ITEM 3.
LEGAL PROCEEDINGS
We are not a party to any legal proceedings which management believes will have a material adverse effect on our consolidated results of operations or financial condition.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of our security holders during the fourth quarter of 2004.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
Our common stock is listed for trading on the New York Stock Exchange under the symbol “CRK.” The following table sets forth, on a per share basis for the periods indicated, the high and low sales prices by calendar quarter for the periods indicated as reported by the New York Stock Exchange.
As of March 17, 2005, we had 36,037,868 shares of common stock outstanding, which were held by 376 holders of record and approximately 10,000 beneficial owners who maintain their shares in “street name” accounts.
We have never paid cash dividends on our common stock. We presently intend to retain any earnings for the operation and expansion of our business and we do not anticipate paying cash dividends in the foreseeable future. Any future determination as to the payment of dividends will depend upon the results of our operations, capital requirements, our financial condition and such other factors as our board of directors may deem relevant. In addition, we are limited under our bank credit facility and by the terms of the indenture for our senior notes from paying or declaring cash dividends.
The following table summarizes certain information regarding our equity compensation plans as of December 31, 2004:
(1)
Plus 1% of the number of shares of common stock outstanding as of January 1, 2005 and increased each year by 1% of the number of shares outstanding on each subsequent January 1.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The historical financial data presented in the table below as of and for each of the years in the five-year period ended December 31, 2004 are derived from our consolidated financial statements. The financial results are not necessarily indicative of our future operations or future financial results. The data presented below should be read in conjunction with our consolidated financial statements and the notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Statement of Operations Data:
(1)
Includes lease operating costs and production and ad valorem taxes.
Balance Sheet Data:
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with our selected historical consolidated financial data and our accompanying consolidated financial statements and the notes to those financial statements included elsewhere in this report. The following discussion includes forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed below and elsewhere in this report, particularly in “Cautionary Note Regarding Forward-Looking Statements.”
Overview
We are a growing independent exploration company engaged in the acquisition, discovery and production of oil and natural gas in the United States. We own interests in 1,356 (586.7 net to us) producing oil and natural gas wells and we or Bois d’Arc Energy operate 595 of these wells. In managing our business, we are concerned primarily with maximizing return on our stockholders’ equity. To accomplish this goal, we focus on profitably increasing our oil and natural gas reserves and production.
Our future growth will be driven primarily by acquisition, development and exploration activities. Under our current drilling budget, we plan to spend approximately $175.0 million in 2005 for development and exploration activities. We plan to drill approximately 114 development wells, 58.9 net to us and 29 exploratory wells, 14.3 net to us. However, the number of wells that we drill in 2005 will be subject to the availability of drilling rigs that we can hire. In addition, we could reduce the wells that we drill if oil and natural gas prices were to decline significantly. We do not budget for acquisitions as the timing and size of acquisitions are not predictable. We use the successful efforts method of accounting which allows only for the capitalization of costs associated with developing proven oil and natural gas properties as well as exploration costs associated with successful exploration activities. Accordingly, our exploration costs consist of costs we incur to acquire and reprocess 3-D seismic data, impairments of our unevaluated leasehold where we were not successful in discovering reserves and the costs of unsuccessful exploratory wells that we drill.
We generally sell our oil and natural gas at current market prices at the point our wells connect to third party purchaser pipelines. We market our products several different ways depending upon a number of factors, including the availability of purchasers for the product, the availability and cost of pipelines near our wells, market prices, pipeline constraints and operational flexibility. Accordingly, our revenues are heavily dependent upon the prices of, and demand for, oil and natural gas. Oil and natural gas prices have historically been volatile and are likely to remain volatile in the future. Our revenues for 2004 benefited from a general increase in oil and natural gas prices. We have entered into certain hedging arrangements on a small part of our anticipated natural gas sales in 2005 and 2006. We may in the future enter into additional arrangements in order to reduce our exposure to price risks. Such arrangements may also limit our ability to benefit from increases in oil and natural gas prices.
Our operating costs include the expense of operating our wells and production facilities and transporting our products to the point of sale. Our operating costs are generally comprised of several components, including costs of field personnel, repair and maintenance cost, production supplies, fuel used in operations, transportation cost, state production taxes, workover cost and state ad valorem taxes.
Like all oil and natural gas exploration and production companies, we face the challenge of replacing our reserves. Although in the past we have offset the effect of declining production rates from our existing properties from acquisitions and through successful drilling efforts, there can be no assurance that we will be able to offset future production declines or maintain our current production level. Our future growth will depend on our ability to continue to add new reserves in excess of our production.
In December 1997, we established a joint exploration venture with Bois d’Arc to explore for oil and natural gas in the Gulf of Mexico. Under the joint exploration venture, Bois d’Arc was responsible for generating exploration prospects in the Gulf of Mexico utilizing 3-D seismic data and their extensive geological expertise in the region. We advanced the funds for the acquisition of 3-D seismic data and leases. We were reimbursed for all advanced costs and were entitled to a non-promoted working interest in each prospect generated. For each successful discovery well drilled pursuant to the joint exploration venture, we issued to the two principals of Bois d’Arc warrants exercisable for the purchase of shares of our common stock.
In July 2004, we together with the Bois d’Arc Participants formed Bois d’Arc Energy to replace the joint exploration venture. We and each of the Bois d’Arc Participants contributed substantially all of our Gulf of Mexico related assets and assigned our related liabilities, including certain debt, in exchange for equity interests in Bois d’Arc Energy. We contributed interests in our offshore oil and natural gas properties and assigned $83.2 million of related debt in exchange for an approximately 59.9% ownership interest in Bois d’Arc Energy. Each of the Bois d’Arc Participants contributed its interest in commonly owned Gulf of Mexico properties as well as ownership of Bois d’Arc Offshore, Ltd., the operator of the properties, and assigned in the aggregate $28.2 million of related liabilities in exchange for an approximately 40.1% aggregate ownership interest in Bois d’Arc Energy. The Bois d’Arc Participants also received $27.6 million in cash to equalize the amount that our debt exceeded our proportional share of the liabilities assigned. We were also reimbursed $12.7 million for advances made under the joint exploration venture for undrilled prospects. Our 59.9% proportionate share of Bois d’Arc Energy’s operations are included in our consolidated financial statements beginning in July 2004.
Bois d’Arc Energy’s exploration and production activities are conducted exclusively in the Gulf of Mexico. Consequently, its operations are significantly impacted by conditions in the Gulf of Mexico, such as adverse weather conditions; the availability of equipment, facilities or services; delays and decreases in the availability of capacity to transport, gather or process production; and changes in the regulatory environment. In September 2004, Bois d’Arc Energy shut in substantially all of its production for four days because of Hurricane Ivan and part of its production was also shut in during the fourth quarter of 2004 awaiting repairs to third party pipelines that were damaged by the hurricane. As a result of the shut-ins, Bois d’Arc Energy was forced to defer production of approximately 2.2 Bcfe, 1.3 net to us, in 2004. Bois d’Arc Energy also had three drilling rigs under contract standing idle for a combined total of 22 days and the start up of a new production facility planned for November 2004 was delayed until January 2005. Operating costs in 2004 included $0.7 million for repairs related to the hurricane.
Our operations and facilities are subject to extensive federal, state and local laws and regulations relating to the exploration for, and the development, production and transportation of, oil and natural gas, and operating safety. Future laws or regulations, any adverse changes in the interpretation of existing laws and regulations or our failure to comply with existing legal requirements may harm our business, results of operations and financial condition. Applicable environmental regulations require us to remove our platforms after production has ceased, to plug and abandon our wells and to remediate any environmental damage our operations may have caused. The fair value of our liability to plug and abandon our oil and gas wells and to dismantle and remove our production facilities is included in our reserve for future abandonment costs, which was $19.2 million as of December 31, 2004.
Results of Operations
Our operating data for the last three years is summarized below:
(1)
Includes lease operating costs and production and ad valorem taxes.
(2)
Represents depreciation, depletion and amortization of oil and gas properties only.
Year Ended December 31, 2004 Compared to Year Ended December 31, 2003
Oil and gas sales. Our oil and gas sales increased $26.5 million or 11% in 2004 to $261.6 million from $235.1 million in 2003. The increase in sales was mostly due to higher natural gas and crude oil prices, which was partially offset by a decrease in our oil and natural gas production in 2004. Our average natural gas price increased by 11% and our average oil price increased by 30%. On an equivalent unit basis, our average price received for our production in 2004 was $6.12 per Mcfe, which was 15% higher than our average price in 2003 of $5.34 per Mcfe. Our natural gas production decreased by 2% and our oil production decreased by 5%. The decrease in production primarily due to the disruption to Bois d’Arc Energy’s production operations caused by Hurricane Ivan. Approximately 1.3 Bcfe of production was deferred in 2004 because of shut-ins due to the hurricane.
Oil and gas operating expenses. Our oil and gas operating expenses, including production taxes, increased $6.3 million (14%) to $52.1 million in 2004 from $45.7 million in 2003. Oil and gas operating expenses per equivalent Mcf produced increased $0.18 (17%) to $1.22 in 2004 from $1.04 in 2003. The increase in operating expenses is due primarily to higher production and ad valorem taxes resulting from the higher oil and gas prices in 2004 and the lower production volumes due to the deferred production during September 2004 in the Gulf of Mexico, which was shut-in due to hurricane activity. In addition, operating expenses in 2004 include $0.7 million for repairs resulting from damage caused by the hurricane activity in the Gulf of Mexico.
Exploration expense. In 2004, we incurred $15.6 million in exploration expense as compared to $4.4 million in 2003. The 2004 expense primarily relates to five exploratory dry holes drilled by Bois d’Arc Energy in the Gulf of Mexico together with six exploratory dry holes drilled in our South Texas region.
DD&A. Depreciation, depletion and amortization (“DD&A”) increased $2.7 million (4%) to $63.9 million in 2004 from $61.2 million in 2003. DD&A per equivalent Mcf produced for 2004 was $1.46, as compared to $1.37 for 2003. The higher DD&A rates are attributable to increased capitalized costs of our properties.
Impairment. We recorded impairments to our oil and gas properties of $1.6 million in 2004 and $4.3 million in 2003. These impairments relate to some minor valued fields where an impairment was indicated based on estimated future cash flows attributable to the fields’ estimated proved oil and natural gas reserves.
General and administrative expenses. General and administrative expenses, which are reported net of overhead reimbursements, of $14.6 million for 2004 were $7.6 million higher than general and administrative expenses of $7.0 million for 2003. The increase is primarily related to stock-based compensation expense that we recorded in 2004 of $6.2 million, resulting from our adoption of a fair value-based method of accounting for employee stock-based compensation including our employee stock options on January 1, 2004. The remaining increase is a result of higher personnel costs in 2004 and higher professional fees related to the increased compliance costs.
Interest income. Our interest income in 2004 was $1.2 million as compared to $0.1 million in 2003. Included in interest income in 2004 was $1.1 million related to interest paid by the other owners of Bois d’Arc Energy to us.
Interest expense. Interest expense decreased $8.7 million (29%) to $21.2 million in 2004 from $29.9 million in 2003. The decrease is related to the early retirement of $220.0 million of principal amount of our 111/4% senior notes which were refinanced with $175.0 million new 67/8% senior notes along with the borrowings under a new bank credit facility. The refinancing of our 111/4% senior notes reduced our interest expense by $10.8 million on an annual basis. Our average borrowings outstanding under our bank credit facility increased to $176.7 million in 2004 as compared to $119.7 million in 2003. The average interest rate on the outstanding borrowings under the bank credit facility also increased to 3.2% in 2004 as compared to 3.0% in 2003.
Net income. We reported net income of $46.9 million in 2004 as compared to net income of $53.9 million in 2003. Net income per share for 2004 was $1.29 on weighted average diluted shares outstanding of 36.3 million as compared to $1.53 for 2003 on weighted average diluted shares outstanding of 35.3 million. The 2004 results include a charge of $19.6 million ($0.35 per diluted share) relating to the early retirement of our 111/4% senior notes. The 2004 results also include a charge of $1.1 million related to the formation of Bois d’Arc Energy. Net income for 2003 included $0.7 million in income ($0.02 per share) related to the cumulative effect of a change in our accounting for future abandonment cost for our oil and gas properties.
