservoir in a field previously found to be productive of oil or natural gas in another reservoir, or to extend a known reservoir.
Gross Acres or Gross Wells -- The total acres or wells, as the case may be, in which a Working Interest is owned.
Infill Well -- A well drilled between known producing wells.
Mbbl -- One thousand Bbl.
Mcf -- One thousand cubic feet.
Mcfe -- One thousand cubic feet of Natural Gas Equivalent.
Mmcf -- One million cubic feet.
Mmcfe -- One million cubic feet of Natural Gas Equivalent.
Natural Gas Equivalent -- The ratio of one Bbl of crude oil to six Mcf of natural gas.
Net Acres or Net Wells -- The sum of the fractional Working Interests owned in Gross Acres or Gross Wells.
NYMEX -- New York Mercantile Exchange.
Oil, Gas and Mineral Lease -- An instrument by which a mineral fee owner grants to a lessee the right for a specific period of time to explore for oil and natural gas underlying the lands covered by the lease and the
right to produce any oil and natural gas so discovered generally for so long as there is production in economic quantities from such lands.
OPEC -- Organization of Petroleum Exporting Countries.
Overriding Royalty Interest -- A fractional undivided interest in an oil and natural gas property entitling the owner of a share of oil and natural gas production, in addition to the usual royalty paid to the owner, free of costs of production.
PDNP -- Proved developed, nonproducing, or Behind the Pipe reserves.
Productive Well -- A well that is producing oil or natural gas or that is capable of production.
Proved Developed Producing Reserves -- Proved reserves that can be expected to be recovered from currently producing zones under the continuation of present operating methods.
Proved Developed Reserves -- Reserves that can be expected to be recovered through existing wells with existing equipment and operating methods.
Proved Reserves -- The estimated quantities of crude oil, natural gas, and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions.
Proved Undeveloped Reserves -- Reserves that are expected to be recovered from new wells on undrilled acreage, or from existing wells where a relatively major expenditure is required for completion.
PUD -- See Proved Undeveloped Reserves.
PV 10% -- The discounted future net cash flows for Proved Reserves of oil and natural gas computed on the same basis as the Standardized Measure, but without deducting income taxes, which is not in accordance with generally accepted accounting principles. PV 10% is an important financial measure for evaluating the relative significance of oil and natural gas properties and acquisitions, but should not be construed as an alternative to the Standardized Measure (as determined in accordance with generally accepted accounting principles).
Revenue Interest -- The interest in a lease or well that receives a proportionate share of all revenues from that lease or well as identified in the division order.
Royalty Interest -- An interest in an oil and natural gas property entitling the owner to a share of oil and natural gas production free of costs of production.
Secondary Recovery -- A method of oil and natural gas extraction in which energy sources extrinsic to the reservoir are utilized.
Standardized Measure -- The estimated future net cash flows from Proved Reserves of oil and natural gas computed using prices and costs, at the date indicated, after income taxes and discounted at 10%.
Undeveloped Acreage -- Lease acreage on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and natural gas regardless of whether such acreage contains Proved Reserves.
Working Interest -- The operating interest which gives the owner the right to participate in the drilling, producing, and conducting operating activities on the property and a share of all costs of exploration, development, and operations and all risks in connection therewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
NATIONAL ENERGY GROUP, INC.
POWER OF ATTORNEY AND SIGNATURES
The undersigned directors and officers of National Energy Group, Inc. hereby constitute and appoint Bob G. Alexander with full power to act and with full power of substitution and resubstitution, our true and lawful attorney-in-fact with full power to execute in our name and on our behalf in the capacities indicated below any and all amendments to this Form 10-K and to file the same, with all exhibits thereto and other documents in connection therewith with the Commission, and hereby ratify and confirm all that such attorney-in-fact, which he or his substitute shall lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities on April 1, 2002.
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
FINANCIAL STATEMENTS
FINANCIAL STATEMENT SCHEDULES
All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Shareholders National Energy Group, Inc.
We have audited the accompanying consolidated balance sheet of National Energy Group, Inc., as of December 31, 2001, and the related consolidated statement of operations, stockholders' equity (deficit), and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of National Energy Group, Inc., at December 31, 2001, and the results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
/s/ KPMG LLP
Dallas, Texas March 22, 2002
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Shareholders National Energy Group, Inc.
We have audited the accompanying consolidated balance sheets of National Energy Group, Inc., as of December 31, 2000, and the related consolidated statements of operations, stockholders' equity (deficit), and cash flows for each of the two years in the period ended December 31, 2000. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Energy Group, Inc., at December 31, 2000, and the consolidated results of its operations and its cash flows for each of the two years in the period ended December 31, 2000, in conformity with accounting principles generally accepted in the United States.
/s/ ERNST & YOUNG LLP
Dallas, Texas April 16, 2001
NATIONAL ENERGY GROUP, INC.
CONSOLIDATED BALANCE SHEETS
See accompanying notes.
NATIONAL ENERGY GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes.
NATIONAL ENERGY GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes.
NATIONAL ENERGY GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
See accompanying notes.
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2001
1. BACKGROUND AND BANKRUPTCY FILING
National Energy Group, Inc. (the "Company") was incorporated under the laws of the State of Delaware on November 20, 1990. Effective June 11, 1991, Big Piney Oil and Gas Company and VP Oil, Inc. merged with and into the Company. On August 29, 1996, Alexander Energy Corporation was merged with and into a wholly-owned subsidiary of the Company, which subsidiary was merged with and into the Company on December 31, 1996.
The Company was an independent energy company engaged in the acquisition, exploration, exploitation, development and production of oil and natural gas properties in major producing basins onshore in Texas, Louisiana, Oklahoma, and Arkansas.
On February 11, 1999, the United States Bankruptcy Court for the Northern District of Texas, Dallas Division ("Bankruptcy Court") entered an involuntary petition placing the Company under protection of the Bankruptcy Court pursuant to Title 11, Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Proceeding"). On July 24, 2000, the Bankruptcy Court entered a subsequent order confirming a Plan of Reorganization (the "Plan of Reorganization") jointly proposed by the Company and the official committee of unsecured creditors, which Plan of Reorganization became effective on August 4, 2000. The Bankruptcy Court issued a final decree closing the case effective December 13, 2001. Accordingly, the Company has effectively settled all matters relating to the Bankruptcy Proceeding.
As mandated by the Plan of Reorganization and the Bankruptcy Court, NEG Holding LLC ("Holding LLC"), a Delaware limited liability company, was formed in August 2000. In exchange for an initial 50% membership interest in Holding LLC, on September 12, 2001, but effective as of May 1, 2001, the Company contributed to Holding LLC all of its operating assets and oil and natural gas properties excluding cash of $4.3 million ("LLC Contribution"). In exchange for its initial 50% membership interest in Holding LLC, Gascon Partners, an affiliate of the Company's largest stockholder ("Gascon"), contributed its sole membership interest in Shana National LLC, an oil and natural gas producing company, and cash, including a $10.9 million Revolving Note issued to Arnos Corp., an affiliate of the Company's largest stockholder ("Arnos"), evidencing the borrowings under the Company's revolving credit facility. In connection with the foregoing, Holding LLC initially owns 100% of the membership interest in NEG Operating LLC ("Operating LLC"), a Delaware limited liability company. All of the oil and natural gas assets contributed by the Company and all of the oil and natural gas assets associated with Gascon's contribution to Holding LLC were transferred from Holding LLC to Operating LLC on September 12, 2001, but effective as of May 1, 2001.
The assets contributed by the Company to Holding LLC were current assets of $11.5 million, net oil and natural gas assets of $85.0 million and other assets of $4.8 million. The liabilities assumed by Holding LLC were current liabilities of $4.2 million, intercompany payable to Gascon of $4.8 million and long-term liabilities of $1.0 million.
