Item 1. Business
Overview
We are an independent exploration, development and production company that utilizes 3−D seismic imaging and other advanced technologies to systematically explore for and develop domestic onshore oil and natural gas reserves. We focus our exploration and development activities in provinces where we believe technology and the knowledge of our technical staff can be effectively used to maximize our return on invested capital by reducing drilling risk and enhancing our ability to grow reserves and production volumes. Our exploration and development activities are currently concentrated in four provinces: the Onshore Gulf Coast, the Anadarko Basin, the Rocky Mountains and West Texas.
We regularly evaluate opportunities to expand our activities to other areas that may offer attractive exploration and development potential, with a particular interest in those areas with plays that complement our current exploration, development and production activities. As a result of this strategy, during late 2005 and throughout 2006 we have been accumulating significant acreage positions in the Powder River Basin and the Williston Basin. Operations within these two basins are included in and constitute the bulk of our activity in our Rocky Mountains province. We also entered into two joint ventures in Southern Louisiana in 2006. We consider these joint ventures to be logical extensions of our prospect generating activities in the onshore Texas Gulf Coast.
At December 31, 2006, our estimated proved reserves of 146.5 Bcfe had a standardized measure value of $302.7 million and a pre-tax PV10% value of $338.5 million. Approximately 82% of our proved reserves were natural gas and we operated approximately 62.4% of the pre-tax PV10% value. For the twelve month period ended December 31, 2006, our total revenue and net income were $106.3 million and $19.8 million, respectively. Our average daily production for 2006 was 36.8 MMcfe, which represents an increase of 11% from our production in 2005.
The following table provides information regarding our assets and operations located in our core areas.
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(a)
The prices used to calculate this measure were $61.06 per barrel of oil and $5.475 per MMbtu of natural gas, both as of December 31, 2006.
(b)
The standardized measure for our proved reserves at December 31, 2006 was $302.7 million. See “Item 2. Properties - Reconciliation of Standardized Measure to Pre-tax PV10%” for a definition of pre-tax PV10% and a reconciliation of our standardized measure to our pre-tax PV10% value.
Since inception through December 31, 2006, we have drilled, completed, or are completing 731 wells, consisting of 505 exploration and 226 development wells with an average completion rate of 73%. Over the three year period ended December 31, 2006, we drilled, completed, or were completing 139 wells, consisting of 53 exploratory and 86 development wells with an average completion rate of 88%. During 2006, we spud a total of 43 wells, consisting of 23 exploration wells and 20 development wells and retained an average working interest in these wells of approximately 59%. At December 31, 2006, thirty-three of these wells have been or were being completed while nine of these wells were not completed and one was in the process of drilling. Including two wells that began drilling in 2005 and were completed in 2006, our average completion rate for 2006 was 76%.
As part of our exploration activities, we have accumulated 3-D seismic data covering approximately 11,337 square miles (7.3 million acres) in ten states. We generally focus our 3-D seismic acquisition efforts in and around existing producing fields where we can benefit from the imaging of producing analog wells. These 3-D defined analogs, combined with our experience in drilling wells in our project areas, provide us with a knowledge base to evaluate other potential geologic trends, 3-D seismic projects within these trends and prospective drilling locations. Over the three year period ended December 31, 2006, within our core provinces we spent $64.3 million on land and seismic activities. We currently plan to spend approximately $11.2 million in 2007 on land and seismic activities. As a result of these activities, we have generated a multi-year inventory of exploration prospects, which due to our field discoveries, is complemented by a multi-year inventory of development locations.
Combining our geologic and geophysical expertise with a sophisticated land effort, we manage a significant majority of our projects from conception through leasing. In addition, we manage the negotiation and drafting of most of our geophysical exploration agreements, resulting in reduced contract risk and more consistent deal terms. Because we generate most of our projects, we can often control the size of the working interest that we retain as well as the selection of the operator and the non-operating participants. We expect to operate the drilling of the majority of the wells in the Onshore Gulf Coast, the Anadarko Basin, Powder River Basin and the Williston Basin.
In 2006, we increased our level of drilling activity to capitalize on our multi-year inventory of exploration and development prospects by spending a total of $142.3 million on drilling expenditures. This represents a 57% increase over the amounts we spent on drilling in 2005. These drilling expenditures were used to drill 23 exploratory wells and 20 development wells and for other development activities. We had three exploration and three development wells that were completing and one development well that was drilling as of December 31, 2006.