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002
Oil and gas sales. Our oil and gas sales increased $93.0 million or 65% in 2003 to $235.1 million from $142.1 million in 2002. The increase in sales was mostly due to higher natural gas and crude oil prices and increased oil and natural gas production in 2003. Our average natural gas price decreased by 64% and our average oil price increased by 23%. On an equivalent unit basis, our average price received for our production in 2003 was $5.34 per Mcfe, which was 54% higher than our average price in 2002 of $3.47 per Mcfe. The higher prices were accompanied by a 7% increase in our production. Our natural gas production increased by 3% while our oil production increased by 24%. The production increases are primarily related to new production resulting from wells drilled in our 2002 and 2003 drilling programs.
Oil and gas operating expenses. Our oil and gas operating expenses, including production taxes, increased $12.2 million (37%) to $45.7 million in 2003 from $33.5 million in 2002. Oil and gas operating expenses per equivalent Mcf produced increased $0.22 (27%) to $1.04 in 2003 from $0.82 in 2002. The increase in operating expenses is primarily related to the 7% increase in production and higher ad valorem and production taxes resulting from the significantly higher oil and gas prices in 2003.
Exploration expense. In 2003, we had $4.4 million in exploration expense, which primarily related to the write-off of exploratory dry holes, impairment of certain of our exploratory leasehold and the acquisition of seismic data. Exploration expense for 2002 was $5.5 million, which related to the write-off of exploratory dry holes.
DD&A. Our DD&A increased $8.0 million (15%) to $61.2 million in 2003 from $53.2 million in 2002. The increase is attributable to our higher production in 2003. Our depreciation, depletion and amortization per equivalent Mcf produced also increased to $1.37 in 2003 from $1.29 in 2002.
Impairment. In 2003, we had a $4.3 million impairment of our oil and gas properties which primarily relates to some minor valued fields where an impairment was indicated based on estimated future cash flows attributable to the fields’ estimated proved oil and natural gas reserves.
General and administrative expenses. General and administrative expenses, which are reported net of overhead reimbursements, of $7.0 million for 2003 were 37% higher than general and administrative expenses of $5.1 million for 2002. The increase was due primarily to the opening of an offshore operations office in Houston, Texas as well as an increase in the number of employees and higher compensation paid to our employees in 2003.
Other income. Our other income in 2003 was $0.2 million as compared to $8.0 million in 2002. Included in other income in 2002 was $7.7 million related to refunds of severance taxes paid in prior years.
Interest expense. Interest expense decreased $1.4 million (4%) to $29.9 million for 2003 from $31.3 million in 2002. The decrease was due to a reduction in the average borrowings outstanding under our credit facility of $119.7 million during 2003 as compared to an average of $172.0 million outstanding in 2002. The average interest rate on the outstanding borrowings under the credit facility also decreased to 3.0% in 2003 as compared to 3.6% in 2002.
Net income. For 2003, we reported net income of $53.4 million, after deducting preferred stock dividends of $0.6 million. These results compared to net income from continuing operations in 2002 of $11.0 million, after deducting preferred stock dividends of $1.6 million. Our income from continuing operations per share for 2003 was $1.53 on diluted weighted average shares outstanding of 35.3 million as compared to net income from continuing operations per share of $0.37 for 2002 on diluted weighted average shares outstanding of 33.9 million. Net income for 2003 included $0.7 million in income ($0.02 per share) related to the cumulative effect of a change in our accounting for future abandonment cost for our oil and gas properties. In 2002, we sold certain marginal oil and gas properties. The operating results of these properties in 2002 including the loss on disposal of $1.1 million ($0.03 per share) have been reflected as discontinued operations.
Liquidity and Capital Resources
Funding for our activities has historically been provided by our operating cash flow, debt or equity financings or asset dispositions. In 2004, our net cash flow provided by operating activities totaled $171.4 million and we received proceeds of $175.0 million from a public sale of new eight-year 67/8% senior notes. We also increased the debt outstanding under our bank credit facility by $142.0 million.
Our primary needs for capital, in addition to funding our ongoing operations, relate to our acquisition, development and exploration activities and the repayment of our debt. In 2004, we incurred capital expenditures of $209.8 million primarily for our development and exploration activities. We also retired our 111/4% senior notes and we loaned Bois d’Arc Energy $48.3 million.
Our annual capital expenditure activity is summarized in the following table:
The timing of most of our capital expenditures is discretionary because we have no material long-term capital expenditure commitments. Consequently, we have a significant degree of flexibility to adjust the level of our capital expenditures as circumstances warrant. We spent $70.6 million, $86.1 million and $146.7 million on development and exploration activities in 2002, 2003 and 2004, respectively. We have budgeted approximately $175.0 million for development and exploration projects in 2005. We expect to use internally generated cash flow to fund development and exploration activity. Our operating cash flow is highly dependent on oil and natural gas prices, especially natural gas prices.
We spent $11.4 million, $4.8 million and $62.7 million on acquisition activities in 2002, 2003 and 2004, respectively. In October 2004, we acquired producing oil and gas properties in the East Texas, Arkoma, Anadarko and San Juan basins from Ovation Energy, L.P. for $62.0 million. We do not have a specific acquisition budget for 2005 since the timing and size of acquisitions are not predictable. We intend to use borrowings under our bank credit facility, or other debt or equity financings to the extent available, to finance significant acquisitions. The availability and attractiveness of these sources of financing will depend upon a number of factors, some of which will relate to our financial condition and performance and some of which will be beyond our control, such as prevailing interest rates, oil and natural gas prices and other market conditions.
On January 1, 2004 we had $220.0 million in principal amount of our 111/4% senior notes due 2007 (the “1999 Notes”) outstanding. Pursuant to a tender offer, on February 25, 2004, we repurchased $197.7 million in principal amount of the 1999 Notes for $212.2 million plus accrued interest. On May 1, 2004, we redeemed the remaining $22.3 million in principal amount of the 1999 Notes outstanding for $23.6 million plus accrued interest. The early extinguishment of the 1999 Notes resulted in a loss of $19.6 million, which was comprised of the premium paid for the repurchase of the 1999 Notes together with the write-off of unamortized debt issuance costs related to the 1999 Notes.
In connection with the repurchase of the 1999 Notes, we sold $175.0 million of senior notes in an underwritten public offering. The new senior notes are due March 1, 2012 and bear interest at 67/8%, which is payable semiannually on March 1 and September 1. The 67/8% senior notes are unsecured obligations and are currently guaranteed by all of our subsidiaries.
On February 25, 2004, we also entered into a new $400.0 million bank credit facility with Bank of Montreal, as the administrative agent, which replaced our former credit facility. The bank credit facility is a four-year revolving credit commitment that matures on February 25, 2008. Borrowings under the bank credit facility were used to refinance amounts outstanding under our prior bank credit facility and to fund the repurchase of the 1999 Notes. Indebtedness under our bank credit facility is secured by substantially all of our and our subsidiaries’ assets and is guaranteed by all of our subsidiaries. The bank credit facility is subject to borrowing base availability, which is redetermined semiannually based on the banks’ estimates of the future net cash flows of our oil and natural gas properties. The borrowing base may be affected by the performance of our properties and changes in oil and natural gas prices. The determination of the borrowing base is at the sole
discretion of the administrative agent and the bank group. Borrowings under the bank credit facility bear interest, based on the utilization of the borrowing base, at our option at either LIBOR plus 1.25% to 1.75% or the base rate (which is the higher of the prime rate or the federal funds rate) plus 0% to 0.5%. A commitment fee of 0.375% is payable on the unused borrowing base. The bank credit facility contains covenants that, among other things, restrict the payment of cash dividends, limit the amount of consolidated debt that we may incur and limit our ability to make certain loans and investments. The only financial covenants are the maintenance of a current ratio and maintenance of a minimum tangible net worth. We were in compliance with these covenants as of December 31, 2004.
In connection with the formation of Bois d’Arc Energy, we have made available to Bois d’Arc Energy a revolving line of credit in a maximum outstanding amount of $200.0 million, of which approximately $148.0 million was outstanding on December 31, 2004. In consideration for the line of credit, Bois d’Arc Energy and its subsidiaries each became guarantors of our bank credit facility and our 67/8% senior notes.
On October 4, 2004, Bois d’Arc Energy filed a registration statement on Form S-1 with the SEC related to a proposed underwritten initial public offering of $150.0 million of its common stock. As of the date of this report, the Form S-1 is not yet effective. Such an offering will have the effect of diluting our current 59.9% interest in Bois d’Arc Energy. The net proceeds of the offering are expected to be used to refinance the amounts outstanding under the credit facility provided by us. If Bois d’Arc Energy does not complete a financing transaction that generates sufficient proceeds to repay all of the amounts outstanding under the credit facility by May 1, 2005 (or such later date as is determined by Bois d’Arc Energy’s board of managers), Bois d’Arc Energy will be dissolved and liquidated in a manner designed to put its members in a position as near as possible to the same economic position that the members would have been in if they had never formed Bois d’Arc Energy and instead had continued to own their respective properties individually.
We believe that our cash flow from operations and available borrowings under the bank credit facility will be sufficient to fund our operations and future growth as contemplated under our current business plan. However, if our plans or assumptions change or if our assumptions prove to be inaccurate, we may be required to seek additional capital. We cannot provide any assurance that we will be able to obtain such capital, or if such capital is available, that we will be able to obtain it on acceptable terms.
The following table summarizes our aggregate liabilities and commitments by year of maturity:
(1)
Reflects our 59.9% of commitments made by Bois d’Arc Energy as of December 31, 2004.
Federal Taxation
At December 31, 2004, we had federal income tax net operating loss carryforwards of approximately $53.4 million. We have established a $23.0 million valuation allowance against part of the net operating loss carryforwards that we acquired in an acquisition due to a “change in control” limitation which will prevent us from fully realizing these carryforwards. The carryforwards expire from 2017 through 2023. The value of these carryforwards depends on our ability to generate future taxable income in order to utilize these carryforwards.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and use assumptions that can affect the reported amounts of assets, liabilities, revenues or expenses.
Successful efforts accounting. We are required to select among alternative acceptable accounting policies. There are two generally acceptable methods for accounting for oil and gas producing activities. The full-cost method allows the capitalization of all costs associated with finding oil and natural gas reserves, including certain general and administrative expenses. The successful efforts method allows only for the capitalization of costs associated with developing proven oil and natural gas properties as well as exploration costs associated with successful exploration projects. Costs related to exploration that are not successful are expensed when it is determined that commercially productive oil and gas reserves were not found. We have elected to use the successful efforts method to account for our oil and gas activities and we do not capitalize any of our general and administrative expenses.
Oil and natural gas reserve quantities. The determination of depreciation, depletion and amortization expense as well as impairments that are recognized on our oil and gas properties are highly dependent on the estimates of the proved oil and natural gas reserves attributable to our properties. Reserve engineering is a subjective process of estimating underground accumulations of oil and natural gas that cannot be precisely measured. The accuracy of any reserve estimate depends on the quality of available data, production history and engineering and geological interpretation and judgment. Because all reserve estimates are to some degree imprecise, the quantities of oil and natural gas that are ultimately recovered, production and operating costs, the amount and timing of future development expenditures and future oil and natural gas prices may all differ materially from those assumed in these estimates. The information regarding present value of the future net cash flows attributable to our proved oil and natural gas reserves are estimates only and should not be construed as the current market value of the estimated oil and natural gas reserves attributable to our properties. Thus, such information includes revisions of certain reserve estimates attributable to proved properties included in the preceding year’s estimates. Such revisions reflect additional information from subsequent activities, production history of the properties involved and any adjustments in the projected economic life of such properties resulting from changes in product prices. Any future downward revisions could adversely affect our financial condition, our borrowing ability, our future prospects and the value of our common stock.