The Holding LLC Operating Agreement entered into on September 12, 2001, contains a provision that allows Gascon at any time, in its sole discretion, to redeem the Company's membership interest in Holding LLC at a price equal to the fair market value of such interest determined as if Holding LLC had sold all of its assets for fair market value and liquidated. Since all of the Company's operating assets and oil and natural gas properties have been contributed to Holding LLC, as noted above, following such a redemption, the Company's principal assets would consist solely of its cash balances. In the event that such redemption right is exercised by Gascon and there follows a liquidation and distribution of the proceeds, the Company may be obligated to use the proceeds that it would receive for its redeemed membership interest to pay outstanding indebtedness and operating expenses before the distribution of any portion of such proceeds to the Company's shareholders. Following the payment of the Company's indebtedness (currently held by entities
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
owned or controlled by Carl C. Icahn) and its operating expenses, there is a substantial risk that there will be no proceeds remaining for distribution to the Company's shareholders.
As a result of the foregoing transactions and as mandated by the Plan of Reorganization, the Company is a holding company of which (i) the principal assets are its remaining cash balances, accounts receivable from affiliates, deferred tax asset, and its initial 50% membership interest in Holding LLC, and (ii) the principal liabilities are the $10.9 million outstanding under its existing $25 million revolving credit facility with Arnos and its 10 3/4% senior notes and Reinstated Interest (defined below). None of the Company's employees have been transferred to Holding LLC or Operating LLC.
Pursuant to the Plan of Reorganization, as of December 31, 2000, the Company reinstated $45.8 million of interest expense on the senior notes ("Reinstated Interest"). This Reinstated Interest consisted of $10.5 million of prepetition interest and $35.3 million of interest expense that did not accrue during the pendancy of the Bankruptcy Proceeding pursuant to Bankruptcy Court rules and regulations. Accordingly, interest will accrue at 10.75% on the revised obligation amount at December 31, 2000, of $210.8 million pursuant to terms of the senior notes indenture. The Reinstated Interest plus interest accrued thereon becomes due in installments beginning in April 2003. The Company will continue to pay the semi-annual interest on the original senior note face amount of $165 million. The senior note balance is $148.6 million as of December 31, 2001.
The Company remains highly leveraged after confirmation of the Plan of Reorganization.
2. SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying financial statements for periods during the Bankruptcy Proceeding have been presented in accordance with Statement of Position 90-7, Financial Reporting by Entities in Reorganization under the Bankruptcy Code("SOP 90-7"). In accordance with SOP 90-7, no interest was accrued on unsecured debt, no dividends on preferred stock were accrued, unamortized premiums and debt issuance costs relating to unsecured debt were expensed during 1999, costs relating to the bankruptcy proceeding and interest earned on accumulating cash resulting from the bankruptcy proceeding were reported as reorganization items in the accompanying statements of operations, and liabilities subject to compromise have been separately reported in the accompanying balance sheets.
The Company's contribution of all its operating assets and oil and natural gas properties occurred on September 12, 2001. For tax and valuation purposes, the effective date is as of May 1, 2001, however, solely for financial reporting purposes the transaction is as of September 1, 2001. Operations from September 1 to September 12 were not significant. Management fees and guaranteed payments accruing from May 1 through September 1, 2001 aggregating $7,465,694 were recorded as an increase to additional paid-in capital.
CONSOLIDATION
The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been eliminated.
ACCOUNTING ESTIMATES
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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. Actual results could differ from these estimates.
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
CASH AND CASH EQUIVALENTS
Cash and cash equivalents may include demand deposits, short-term commercial paper, and/or money-market investments with maturities of three months or less when purchased. At December 31, 2001, all cash and cash equivalents were invested with Bank One, Texas, N.A.
INVESTMENT IN NEG HOLDING LLC
The Company accounts for its investment in Holding LLC as a preferred investment. Income is recognized based on the interest method through the accretion of guaranteed payments and priority distributions to be received from Holding LLC through November 1, 2006 (see Note 8). Cash distributions are recorded as reductions in the carrying value of the investment when received. Following receipt of the guaranteed payments and priority distributions, there is substantial doubt that the Company will receive additional distributions from Holding LLC. Accordingly, the residual interest will then be valued at zero.
The Company periodically evaluates the propriety of the carrying amount of its investment in Holding LLC to determine whether current events or circumstances warrant adjustments to the carrying value and/or revisions to accretion of income. The Company currently believes that no such impairment has occurred and that no revision to the accretion of income is warranted.
OIL AND NATURAL GAS PROPERTIES
Prior to the LLC Contribution, the Company utilized the full cost method of accounting for its crude oil and natural gas properties. Under the full cost method, all productive and nonproductive costs incurred in connection with the acquisition, exploration, and development of crude oil and natural gas reserves were capitalized and amortized on the units-of-production method based upon total proved reserves. The costs of unproven properties were excluded from the amortization calculation until the individual properties were evaluated and a determination was made as to whether reserves exist. Conveyances of properties, including gains or losses on abandonments of properties, were treated as adjustments to the cost of crude oil and natural gas properties, with no gain or loss recognized.
Under the full cost method, the net book value of oil and natural gas properties, less related deferred income taxes, may not exceed the estimated after-tax future net revenues from proved oil and natural gas properties, discounted at 10% per year (the ceiling limitation). In arriving at estimated future net revenues, estimated lease operating expenses, development costs, abandonment costs, and certain production related and ad-valorem taxes are deducted. In calculating future net revenues, prices and costs in effect at the time of the calculation are held constant indefinitely, except for changes which are fixed and determinable by existing contracts. The net book value is compared to the ceiling limitation on a quarterly and yearly basis. The excess, if any, of the net book value above the ceiling limitation is required to be written off as a non-cash expense. The Company did not incur ceiling limitation writedowns during 1999, 2000, or 2001.
The Company contributed all of its oil and natural gas assets to Holding LLC in September 2001.
The Company has capitalized internal costs of $814,000, $559,000, and $454,000 for the years ended December 31, 1999, 2000, and 2001, respectively, as costs of oil and natural gas properties. Such capitalized costs include salaries and related benefits of individuals directly involved in the Company's acquisition, exploration, and development activities based on the percentage of their time devoted to such activities. The Company did not capitalize interest during 1999, 2000 or 2001. Effective with the transfer of the Company's oil and natural gas assets to Holding LLC, the Company no longer capitalizes internal costs.
As an operator of oil and natural gas properties, the Company was subject to extensive federal, state, and local environmental laws and regulations. These laws, which are constantly changing, regulate the discharge of materials into the environment and may require the Company to remove or mitigate the environment effects
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
of the disposal or release of petroleum or chemical substances at various sites. Environmental expenditures were expensed or capitalized depending on their future economic benefit. Expenditures that relate to an existing condition caused by past operations and that have no future economic benefits were expensed. Liabilities for expenditures of a noncapital nature were recorded when environmental assessment and/or remediation is probable, and the costs can be reasonably estimated. Effective with the LLC Contribution, the Company no longer owns any oil and natural gas properties and is not subject to the above expenditures.
Prior to the LLC Contribution, the Company's operations were subject to all of the risks inherent in oil and natural gas exploration, drilling and production. These hazards can result in substantial losses to the Company due to personal injury and loss of life, severe damage to and destruction of property and equipment, pollution or environmental damage, or suspension of operations. The Company maintained insurance of various types customary in the industry to cover its operations and believed it was insured prudently against certain of these risks. In addition, the Company maintained operator's extra expense coverage that provided coverage for the care, custody and control of wells drilled by the Company. The Company's insurance did not cover every potential risk associated with the drilling and production of oil and natural gas. As a prudent operator, the Company maintained levels of insurance customary in the industry to limit its financial exposure in the event of a substantial environmental claim resulting from sudden and accidental discharges. However, 100% coverage was not maintained. The occurrence of a significant adverse event, the risks of which are not fully covered by insurance, could have had material adverse effect on the Company's financial condition and results of operations. The Company believed that it operates in compliance with government regulations and in accordance with safety standards which meet or exceed industry standards.
OTHER PROPERTY AND EQUIPMENT
Other property and equipment includes furniture, fixtures, and other equipment. Such assets are recorded at cost and are depreciated over their estimated useful lives using the straight-line method. Effective with the LLC Contribution, the Company no longer owns any property and equipment.