In 2006, we also increased our investment in new acreage and seismic inventory. We invested $13.6 million in land and $18.1 million in 3-D acquisitions, as compared to $13.9 million and $5.7 million in 2005. Our land and 3-D investments represent an increase of 62% relative to 2005. The majority of our new acreage was acquired in the Powder River Basin, the Williston Basin and Southern Louisiana. The majority of our new 3-D acquisition was in the western Anadarko Basin, where we acquired 177 square miles of proprietary high resolution 3-D seismic data targeting primarily the Hunton play in the Texas Panhandle. We expect this data to be processed by mid-year 2007, and believe the data will enhance the imaging of our Mills Ranch Field, further reduce the drilling risk of our current inventory of prospects in the play, and potentially generate new prospects for drilling in future years.
For 2007, we plan to continue with an active drilling program and anticipate spending $91.2 million to drill seven exploratory wells and 15 development wells. In addition, we will complete wells that were in progress at December 31, 2006 and incur costs related to other development activities.
Business Strategy
Our business strategy is to create value for our stockholders by growing reserves, production volumes and cash flow through exploration and development drilling in areas where we can use technology to generate high rates of return on our invested capital. Key elements of our business strategy include:
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Focus on Core Provinces and Trends. We have built our multi-year inventory of drilling prospects by leveraging our staff’s strong technical knowledge base in the following four core provinces and their associated trends: 1) our Onshore Gulf Coast province which includes the Vicksburg trend in South Texas, the Frio trend in and around Matagorda County, Texas and the Miocene and Upper Oligocene trends in Southern Louisiana; 2) our Anadarko Basin province in the Texas Panhandle and northwest Oklahoma, including the Hunton and Springer trends; 3) our Rocky Mountains province, which includes the Powder River Basin in Wyoming and the Williston Basin in North Dakota and Montana; and 4) our West Texas province. Further, we believe our focus on these trends within our four core provinces provides us with important drilling investment diversification. Since 1999, our exploration success in these trends has resulted in seven significant field discoveries and a resulting multi-year inventory of development drilling locations. We plan to focus the majority of our near term capital expenditures in these trends, where we believe our accumulated 3-D seismic data and knowledge base provides us with a substantial competitive advantage.
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Internally Generate Inventory of High Quality Exploratory Prospects. Utilizing 3-D seismic data and other advanced technologies, our highly skilled staff of 13 geologists, four geophysicists, and one petrophysicist generates the majority of our drilling prospects. Historically, we have not relied heavily on third party generated opportunities, which usually involve the payment of consideration over and above the costs incurred to generate and drill the prospect. We believe that our seven significant field discoveries reflect the quality and depth of our 3-D delineated prospect inventory as well our ability to continue to generate such opportunities.
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Leverage our Operational Expertise. In addition to our utilization of advanced 3-D seismic imaging techniques, our staff is very proficient with state-of-the-art drilling and completion techniques, including directional drilling, horizontal drilling and fracture stimulations. We have a demonstrated successful track record of drilling in difficult, deep and highly pressured environments. During 2006, 55% of the vertical wells we drilled were directional and the average depth of these wells was over 14,700 feet. Since 1997, we have successfully utilized directional drilling with extensive fracture stimulations at depths of between 13,000 and 14,000 feet in the pressured Vicksburg trend of South Texas, where we have proven over 190 Bcfe in gross reserves by drilling 36 wells to date. Our current activity in the Bakken of the Williston Basin and the Mowry of the Powder River Basin leverages our staff’s expertise at drilling and completing horizontal wells in unconventional plays.
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Evaluate and Selectively Pursue New Potential Plays. We have a 16 year track record of successfully evaluating and initiating new oil and natural gas plays. We are particularly interested in those plays with attractive exploration and development potential that complement our current exploration and production activities. After identifying such a play, we will often selectively build an acreage position in the play. Our current Vicksburg and Hunton plays are examples of successful plays where our position in the play was identified and originated by us. We believe our recent acreage acquisitions in the Powder River Basin of Wyoming, the Williston Basin of North Dakota and Montana, and Southern Louisiana should lead to additional growth in our reserves and production. For 2007, we currently plan to spend approximately $38.2 million in the Mowry, the Bakken and South Louisiana.