The estimates of our proved oil and gas reserves used in the preparation of our consolidated financial statements were determined by an independent petroleum engineering consulting firm and were prepared in accordance with the rules promulgated by the SEC and the Financial Accounting Standards Board (the “FASB”).
Impairment of oil and gas properties. The determination of impairment of our oil and gas reserves is based on the oil and natural gas reserve estimates using projected future oil and natural gas prices that we have determined to be reasonable. The projected prices that we employ represent our long-term oil and natural gas price forecast and may be higher or lower than the December 31, 2004 market prices for crude oil and natural gas. For the impairment review of our oil and gas properties that we conducted as of December 31, 2004, we used oil and natural gas prices that were based on the current futures market. We used oil prices of $45.86, $42.86 and $40.93 per barrel for 2005, 2006 and 2007, respectively, and escalated prices by 3% each year thereafter to a maximum price of $48.60 per barrel. For natural gas we used prices of $6.20, $6.27 and $5.87 per Mcf for 2005, 2006 and 2007, respectively, and escalated prices by 3% each year thereafter to a maximum price of $6.75 per Mcf. To the extent we had used lower prices in our impairment review, an impairment could have been indicated on certain of our oil and gas properties.
Accounting for asset retirement obligations. We adopted Statement of Financial Accounting Standards No. 143 (“SFAS 143”) “Accounting for Asset Retirement Obligations,” on January 1, 2003. This statement requires us to record a liability in the period in which an asset retirement obligation (“ARO”) is incurred, in an amount equal to the discounted estimated fair value of the obligation that is capitalized. Thereafter, each quarter this liability is accreted up to the final retirement cost. The adoption of SFAS 143 on January 1, 2003
resulted in a gain of $0.7 million which was reflected as a cumulative effect of a change in accounting principle. The determination of our asset retirement obligations is based on our estimate of the fair value to plug and abandon our oil and gas wells and to dismantle and dispose of our offshore production facilities. The actual costs could be higher or lower than our current estimates.
Stock-based compensation. Prior to January 1, 2004, we accounted for employee stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Under the intrinsic method, compensation cost for stock options is measured as the excess, if any, of the fair value of our common stock at the date of the grant over the amount an employee must pay to acquire the common stock. Effective January 1, 2004, we changed our method of accounting for employee stock-based compensation to the preferable fair value based method prescribed in Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under the fair value based method, compensation cost is measured at the grant date based on the fair value of the award and is recognized over the award vesting period. We determine the fair value of each stock option at the date of grant using the Black-Scholes options pricing model. Under the modified prospective transition method selected by us as described in Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” stock-based compensation expense recognized for 2004, is the same as that which would have been recognized had the fair value method of SFAS 123 been applied from its original effective date. Accordingly, during 2004 our general and administrative expenses included $6.2 million in stock-based compensation. In accordance with the modified prospective transition method, results for years prior to 2004 were not restated. For years prior to 2004, no compensation cost was recognized for our employee stock options. If compensation costs had been determined in accordance with SFAS 123, we would have recorded an additional compensation expense of $1.6 million and $3.0 million in 2002 and 2003, respectively.
Included in our 2004 stock-based compensation was $1.5 million attributable to our ownership in Bois d’Arc Energy. In connection with its formation, Bois d’Arc Energy established a long-term incentive plan to provide for equity-based compensation for its executive officers, employees and consultants. The awards made under this plan were comprised of either options to purchase class B LLC units or restricted class C LLC units, representing solely a profits interest. All of the awards made under the Bois d’Arc Energy incentive plan vest over a five year period. At the time of its formation, Bois d’Arc Energy granted options to purchase a total of 2,800,000 class B units at an exercise price of $6.00 per unit and 4,290,000 restricted class C units. In determining the fair value of the class B units and class C units underlying the equity awards granted, Bois d’Arc Energy used a valuation methodology that it believes is consistent with the practices recommended by the AICPA Audit and Accounting Practice Aid Series, Valuation of Privately-Held-Company Equity Securities Issued as Compensation (the “Practice Aid”). Bois d’Arc Energy reviewed the guidance set forth in the Practice Aid and performed a retrospective valuation on a “top down” basis, using an enterprise valuation model. Bois d’Arc Energy determined the fair value of the entity and then allocated the enterprise value to the various classes of member units. Bois d’Arc Energy also consulted with an independent valuation specialist regarding the methods and procedures used to determine, on a retrospective basis, the fair value of the class B units and the class C units at the time of issuance. The valuation conducted determined that the fair value of a class B unit at the date of the issuance was $8.42 per unit. The fair value of a class C unit was determined to be $3.40 per unit. The fair value of each option awarded under the incentive plan was estimated using the Black-Scholes option-pricing model and determined to be $4.55 per option.
New accounting standards. On December 16, 2004, the FASB issued Statement 123 (revised 2004), “Share-Based Payment” (“SFAS 123 R”) that requires compensation costs related to share-based payment transactions (issuance of stock options and restricted stock) to be recognized in the financial statements. With limited exceptions, the amount of compensation cost is to be measured based on the grant date fair value of the equity or liability instruments issued. Compensation cost is recognized over the period that an employee provides service in exchange for the award. Statement 123 R replaces SFAS 123, “Accounting for Stock-Based Compensation”, and supersedes APB 25. SFAS 123 R is effective for the first reporting period after June 15, 2005. Entities that use the fair value-based method for either recognition or disclosure under SFAS 123 are required to apply SFAS 123 R using a modified version of prospective application whereby the
entity is required to record compensation expense for all awards it grants after the date of adoption and the unvested portion of previously granted awards that remain outstanding at the date of adoption. Effective January 1, 2004, we adopted the fair value-based measure as proscribed in SFAS 123 using the modified prospective application. Therefore, SFAS 123 R will not have a significant impact on us.
On December 16, 2004, the FASB also issued Statement 153, “Exchanges of Nonmonetary Assets”, an amendment of APB Opinion No. 29, to clarify the accounting for nonmonetrary exchanges of similar productive assets. SFAS 153 provides a general exception from fair value measurement for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The Statement will be applied prospectively and is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005.
Related Party Transactions
In recent years, we have not entered into any material transactions with our officers or directors apart from the compensation they are provided for their services. We also have not entered into any business transactions with our significant stockholders or any other related parties.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS
Oil and Natural Gas Prices
Our financial condition, results of operations and capital resources are highly dependent upon the prevailing market prices of oil and natural gas. These commodity prices are subject to wide fluctuations and market uncertainties due to a variety of factors that are beyond our control. Factors influencing oil and natural gas prices include the level of global demand for crude oil, the foreign supply of oil and natural gas, the establishment of and compliance with production quotas by oil exporting countries, weather conditions which determine the demand for natural gas, the price and availability of alternative fuels and overall economic conditions. It is impossible to predict future oil and natural gas prices with any degree of certainty. Sustained weakness in oil and natural gas prices may adversely affect our financial condition and results of operations, and may also reduce the amount of oil and natural gas reserves that we can produce economically. Any reduction in our oil and natural gas reserves, including reductions due to price fluctuations, can have an adverse affect on our ability to obtain capital for our exploration and development activities. Similarly, any improvements in oil and natural gas prices can have a favorable impact on our financial condition, results of operations and capital resources. Based on our oil and natural gas production in 2004, a $1.00 change in the price per barrel of oil would have resulted in a change in our cash flow for such period by approximately $1.4 million and a $1.00 change in the price per Mcf of natural gas would have changed our cash flow by approximately $32.1 million.
We periodically use derivative transactions with respect to a portion of our oil and natural gas production to mitigate our exposure to price changes. We did not hedge any of our 2004 oil and natural gas production. While the use of these derivative arrangements limits the downside risk of price declines, such use may also limit any benefits which may be derived from price increases. We use swaps, floors and collars to hedge oil and natural gas prices. Swaps are settled monthly based on differences between the prices specified in the instruments and the settlement prices of futures contracts quoted on the New York Mercantile Exchange. Generally, when the applicable settlement price is less than the price specified in the contract, we receive a settlement from the counterparty based on the difference multiplied by the volume hedged. Similarly, when the applicable settlement price exceeds the price specified in the contract, we pay the counterparty based on the difference. We generally receive a settlement from the counterparty for floors when the applicable settlement price is less than the price specified in the contract, which is based on the difference multiplied by the volumes hedged. For collars, we generally receive a settlement from the counterparty when the settlement price is below the floor and pay a settlement to the counterparty when the settlement price exceeds the cap. No settlement occurs when the settlement price falls between the floor and the cap.
The following table sets forth the derivative financial instruments that we entered into during 2004 which relate to our 2005 and 2006 natural gas production:
The fair market value of these derivative financial instruments at December 31, 2004, was a liability of $155,000. We did not designate these instruments as cash flow hedges and, accordingly, a loss on derivatives of $155,000 was recorded in 2004.
Interest Rates
At December 31, 2004, we had long-term debt of $403.0 million. Of this amount, $175.0 million bears interest at a fixed rate of 67/8%. The fair market value of the fixed rate debt as of December 31, 2004 was $180.3 million based on the market price of 103% of the face amount. At December 31, 2004, we had $228.0 million outstanding under our bank credit facility, which was subject to floating market rates of interest. Borrowings under the bank credit facility bear interest at a fluctuating rate that is tied to LIBOR or the corporate base rate, at our option. Any increases in these interest rates can have an adverse impact on our results of operations and cash flow. Based on borrowings outstanding at December 31, 2004, a 100 basis point change in interest rates would change our interest expense on our variable rate debt by approximately $2.3 million. We had no interest rate derivatives outstanding in 2004 or at December 31, 2004.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements are included on pages to of this report.
We have prepared these financial statements in conformity with generally accepted accounting principles. We are responsible for the fairness and reliability of the financial statements and other financial data included in this report. In the preparation of the financial statements, it is necessary for us to make informed estimates and judgments based on currently available information on the effects of certain events and transactions.
Our independent registered public accounting firm, Ernst & Young LLP, are engaged to audit our financial statements and to express an opinion thereon. Their audit is conducted in accordance with auditing standards generally accepted in the United States to enable them to report whether the financial statements present fairly, in all material respects, our financial position and results of operations in accordance with accounting principles generally accepted in the United States.
The audit committee of our board of directors is composed of three directors who are not our employees. This committee meets periodically with our independent public accountants and management. Our independent public accountants have full and free access to the audit committee to meet, with and without management being present, to discuss the results of their audits and the quality of our financial reporting.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. Our chief executive officer and our chief financial officer have evaluated, as required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) as of the end of the period covered by this Annual Report on Form 10-K. Based on that evaluation, our chief executive officer and chief financial officer concluded that the design and operation of our disclosure controls and procedures are adequate and effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.
Changes in internal control over financial reporting. There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the fourth quarter of 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
The management of Comstock Resources, Inc. (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external purposes in accordance with generally accepted accounting principles.
As of December 31, 2004, management assessed the effectiveness of the Company’s internal control over financial reporting based on the criteria for effective internal control over financial reporting established in “Internal Control - Integrated Framework”, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on the assessment, management determined that the Company maintained effective internal control over financial reporting as of December 31, 2004, based on those criteria.
Ernst & Young LLP, the independent registered public accounting firm that audited the consolidated financial statements of the Company included in this Annual Report on Form 10-K, has issued an audit report on management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004. The report, which expresses unqualified opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004 is included below.
Report of Independent Registered Public Accounting Firm
on Internal Control over Financial Reporting
The Board of Directors and Stockholders
Comstock Resources, Inc.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Comstock Resources, Inc. maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO criteria”). Comstock Resources, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Comstock Resources, Inc. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Comstock Resources, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Comstock Resources, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for the years then ended of Comstock Resources, Inc. and our report dated March 17, 2005 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Dallas, Texas
March 17, 2005
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item is incorporated herein by reference to our definitive proxy statement which will be filed with the SEC within 120 days after December 31, 2004.