Maintenance and repairs are charged against income when incurred; renewals and betterments, which extend the useful lives of property and equipment, are capitalized.
INCOME TAXES
Deferred tax assets and liabilities are determined based on differences between financial reporting and tax basis of assets and liabilities and are measured using enacted tax rates. The effect on deferred tax assets and liabilities of a change in tax rate is recognized in the period that includes the enactment date. The measurement of deferred tax assets is adjusted by a valuation allowance, if necessary, to recognize the extent to which, based on available evidence, the future tax benefits more likely than not will be realized.
FINANCIAL INSTRUMENTS
See Notes 5 and 6 for disclosure of the fair value of borrowings under the Company's credit facility and the 10 3/4% Senior Notes, respectively.
The Company's marketable securities were classified as available-for-sale. Available-for-sale securities were carried at fair value, with the unrealized gains and losses, net of tax, reported as a separate component of stockholders' equity. Realized gains and losses and declines in value judged to be other-than-temporary were included in income. The cost of securities sold is based on the specific identification method.
The Company sold its marketable securities in 2000 for $413,147, recognizing a loss of $102,197. The Company's investment in marketable securities was comprised of securities of another independent oil and natural gas company. The Company had no sales of marketable securities during 1999 or 2001.
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company sold crude oil and natural gas to various customers. In addition, the Company participated with other parties in the operation of crude oil and natural gas wells. Substantially all of the Company's accounts receivable were due from either purchasers of crude oil and natural gas or participants in crude oil and natural gas wells for which the Company served as the operator. Generally, operators of crude oil and natural gas properties have the right to offset future revenues against unpaid charges related to operated wells. Crude oil and natural gas sales were generally unsecured.
Allowances for bad debt totaled approximately $229,000 at December 31, 2000. At December 31, 2000 and 2001, the carrying value of the Company's accounts receivable approximates fair value.
NATURAL GAS PRODUCTION IMBALANCES
Prior to the LLC Contribution, the Company accounted for natural gas production imbalances using the sales method, whereby the Company recognized revenue on all natural gas sold to its customers notwithstanding the fact that its ownership may be less than 100% of the natural gas sold. Liabilities were recorded by the Company for imbalances greater than the Company's proportionate share of remaining estimated natural gas reserves. After the LLC Contribution, the Company had no oil and natural gas production imbalances.
STOCK COMPENSATION
The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, in accounting for its employee stock options. Under APB 25, if the exercise price of an employee's stock options equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense is recognized.
In March 2000, the Financial Accounting Standards Board issued Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation" ("FIN 44"), an interpretation of APB 25. FIN 44, which was adopted prospectively by the Company as of July 1, 2000, requires certain changes to the previous practice regarding the accounting for certain stock compensation arrangements. FIN 44 does not change APB 25's intrinsic value method, under which compensation expense is generally not recognized for grants of stock options to employees with an exercise price equal to the market price of the stock at the date of grant, but it has narrowed its application. The adoption of FIN 44 did not have a significant effect on the Company's existing accounting for its employee stock options.
EARNINGS (LOSS) PER SHARE
Earnings (loss) per share is computed in accordance with Financial Accounting Standards Board Statement No. 128, Earnings per Share. Basic earnings per share data is computed by dividing net income (loss) applicable to common shareholders by the weighted average number of common shares outstanding and excludes any dilutive effects of options, warrants, and convertible securities. Shares issuable upon exercise of options and warrants are included in the computation of diluted earnings per common and common equivalent share to the extent that they are dilutive. Diluted earnings per share computations also assume the conversion of the Company's preferred stock (Note 9) if such conversion has a dilutive effect. For the year ended December 31, 1999 and in 2000, prior to the confirmation of the Joint Plan, neither the options and warrants nor the assumed conversion of the preferred stock had a dilutive effect on the loss per share calculations. Subsequent to the confirmation of the Plan of Reorganization and in 2001, all common stock equivalents had been canceled. Accordingly, both basic and diluted loss per share calculations for such periods are based on the weighted average number of common shares outstanding during each year.
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
COMPREHENSIVE INCOME
Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. For 1999 and 2000, the differences between the Company's net earnings and total comprehensive income were not material, consisting solely of unrealized gains and losses on the Company's available for sale marketable securities. There were no differences between net earnings and total comprehensive income in 2001.
DERIVATIVES
In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Certain Hedging Activities." In June 2000, the FASB issued SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activity, an Amendment of SFAS 133." SFAS No. 133 and SFAS No. 138 require that all derivative instruments be recorded on the balance sheet at their respective fair values. SFAS No. 133 and SFAS No. 138 are effective for all fiscal quarters of all fiscal years beginning after June 30, 2000; the Company adopted SFAS No. 133 and SFAS No. 138 on July 1, 2000, at which time it was not a party to any derivative financial instruments.
All derivatives are recognized on the balance sheet at their fair value. Prior to the LLC Contribution, the Company periodically managed its exposure to fluctuations in oil and natural gas prices by entering into various derivative instruments consisting principally of collar options and swaps. The Company elected not to designate these instruments as hedges for accounting purposes, accordingly the change in unrealized gains and losses is included in other income and expense. Cash settlements of these instruments are included in oil and natural gas sales. The following summarizes the cash settlements and unrealized gains and losses for the years ended December 31, 1999, 2000 and 2001:
In connection with the LLC Contribution in September 2001, the Company contributed all of its derivative financial instruments with a fair value of $(135,954) to NEG Holding LLC. The fair value of the Company's derivative financial instruments was $580,500 at December 31, 2000.
3. MANAGEMENT AGREEMENT
The management and operation of Operating LLC is being undertaken by the Company pursuant to a Management Agreement (the "Management Agreement") which the Company has entered into with Operating LLC. However, neither the Company's officers nor directors will control the strategic direction of Operating LLC's oil and natural gas business including oil and natural gas drilling and capital investments, which shall be controlled by the managing member of Holding LLC (currently Gascon). The Management Agreement provides that the Company will manage Operating LLC's oil and natural gas assets and business until the earlier of November 1, 2006, or such time as Operating LLC no longer owns any of the managed oil and natural gas properties. The Company's employees will conduct the day-to-day operations of Operating LLC's oil and natural gas properties, and all costs and expenses incurred in the operation of the oil and natural gas properties shall be borne by Operating LLC; although the Management Agreement provides that the salary of the Company's Chief Executive Officer shall be 70% attributable to the managed oil and natural gas properties, and the salaries of each of the General Counsel and Chief Financial Officer shall be 20% attributable to the managed oil and natural gas properties. In exchange for the Company's management services, Operating LLC shall pay the Company a management fee equal to 115% of the actual direct and
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
indirect administrative and reasonable overhead costs incurred by the Company in operating the oil and natural gas properties, which either the Company or Operating LLC may seek to change within the range of 110%-115% as such change is warranted; however, the parties have agreed to consult with each other to ensure that such administrative and reasonable overhead costs attributable to the managed properties are properly reflected in the management fee paid to the Company. In addition, Operating LLC has agreed to indemnify the Company to the extent it incurs any liabilities in connection with its operation of the assets and properties of Operating LLC, except to the extent of its gross negligence, or misconduct. The Company recorded $2.7 million as a management fee for the four month period ended December 31, 2001.
4. ACQUISITIONS AND DISPOSALS
In December 1999, the Company sold its interest at an oil and natural gas auction in 142 non-strategic and non-producing oil and natural gas properties to various purchasers. Net proceeds from this sale approximated $3.0 million. The sale of these properties did not have a significant impact on the Company's results of operations for 1999.
In September 2000, the Company sold its interest in the Mustang Island areas producing and non-producing leases, along with the associated facilities and platforms for $.4 million and retained a right to take a 10% proportionately reduced working interest in the first exploration well drilled. The sale of this property did not have a significant impact on the Company's results of operations for 2000.
In October 2000, the Company sold its interest at an oil and natural gas auction in 39 non-strategic oil and natural gas properties to various purchasers. Net proceeds from this sale approximated $1.4 million.