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Capitalize on Exploration Successes Through Development of Field Discoveries. From 1990 to 1999, we grew our reserves and production volumes primarily through successful 3-D delineated exploration drilling. In recent years, our exploratory drilling success has resulted in a multi-year inventory of development drilling locations, and over the three year period ended December 31, 2006, approximately 62% of our drilling expenditures were spent on development activities. We believe our ability to balance our higher risk exploratory drilling with lower risk development drilling has reduced our risk profile. For 2007, we anticipate allocating approximately 74% of our planned drilling expenditures to development activities.
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Continue to Actively Drill Our Multi-Year Prospect Inventory. To capitalize on our multi-year inventory of exploration and development locations, we plan to continue with the accelerated level of drilling activity that we began in 2004. In 2007, we currently plan to spend $91.2 million in drilling capital to drill a total of 22 wells.
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Enhance Returns Through Operational Control. We seek to maintain operational control of our exploration and drilling activities. As operator, we retain more control over the timing and selection of drilling prospects, which enhances our ability to optimize our finding and development costs and to maximize our return on invested capital. Since we generate most of our projects, we generally have the ability to retain operational control over all phases of our exploration and development activities. As of December 31, 2006, we operated approximately 62.4% of the pre-tax PV10% value of our proved reserves. Further, in 2006 we operated 65% of the wells we drilled, representing 93% of our drilling capital expenditures. We expect to operate approximately 91% of our wells planned for 2007, representing approximately 92% of our planned 2007 drilling capital expenditures.
Exploration and Development Staff
Our experienced exploration staff includes 13 geologists, four geophysicists, one petrophysicist, two computer applications specialists and two geological technicians. Our geologists and geophysicists have varied but complementary backgrounds, and their diversity of experience in a wide-range of geological and geophysical settings, combined with various technical specializations (from hardware and systems to software and seismic data processing), provides us with valuable technical intellectual resources. Our geologists and geophysicists have an average of more than 21 years of experience in the industry. We have assembled our team of geologists and geophysicists with backgrounds that complement the areas where we focus our exploration and development activities. By integrating both geologic and geophysical expertise within our project teams, we believe we possess a competitive advantage in our exploration approach.
Our land department staff includes four landmen with an average of more than 23 years of experience, primarily within our core provinces, and three lease and division order analysts. Our land department contributed to pioneering many of the innovations that have facilitated exploration using large 3-D seismic projects.
Operations and Operations Staff
In an effort to retain better control of our project timing, drilling, operational costs and production volumes, we have significantly increased the percentage of the wells that we operate. We operated 65% of the gross wells and 85% of the net wells that we drilled during 2006, as compared with 10% of the gross wells and 17% of the net wells we drilled during 1996. As a result of our increased operational control, wells operated by us constituted 62.4% of the pre-tax PV10% value of our proved reserves at year-end 2006, as compared to only 5% at year-end 1996.
Our operations staff includes seven engineers who have an average of over 12 years of experience in drilling, reservoir, environmental or operations engineering primarily within our four core operating provinces. These engineers work closely with our geologists and geophysicists and are integrally involved in all phases of the exploration and development process, including preparation of pre- and post-drill reserve estimates, well design, production management and analysis of full cycle risked drilling economics. We conduct field operations for our operated oil and natural gas properties through our field production superintendent and third party contract personnel.
Oil and Natural Gas Market and Major Customers
In an effort to achieve better price realizations from the sale of our oil and natural gas, we manage our commodities marketing activities in-house so that we are able to market and sell our oil and natural gas to a broader universe of potential purchasers. Due to the availability of other markets and pipeline connections, we do not believe that the loss of any single oil or natural gas customer would have a material adverse effect on our results of operations or cash flows.
We sell our oil and condensate at the lease to a variety of purchasers at prevailing market prices under short-term contracts that normally provide for us to receive an applicable posted price plus a market-based bonus.
Our natural gas production is sold to various purchasers including intrastate pipeline purchasers, operators of processing plants, and marketing companies under both monthly spot market contracts and multi-year arrangements. The vast majority of our natural gas sales are based on related natural gas index pricing, and in some cases our gas is processed at a plant and we receive a percentage of the value the plant operator receives from the resale of the natural gas liquids recovered and the remaining residue gas.