Code of Ethics. We have adopted a Code of Business Conduct and Ethics that is applicable to all of our directors, officers and employees as required by New York Stock Exchange rules. We have also adopted a Code of Ethics for Senior Financial Officers that is applicable to our Chief Executive Officer and senior financial officers. Both the Code of Business Conduct and Ethics and Code of Ethics for Senior Financial Officers may be found on our website at http://www.comstockresources.com. Both of these documents are also available, without charge, to any stockholder upon request to: Comstock Resources, Inc., Attn: Investor Relations, 5300 Town and Country Blvd., Suite 500, Frisco, Texas 75034, (972) 668-8800. We intend to disclose any amendments or waivers to these codes that apply to our Chief Executive Officer and senior financial officers on our website in accordance with applicable SEC rules. Please see the definitive proxy statement for our 2005 annual meeting, which will be filed with the SEC within 120 days of December 31, 2004 for additional information regarding our corporate governance policies.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
The information required by this item is incorporated herein by reference to our definitive proxy statement which will be filed with the SEC within 120 days after December 31, 2004.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item is incorporated herein by reference to our definitive proxy statement which will be filed with the SEC within 120 days after December 31, 2004.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated herein by reference to our definitive proxy statement which will be filed with the SEC within 120 days after December 31, 2004.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is incorporated herein by reference to our definitive proxy statement which will be filed with the SEC within 120 days after December 31, 2004.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Financial Statements:
1. The following consolidated financial statements are included on Pages to of this report.
2. All financial statement schedules are omitted because they are not applicable, or are immaterial or the required information is presented in the consolidated financial statements or the related notes.
(b) Exhibits:
The exhibits to this report required to be filed pursuant to Item 15(c) are listed below.
*
Filed herewith.
+
Furnished herewith.
#
Management contract or compensatory plan document.
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.
COMSTOCK RESOURCES, INC.
By:
/s/ M. JAY ALLISON
M. Jay Allison
President and Chief Executive Officer
(Principal Executive Officer)
Date: March 17, 2005
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
INDEX
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Comstock Resources, Inc.
We have audited the accompanying consolidated balance sheets of Comstock Resources, Inc. and subsidiaries as of December 31, 2003 and 2004, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for each of the years 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 audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (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 Comstock Resources, Inc. and subsidiaries at December 31, 2003 and 2004, and the consolidated results of their operations and their cash flows for each of the years then ended, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Comstock Resources, Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 17, 2005 expressed an unqualified opinion thereon.
As discussed in Note 1 to the consolidated financial statements, on January 1, 2003, the Company adopted Statement of Financial Standards No. 143, “Accounting for Asset Retirements Obligations” and on January 1, 2004, the Company changed its method of accounting for employee stock based compensation to the fair value based method.
/s/ ERNST & YOUNG LLP
Dallas, Texas
March 17, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Comstock Resources, Inc.:
We have audited the accompanying consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows of Comstock Resources, Inc. (the “Company”) and subsidiaries for the year ended December 31, 2002. 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 the standards of the Public Company Accounting Oversight Board (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 provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of Comstock Resources, Inc.’s operations and their cash flows for the year ended December 31, 2002, in conformity with U.S. generally accepted accounting principles.
/s/ KPMG LLP
Dallas, Texas
March 19, 2003
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
As of December 31, 2003 and 2004
The accompanying notes are an integral part of these statements.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended December 31, 2002, 2003 and 2004
The accompanying notes are an integral part of these statements.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
For the Years Ended December 31, 2002, 2003 and 2004
The accompanying notes are an integral part of these statements.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2002, 2003 and 2004
The accompanying notes are an integral part of these statements.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1)
Summary of Significant Accounting Policies
Accounting policies used by Comstock Resources, Inc. (“Comstock” or the “Company”) reflect oil and natural gas industry practices and conform to accounting principles generally accepted in the United States of America.
Basis of Presentation and Principles of Consolidation
Comstock is engaged in oil and natural gas exploration, development and production, and the acquisition of producing oil and natural gas properties. The consolidated financial statements include the accounts of Comstock and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The Company accounts for its undivided interest in properties using the proportionate consolidation method, whereby its share of assets, liabilities, revenues and expenses are included in the consolidated financial statements.
Formation of Bois d’Arc Energy
In July 2004, Bois d’Arc Energy, LLC (“Bois d’Arc Energy”) was formed by Comstock Offshore, LLC (“Comstock Offshore”), an indirect wholly-owned subsidiary of the Company, and Bois d’Arc Resources, Ltd. (“Bois d’Arc Resources”), Bois d’Arc Offshore, Ltd. and certain participants in their exploration activities (collectively, the “Bois d’Arc Participants”) to replace a joint exploration venture established in 1997 by Comstock Offshore and Bois d’Arc Resources to explore for oil and natural gas in the Gulf of Mexico. Under the joint exploration venture, Bois d’Arc Resources was responsible for developing a budget for exploration activities and generating exploration prospects in the Gulf of Mexico utilizing 3-D seismic data and its extensive geological expertise in the region. Comstock Offshore had to approve the budget and would advance the funds for the acquisition of 3-D seismic data and leases needed for exploration activities. Comstock Offshore was reimbursed for all advanced costs and was entitled to a non-promoted working interest in each prospect generated. For each successful discovery well drilled pursuant to the joint exploration venture, Comstock issued to the two principals of Bois d’Arc Resources warrants exercisable for the purchase of shares of Comstock’s common stock. Successful wells drilled under the exploration venture were operated by Bois d’Arc Offshore, Ltd. pursuant to a joint operating agreement entered into by the parties participating in the prospect, including Comstock Offshore and the Bois d’Arc Participants. Any future operation on the lease including drilling additional wells on the acreage associated with the prospect was conducted under the joint operating agreement and had to be approved by the participating parties.
In July 2004, each of the Bois d’Arc Participants and Comstock Offshore contributed to Bois d’Arc Energy substantially all of their Gulf of Mexico related assets and assigned their related liabilities, including certain debt, in exchange for equity interests in Bois d’Arc Energy. The equity interests issued in exchange for the contributions were determined by using a valuation of the properties contributed by the particular contributor relative to the value of the properties contributed by all contributors. Comstock Offshore contributed its interests in its Gulf of Mexico properties and assigned to Bois d’Arc Energy $83.2 million of related debt in exchange for an approximately 59.9% ownership interest in Bois d’Arc Energy (29,935,761 class B LLC units out of 50,000,000 class B LLC units issued). The Bois d’Arc Participants contributed their offshore oil and natural gas properties as well as ownership of Bois d’Arc Offshore, Ltd., the operator of the properties, and assigned to Bois d’Arc Energy $28.2 million of related liabilities in exchange for an approximately 40.1% aggregate ownership interest in Bois d’Arc Energy. The Bois d’Arc Participants also received $27.6 million in cash to equalize the amount that Comstock Offshore’s debt exceeded its proportional share of the liabilities assigned. Bois d’Arc Energy also reimbursed Comstock Offshore $12.7 million and Bois d’Arc $0.8 million for advances made under the exploration joint venture for undrilled prospects.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table sets forth the assets contributed and the liabilities assumed on the date of the formation of Bois d’Arc Energy:
Under the terms of Bois d’Arc Energy’s operating agreement, management of Bois d’Arc Energy is shared jointly by Comstock and the principals of Bois d’Arc Resources. Management and operating decisions are made based on unanimous agreement between the parties. Because the Company has the ability to exercise significant influence over Bois d’Arc Energy, but not control it, the Company accounts for its interest in Bois d’Arc Energy’s assets, liabilities and operations under the proportionate consolidation method in accordance with Emerging Issues Task Force (“EITF”) 00-1, “Investor Balance Sheet and Income Statement Display Under the Equity Method for Investments in Partnerships and Certain other Ventures” and EITF 03-16 “Accounting for Investments in Limited Liability Companies,” and because Bois d’Arc Energy is similar to a partnership in that it maintains a specific ownership for each member.
Receivable from Bois d’Arc Energy
In connection with the formation of Bois d’Arc Energy, Comstock provided to Bois d’Arc Energy a revolving line of credit with a maximum outstanding amount of $200.0 million, of which $148.1 million was outstanding at December 31, 2004. Approximately $59.4 million of the outstanding balance is attributable to the Bois d’Arc Participants and is reflected in the consolidated balance sheet as a receivable from Bois d’Arc Energy. Borrowings under the credit facility bear interest at Bois d’Arc Energy’s option at either LIBOR plus 2% or the base rate (which is the higher of the prime rate or the federal funds rate) plus 0.75%. The credit facility matures on April 1, 2006. Interest expense of $2.7 million was charged by the Company to Bois d’Arc Energy under the credit facility during the period from July 16, 2004 to December 31, 2004. Approximately $1.1 million was attributable to the Bois d’Arc Participants and is included in interest income in the consolidated statement of operations.
In consideration for the credit facility, Bois d’Arc Energy agreed to become a guarantor with respect to Comstock’s $400 million bank credit facility and Comstock’s 67/8% senior notes due 2012. Bois d’Arc Energy’s operating agreement provides that it is to be dissolved and liquidated if a financing transaction does not occur by May 1, 2005 or such later date as determined by Bois d’Arc Energy’s board of managers. A financing transaction is defined as an initial public offering or another transaction that generates proceeds sufficient to repay all indebtedness owing to Comstock under the credit facility, which will also result in Bois d’Arc Energy being released as a guarantor of Comstock’s debt. Bois d’Arc Energy intends to repay the indebtedness owing to Comstock from the net proceeds of an initial public offering and through the issuance of shares of its common stock to Comstock.
On October 4, 2004, Bois d’Arc Energy filed a registration statement on Form S-1 with the Securities and Exchange Commission related to a proposed underwritten initial public offering of $150.0 million of its
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
common stock. As of March 17, 2005, the Form S-1 was not yet effective. Such an offering will have the effect of diluting Comstock’s current 59.9% interest in Bois d’Arc Energy. The net proceeds of the offering are expected to be used to refinance the amounts outstanding under the credit facility provided by Comstock. If Bois d’Arc Energy does not complete a financing transaction that generates sufficient proceeds to repay all of the amounts outstanding under the credit facility by May 1, 2005 (or such later date as is determined by Bois d’Arc Energy’s board of managers), Bois d’Arc Energy will be dissolved and liquidated in a manner designed to put its members in a position as near as possible to the same economic position that the members would have been in if they had never formed Bois d’Arc Energy and instead had continued to own their respective properties individually.
Formation Costs
The consolidated financial statements include $1.1 million of costs incurred in connection with the formation of Bois d’Arc Energy, including a termination fee of $0.7 million for the cancellation of a service agreement for accounting and administrative services provided to Bois d’Arc Offshore Ltd.
Reclassifications
Certain reclassifications have been made to prior periods’ financial statements to conform to the current presentation.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted accounting principles 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 amounts could differ from those estimates. Changes in the future estimated oil and natural gas reserves or the estimated future cash flows attributable to the reserves that are utilized for impairment analysis could have a significant impact on the future results of operations.
Concentration of Credit Risk and Accounts Receivable
Financial instruments that potentially subject Comstock to a concentration of credit risk consist principally of cash and cash equivalents, accounts receivable and derivative financial instruments, Comstock places its cash with high credit quality financial institutions and its derivative financial instruments with financial institutions and other firms that management believes have high credit rating. For a discussion of the credit risks associated with Comstock’s hedging activities, see Note 11. Substantially all of Comstock’s accounts receivable are due from either purchasers of oil and gas or participants in oil and gas wells for which Comstock serves as the operator. Generally, operators of oil and gas wells have the right to offset future revenues against unpaid charges related to operated wells. Oil and gas sales are generally unsecured. The Company has not had any significant credit losses in the past and believes its accounts receivable are fully collectable. Accordingly, no allowance for doubtful accounts has been provided.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Fair Value of Financial Instruments
The following table presents the carrying amounts and estimated fair value of the Company’s financial instruments as of December 31, 2003 and 2004:
The fair market value of the fixed rate debt was based on the market price as of December 31, 2003 and 2004.
Derivatives are presented at their estimated fair value. The carrying amounts of cash and cash equivalents, accounts receivable, other current assets, receivable from Bois d’Arc Energy, accounts payable and accrued expenses approximate fair value due to the short maturity of these instruments.