In January 2001, the Company sold its interest in the Shell Bayou Sorrel field located in Iberville Parish Louisiana for $.75 million.
In the first quarter of 2001, the Company purchased additional working interests in the Goldsmith Adobe Unit, for approximately $2.3 million. The Company now owns an approximate 99.9% working interest in this property.
5. CREDIT FACILITIES
The Company has an outstanding credit facility with Arnos Corp. with a borrowing base of $25 million. The Company had $25 million outstanding under the credit facility at December 31, 2000, and $10.9 million outstanding at December 31, 2001. Arnos continues to be the holder of the credit facility, however, the $10.9 million note currently outstanding under the credit facility was contributed to Holding LLC as part of Gascon's contribution on September 12, 2001. The credit facility was originally secured by liens granted by the Company on substantially all of the Company's oil and natural gas properties, whether currently owned or hereafter acquired, and a negative pledge on all other oil and natural gas properties. The Company contributed all of its oil and natural gas properties to Holding LLC and therefore, the credit facility is currently secured by oil and natural gas properties held by Holding LLC. The credit facility requires, among other things, semiannual engineering reports covering oil and natural gas properties, and maintenance of certain financial ratios, including the maintenance of a minimum interest coverage, a current ratio, and a minimum tangible net worth.
The credit facility contains other covenants prohibiting cash dividends, distributions, loans, or advances to third parties, except that cash dividends on preferred stock will be allowed so long as no event of default exists or would exist as a result of the payment thereof.
The Company was in compliance with the covenants at December 31, 2000, but classified the amount outstanding as current since the credit facility matured on August 29, 2000. On December 15, 2001, the maturity date was extended to December 31, 2003, and there was a waiver of compliance with any and all
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
covenant violations through that date. At December 31, 2001, the balance outstanding was classified as long-term. The Company was not in compliance with the interest coverage ratio at December 31, 2001, however, there was no violation due to the covenant waiver.
At December 31, 2001, the fair value of borrowings under the credit facility approximates the carrying value of the liability, as interest on borrowings under the facility accrues at variable rates based on prime rates.
6. 10 3/4 SENIOR NOTES DUE 2006
In 1996, the Company issued $100 million aggregate principal amount of unregistered Series A 10 3/4% Senior Notes due 2006 which were exchanged in 1997 for registered Series B 10 3/4% Senior Notes due 2006 with substantially identical terms. Collectively, the Series A Notes and Series B Notes are referred to as the "Series A/B Notes." In August 1997, the Company issued $65 million aggregate principal amount of its unregistered Series C 10 3/4% Senior Notes. In December 1997, the Company exchanged substantially all of the Series A/B Notes and all of the Series C Notes for registered Series D 10 3/4% Senior Notes due 2006. The Series D Notes are substantially identical to the Series A/B Notes and the Series C Notes. Upon confirmation of the Joint Plan, the senior notes are held in their entirety by Arnos and its affiliates. The Senior Notes bear interest at an annual rate of 10 3/4%, payable semiannually in arrears on May 1 and November 1 of each year. The Senior Notes are senior, unsecured obligations of the Company, ranking pari passu with all existing and future senior indebtedness of the Company, and senior in right of payment to all future subordinated indebtedness of the Company. Subject to certain limitations set forth in the indenture covering the Senior Notes (the "Indenture"), the Company and its subsidiaries may incur additional senior indebtedness and other indebtedness.
The Indenture contains certain covenants limiting the Company with respect to the following: (i) asset sales; (ii) restricted payments; (iii) the incurrence of additional indebtedness and the issuance of certain redeemable preferred stock; (iv) liens; (v) sale and leaseback transactions; (vi) lines of business; (vii) dividend and other payment restrictions affecting subsidiaries; (viii) mergers and consolidations; and (ix) transactions with affiliates.
On December 4, 1998, certain holders of the Senior Notes filed an Involuntary Petition for an Order for Relief under Chapter 11 of Title 11 of the United States Bankruptcy Code (Note 1). Accrual of interest on the Senior Notes was discontinued during the Bankruptcy Proceeding. Approximately $10.5 million additional interest expense would have been recognized by the Company during 2000 if not for the discontinuation of the interest accrual. In connection with the Plan of Reorganization, Unaccrued Interest (including compounding interest) totalling approximately $35.3 million was reinstated (Note 1).
The Company is unable to determine the fair value of the senior notes at December 31, 2001, due to a lack of available market quotations and inability to determine an appropriate discount rate.
In August 2001, the Company redeemed both $16.4 million of principal outstanding under the senior note obligations and $4.8 million of Reinstated Interest for $10.5 million. The Company paid two Arnos affiliates approximately $.4 million in current interest on the redeemed senior note obligations at the date of redemption related to interest owed from the last semi-annual interest payment date of May 1, 2001, to the date of redemption. As this was a partial redemption of the senior notes, it has been accounted for as a modification of terms that changes the amounts of future cash payments. Accordingly, the excess of redeemed principal and interest over the redemption payment of $10.5 million will be amortized as a reduction to interest expense over the remaining life of the bonds. In connection with this transaction, the Company borrowed $10.9 million under its existing credit facility with Arnos.
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
7. COMMITMENTS AND CONTINGENCIES
The Company leases office space under an operating lease. Rental expense charged to operations was approximately $449,000, $500,000, and $553,000 during the years ended December 31, 1999, 2000, and 2001, respectively. Minimum lease payments under future operating lease commitments at December 31, 2001, are as follows:
The Company is not a party to any material pending legal proceedings. The Company's Joint Plan became effective August 4, 2000, at which time the Company emerged from bankruptcy with the authority to conduct its business operations without Bankruptcy Court approval.
8. INVESTMENT IN NEG HOLDING LLC
As explained below, the Company's investment in NEG Holding LLC is recorded as a preferred investment. The initial investment was recorded at historical carrying value of the net assets contributed with no gain or loss recognized on the transfer.
The following is a summary income statement for NEG Holding LLC for the year ended December 31, 2001.
Under the Holding LLC Operating Agreement, the Company is to receive guaranteed payments in addition to a priority distribution amount of $202.2 million before Gascon receives any monies. The priority distribution is to be made on or before November 1, 2006. Guaranteed payments are to be paid, on a semi annual basis, based on 10.75% of the outstanding priority distribution amount. After the payments to the Company, Gascon is to receive distributions equivalent to the priority distribution amount and guaranteed payments plus other amounts as defined. Following the above distributions to the Company and Gascon, additional distributions, if any, are to be made in accordance with their respective capital accounts. The order of distributions is listed below. Because of the substantial uncertainty that the Company will receive any distributions above the priority and guaranteed payment amounts, the Company will account for its investment in Holding LLC as a preferred investment whereby guaranteed payment amounts received and receipts of the priority distribution amount are recorded as reductions in the investment, and income is recognized from accretion of the investment up to the priority distribution amount including the guaranteed payments (based on the interest method) and the residual interest attributable to Holding LLC will be valued at zero.
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company received a guaranteed payment of $10.9 million from NEG Holding in November 2001. The portion of the guaranteed payment related to the period prior to the transfer has been reflected as a contribution to the Company's equity.
The Holding LLC Operating Agreement requires that (provided full payment of all outstanding guaranteed payments has been made) distributions shall be made to both the Company and Gascon as follows:
- First and through November 1, 2006, to the Company in an amount equal to the Company's initial priority amount of $202.2 million minus any distributions previously made to the Company.
- Second, to Gascon in an amount equal to the excess of (a) the sum of (i) the Company's initial priority amount of $202.2 million, (ii) any additional capital contributions made by Gascon, (iii) the aggregate sum of all Guaranteed Payments, and (iv) an amount equal to the Accrued Gascon Amount (which, under the Holding LLC Operating Agreement, means an amount equal to the aggregate of interest that would be computed annually if interest were imposed at a rate equal to the prime rate plus 1/2% as of the close of each fiscal year on the excess of (a) the sum of (i) the cumulative Guaranteed Payments and (ii) the aggregate of any Accrued Gascon Amount computed in prior years, over (b) the cumulative distributions by Holding LLC to Gascon), over (b) distributions previously made to Gascon pursuant to this provision in the Holding LLC Operating Agreement.