Since most of our oil and natural gas production is sold under price sensitive or spot market contracts, the revenues generated by our operations are highly dependent upon the prices of and demand for oil and natural gas. The price we receive for our oil and natural gas production depends upon numerous factors beyond our control, including seasonality, weather, competition, the condition of the United States economy, foreign imports, political conditions in other oil-producing and natural gas-producing countries, the actions of the Organization of Petroleum Exporting Countries, and domestic government regulation, legislation and policies. See “Item 1A.
Item 1A. Risk Factors
You should carefully consider the following risk factors, in addition to the other information set forth in this report. Each of these risk factors could adversely affect our business, operating results and financial condition.
Oil and natural gas prices are volatile and a substantial reduction in these prices could adversely affect our results and the price of our common stock.
Our revenues, operating results and future rate of growth depend highly upon the prices we receive for our oil and natural gas production. Historically, the markets for oil and natural gas have been volatile and are likely to continue to be volatile in the future.
The NYMEX daily settlement price for the prompt month natural gas contract in 2006 ranged from a high of $10.63 per MMBtu to a low of $4.20 per MMBtu. In 2005, the same index ranged from a high of $15.38 per MMBtu to a low of $5.79 per MMBtu.
The NYMEX daily settlement price for the prompt month oil contract in 2006 ranged from a high of $77.03 per barrel to a low of $55.81 per barrel. In 2005, the same index ranged from a high of $69.81 per barrel to a low of $42.12 per barrel.
The markets and prices for oil and natural gas depend on numerous factors beyond our control. These factors include demand for oil and natural gas, which fluctuate with changes in market and economic conditions and other factors, including:
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worldwide and domestic supplies of oil and natural gas;
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actions taken by foreign oil and natural gas producing nations;
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political conditions and events (including instability or armed conflict) in oil-producing or natural gas-producing regions;
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the level of global and domestic oil and natural gas inventories;
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the price and level of foreign imports including liquefied natural gas imports;
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the level of consumer demand;
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the price and availability of alternative fuels;
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the availability of pipeline or other takeaway capacity;
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weather conditions;
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domestic and foreign governmental regulations and taxes; and
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the overall worldwide and domestic economic environment.
Significant declines in oil and natural gas prices for an extended period may have the following effects on our business:
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limiting our financial condition, liquidity, ability to finance planned capital expenditures and results of operations;
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reducing the amount of oil and natural gas that we can produce economically;
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causing us to delay or postpone some of our capital projects;
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reducing our revenues, operating income and cash flow;
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reducing the carrying value of our oil and natural gas properties; and
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limiting our access to sources of capital, such as equity and long-term debt.
We may have difficulty financing our planned capital expenditures, which could adversely affect our business.
We make and will continue to make substantial capital expenditures in our exploration and development projects. Without additional capital resources, our drilling and other activities may be limited and our business, financial condition and results of operations may suffer. We may not be able to secure additional financing on reasonable terms or at all and financing may not continue to be available to us under our existing or new financing arrangements. If additional capital resources are unavailable, we may curtail our drilling, development and other activities or be forced to sell some of our assets on an untimely or unfavorable basis. Any such curtailment or sale could have a material adverse effect on our business, financial condition and results of operation.
Our exploration, development and drilling efforts and the operation of our wells may not be profitable or achieve our targeted returns.
We require significant amounts of undeveloped leasehold acreage in order to further our development efforts. Exploration, development, drilling and production activities are subject to many risks, including the risk that commercially productive reservoirs will not be discovered. We invest in property, including undeveloped leasehold acreage, which we believe will result in projects that will add value over time. However, we cannot guarantee that all of our prospects will result in viable projects or that we will not abandon our initial investments. Additionally, we cannot guarantee that the leasehold acreage we acquire will be profitably developed, that new wells drilled by us in provinces that we pursue will be productive or that we will recover all or any portion of our investment in such leasehold acreage or wells. Drilling for oil and natural gas may involve unprofitable efforts, not only from dry wells but also from wells that are productive but do not produce sufficient net reserves to return a profit after deducting operating and other costs. In addition, wells that are profitable may not achieve our targeted rate of return. Our ability to achieve our target results is dependent upon the current and future market prices for oil and natural gas, costs associated with producing oil and natural gas and our ability to add reserves at an acceptable cost. We rely to a significant extent on 3-D seismic data and other advanced technologies in identifying leasehold acreage prospects and in conducting our exploration activities. The 3-D seismic data and other technologies we use do not allow us to know conclusively prior to the acquisition of leasehold acreage or the drilling of a well whether oil or natural gas is present or may be produced economically. The use of 3-D seismic data and other technologies also requires greater pre-drilling expenditures than traditional drilling strategies.