Other Current Assets
Other current assets at December 31, 2003 and 2004 consist of the following:
Property and Equipment
Comstock follows the successful efforts method of accounting for its oil and natural gas properties. Acquisition costs for proved oil and natural gas properties, costs of drilling and equipping productive wells, and costs of unsuccessful development wells are capitalized and amortized on an equivalent unit-of-production basis over the life of the remaining related oil and gas reserves. Equivalent units are determined by converting oil to natural gas at the ratio of six barrels of oil for one thousand cubic feet of natural gas. Cost centers for amortization purposes are determined on a field area basis. Costs incurred to acquire oil and gas leasehold are capitalized. Unproved oil and gas properties are periodically assessed and any impairment in value is charged to exploration expense. The costs of unproved properties which are determined to be productive are transferred to proved oil and gas properties and amortized on an equivalent unit-of-production basis. Exploratory expenses, including geological and geophysical expenses and delay rentals for unevaluated oil and gas properties, are charged to expense as incurred. Exploratory drilling costs are initially capitalized as unproved property but charged to expense if and when the well is determined not to have found proved oil and gas reserves. In accordance with Statement of Financial Accounting Standards No. 19, exploratory drilling costs are evaluated within a one-year period after the completion of drilling.
In accordance with Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS 143”) Comstock records a liability in the period in which an asset retirement obligation (“ARO”) is incurred, in an amount equal to the discounted estimated fair value of the obligation that is capitalized. Thereafter this liability is accreted up to the final retirement liability. Comstock’s ARO’s relate to future plugging and abandonment expenses of its oil and gas properties and related facilities disposal.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes the changes in Comstock’s total estimated liability:
The adoption of SFAS 143 on January 1, 2003 resulted in a cumulative effect adjustment to record (i) a $3.7 million decrease in the carrying value of oil and gas properties, (ii) a $3.3 million decrease in accumulated depletion, depreciation and amortization, (iii) a $1.5 million decrease in reserve for future abandonment, and (iv) a gain of $675,000, net of income taxes, which was reflected as the cumulative effect of a change in accounting principle. The following pro forma data summarizes the Company’s net income and net income per share for the years ended December 31, 2002 and 2003 as if the Company had adopted the provisions of SFAS 143 on December 31, 2001, including aggregate pro forma asset retirement obligations on that date of $15.2 million.
In accordance with the Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), Comstock assesses the need for an impairment of the costs capitalized of its oil and gas properties on a property or cost center basis. If an impairment is indicated based on undiscounted expected future cash flows, then an impairment is recognized to the extent that net capitalized costs exceed discounted expected future cash flows based on escalated prices. Comstock had a $4.3 million and $1.6 million impairment of its oil and gas properties in 2003 and 2004, respectively, which primarily related to some minor valued fields where an impairment was indicated based on estimated future cash flows attributable to the fields’ estimated proved oil and natural gas reserves.
Other property and equipment consists primarily of work boats, gas gathering systems, computer equipment, furniture and fixtures and interests in private airplanes which are depreciated over estimated useful lives ranging from 5 to 311/2 years on a straight-line basis.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Other Assets
Other assets primarily consist of deferred costs associated with issuance of the Company’s long-term debt. These costs are amortized over the respective life of the debt instrument on a straight-line basis which approximates the amortization that would be calculated using an effective interest rate method.
Stock Options
Prior to January 1, 2004, Comstock accounted for employee stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Under the intrinsic method, compensation cost for stock options is measured as the excess, if any, of the fair value of the Company’s common stock at the date of the grant over the amount an employee must pay to acquire the common stock. Effective January 1, 2004, the Company changed its method of accounting for employee stock-based compensation to the preferable fair value based method prescribed in Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under the fair value based method, compensation cost is measured at the grant date based on the fair value of the award and is recognized on a straight-line basis over the award vesting period. The fair value of each award is estimated as of the date of grant using the Black-Scholes options pricing model. Under the modified prospective transition method selected by Comstock as described in Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” stock-based compensation expense recognized for 2004 is the same as that which would have been recognized had the fair value method of SFAS 123 been applied from its original effective date. During 2004, the Company recorded $6.2 million in stock-based compensation expense in general and administrative expenses. The 2004 stock-based compensation included $2.8 million for restricted stock grants, $1.9 million for employee stock options and $1.5 million attributable to our ownership in Bois d’Arc Energy relating to its stock-based compensation.
In accordance with the modified prospective transition method, results for years prior to 2004 have not been restated. In 2002 and 2003, the Company accounted for stock-based compensation for employees under APB 25 and related interpretations, under which no compensation cost was recognized for employee stock options. If compensation costs had been determined in accordance with SFAS 123, the Company’s net income and earnings per share would approximate the following pro forma amounts:
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 2002, 2003 and 2004, respectively: average risk-free interest rates of 3.8, 3.0 and 3.6%; average expected lives of 5.9, 5.9 and 4.1 years; average expected volatility factors of 68.9, 32.8 and 46.9; and 0% dividend yield for all years. The estimated weighted average fair value of options to purchase one share of common stock issued under the Company’s incentive plans was $5.88 in 2002, $6.38 in 2003 and $7.75 in 2004.
Segment Reporting
Comstock presently operates in one business segment, the exploration and production of oil and natural gas.
Derivative Instruments and Hedging Activities
Comstock follows Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), which requires that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded on the balance sheet as either an asset or liability measured at its fair value. SFAS 133 requires that changes in the derivative’s fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Comstock estimates fair value based on quotes obtained from the counterparties to the derivative contract. The fair value of derivative contracts that expire in less than one year are recognized as current assets or liabilities. Those that expire in more than one year are recognized as long-term assets or liabilities. Derivative financial instruments that are not accounted for as hedges are adjusted to fair value through income. If the derivative is designated as a cash flow hedge, changes in fair value are recognized in other comprehensive income until the hedged item is recognized in earnings.
Major Purchasers
In 2004, Comstock had two purchasers of its oil and natural gas production that individually accounted for 10% or more of total oil and gas sales. Such purchasers accounted for 20% and 16% of total 2004 oil and gas sales. In 2003, Comstock had three purchasers that accounted for 18%, 14% and 10% of total 2003 oil and gas sales. In 2002, Comstock had two purchasers that accounted for 16% and 15% of total 2002 oil and gas sales.
Revenue Recognition and Gas Balancing
Comstock utilizes the sales method of accounting for oil and natural gas revenues whereby revenues are recognized based on the amount of oil or natural gas sold to purchasers. The amount of oil or natural gas sold may differ from the amount to which the Company is entitled based on its revenue interests in the properties. Comstock did not have any significant imbalance positions at December 31, 2002, 2003 or 2004.
General and Administrative Expenses
General and administrative expenses are reported net of reimbursements of overhead costs that are allocated to working interest owners of the oil and gas properties operated by Comstock.
Other Income
Included in other income in 2002 was $7.7 million related to refunds received in 2002 of severance taxes paid in prior years.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Income Taxes
Comstock accounts for income taxes using the asset and liability method, whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax basis, as well as the future tax consequences attributable to the future utilization of existing tax net operating loss and other types of carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and carryforwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
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. The Company’s other comprehensive income consists of unrealized gains or losses on cash flow hedges.
Earnings Per Share
Basic and diluted earnings per share for 2002, 2003 and 2004 were determined as follows:
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Stock options and warrants to purchase common stock at exercise prices in excess of the average actual stock price for the period that were anti-dilutive and that were excluded from the determination of diluted earnings per share are as follows:
Statements of Cash Flows
For the purpose of the consolidated statements of cash flows, Comstock considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.
The following is a summary of all significant noncash investing and financing activities and cash payments made for interest and income taxes:
New Accounting Standards
On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued Statement 123 (revised 2004),“Share-Based Payment” (“SFAS 123 R”) that requires compensation costs related to share-based payment transactions (issuance of stock options and restricted stock) to be recognized in the financial statements. With limited exceptions, the amount of compensation cost is to be measured based on the grant date fair value of the equity or liability instruments issued. Compensation cost is recognized over the period that an employee provides service in exchange for the award. Statement 123 R replaces SFAS 123, “Accounting for Stock-Based Compensation”, and supersedes APB25. SFAS 123 R is effective for the first reporting period after June 15, 2005. Entities that use the fair-value-based method for either recognition or disclosure under SFAS 123 are required to apply SFAS 123 R using a modified version of prospective application whereby the entity is required to record compensation expense for all awards it grants after the date of adoption and the unvested portion of previously granted awards that remain outstanding at the date of adoption. Effective January 1, 2004, Comstock adopted the fair value-based measure as proscribed in SFAS 123 using the modified prospective application. Given the similarities between SFAS 123 and SFAS 123 R, SFAS 123 R will not have a significant impact on the Company. SFAS 123 R will require that the Company recognize the tax benefit of stock option exercises as a financing cash flow in future years.
On December 16, 2004, the FASB issued Statement 153, “Exchanges of Nonmonetary Assets”, an amendment of APB Opinion No. 29, to clarify the accounting for nonmonetrary exchanges of similar productive assets. SFAS 153 provides a general exception from fair value measurement for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Statement will be applied prospectively and is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005.
(2)
Acquisitions
In October 2004, Comstock acquired producing oil and gas properties in the East Texas, Arkoma, Anadarko and San Juan basins from Ovation Energy, L.P. for $62.0 million. The properties acquired had estimated proved reserves of approximately 41.0 billion cubic feet of gas equivalent and included 165 active wells, of which 69 are operated by the Company. The acquisition was funded by borrowings under the Company’s bank credit facility.
In December 2002, Comstock acquired an interest in the Ship Shoal 113 Unit for $7.8 million. The acquisition included interests in 26 producing wells, 11.7 net wells, and seven production facilities in the Gulf of Mexico. In October 2003, Comstock acquired an additional interest in the Ship Shoal 113 Unit for $4.6 million.
(3)
Oil and Gas Producing Activities
Set forth below is certain information regarding the aggregate capitalized costs of oil and gas properties and costs incurred by Comstock for its oil and gas property acquisition, development and exploration activities:
Capitalized Costs
Costs Incurred
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
In 2002, 2003 and 2004, Comstock capitalized interest expense of $281,000, $422,000 and $363,000, respectively, on its unproved properties under development which is included in the unproved property acquisition costs in each year.
Results of Operations for Oil and Gas Producing Activities
The following table includes revenues and expenses associated directly with Comstock’s oil and natural gas producing activities. The amounts presented do not include any allocation of Comstock’s interest costs or general corporate overhead and, therefore, are not necessarily indicative of the contribution to net earnings of Comstock’s oil and gas operations. Income tax expense has been calculated by applying statutory income tax rates to oil and gas sales after deducting costs, including depreciation, depletion and amortization and after giving effect to permanent differences.
(4)
Long-Term Debt
Long-term debt is comprised of the following:
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes our debt as of December 31, 2004 by year of maturity:
On January 1, 2004, Comstock had $220.0 million in principal amount of 111/4% Senior Notes due 2007 (the “1999 Notes”) outstanding. Pursuant to a tender offer, on February 25, 2004, Comstock repurchased $197.7 million in principal amount of the 1999 Notes for $212.2 million plus accrued interest. On May 1, 2004, Comstock redeemed the remaining $22.3 million in principal amount of the 1999 Notes outstanding for $23.6 million plus accrued interest. The early extinguishment of the 1999 Notes resulted in a loss of $19.6 million, which was comprised of the premium paid for repurchase of the 1999 Notes together with the write-off of unamortized debt issuance costs related to the 1999 Notes.
In connection with the repurchase of the 1999 Notes, Comstock sold $175.0 million of senior notes in an underwritten public offering. The new senior notes are due on March 1, 2012 and bear interest at 67/8%, which is payable semiannually on March 1 and September 1. The notes are unsecured obligations of Comstock and are currently guaranteed by all of its subsidiaries.