- Third, to the Company and Gascon in accordance with their then respective Capital Accounts.
9. STOCKHOLDERS' EQUITY
PREFERRED STOCK
At December 31, 1999, the Company had authorized 330,000 shares of $1.00 par value convertible preferred stock designated in four series B through E:
The preferred stock series had certain liquidation and dividend preferences over the Company's common stock, and certain rights relating to the approval of corporate actions and appointment of members to the Company's Board of Directors.
In connection with the Plan of Reorganization, all of the Company's preferred stock issuances were converted into 714,286 shares of newly issued common stock of the reorganized Company. Accordingly, no shares of preferred stock are outstanding as of December 31, 2000 and 2001.
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
COMMON STOCK
Holders of common stock are entitled to one vote for each share held of record on all matters voted on by stockholders. The shares of the common stock do not have cumulative voting rights, which means that the holders of more than 50% of the shares of the common stock voting for the election of the directors can elect all of the directors to be elected by holders of the common stock, in which event the holders of the remaining shares of common stock will not be able to elect any director. Upon any liquidation, dissolution, or winding-up of the affairs of the Company, holders of the common stock would be entitled to receive, pro rata, all of the assets of the Company available for distribution to stockholders, after payment of any liquidation preference of any Preferred Stock that may be issued and outstanding at the time. Holders of the common stock have no subscription, redemption, sinking fund, or preemptive rights. The Company has never paid cash dividends on its common stock and does not expect to declare cash dividends in the foreseeable future.
Under terms of the Plan of Reorganization, each holder of common stock received one share of stock in the reorganized Company for every seven shares cancelled as a result of the reorganization. The new certificates were issued pursuant to a registration exemption under Section 1145 of the United States Bankruptcy Code and include a restrictive legend mandated by the Plan of Reorganization which prohibits transactions in the Company's common stock by anyone who is or will become, as a result of any such transaction, a "5 percent shareholder" within the meaning of Section 382 of the Internal Revenue Code. All information relating to shares of common stock for periods prior to confirmation of the Plan of Reorganization have been restated to reflect the effects of this reverse stock split.
WARRANTS
During 1996 and 1997, the Company issued an aggregate of approximately 2,846,000 warrants to purchase shares of the Company's common stock with exercise prices ranging form $2.07 to $4.09 per share. Approximately 2,450,000 warrants remaining outstanding were cancelled upon confirmation of the Plan of Reorganization.
STOCK OPTIONS
A summary of the Company's stock option activity, and related information for the years ended December 31, 1999, 2000, and 2001, follows:
All outstanding stock options were cancelled pursuant to confirmation of the Plan of Reorganization.
The Company has not issued any options subsequent to the confirmation of the Plan of Reorganization.
Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation, requires the disclosure of pro forma net income and earnings per share information computed as if the
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Company had accounted for its employee stock options under the fair value method set forth in SFAS 123. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for 1998: risk-free interest rates of 5.5%, a dividend yield of 0%, and volatility factors of .53. In addition, the fair value of these options was estimated based on an expected life of three to five years for options granted by the Company.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. All options were canceled in 2000 upon confirmation of the Joint Plan. The Company's pro forma information follows:
STOCK PURCHASE PLAN
During 1998, the Company's shareholders approved the Company's Employee Stock Purchase Plan ("ESPP"). Pursuant to the ESPP, employees can purchase the common stock of the Company at a specified price through payroll deductions during an offering period, currently established on a semi-annual basis. In June 1998, approximately 46,000 shares were issued to employees under the ESPP. During 1999 and 2000, no shares were issued to employees under the ESPP. This plan was terminated during 2001.
10. INCOME TAXES
The (provision) benefit for U.S. federal income taxes attributable to continuing operations is as follows:
The reconciliation of income taxes computed at the U.S. federal statutory tax rates to the benefit for income taxes on income from continuing operations is as follows:
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The computation of the net deferred tax asset (liability) follows:
At December 31, 2001, the Company had net operating loss carryforwards available for federal income tax purposes of approximately $129.3 million which begin expiring in 2002. Utilization of approximately $27.6 million of the net operating loss carryforwards is subject to various limitations because of previous changes in control of ownership (as defined in the Internal Revenue Code) of the Company and Alexander Energy. Additional net operating loss limitations may be imposed as a result of subsequent changes in stock ownership of the Company. Prior to the formation of Holding LLC, the income tax benefit associated with the loss carryforwards had not been recognized since, in the opinion of management, there was not sufficient positive evidence of future taxable income to justify recognition of a benefit. Upon the formation of Holding LLC, management again evaluated all evidence, both positive and negative, in determining whether a valuation allowance to reduce the carrying value of deferred tax assets was still needed and concluded, based on the projected allocations of taxable income by Holding LLC, the company more likely than not will realize a partial benefit from the loss carryforwards. Accordingly, the Company recorded a deferred tax asset of $31.9 million in September 2001. Ultimate realization of the deferred tax asset is dependent upon, among other factors, the Company's ability to generate sufficient taxable income within the carryforward periods and is subject to change depending on the tax laws in effect in the years in which the carryforwards are used. As a result of the recognition of expected future income tax benefits, subsequent periods will reflect a full effective tax rate provision.
11. NATURAL GAS HEDGING ACTIVITIES AND FORWARD SALES CONTRACTS
While the use of derivative contracts can limit the downside risk of adverse price movements, it may also limit future gains from favorable movements. The Company addressed market risk by selecting instruments whose value fluctuations correlated strongly with the underlying commodity. Credit risk related to derivative activities was managed by requiring minimum credit standards for counterparties, periodic settlements, and mark to market valuations.
During 2001, the Company entered into several derivative contracts. These contracts were contributed to Holding LLC in September 2001.
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
12. CRUDE OIL AND NATURAL GAS PRODUCING ACTIVITIES
The Company contributed all of its oil and natural gas assets to Holding LLC in September 2001.
Costs incurred in connection with the exploration acquisition, development, and exploitation of the Company's crude oil and natural gas properties for the years ended December 31, 1999, 2000, and 2001, are as follows:
The Company did not incur ceiling limitation writedowns during 1999, 2000 or 2001.
Revenues from individual purchasers that exceed 10% of total crude oil and natural gas sales are as follows:
The Company no longer owns any oil and natural gas assets and, consequently, no longer transacted business with the above purchasers from September 2001 due to the transfer of it's oil and natural gas assets to Holding LLC.
13. SUPPLEMENTARY CRUDE OIL AND NATURAL GAS RESERVE INFORMATION (UNAUDITED)
The revenues generated by the Company's operations are highly dependent upon the prices of, and demand for, oil and natural gas. The price received by the Company for its oil and natural gas production depends on numerous factors beyond the Company's control, including seasonality, the condition of the U.S. economy, foreign imports, political conditions in other oil and natural gas producing countries, the actions of the Organization of Petroleum Exporting Countries and domestic governmental regulations, legislation and policies.
The Company has made ordinary course capital expenditures for the development, and exploitation of oil and natural gas reserves, subject to economic conditions. The Company has interests in crude oil and natural gas properties that are principally located onshore in Texas, Louisiana, Oklahoma, and Arkansas. The Company does not own or lease any crude oil and natural gas properties outside the United States.
In 1999 and 2000, estimates of the Company's net recoverable crude oil, natural gas, and natural gas liquid reserves were prepared by Netherland, Sewell & Associates, Inc. The estimated reserves and related future net revenues as of August 31, 2001, were prepared internally using the estimated reserves and related future net revenues prepared by Netherland, Sewell & Associates, Inc. as of December 31, 2001 for the oil and natural gas properties contributed to Holding LLC. This was accomplished by adding back production for the four month period August 31, 2001 to December 31, 2001 and using constant prices in effect at August 31,
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2001. Estimated proved net recoverable reserves as shown below, include only those quantities that can be expected to be recoverable at prices and costs in effect at the balance sheet dates under existing regulatory practices and with conventional equipment and operating methods.