In addition, we may not be successful in implementing our business strategy of controlling and reducing our drilling and production costs in order to improve our overall return. The cost of drilling, completing and operating a well is often uncertain and cost factors can adversely affect the economics of a project. We cannot predict the cost of drilling, and we may be forced to limit, delay or cancel drilling operations as a result of a variety of factors, including:
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unexpected drilling conditions;
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pressure or irregularities in formations;
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equipment failures or accidents;
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adverse weather conditions;
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compliance with governmental requirements; and
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shortages or delays in the availability of drilling rigs and the delivery of equipment.
Exploratory drilling is a speculative activity that may not result in commercially productive reserves and may require expenditures in excess of budgeted amounts.
Our future rate of growth greatly depends on the success of our exploratory drilling program. Exploratory drilling involves a higher degree of risk that we will not encounter commercially productive oil or natural gas reservoirs than developmental drilling. We may not be successful in our future drilling activities because even with the use of 3-D seismic and other advanced technologies, exploratory drilling is a speculative activity.
Although our oil and natural gas reserve data is independently estimated, these estimates may still prove to be inaccurate.
Our proved reserve estimates are generated each year by Cawley, Gillespie & Associates, Inc., an independent petroleum consulting firm. In conducting its evaluation, the engineers and geologists of Cawley, Gillespie & Associates, Inc. evaluate our properties and independently develop proved reserve estimates. There are numerous uncertainties and risks that are inherent in estimating quantities of oil and natural gas reserves and projecting future rates of production and timing of development expenditures as many factors are beyond our control. We incorporate many factors and assumptions into our estimates including:
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expected reservoir characteristics based on geological, geophysical and engineering assessments;
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future production rates based on historical performance and expected future operating and investment activities;
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future oil and gas prices and quality and location differentials; and
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future development and operating costs.
Although we believe the Cawley, Gillespie & Associates, Inc. reserve estimates are reasonable based on the information available to them at the time they prepare their estimates, our actual results could vary materially from these estimated quantities of proved oil and natural gas reserves (in the aggregate and for a particular location), production, revenues, taxes and development and operating expenditures. In addition, these estimates of proved reserves may be subject to downward or upward revision based upon production history, results of future exploration and development, prevailing oil and natural gas prices, operating and development costs and other factors.
Finally, recovery of proved undeveloped reserves generally requires significant capital expenditures and successful drilling operations. At December 31, 2006, approximately 45% of our estimated proved reserves were classified as undeveloped. At December 31, 2006, we estimated that it would require additional capital expenditures of approximately $135 million to develop our proved undeveloped reserves. Our reserve estimates assume that we can and will make these expenditures and conduct these operations successfully, which may not occur.
We need to replace our reserves at a faster rate than companies whose reserves have longer production periods. Our failure to replace our reserves would result in decreasing reserves and production over time.
In general, production from oil and natural gas properties declines as reserves are depleted, with the rate of decline depending on reservoir characteristics. Except to the extent we conduct successful exploration and development activities or acquire properties containing proved reserves, or both, our proved reserves and production will decline as reserves are produced.
We may not be able to find, develop or acquire additional reserves to replace our current and future production. Accordingly, our future oil and natural gas reserves and production and therefore our future cash flow and income, are dependent upon our success in economically finding or acquiring new reserves and efficiently developing our existing reserves.
Our reserves in the Gulf Coast have high initial production rates followed by steep declines in production, resulting in a reserve life for wells in this area that is shorter than the industry average. This production volatility has impacted and, in the future, may continue to impact our quarterly and annual production levels.
We generally must locate and develop or acquire new oil and natural gas reserves to replace those being depleted by production. Without successful drilling and exploration or acquisition activities, our reserves and revenues will decline rapidly. We may not be successful in extending the reserve life of our properties generally and our Gulf Coast properties in particular. Our current strategy includes increasing our reserve base through drilling activities on our existing Gulf Coast properties and properties located in our other core areas, which have historically had longer-lived reserves. Our existing and future exploration and development projects may not result in significant additional reserves and we may not be able to drill productive wells at economically viable costs.