On February 25, 2004, Comstock also entered into a $400.0 million bank credit facility with Bank of Montreal, as the administrative agent, which replaced the Company’s former credit facility. The credit facility is a four year revolving credit commitment that matures on February 25, 2008. Borrowings under the credit facility were used to refinance amounts outstanding under the prior bank credit facility and to fund the repurchase of the 1999 Notes. Indebtedness under the credit facility is secured by substantially all of Comstock’s assets and is guaranteed by all of its subsidiaries. The credit facility is subject to borrowing base availability, which was $300.0 million as of December 31, 2004 and will be redetermined semiannually based on the banks’ estimates of the future net cash flows of the Company’s oil and natural gas properties. The borrowing base may be affected by the performance of the properties and changes in oil and natural gas prices. The determination of the borrowing base is at the sole discretion of the administrative agent and the bank group. Borrowings under the credit facility bear interest, based on the utilization of the borrowing base, at Comstock’s option at either (1) LIBOR plus 1.25% to 1.75% or (2) the base rate (which is the higher of the prime rate or the federal funds rate) plus 0% to 0.5%. A commitment fee of 0.375% is payable on the unused borrowing base. The credit facility contains covenants that, among other things, restrict the payment of cash dividends, limit the amount of consolidated debt that Comstock may incur and limit the Company’s ability to make certain loans and investments. The only financial covenants are the maintenance of a current ratio and maintenance of a minimum tangible net worth. The Company was in compliance with these covenants as of December 31, 2004.
Each of Comstock’s wholly owned subsidiaries and Bois d’Arc Energy and its subsidiaries are guarantors of Comstock’s 67/8% senior notes due 2012 and the bank credit facility.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(5)
Commitments and Contingencies
Lease Commitments
Comstock rents office space under noncancelable leases. Rent expense for the years ended December 31, 2002, 2003 and 2004 was $495,000, $535,000 and $625,000 respectively. Minimum future payments under the leases are as follows:
Contingencies
From time to time, Comstock is involved in certain litigation that arises in the normal course of its operations. The Company records a loss contingency for these matters when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Comstock has accrued $1.5 million related to its estimate of losses to be incurred in resolving a specific contingency. After consideration of amounts accrued, the Company does not believe the resolution of these matters will have a material effect on the Company’s financial position or results of operations.
(6)
Stockholders’ Equity
The authorized capital stock of Comstock consists of 50 million shares of common stock, $.50 par value per share (the “Common Stock”), and 5 million shares of preferred stock, $10.00 par value per share. The preferred stock may be issued in one or more series, and the terms and rights of such stock will be determined by the Board of Directors. There were no shares of preferred stock outstanding at December 31, 2003 or 2004.
On December 31, 2002, Comstock had 1,757,310 shares of convertible preferred stock (the “Series 1999 Preferred Stock”) outstanding. The Series 1999 Preferred Stock accrued dividends at an annual rate of 9% which were payable quarterly in cash or Comstock had the option to issue shares of common stock. Dividends paid per share were $0.91 per share in 2002 and $0.33 in 2003. Each share of the Series 1999 Preferred Stock was convertible, at the option of the holder, into 2.5 shares of common stock. In April and June of 2003, the holders of the Series 1999 Preferred Stock converted their preferred shares into 4,393,275 shares of common stock, resulting in no shares of the Series 1999 Preferred Stock remaining outstanding. This conversion reduced Comstock’s annual preferred stock dividend requirement by $1.6 million and increased stockholders’ equity by $17.6 million.
Comstock’s Board of Directors has designated 500,000 shares of the preferred stock as Series B Junior Participating Preferred Stock (the “Series B Junior Preferred Stock”) in connection with the adoption of a shareholder rights plan. At December 31, 2004, there were no shares of Series B Junior Preferred Stock issued or outstanding. The Series B Junior Preferred Stock is entitled to receive cumulative quarterly dividends per share equal to the greater of $1.00 or 100 times the aggregate per share amount of all dividends (other than stock dividends) declared on Common Stock since the immediately preceding quarterly dividend payment date or, with respect to the first payment date, since the first issuance of Series B Junior Preferred Stock. Holders of the Series B Junior Preferred Stock are entitled to 100 votes per share (subject to adjustment to
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
prevent dilution) on all matters submitted to a vote of the stockholders. The Series B Junior Preferred Stock is neither redeemable nor convertible. The Series B Junior Preferred Stock ranks prior to the Common Stock but junior to all other classes of preferred stock.
Stock options and stock purchase warrants were exercised to purchase 310,758 shares, 576,025 shares and 1,064,881 shares in 2002, 2003 and 2004, respectively. Such exercises yielded net proceeds of approximately $1.1 million, $3.0 million and $9.4 million in 2002, 2003, and 2004, respectively.
Stock Options
On June 23, 1999, the stockholders approved the 1999 Long-term Incentive Plan for the management including officers, directors and managerial employees, which replaced the 1991 Long-term Incentive Plan. The 1999 Long-term Incentive Plan together with the 1991 Long-term Incentive Plan (collectively, the “Incentive Plans”) authorize the grant of non-qualified stock options and incentive stock options and the grant of restricted stock to key executives of Comstock. The options under the Incentive Plans have contractual lives ranging from five to ten years and become exercisable after lapses in vesting periods ranging from zero to ten years from the grant date. As of December 31, 2004, the Incentive Plans provide for future awards of stock options or restricted stock grants of up to 378,171 shares of Common Stock plus 1% of the outstanding shares of Common Stock each year beginning on January 1, 2005.
The following table summarizes information about the Incentive Plan’s stock options outstanding at December 31, 2004:
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes stock option activity during 2002, 2003 and 2004 under the Incentive Plans:
Restricted Stock Grants
Under the Incentive Plans, officers and managerial employees may be granted shares of restricted Common Stock without cost to the employee. The shares vest over a specified period. Restricted stock grants were made for 56,250, 420,000 and 275,000 shares in 2002, 2003 and 2004 respectively. The weighted average fair value per share of the restricted stock grants were $9.20, $18.20 and $20.03 in 2002, 2003 and 2004, respectively. In the aggregate, 1,418,750 restricted stock grants have been awarded under the Incentive Plans. As of December 31, 2004, 611,250 shares of such awards are vested. A provision for the restricted stock grants is made over the related vesting period. Compensation expense recognized for restricted stock grants for the years ended December 31, 2002, 2003 and 2004 was $217,000, $359,000 and $2,848,000, respectively.
(7)
Exploration Venture
On July 31, 2001, Comstock entered into a new exploration agreement with Bois d’Arc Offshore, Ltd. and its principals (collectively, “Bois d’Arc”), which replaced an exploration agreement entered into on December 8, 1997. Comstock did not have any ownership interest in Bois d’Arc. The 2001 exploration agreement established a joint exploration venture between Comstock and Bois d’Arc covering the state coastal waters of Louisiana and Texas and corresponding federal offshore waters in the Gulf of Mexico. The new venture was effective April 1, 2001 and was to continue until December 31, 2006. Under the joint exploration venture, Bois d’Arc was responsible for developing a budget for exploration activities and for generating exploration prospects in the Gulf of Mexico utilizing 3-D seismic data and their extensive geological expertise in the region. Comstock had to approve the budget and would advance funds for the acquisition of 3-D seismic data and leases needed to conduct exploration activities. Comstock Offshore was reimbursed for all advanced costs and was entitled to a non-promoted working interest in each prospect generated. The agreement required Comstock to fund a minimum of $5.0 million for the acquisition of seismic data over the term of the agreement or Bois d’Arc had the right to terminate the agreement. Comstock was to recover its advances based on Bois d’Arc’s ability to generate drilling prospects on the acreage acquired that could either be sold to third parties or drilled by Comstock and Bois d’Arc. Prior to drilling a prospect under the joint exploration
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
venture, Comstock was reimbursed for the costs that were advanced and had the right to participate in drilling the prospect with up to a 40% working interest. The amounts advanced by Comstock Offshore for leasehold and seismic data acquisitions were recorded as unevaluated properties and as exploration expense as the reimbursements or repayment of such advances by Bois d’Arc were not unconditional. The collection of the advances was subject to a drillable prospect being developed that Comstock Offshore, Bois d’Arc or other third parties would agree to drill. At December 31, 2003 Comstock had $7.1 million in advances outstanding for acquisition costs of unevaluated properties and $2.6 million for acquisition costs of seismic data. In connection with the formation of Bois d’Arc Energy these advances were repaid in July 2004.
Under the exploration agreement, the principals of Bois d’Arc had the opportunity to earn warrants to purchase up to 1,620,000 shares of Common Stock. Warrants to purchase 60,000 shares were earned for each prospect that resulted in a successful discovery, which was defined as an exploratory well drilled under the exploration agreement that was not plugged and abandoned and in which Comstock agreed to participate in the completion operation. The exercise price for the warrants earned was determined on a semiannual basis each year that the venture was in effect based on the then-current market price for the Common Stock. The principals of Bois d’Arc had also earned warrants to purchase 600,000 shares of Common Stock at $14.00 per share under the prior exploration agreement during the period from January 1998 to April 2001. The value of these warrants based on the Black-Scholes option pricing model was $9.97 per option share. The estimated value of $6.0 million for the warrants earned under the prior exploration agreement were capitalized to oil and gas properties in 1998 through 2001. The exploration venture was terminated on July 16, 2004 in connection with the formation of Bois d’Arc Energy.
The following table summarizes the stock purchase warrants issued to the principals of Bois d’Arc that were outstanding at December 31, 2004:
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes stock purchase warrant activity during 2002, 2003 and 2004 under the exploration venture:
The value of the stock purchase warrants based on the Black-Scholes option pricing model was $5.36 per share or an aggregate of $1.3 million in 2002, $8.36 per share or an aggregate of $7.5 million in 2003 and $9.69 per share or $2.3 million in 2004. Such costs were capitalized as a cost of oil and gas properties.
(8)
Retirement Plan
Comstock has a 401(k) Profit Sharing Plan which covers all of its employees. At its discretion, Comstock may match a certain percentage of the employees’ contributions to the plan. The matching percentage is determined annually by the Board of Directors. Comstock’s matching contributions to the plan were $116,000, $125,000 and $130,000 for the years ended December 31, 2002, 2003 and 2004, respectively.
(9)
Income Taxes
The tax effects of significant temporary differences representing the net deferred tax liability at December 31, 2003 and 2004 were as follows:
The following is an analysis of the consolidated income tax expense:
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
There were no significant differences between income taxes computed using the statutory rate of 35% and Comstock’s effective tax rate in 2002 of 35%. In 2003 and 2004, Comstock’s effective tax rate was 36% which differed from the statutory rate of 35% because of state income taxes.
At December 31, 2004, Comstock had the following carryforwards available to reduce future income taxes:
The utilization of $35.2 million of the net operating loss carryforwards are limited to approximately $1.1 million per year pursuant to a prior change of control of an acquired company. Accordingly, a valuation allowance of $23.0 million, with a tax effect of $8.0 million, has been established for Comstock’s estimate of the net operating loss carryforwards that it will not be able to utilize. Realization of the net operating carryforwards requires Comstock to generate taxable income within the carryforward period.
(10)
Derivatives and Hedging Activities
Comstock periodically uses swaps, floors and collars to hedge oil and natural gas prices and interest rates. Swaps are settled monthly based on differences between the prices specified in the instruments and the settlement prices of futures contracts. Generally, when the applicable settlement price is less than the price specified in the contract, Comstock receives a settlement from the counter party based on the difference multiplied by the volume or amounts hedged. Similarly, when the applicable settlement price exceeds the price specified in the contract, Comstock pays the counter party based on the difference. Comstock generally receives a settlement from the counter party for floors when the applicable settlement price is less than the price specified in the contract, which is based on the difference multiplied by the volumes hedged. For collars, generally Comstock receives a settlement from the counter party when the settlement price is below the floor and pays a settlement to the counter party when the settlement price exceeds the cap. No settlement occurs when the settlement price falls between the floor and cap.
The following table sets out the derivative financial instruments, outstanding at December 31, 2004, which are held for natural gas price risk management:
The fair market value of these derivative financial instruments at December 31, 2004, was a liability of $155,000 which is included in accrued expenses in the accompanying consolidated financial statements. Comstock has not designated these instruments as hedges and accordingly the loss on derivatives of $155,000 is reflected in the consolidated statements of operations for 2004.