Proved developed reserves represent only those reserves expected to be recovered through existing wells. Proved undeveloped reserves include those reserves expected to be recovered from new wells on undrilled acreage or from existing wells on which a relatively major expenditure is required for recompletion.
Net quantities of proved developed and undeveloped reserves of natural gas and crude oil, including condensate and natural gas liquids, are summarized as follows:
The Company contributed all of its oil and natural gas assets to Holding LLC in September 2001.
Reservoir engineering is a subjective process of estimating the volumes of underground accumulations of oil and natural which cannot be measured precisely. The accuracy of any reserve estimates is a function of the quality of available data and of engineering and geological interpretation and judgment. Reserve estimates prepared by other engineers might differ from the estimates contained herein. Results of drilling, testing, and production subsequent to the date of the estimate may justify revision of such estimate. Future prices received for the sale of oil and natural gas may be different from those used in preparing these reports. The amounts and timing of future operating and development costs may also differ from those used. Accordingly, reserve estimates are often different from the quantities of oil and natural gas that are ultimately recovered.
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following is a summary of a standardized measure of discounted net cash flows related to the Company's proved crude oil and natural gas reserves. For these calculations, estimated future cash flows from estimated future production of proved reserves were computed using crude oil and natural gas prices as of the end of each period presented. Future development, production and abandonment costs attributable to the proved reserves were estimated assuming that existing conditions would continue over the economic lives of the individual leases and costs were not escalated for the future. Estimated future income tax expenses were calculated by applying future statutory tax rates (based on the current tax law adjusted for permanent differences and tax credits) to the estimated future pretax net cash flows related to proved crude oil and natural gas reserves, less the tax basis of the properties involved and net operating loss carryforwards.
The Company cautions against using this data to determine the fair value of its crude oil and natural gas properties. To obtain the best estimate of fair value of the crude oil and natural gas properties, forecasts of future economic conditions, varying discount rates, and consideration of other than proved reserves would have to be incorporated into the calculation. In addition, there are significant uncertainties inherent in estimating quantities of proved reserves and in projecting rates of production that impair the usefulness of the data.
The standardized measure of discounted future net cash flows relating to proved crude oil and natural gas reserves are summarized as follows:
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following are the principal sources of change in the standardized measure of discounted future net cash flows:
During recent years, there have been significant fluctuations in the prices paid for crude oil in the world markets. This situation has had a destabilizing effect on crude oil posted prices in the United States, including the posted prices paid by purchasers of the Company's crude oil. The net weighted average prices of crude oil and natural gas at December 31, 1999, 2000, and August 31, 2001, used in the above table were $24.97, $25.95 and $26.02 per barrel of crude oil, respectively, and $2.26, $10.53 and $2.49 per thousand cubic feet of natural gas, respectively.
14. QUARTERLY FINANCIAL RESULTS (UNAUDITED)
In connection with confirmation of the Joint Plan, the Company recorded an extraordinary gain on the discharge of indebtedness during the three months ended September 30, 2000, of approximately $11.3 million. This extraordinary gain was primarily composed of the reversal of interest accrued on the senior notes prior to the Bankruptcy Proceeding of approximately $10.5 million ("Prepetition Interest"). In accordance with Bankruptcy Court rules and regulations, the Company did not accrue interest on the senior notes during the Bankruptcy Proceeding ("Unaccrued Interest"). It was determined that reinstatement of the Prepetition Interest and the Unaccrued Interest is necessary and consistent with the Joint Plan. As a result, the Company has recognized Unaccrued Interest (including interest on the Prepetition Interest and Unaccrued Interest) of $35.3 million and Prepetition Interest of $10.5 million as long-term interest payable in the accompanying balance sheet. The reinstatement of Unaccrued Interest has been recognized as an extraordinary loss in the accompanying statement of operations. The Company and Arnos have agreed this interest will not be due earlier than April 2003. Accordingly, interest will accrue on the revised obligation amount of $210.8 million pursuant to terms of the senior notes indenture.
NATIONAL ENERGY GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company's operating results for each quarter of 2000 and 2001 are summarized below (in thousands, except per share data).
REPORT OF INDEPENDENT AUDITORS
The Members NEG Holding LLC
We have audited the accompanying consolidated balance sheet of NEG Holding LLC, as of December 31, 2001, and the related consolidated statements of operations, members' equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of NEG Holding LLC, at December 31, 2001, and the consolidated results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
/s/ KPMG LLP
Dallas, Texas March 22, 2002
NEG HOLDING LLC
CONSOLIDATED BALANCE SHEET DECEMBER 31, 2001
See accompanying notes.
NEG HOLDING LLC
CONSOLIDATED STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2001
See accompanying notes.
NEG HOLDING LLC
CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2001
See accompanying notes.
NEG HOLDING LLC
CONSOLIDATED STATEMENT OF MEMBERS' EQUITY
See accompanying notes.
NEG HOLDING LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2001
1. BACKGROUND AND BANKRUPTCY FILING
NEG Holding LLC (the "Company"), a Delaware limited liability company, was formed in August 2000. Start up costs of the Company were incurred by Gascon and were not significant. No other activity occurred from August 2000 until the Members' contributions in September 2001. In exchange for an initial 50% membership interest in the Company, on September 12, 2001, but effective as of May 1, 2001, National Energy Group, Inc. ("NEG") contributed to the Company all of its operating assets and oil and natural gas properties. In exchange for its initial 50% membership interest in the Company, Gascon Partners ("Gascon"), contributed its sole membership interest in Shana National LLC, an oil and natural gas producing company, and cash, including a $10.9 million Revolving Note issued to Arnos Corp. ("Arnos"), evidencing the borrowings under the NEG revolving credit facility. In connection with the foregoing, the Company initially owns 100% of the membership interest in NEG Operating LLC ("Operating LLC"), a Delaware limited liability company. All of the oil and natural gas assets contributed by NEG and all of the oil and natural gas assets associated with Gascon's contribution to the Company were transferred from the Company to Operating LLC on September 12, 2001, but effective as of May 1, 2001. Allocation of membership interest was based principally on the estimated fair value of the assets contributed as of May 1, 2001. The following summarizes the carrying value of the net assets contributed as of September 1, 2001.
The Holding LLC Operating Agreement entered into on September 12, 2001, contains a provision that allows Gascon at any time, in its sole discretion, to redeem NEG's membership interest in the Company at a price equal to the fair market value of such interest determined as if Holding LLC had sold all of its assets for fair market value and liquidated.
The Company shall be dissolved and its affairs wound up in accordance with the Delaware Limited Liability Company Act and the Holding LLC Operating Agreement on December 31, 2024, unless the Company shall be dissolved sooner and its affairs wound up in accordance with the Delaware Limited Liability Company Act or the Holding LLC Operating Agreement.
2. SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION
The consolidated financial statements include the accounts of the Company, and its sole subsidiary Operating LLC. All significant intercompany transactions and balances have been eliminated.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
ACCOUNTING ESTIMATES
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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. Actual results could differ from these estimates.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents may include demand deposits, short-term commercial paper, and/or money-market investments with maturities of three months or less when purchased. At December 31, 2001, all cash and cash equivalents were invested with Bank One, Texas, N.A., Concordia Bank and Trust Company, AmSouth Bank and Fleet Bank, N.A.
OIL AND NATURAL GAS PROPERTIES
The Company utilizes the full cost method of accounting for its crude oil and natural gas properties. Under the full cost method, all productive and nonproductive costs incurred in connection with the acquisition, exploration, and development of crude oil and natural gas reserves are capitalized and amortized on the units-of-production method based upon total proved reserves. The costs of unproven properties are excluded from the amortization calculation until the individual properties are evaluated and a determination is made as to whether reserves exist. Conveyances of properties, including gains or losses on abandonments of properties, are treated as adjustments to the cost of crude oil and natural gas properties, with no gain or loss recognized.