Our future cash flows are subject to a number of variables, such as the level of production from existing wells, prices of oil and natural gas and our success in finding and producing new reserves. If our revenues were to decrease as a result of lower oil and natural gas prices, decreased production or otherwise, and our access to capital were limited, we would have a reduced ability to replace our reserves or to maintain production at current levels, potentially resulting in a decrease in production and revenue over time.
Drilling locations that we decide to drill may not yield oil or natural gas in commercially viable quantities or quantities sufficient to meet our targeted rate of return.
Our drilling locations are in various stages of evaluation, ranging from locations that are ready to be drilled to locations that will require substantial additional evaluation and interpretation. There is no way to predict in advance of drilling and testing whether any particular drilling location will yield oil or natural gas in sufficient quantities to recover our drilling or completion costs or to be economically viable. Our use of seismic data and other technologies and the study of producing fields in the same area will not enable us to know conclusively prior to drilling whether oil and natural gas will be present or, if present, whether oil and natural gas will be present in commercial quantities. The analysis that we perform using data from other wells, more fully explored prospects and/or producing fields may not be useful in predicting the characteristics and potential reserves associated with our drilling locations. As a result, we may not find commercially viable quantities of oil and natural gas and, therefore, we may not achieve a targeted rate of return or have a positive return on investment.
The unavailability or high cost of drilling rigs, equipment, supplies, insurance, personnel and oil field services could adversely affect our ability to execute our exploration and development plans on a timely basis and within our budget.
Our industry is cyclical and, from time to time, there is a shortage of drilling rigs, equipment, supplies, insurance or qualified personnel. During these periods, the costs and delivery times of rigs, equipment and supplies are substantially greater. In addition, the demand for, and wage rates of, qualified drilling rig crews rise as the number of active rigs in service increases. As a result of increasing levels of exploration and production in response to strong prices of oil and natural gas, the demand for oilfield services has risen, and the costs of these services has increased, while the quality of these services may suffer. If the unavailability or high cost of drilling rigs, equipment, supplies, insurance or qualified personnel were particularly severe in Texas, Southern Louisiana, Oklahoma, Wyoming, North Dakota or Montana, we could be materially and adversely affected because our operations and properties are concentrated in those areas.
The marketability of our oil and natural gas production depends on services and facilities that we typically do not own or control. The failure or inaccessibility of any such services or facilities could result in a curtailment of production and revenues.
The marketability of our production depends in part upon the availability, proximity and capacity of natural gas gathering systems, pipelines and processing facilities. We generally deliver natural gas through gas gathering systems and gas pipelines that we do not own under interruptible or short term transportation agreements. Under the interruptible transportation agreements, the transportation of our natural gas may be interrupted due to capacity constraints on the applicable system, for maintenance or repair of the system, or for other reasons as dictated by the particular agreements. If any of the pipelines or other facilities become unavailable, we would be required to find a suitable alternative to transport and process the natural gas, which could increase our costs and reduce the revenues we might obtain from the sale of the natural gas. For example, in 2005, Hurricane Rita disrupted the operations of natural gas pipelines and fractionators and required the evacuation of personnel required to oversee some of our facilities in the Gulf Coast area. As a result of these disruptions, we were forced temporarily to curtail some of our production in our Onshore Gulf Coast province for approximately six days.
Our level of indebtedness may adversely affect our cash available for operations, which would limit our growth, our ability to make interest and principal payments on our indebtedness as they become due and our flexibility to respond to market changes.
At December 31, 2006, we had indebtedness of $123.4 million outstanding under our 9 5/8% Senior Notes due 2014 (the “Senior Notes”), $25.9 million outstanding under our senior credit agreement, and $10.1 million of Series A preferred stock. Our level of indebtedness will have several important effects on our operations, including those listed below.
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We will dedicate a portion of our cash flow from operations to the payment of interest on our indebtedness and to the payment of our other current obligations and will not have these cash flows available for other purposes.
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The covenants of our credit agreements limit our ability to borrow additional funds or dispose of assets and may affect our flexibility in planning for, and reacting to, changes in business conditions.
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Our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions, general corporate purposes or other purposes may be impaired.
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We may be more vulnerable to economic downturns and our ability to withstand sustained declines in oil and natural gas prices may be impaired.
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Since a portion of our indebtedness is subject to variable interest rates, we are vulnerable to increases in interest rates.