Comstock periodically enters into interest rate swap agreements to hedge the impact of interest rate changes on its floating rate long-term debt. As a result of certain hedging transactions for interest rates, interest expense included a loss of $218,000 and $108,000 in 2002 and 2003, respectively. The ineffectiveness of these hedges was determined to be insignificant. As of December 31, 2003 and 2004, Comstock had no interest rate financial instruments outstanding.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(11)
Discontinued Operations
In April and July 2002, Comstock sold certain marginal oil and gas properties for cash proceeds of $3.5 million plus forgiveness of certain accounts payables related to the properties. The properties sold include various interests in nonoperated properties in Nueces, Hardeman, Montague and Wharton counties in Texas. Comstock realized a loss of $1.8 million ($1.2 million, after tax) on these property sales. The results of operations of these sold properties, including the losses on disposal, have been presented as discontinued operations in the accompanying consolidated statements of operations. Results for these properties reported as discontinued operations were as follows:
(12)
Supplementary Quarterly Financial Data (Unaudited)
2003 -
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2004 -
(13)
Oil and Gas Reserves Information (Unaudited)
Set forth below is a summary of the changes in Comstock’s net quantities of crude oil and natural gas reserves for each of the three years ended December 31, 2004:
(1)
Net change in reserves related to the formation of Bois d’Arc Energy.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table sets forth the standardized measure of discounted future net cash flows relating to proved reserves at December 31, 2003 and 2004:
The following table sets forth the changes in the standardized measure of discounted future net cash flows relating to proved reserves for the years ended December 31, 2002, 2003 and 2004:
(1)
Net change in reserves related to the formation of Bois d’Arc Energy.
The estimates of proved oil and gas reserves utilized in the preparation of the financial statements were estimated by Lee Keeling and Associates, Inc., independent petroleum consultants, in accordance with guidelines established by the Securities and Exchange Commission and the Financial Accounting Standards Board, which require that reserve reports be prepared under existing economic and operating conditions with no provision for price and cost escalation except by contractual agreement. All of Comstock’s reserves are located onshore in or offshore to the continental United States of America and include Comstock’s proportionate share of the proved reserves of Bois d’Arc Energy.
COMSTOCK RESOURCES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Future cash inflows are calculated by applying year-end prices adjusted for transportation and other charges to the year-end quantities of proved reserves, except in those instances where fixed and determinable price changes are provided by contractual arrangements in existence at year-end.
Comstock’s average year-end prices used in the reserve estimates were as follows:
Future development and production costs are computed by estimating the expenditures to be incurred in developing and producing proved oil and gas reserves at the end of the year, based on year-end costs and assuming continuation of existing economic conditions. Future income tax expenses are computed by applying the appropriate statutory tax rates to the future pre-tax net cash flows relating to proved reserves, net of the tax basis of the properties involved. The future income tax expenses give effect to permanent differences and tax credits, but do not reflect the impact of future operations.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Managers and Members of Bois d’Arc Energy, LLC
We have audited the accompanying consolidated balance sheet of Bois d’Arc Energy, LLC and subsidiaries as of December 31, 2004 and the related consolidated statements of income, changes in members’ equity, and cash flows for the period from July 16, 2004 (Inception) to December 31, 2004. 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 the standards of the Public Company Accounting Oversight Board (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 Bois d’Arc Energy, LLC and subsidiaries at December 31, 2004 and the consolidated results of their operations and their cash flows for the period from July 16, 2004 (inception) to December 31, 2004 in conformity with U.S. generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
Dallas, Texas
March 17, 2005
BOIS D’ARC ENERGY, LLC
CONSOLIDATED BALANCE SHEET
December 31, 2004
The accompanying notes are an integral part of these statements.
BOIS D’ARC ENERGY, LLC
CONSOLIDATED STATEMENT OF OPERATIONS
For the Period from Inception (July 16, 2004) to December 31, 2004
The accompanying notes are an integral part of these statements.
BOIS D’ARC ENERGY, LLC
CONSOLIDATED STATEMENT OF CHANGES IN MEMBERS’ EQUITY
For the Period from Inception (July 16, 2004) to December 31, 2004
The accompanying notes are an integral part of these statements.
BOIS D’ARC ENERGY, LLC
CONSOLIDATED STATEMENT OF CASH FLOW
For the Period from Inception (July 16, 2004) to December 31, 2004
The accompanying notes are an integral part of these statements.
BOIS D’ARC ENERGY, LLC
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1)
Organization
Bois d’Arc Energy, LLC (“Bois d’Arc Energy” or the “Company”) is engaged in oil and natural gas exploration, development and production in state and federal waters in the Gulf of Mexico. The Company was formed on July 16, 2004 (“Inception”) by Bois d’Arc Resources, Ltd., Bois d’Arc Offshore, Ltd. and certain participants in their exploration activities (collectively, the “Bois d’ Arc Participants”) and Comstock Offshore, LLC (“Comstock Offshore”), an indirect wholly-owned subsidiary of Comstock Resources, Inc. (“Comstock”).
In December 1997, Comstock Offshore acquired from a predecessor of Bois d’Arc Resources, Ltd. and other interest owners certain offshore oil and natural gas properties in the Gulf of Mexico. Subsequent to the acquisition, the predecessor to Bois d’Arc Resources, Ltd. was dissolved and Bois d’Arc Resources, Ltd. and Bois d’Arc Offshore, Ltd. (collectively, “Bois d’Arc”) were created. In connection with the December 1997 acquisition, Comstock Offshore and Bois d’Arc established a joint exploration venture to explore for oil and natural gas in the Gulf of Mexico. Under the joint exploration venture, Bois d’Arc was responsible for developing a budget for exploration activities and for generating exploration prospects in the Gulf of Mexico utilizing 3-D seismic data and their extensive geological expertise in the region. Comstock Offshore had to approve the budget and would advance funds for the acquisition of 3-D seismic data and leases needed to conduct exploration activities. Comstock Offshore was reimbursed for all advanced costs and was entitled to a non-promoted working interest in each prospect generated. For each successful discovery well drilled pursuant to the joint exploration venture, Comstock issued to the two principals of Bois d’Arc warrants exercisable for the purchase of shares of Comstock’s common stock. Successful wells drilled under the exploration venture were operated by Bois d’Arc Offshore, Ltd. pursuant to a joint operating agreement entered into by the parties participating in the prospect, including Comstock Offshore and the Bois d’Arc Participants. Any future operation on the lease including drilling additional wells on the acreage associated with the prospect was conducted under the joint operating agreement and had to be approved by the participating parties.
On July 16, 2004, Bois d’Arc Energy was formed to replace the joint exploration venture. Each of the Bois d’Arc Participants and Comstock Offshore contributed to Bois d’Arc Energy substantially all of their Gulf of Mexico related assets and assigned to the Company their related liabilities, including certain debt, in exchange for equity interests in Bois d’Arc Energy. The equity interests issued in exchange for the contributions were determined by using a valuation of the properties contributed by the particular contributor conducted by Lee Keeling and Associates, Inc., independent petroleum consultants, relative to the value of the properties contributed by all contributors. Comstock Offshore contributed its interests in its Gulf of Mexico properties and assigned to Bois d’Arc Energy $83.2 million of related debt in exchange for an approximately 59.9% ownership interest in Bois d’Arc Energy. Each of the Bois d’Arc Participants contributed its interest in commonly owned Gulf of Mexico properties as well as ownership of Bois d’Arc Offshore, Ltd., the operator of the properties, and assigned in the aggregate $28.2 million of related liabilities in exchange for an approximately 40.1% aggregate ownership interest. The Bois d’Arc Participants also received $27.6 million in cash to equalize the amount that Comstock Offshore’s debt exceeded its proportional share of the liabilities assigned. Bois d’Arc Energy also reimbursed Comstock Offshore $12.7 million and Bois d’Arc $0.8 million for advances made under the joint exploration venture for undrilled prospects.
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The following table presents the assets and liabilities of Comstock Offshore and the Bois d’Arc Participants that were contributed to Bois d’Arc Energy:
Comstock and the Bois d’Arc Participants combined their respective Gulf of Mexico offshore properties into the Company, a newly formed limited liability company. Comstock Offshore and Bois d’Arc Resources have conducted joint exploration activities over the last six and one-half years and have interests in the same offshore properties. The ownership in the Company is based on the relative values of the properties that each entity contributed at the time of formation, approximately 59.9% by Comstock and 40.1% by the Bois d’Arc Participants. The Company’s operating agreement provides that the board is to be composed of four persons, two of which are appointed by Comstock Offshore and two of which are appointed by the Bois d’Arc Participants. A majority of the board of managers is required to take any action of the board of managers (thereby requiring at least one of the managers appointed by the other group to effect any decision), and all significant matters require unanimous consent of the managers. Accordingly, the Company is jointly controlled and managed. There is an ongoing interest of both companies in the partnership and a sharing of management.
The substance of the formation of the Company was that these companies pooled their separate interests in various properties for a single interest in an entity (the Company) that holds all of their separate offshore properties. Management of the resulting joint venture is consistent with that in place during the term of the joint exploration venture. The Company has continued to account for Comstock Offshore and Bois d’Arc Resources as a joint venture and the net assets of the predecessors, who were also parties to the joint exploration venture, were recorded at historical cost at formation.
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Summary of Significant Accounting Policies
Accounting policies used by Bois d’Arc Energy reflect oil and gas industry practices and conform to accounting principles generally accepted in the United States of America.
Principles of Consolidation
The consolidated financial statements include the accounts of Bois d’Arc Energy and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The Company accounts for its undivided interest in properties using the proportionate consolidation method,
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whereby its share of assets, liabilities, revenues and expenses are included in its consolidated financial statements.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted accounting principles 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 amounts could differ from those estimates. Changes in the future estimated oil and natural gas reserves or the estimated future cash flows attributable to the reserves that are utilized for impairment analysis could have a significant impact on the future results of operations.
Concentration of Credit Risk and Accounts Receivable
Financial instruments that potentially subject the Company to a concentration of credit risk consist principally of cash and cash equivalents, and accounts receivable. Bois d’Arc Energy places its cash with high credit quality financial institutions and its derivative financial instruments with financial institutions and other firms that management believes have high credit rating. Substantially all of Bois d’Arc Energy’s accounts receivable are due from either purchasers of oil and natural gas or participants in oil and natural gas wells for which Bois d’Arc Energy serves as the operator. Generally, operators of oil and natural gas wells have the right to offset future revenues against unpaid charges related to operated wells. Oil and gas sales are generally unsecured. The Company’s credit losses consistently have been within management’s expectations. Bois d’Arc Energy has not had any credit losses in the past and believes its accounts receivable are fully collectable. Accordingly, no allowance for doubtful accounts has been provided.
Fair Value of Financial Instruments
The carrying amounts of cash and cash equivalents, accounts receivable, other current assets, accounts payable, accrued expenses and payable to parent company approximate fair value due to the short maturity of these instruments.
Property and Equipment
Bois d’Arc Energy follows the successful efforts method of accounting for its oil and gas properties. Acquisition costs for proved oil and gas properties, costs of drilling and equipping productive wells and costs of unsuccessful development wells are capitalized and amortized on an equivalent unit-of-production basis over the life of the remaining related oil and natural gas reserves. Equivalent units are determined by converting oil to natural gas at the ratio of six barrels of oil for one thousand cubic feet of natural gas. Wells sharing common production platforms and facilities comprise the cost centers which are used for amortization purposes. The estimated future costs of dismantlement, restoration and abandonment are included in the combined balance sheets in the reserve for future abandonment costs and expensed as part of depreciation, depletion and amortization expense. Costs incurred to acquire oil and gas leases are capitalized. Unproved oil and natural gas properties are periodically assessed and any impairment in value is charged to exploration expense. The costs of unproved properties which are determined to be productive are transferred to proved oil and natural gas properties and amortized on an equivalent unit-of-production basis. Exploratory expenses, including geological and geophysical expenses and delay rentals for unevaluated oil and natural gas properties, are charged to expense as incurred. Exploratory drilling costs are initially capitalized as unproved property but charged to expense if and when the well is determined not to have found proved oil and natural gas reserves. In accordance with Statement of Financial Accounting Standards No. 19, exploratory drilling costs are evaluated within a one-year period after the completion of drilling.