Under the full cost method, the net book value of oil and natural gas properties, less related deferred income taxes, may not exceed the estimated after-tax future net revenues from proved oil and natural gas properties, discounted at 10% per year (the ceiling limitation). In arriving at estimated future net revenues, estimated lease operating expenses, development costs, abandonment costs, and certain production related and ad-valorem taxes are deducted. In calculating future net revenues, prices and costs in effect at the time of the calculation are held constant indefinitely, except for changes which are fixed and determinable by existing contracts. The net book value is compared to the ceiling limitation on a quarterly basis. The excess, if any, of the net book value above the ceiling limitation is required to be written off as a non-cash expense. The Company did not incur a ceiling writedown in 2001. Using December 31, 2001, constant prices and costs in accordance with the published guidelines of the SEC, there was a potential ceiling writedown of $6.3 million in the fourth quarter of 2001. On March 18, 2002, the ceiling limitation test was performed using pricing in effect at that date. The net weighted average prices used were $23.79 per barrel of oil and $3.49 per Mcf of natural gas. Using this pricing, there is no ceiling limitation as of March 18, 2002. There can be no assurance that there will not be additional writedowns in future periods under the full cost method of accounting as a result of sustained decreases in oil and natural gas prices or other factors.
The Company has capitalized internal costs of $779,000 for the year ended December 31, 2001, as costs of oil and natural gas properties. Such capitalized costs include salaries and related benefits of individuals directly involved in the Company's acquisition, exploration, and development activities based on the percentage of their time devoted to such activities.
The Company is subject to extensive federal, state, and local environmental laws and regulations. These laws, which are constantly changing, regulate the discharge of materials into the environment and may require the Company to remove or mitigate the environment effects of the disposal or release of petroleum or chemical substances at various sites. Environmental expenditures are expensed or capitalized depending on their future economic benefit. Expenditures that relate to an existing condition caused by past operations and that have no future economic benefits are expensed. Liabilities for expenditures of a noncapital nature are
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recorded when environmental assessment and/or remediation is probable, and the costs can be reasonably estimated.
The Company's operations are subject to all of the risks inherent in oil and natural gas exploration, drilling and production. These hazards can result in substantial losses to the Company due to personal injury and loss of life, severe damage to and destruction of property and equipment, pollution or environmental damage, or suspension of operations. The Company maintains insurance of various types customary in the industry to cover its operations and believes it is insured prudently against certain of these risks. In addition, the Company maintains operator's extra expense coverage that provides coverage for the care, custody and control of wells drilled by the Company. The Company's insurance does not cover every potential risk associated with the drilling and production of oil and natural gas. As a prudent operator, the Company does maintain levels of insurance customary in the industry to limit its financial exposure in the event of a substantial environmental claim resulting from sudden and accidental discharges. However, 100% coverage is not maintained. The occurrence of a significant adverse event, the risks of which are not fully covered by insurance, could have a material adverse effect on the Company's financial condition and results of operations. Moreover, no assurance can be given that the Company will be able to maintain adequate insurance in the future at rates it considers reasonable. The Company believes that it operates in compliance with government regulations and in accordance with safety standards which meet or exceed industry standards.
OTHER PROPERTY AND EQUIPMENT
Other property and equipment includes furniture, fixtures, and other equipment. Such assets are recorded at cost and are depreciated over their estimated useful lives using the straight-line method.
Maintenance and repairs are charged against income when incurred; renewals and betterments, which extend the useful lives of property and equipment, are capitalized.
INCOME TAXES
The Company will be taxed as a partnership under federal and applicable state laws; therefore, the Company has not provided for federal or state income taxes since these taxes are the responsibility of the Members.
FINANCIAL INSTRUMENTS
The Company sells crude oil and natural gas to various customers. In addition, the Company participates with other parties in the operation of crude oil and natural gas wells. Substantially all of the Company's accounts receivable are due from either purchasers of crude oil and natural gas or participants in crude oil and natural gas wells for which the Company serves as the operator. Generally, operators of crude oil and natural gas properties have the right to offset future revenues against unpaid charges related to operated wells. Crude oil and natural gas sales are generally unsecured.
Allowances for bad debt totaled approximately $229,000 at December 31, 2001. At December 31, 2001, the carrying value of the Company's accounts receivable approximates fair value.
NATURAL GAS PRODUCTION IMBALANCES
The Company accounts for natural gas production imbalances using the sales method, whereby the Company recognizes revenue on all natural gas sold to its customers notwithstanding the fact that its ownership may be less than 100% of the natural gas sold. Liabilities are recorded by the Company for imbalances greater than the Company's proportionate share of remaining estimated natural gas reserves.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
COMPREHENSIVE INCOME
Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. There were no differences between net earnings and total comprehensive income in 2001.
DERIVATIVES
In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Certain Hedging Activities." In June 2000, the FASB issued SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activity, an Amendment of SFAS 133." SFAS No. 133 and SFAS No. 138 require that all derivative instruments be recorded on the balance sheet at their respective fair values. SFAS No. 133 and SFAS No. 138 are effective for all fiscal quarters of all fiscal years beginning after June 30, 2000; NEG adopted SFAS No. 133 and SFAS No. 138 on July 1, 2000. All derivatives contributed to the Company were recorded in this manner.
All derivatives are recognized on the balance sheet at their fair value. Prior to contributing all oil and natural gas assets to the Company, NEG periodically managed its exposure to fluctuations in oil and natural gas prices by entering into various derivative instruments consisting principally of collar options and swaps. NEG elected not to designate these instruments as hedges for accounting purposes, accordingly the change in unrealized gains and losses is included in other income and expense. Cash settlements of these instruments are included in oil and natural gas sales. The Company has accounted for these instruments in the same manner. The following summarizes the cash settlements and unrealized gains and losses for the year ended December 31, 2001:
While the use of derivative contracts can limit the downside risk of adverse price movements, it may also limit future gains from favorable movements. The Company addresses market risk by selecting instruments whose value fluctuations correlate strongly with the underlying commodity. Credit risk related to derivative activities is managed by requiring minimum credit standards for counterparties, periodic settlements, and mark to market valuations.
The Company received various commodity swap agreements ("contracts") from Gascon and NEG as part of their initial contribution of assets and liabilities in September 2001. The counterparty to these instruments was through Enron North America Corp. As of December 2001, Enron Corp. and Enron North America Corp. et al ("Enron") filed for protection under Chapter 11, Title 18 of the United States Code. Enron ceased making payments under the various contracts in November 2001, prior to the bankruptcy filings. Accordingly, each of the contracts shall be administered as a claim in the Enron bankruptcy proceedings. Although no claim has been filed, (nor has any claim required to be filed as of the date of this report) the Company estimates its claim against Enron related to these contracts is approximately $7.25 million. The $7.25 million claim represents a hedge against future oil and natural gas prices and does not reflect a cash gain or loss on the contracts. For this reason, no asset or liability was recorded at December 31, 2001 and the Company recorded a net non cash valuation loss of $4.6 million through December 31, 2001 in connection with these contracts. The Company cannot predict what amount, if any may be ultimately received in the Enron bankruptcy proceeding.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
No derivative assets or liabilities have been recorded by the Company as all of the derivatives entered into by the Company have been canceled.
3. MANAGEMENT AGREEMENT
The management and operation of Operating LLC is being undertaken by NEG pursuant to a Management Agreement (the "Management Agreement") which NEG has entered into with Operating LLC. The strategic direction of Operating LLC's oil and natural gas business, including oil and natural gas drilling and capital investments, which shall be controlled by the managing member of the Company (currently Gascon). The Management Agreement provides that NEG will manage Operating LLC's oil and natural gas assets and business until the earlier of November 1, 2006, or such time as Operating LLC no longer owns any of the managed oil and natural gas properties. NEG's employees will conduct the day-to-day operations of Operating LLC's oil and natural gas properties, and all costs and expenses incurred in the operation of the oil and natural gas properties shall be borne by Operating LLC, although the Management Agreement provides that the salary of NEG's Chief Executive Officer shall be 70% attributable to the managed oil and natural gas properties, and the salaries of each of the General Counsel and Chief Financial Officer shall be 20% attributable to the managed oil and natural gas properties. In exchange for NEG's management services, Operating LLC shall pay NEG a management fee of 115% of the actual direct and indirect administrative and reasonable overhead costs incurred by NEG in operating the oil and natural gas properties which either NEG, or Operating LLC may seek to change within the range of 110%-115% as such change is warranted; however, the parties have agreed to consult with each other to ensure that such administrative and reasonable overhead costs attributable to the managed properties are properly reflected in the management fee paid to NEG. In addition, Operating LLC has agreed to indemnify NEG to the extent it incurs any liabilities in connection with its operation of the assets and properties of Operating LLC, except to the extent of its gross negligence, or misconduct. The Company recorded $2.7 million as a management fee to NEG for the year ended December 31, 2001. This amount is included in general and administrative expenses.