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Our flexibility in planning for or reacting to changes in market conditions may be limited.
We may incur additional debt in order to fund our exploration and development activities. A higher level of indebtedness increases the risk that we may default on our debt obligations. Our ability to meet our debt obligations and reduce our level of indebtedness depends on future performance. General economic conditions, oil and natural gas prices and financial, business and other factors will affect our operations and our future performance. Many of these factors are beyond our control and we may not be able to generate sufficient cash flow to pay the interest on our debt. In addition, borrowings and equity financing may not be available to pay or refinance such debt.
Under the terms of our senior credit agreement, our borrowing base is subject to semi-annual redetermination based in part on prevailing oil and natural gas prices. In the event the amount outstanding exceeds the redetermined borrowing base, we could be forced to repay a portion of our borrowings. We may not have sufficient funds to make such payments. If we do not have sufficient funds and are otherwise unable to negotiate renewals of our borrowings or arrange new financing, we may have to sell assets at unfavorable prices.
Despite current indebtedness levels, we and our subsidiaries may still be able to incur substantially more debt, including secured debt. This could further exacerbate the risks associated with our substantial leverage.
We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the indenture governing the Senior Notes and our senior credit agreement do not prohibit us or our subsidiaries from doing so. In addition to the liens granted under our senior credit agreement, the indenture governing the Senior Notes allows us to grant liens on all of our other assets to secure indebtedness outstanding under the senior secured credit agreement and certain additional other debt without ratably securing the Senior Notes. Our senior credit agreement provides for total revolving credit borrowings up to $200 million (which borrowings are limited by a borrowing base that is subject to re-determination at least semi-annually and is currently set at $110 million) and all of those borrowings would be effectively senior to the Senior Notes and to the subsidiaries’ guarantees thereof to the extent of the value of the assets securing such indebtedness. If new indebtedness is added to our and our subsidiaries’ current debt levels, the related risks that we and they now face could intensify and we may not be able to meet all our debt obligations, including the repayment of the Senior Notes, in whole or in part.
To service our indebtedness, we will require a significant amount of cash. Our ability to generate cash depends on many factors beyond our control.
Our ability to make payments on and to refinance our indebtedness and to fund planned capital expenditures and development efforts will depend on our ability to generate cash in the future. This, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.
We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available to us under our senior credit agreement or otherwise in an amount sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. We may need to refinance all or a portion of our indebtedness on or before the maturity thereof. Any future borrowings under our senior credit agreement will mature in June 2010. As a result, we may be required to refinance any indebtedness then outstanding under our senior credit agreement prior to the maturity of the notes. We may not be able to obtain such financing on commercially reasonable terms or at all. If we are unable to generate sufficiently material cash flow to refinance our debt obligations, including the notes, on favorable terms, it could have a significant adverse effect on our financial condition and on our ability to pay principal and interest on the notes.
In addition, if for any reason we are unable to meet our debt service obligations, we would be in default under the terms of our agreements governing our outstanding debt. If such a default were to occur, the lenders under our senior credit agreement could elect to declare all amounts then outstanding under the senior credit agreement immediately due and payable, and the lenders would not be obligated to continue to advance funds under our senior credit agreement. In addition, if such a default were to occur, the Senior Notes would become immediately due and payable. If the amounts outstanding under these debt agreements are accelerated, we cannot assure you that our assets will be sufficient to repay in full the money owed to the banks or to our debt holders, including holders of notes.
The indenture governing the Senior Notes imposes, and our senior credit agreement imposes, significant operating and financial restrictions, which may prevent us from capitalizing on business opportunities and taking some actions.
The indenture governing the Senior Notes and our senior credit agreement contain, customary restrictions on our activities, including covenants that restrict our and our subsidiaries’ ability to:
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incur additional debt;
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pay dividends on, or redeem or repurchase stock;
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create liens;
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make specified types of investments;
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apply net proceeds from certain asset sales;
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engage in transactions with our affiliates;
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engage in sale and leaseback transactions;
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merge or consolidate;
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restrict dividends or other payments from subsidiaries;
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sell equity interests of subsidiaries; and
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sell, assign, transfer, lease, convey or dispose of assets.
Our senior credit agreement also requires us to meet a minimum current ratio and a minimum interest coverage ratio. We may not be able to maintain these ratios, and if we fail to be in compliance with these tests, we will not be able to borrow funds under our senior credit agreement which would make it difficult for us to operate our business.