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In accordance with the Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), Bois d’Arc Energy assesses the need for an impairment of the costs capitalized of its oil and gas properties on a property or cost center basis. If an impairment is indicated based on undiscounted expected future cash flows, then an impairment is recognized to the extent that net capitalized costs exceed discounted expected future cash flows based on escalated prices. There was no indication of an impairment in 2004. Other property and equipment consists primarily of work boats, computer equipment and furniture and fixtures, which are depreciated over estimated useful lives ranging from three to ten years on a straight-line basis.
Segment Reporting
Bois d’Arc Energy presently operates in one business segment, the exploration and production of oil and natural gas in the Gulf of Mexico.
Major Purchasers
From Inception through December 31, 2004, Bois d’Arc Energy had two purchasers of its oil and natural gas production which individually accounted for 10% or more of total oil and gas sales. Such purchasers accounted for 46% and 37% of total oil and gas sales in the period from Inception to December 31, 2004.
Revenue Recognition and Gas Balancing
Bois d’Arc Energy utilizes the sales method of accounting for natural gas revenues whereby revenues are recognized based on the amount of gas sold to purchasers. The amount of gas sold may differ from the amount to which the Company is entitled based on its revenue interests in the properties. Bois d’Arc Energy did not have any significant imbalance positions at December 31, 2004.
General and Administrative Expense
General and administrative expense in 2004 is reduced by operating fee income of $1.7 million received by the Company.
The operating fee income is a reimbursement of the Company’s general and administrative expense. General and administrative expenses include $120,000 paid by Bois d’Arc Energy to Comstock for accounting services under a service agreement.
Equity-based Compensation
The Company follows the fair value based method prescribed in Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) in accounting for equity-based compensation. Under the fair value based method, compensation cost is measured at the grant date based on the fair value of the award and is recognized on a straight-line basis over the award vesting period.
Income Taxes
Bois d’Arc Energy is a limited liability company that passes through its taxable income to its unit owners. Accordingly, no provision for federal or state corporate income taxes has been made in the accompanying consolidated financial statements.
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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 is no difference between comprehensive income and reported income.
Statements of Cash Flows
For the purpose of the combined statements of cash flows, Bois d’Arc Energy considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.
Asset Retirement Obligations
Bois d’Arc Energy’s primary asset retirement obligations relate to future plugging and abandonment expenses on its oil and gas properties and related facilities disposal. The following table summarizes the changes in Bois d’Arc Energy’s total estimated liability:
New Accounting Standards
On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued Statement 123 (revised 2004),“Share-Based Payment” (“SFAS 123 R”) that requires compensation costs related to share-based payment transactions (issuance of stock options and restricted stock) to be recognized in the financial statements. With limited exceptions, the amount of compensation cost is to be measured based on the grant date fair value of the equity or liability instruments issued. Compensation cost is recognized over the period that an employee provides service in exchange for the award. Statement 123 R replaces SFAS 123, “Accounting for Stock-Based Compensation”, and supersedes APB25. SFAS 123 R is effective for the first reporting period after June 15, 2005. Entities that use the fair-value-based method for either recognition or disclosure under SFAS 123 are required to apply SFAS 123 R using a modified version of prospective application whereby the entity is required to record compensation expense for all awards it grants after the date of adoption and the unvested portion of previously granted awards that remain outstanding at the date of adoption. The Company used a fair value-based measure in connection with its incentive plan awards on formation. Therefore, SFAS 123 R will not have a significant impact on the Company.
On December 16, 2004, the FASB issued Statement 153, “Exchanges of Nonmonetary Assets”, an amendment of APB Opinion No. 29, to clarify the accounting for nonmonetrary exchanges of similar productive assets. SFAS 153 provides a general exception from fair value measurement for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The Statement will be applied prospectively and is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005.
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Payable to Parent Company
In connection with the formation of the Company, Comstock provided a revolving line of credit to Bois d’Arc Energy with a maximum outstanding amount of $200.0 million. Approximately $152.3 million was borrowed on the line of credit to repay the liabilities assigned to the Company at its formation, including the $83.2 million payable to Comstock, $13.5 million of advances made by Comstock Offshore and Bois d’Arc under the joint exploration venture and $55.7 million to refinance the bank loan and other obligations of the Bois d’Arc Participants. Borrowings under the credit facility bear interest at the Company’s option at either LIBOR plus 2% or the base rate (which is the higher of the prime rate or the federal funds rate) plus 0.75%. The credit facility matures on April 1, 2006. Interest expense of $2.7 million was charged by Comstock under the credit facility during the period from Inception to December 31, 2004.
Bois d’Arc Energy expects to refinance the amounts outstanding under the credit facility provided by Comstock. The refinancing may include an initial public offering of its common stock, depending on market conditions and various other factors. If Bois d’Arc Energy does not complete a financing transaction which generates sufficient proceeds to repay all of the amounts outstanding under the line of credit with Comstock by May 1, 2005 (or such later date as is determined by Bois d’Arc Energy’s board of managers), Bois d’Arc Energy will be dissolved and liquidated in a manner designed to put the contributors in a position as near as possible to the same economic position that the contributors would have been in if the contributors had never formed Bois d’Arc Energy and instead had continued to own their portion of the respective properties individually.
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Members’ Equity
Bois d’Arc Energy has three classes of membership units - class A, class B and class C units. Class A units represent an interest in the capital of the Company but no interest in the profits of the Company and have voting rights. Class B units represent an interest in the capital and profits of the Company and have no voting or other decision-making rights except as required by applicable law. Class C units represent an interest only in the profits of the Company and have no voting or other decision-making rights except as required by applicable law.
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Long-term Incentive Plan
On July 16, 2004, the unit holders approved the 2004 Long-term Incentive Plan (the “Incentive Plan”) for management including officers, directors, employees and consultants. The Incentive Plan authorizes the grant of non-qualified options to purchase Class B units and the grant of restricted Class C units. The options under the Incentive Plan have contractual lives of ten years and become exercisable after lapses in vesting periods ranging from one to five years from the grant date. The Incentive Plan provide that awards in the aggregate cannot exceed 11% of the total outstanding class B units. The following table summarizes the options to purchase Class B units that have been awarded under the Incentive Plan and were outstanding at December 31, 2004:
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The options vest over five years with service to the Company.
Also under the Incentive Plan, certain officers, managerial employees and consultants were granted a right to receive Class C units without cost to the recipient. The restrictions on the Class C units lapse over a five year period. The Class C units are entitled to participate in the appreciation of the Company’s value and can convert to a maximum of one-half of a Class B unit. As of December 31, 2004 restricted Class C unit
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awards were outstanding for 4,290,000 units. These Class C units could convert to a maximum of 2,145,000 Class B units based on the future value of the Company.
The fair value of the Incentive Plan awards was initially determined by the Board of Managers as $2.90 per option to acquire the Class B units and $3.00 per Class C unit. In early 2005 in connection with a potential initial public offering, the Board of Managers reassessed the fair value of the Incentive Plan awards. The result of the new valuation was to increase the fair value of the Class B unit at the issuance date from $6.00 per unit to $8.42 per unit. Using the Black-Scholes option pricing model the value of the options to purchase Class B units was determined to be $4.55 per option using the following assumptions: (a) exercise price of $6.00 per unit, (b) fair value on the date of issuance of $8.42 per unit, (c) dividend yield of 0%, (d) expected volatility of 29.8%, (e) risk-free interest rate of 4.0% and (f) expected life of 7.5 years.
The fair value of the Class C units was determined to be $3.40 per unit based on the reassessed fair value of the Class B units. Equity-based compensation expense of $2.5 million was recognized in 2004 for the Incentive Plan awards and is included in general and administrative expenses in the accompanying consolidated statement of operations.
(6) Retirement Plan
Bois d’Arc Energy has a 401(k) profit sharing plan which covers all of its employees. At its discretion, the Company may match a certain percentage of the employees’ contributions to the plan. The matching percentage is determined annually by the Board of Managers. Bois d’Arc Energy’s matching contributions to the plan were $8,000 in 2004.
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Commitments and Contingencies
Guarantees of Comstock Debt
In consideration for the $200.0 million credit facility being provided by Comstock, Bois d’Arc Energy and each of its subsidiaries agreed to become guarantors of Comstock’s 67/8% senior notes due 2012, of which $175.0 million principal amount is outstanding. Bois d’Arc Energy is also a guarantor of and has agreed to pledge substantially all of its assets with respect to Comstock’s $400.0 million bank credit facility. The bank credit facility is a four-year revolving credit commitment that matures on February 25, 2008. At December 31, 2004, Comstock had $228.0 million outstanding under this credit facility. Borrowings under the credit facility are limited to a borrowing base that was $300.0 million as of December 31, 2004.
Contingencies
From time to time, Bois d’Arc Energy is involved in certain litigation that arises in the normal course of its operations. The Company does not believe the resolution of these matters will have a material effect on the Company’s financial position or results of operations.
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Lease Commitments
Beginning on May 1, 2005 the Company will rent office space under a noncancelable lease which expires on April 30, 2012. Rent expense for 2004 was $88,000. Minimum future payments under the lease are as follows:
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Related Party Transactions
An entity owned by the spouse of Wayne L. Laufer, one of the principals of Bois d’Arc, provided accounting services to Bois d’Arc under a service agreement. In connection with the formation of Bois d’Arc Energy, this agreement was terminated which resulted in a termination fee of $1.2 million that is payable in monthly installments over a two year period beginning October 2004. A provision for the termination fee has been included in formation costs in the Consolidated Statement of Operations. In addition to the termination fee, Bois d’Arc Energy paid $197,000 to this entity for accounting services provided in from Inception to December 31, 2004. Bois d’Arc Energy also paid $120,000 to Comstock for accounting services in 2004.
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Oil and Gas Producing Activities
Set forth below is certain information regarding the aggregate capitalized costs of oil and gas properties and costs incurred by Bois d’Arc Energy for its oil and gas property acquisition, development and exploration activities:
Capitalized Costs as of December 31, 2004
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Costs Incurred for the Period from Inception (July 16, 2004) to December 31, 2004
The following table includes revenues and expenses associated directly with the Bois d’Arc Energy’s oil and gas producing activities for the period from Inception to December 31, 2004. The amounts presented do not include any allocation of the Company’s interest costs or general corporate overhead and, therefore, are not necessarily indicative of the contribution to net earnings of the Company’s oil and gas operations.
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Oil and Gas Reserves Information (Unaudited)
Set forth below is a summary of the changes in the Company’s net quantities of crude oil and natural gas reserves from Inception to December 31, 2004:
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The following table sets forth the standardized measure of discounted future net cash flows relating to proved reserves at December 31, 2004:
No income taxes have been deducted because Bois d’Arc Energy is a limited liability company that passes through its taxable income to its unit owners.
The following table sets forth the changes in the standardized measure of discounted future net cash flows relating to proved reserves for the period from Inception to December 31, 2004:
The estimates of proved oil and gas reserves utilized in the preparation of the financial statements were estimated by Lee Keeling and Associates, Inc., independent petroleum consultants, in accordance with guidelines established by the Securities and Exchange Commission and the Financial Accounting Standards Board, which require that reserve reports be prepared under existing economic and operating conditions with no provision for price and cost escalation except by contractual agreement. All of the Company’s reserves are located in the federal and state waters of the Gulf of Mexico.
Future cash inflows are calculated by applying year-end prices adjusted for transportation and other charges to the year-end quantities of proved reserves, except in those instances where fixed and determinable price changes are provided by contractual arrangements in existence at year-end. The Company’s average year-end prices used in the reserve estimates were $42.14 per barrel for crude oil and $6.01 per Mcf for natural gas.
Future development and production costs are computed by estimating the expenditures to be incurred in developing and producing proved oil and gas reserves at the end of the year, based on year-end costs and assuming continuation of existing economic conditions.