4. NOTE RECEIVABLE FROM AFFILIATE
A $10.9 million note receivable from NEG was contributed to the Company as part of Gascon's contribution on September 12, 2001. The maturity date on the note was extended to December 31, 2003. The interest rate on the note accrues at variable rates based on prime rates. The carrying value of the note approximates the fair value at December 31, 2001.
5. COMMITMENTS AND CONTINGENCIES
The Company has entered into a management agreement with NEG to manage Operating LLC's oil and natural gas assets until the earlier of November 1, 2006, or such time as Operating LLC no longer owns any oil and natural gas assets.
The Company is obligated to make semi-annual payments to NEG "Guaranteed Payments" as defined in the Holding LLC Operating Agreement referred herein. A payment for $10.9 million was made in November 2001 under this obligation.
6. INVESTMENT IN NEG HOLDING LLC OPERATING AGREEMENT
Under the Holding LLC Operating Agreement, NEG is to receive guaranteed payments in addition to a priority distribution amount of $202.2 million before Gascon receives any monies. The priority distribution is to be made on or before November 1, 2006. Guaranteed payments are to be paid, on a semi annual basis, based on 10.75% of the outstanding priority distribution amount. After the payments to NEG, Gascon is to receive distributions equivalent to the priority distribution amount and guaranteed payments plus other
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
amounts as defined. After the above distributions to NEG and Gascon, additional distributions, if any, are to be made in accordance with their respective capital accounts. The order of distributions is listed below.
The Holding LLC Operating Agreement requires that (provided full payment of all outstanding guaranteed payments has been made) distributions shall be made to both NEG and Gascon as follows:
- First and through November 1, 2006, to NEG in an amount equal to NEG's initial priority amount of $202.2 million minus any distributions previously made to NEG.
- Second, to Gascon in an amount equal to the excess of (a) the sum of (i) NEG's initial priority amount of $202.2 million, (ii) any additional capital contributions made by Gascon, (iii) the aggregate sum of all Guaranteed Payments, and (iv) an amount equal to the Accrued Gascon Amount (which, under the Holding LLC Operating Agreement, means an amount equal to the aggregate of interest that would be computed annually if interest were imposed at a rate equal to the prime rate plus 1/2% as of the close of each fiscal year on the excess of (a) the sum of (i) the cumulative Guaranteed Payments and (ii) the aggregate of any Accrued Gascon Amount computed in prior years, over (b) the cumulative distributions by the Company LLC to Gascon), over (b) distributions previously made to Gascon pursuant to this provision in the Holding LLC Operating Agreement.
- Third, to NEG and Gascon in accordance with their then respective Capital Accounts.
7. CRUDE OIL AND NATURAL GAS PRODUCING ACTIVITIES
Costs incurred in connection with the exploration acquisition, development, and exploitation of the Company's crude oil and natural gas properties for the year ended December 31, 2001, (all of which occurred after the contribution of assets by NEG and Gascon) are as follows:
Revenues from individual purchasers that exceed 10% of total crude oil and natural gas sales are as follows:
8. SUPPLEMENTARY CRUDE OIL AND NATURAL GAS RESERVE INFORMATION (UNAUDITED)
The revenues generated by the Company's operations are highly dependent upon the prices of, and demand for, oil and natural gas. The price received by the Company for its oil and natural gas production depends on numerous factors beyond the Company's control, including seasonality, the condition of the U.S. economy, foreign imports, political conditions in other oil and natural gas producing countries, the actions of the Organization of Petroleum Exporting Countries and domestic governmental regulations, legislation and policies.
The Company has made ordinary course capital expenditures for the development and exploitation of oil and natural gas reserves, subject to economic conditions. The Company has interests in crude oil and natural gas properties that are principally located onshore in Texas, Louisiana, Oklahoma, and Arkansas. The Company does not own or lease any crude oil and natural gas properties outside the United States.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In 2001, estimates of the Company's net recoverable crude oil, natural gas, and natural gas liquid reserves were prepared by Netherland, Sewell & Associates, Inc. and Prator Bett, LLC. Estimated proved net recoverable reserves as shown below include only those quantities that can be expected to be recoverable at prices and costs in effect at the balance sheet dates under existing regulatory practices and with conventional equipment and operating methods.
Proved developed reserves represent only those reserves expected to be recovered through existing wells. Proved undeveloped reserves include those reserves expected to be recovered from new wells on undrilled acreage or from existing wells on which a relatively major expenditure is required for recompletion.
Net quantities of proved developed and undeveloped reserves of natural gas and crude oil, including condensate and natural gas liquids, are summarized as follows:
Reservoir engineering is a subjective process of estimating the volumes of underground accumulations of oil and natural gas which cannot be measured precisely. The accuracy of any reserve estimates is a function of the quality of available data and of engineering and geological interpretation and judgment. Reserve estimates prepared by other engineers might differ from the estimates contained herein. Results of drilling, testing, and production subsequent to the date of the estimate may justify revision of such estimate. Future prices received for the sale of oil and natural gas may be different from those used in preparing these reports. The amounts and timing of future operating and development costs may also differ from those used. Accordingly, reserve estimates are often different from the quantities of oil and natural gas that are ultimately recovered.
The following is a summary of a standardized measure of discounted net cash flows related to the Company's proved crude oil and natural gas reserves. For these calculations, estimated future cash flows from estimated future production of proved reserves were computed using crude oil and natural gas prices as of the end of each period presented. Future development, production and abandonment costs attributable to the proved reserves were estimated assuming that existing conditions would continue over the economic lives of the individual leases and costs were not escalated for the future.
The Company cautions against using this data to determine the fair value of its crude oil and natural gas properties. To obtain the best estimate of fair value of the crude oil and natural gas properties, forecasts of future economic conditions, varying discount rates, and consideration of other than proved reserves would have to be incorporated into the calculation. In addition, there are significant uncertainties inherent in estimating quantities of proved reserves and in projecting rates of production that impair the usefulness of the data.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The standardized measure of discounted future net cash flows relating to proved crude oil and natural gas reserves are summarized as follows:
The following are the principal sources of change in the standardized measure of discounted future net cash flows:
During recent years, there have been significant fluctuations in the prices paid for crude oil in the world markets. This situation has had a destabilizing effect on crude oil posted prices in the United States, including the posted prices paid by purchasers of the Company's crude oil. The net weighted average prices of crude oil and natural gas at December 31, 2001, used in the above table were $18.48 per barrel of crude oil, respectively, and $2.68 per thousand cubic feet of natural gas, respectively.
INDEX TO EXHIBITS
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(1) Incorporated by reference to the Company's Current Report on Form 8-K, dated August 29, 1996.
(2) Incorporated by reference to the Company's Registration Statement on Form S-4 (No. 33-38331), dated April 23, 1991.
(3) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996.
(4) Incorporated by reference to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1992.
(5) Incorporated by reference to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1995.
(6) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997.
(7) Incorporated by reference to the Company's Schedule 14A filed April 25, 1997.
(8) Incorporated by reference to the Company's Form S-8 filed December 23, 1997.
(9) Incorporated by reference to the Company's Form S-4 (No. 333-38075), filed October 16, 1997.
(10) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1997.
(11) Incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1998.
(12) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 2000.
(13) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2000.
(14) Incorporated by reference to the Company's Annual Report on Form 10-K for the year Ended December 31, 2000.
(15) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 2001.
(16) Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 2001.
(17) Filed herewith.