The restrictions in the indenture governing the Senior Notes and our senior credit agreement may prevent us from taking actions that we believe would be in the best interest of our business, and may make it difficult for us to successfully execute our business strategy or effectively compete with companies that are not similarly restricted. We may also incur future debt obligations that might subject us to additional restrictive covenants that could affect our financial and operational flexibility. We cannot assure you that we will be granted waivers or amendments to these agreements if for any reason we are unable to comply with these agreements, or that we will be able to refinance our debt on terms acceptable to us, or at all.
The breach of any of these covenants and restrictions could result in a default under the indenture governing the Senior Notes or under our senior credit agreement. An event of default under our debt agreements would permit some of our lenders to declare all amounts borrowed from them to be due and payable. If we are unable to repay debt, lenders having secured obligations, such as the lenders under our senior credit agreement, could proceed against the collateral securing the debt. Because the indenture governing the Senior Notes and our senior credit agreement have customary cross-default provisions, if the indebtedness under the Senior Notes or under our senior credit agreements or any of our other facilities is accelerated, we may be unable to repay or finance the amounts due.
We may not have the ability to raise the funds necessary to finance the change of control offer required by the indenture governing the Senior Notes.
Upon the occurrence of certain kinds of change of control events, we will be required to offer to repurchase all outstanding Senior Notes at 101% of the principal amount thereof plus accrued and unpaid interest, if any, to the date of repurchase, unless all Senior Notes have been previously called for redemption. The holders of other debt securities that we may issue in the future, which rank equally in right of payment with the Senior Notes, may also have this right. Our failure to purchase tendered Senior Notes would constitute an event of default under the indenture governing the notes, which in turn, would constitute a default under our senior credit agreement. In addition, the occurrence of a change of control would also constitute an event of default under our senior credit agreement. A default under our senior credit agreement would result in a default under the indenture if the lenders accelerate the debt under our senior credit agreement.
Therefore, it is possible that we may not have sufficient funds at the time of the change of control to make the required repurchase of Senior Notes. Moreover, our senior credit agreement restricts, and any future indebtedness we incur may restrict, our ability to repurchase the Senior Notes, including following a change of control event. As a result, following a change of control event, we would not be able to repurchase the Senior Notes unless we first repay all indebtedness outstanding under our senior credit agreement and any of our other indebtedness that contains similar provisions, or obtain a waiver from the holders of such indebtedness to permit us to repurchase the Senior Notes. We may be unable to repay all of that indebtedness or obtain a waiver of that type. Any requirement to offer to repurchase the outstanding Senior Notes may therefore require us to refinance our other outstanding debt, which we may not be able to do on commercially reasonable terms, if at all. These repurchase requirements may also delay or make it more difficult for others to obtain control of us.
In addition, certain important corporate events, such as leveraged recapitalizations that would increase the level of our indebtedness, would not constitute a “Change of Control” under the indenture.
Lower oil and natural gas prices may cause us to record ceiling limitation write-downs, which would reduce our stockholders’ equity.
We use the full cost method of accounting to account for our oil and natural gas investments. Accordingly, we capitalize the cost to acquire, explore for and develop oil and natural gas properties. Under full cost accounting rules, the net capitalized cost of oil and natural gas properties may not exceed a “ceiling limit” that is based upon the present value of estimated future net revenues from proved reserves, discounted at 10%, plus the lower of the cost or fair market value of unproved properties. If net capitalized costs of oil and natural gas properties exceed the ceiling limit, we must charge the amount of the excess to earnings. This is called a “ceiling limitation write-down.” The risk that we will experience a ceiling test write-down increases when oil and gas prices are depressed or if we have substantial downward revisions in its estimated proved reserves. Once incurred, a write-down of oil and gas properties is not reversible at a later date. Write-downs required by these rules do not impact our cash flow from operating activities, but do reduce net income and stockholders’ equity.
We are subject to various operating and other casualty risks that could result in liability exposure or the loss of production and revenues.
Our operations are subject to hazards and risks inherent in drilling for and producing and transporting oil and natural gas, such as:
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fires;
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natural disasters;
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formations with abnormal pressures;
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blowouts, cratering and explosions; and
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pipeline ruptures and spills.
Any of these hazards and risks can result in the loss of hydrocarbons, environmental pollution, personal injury claims and other damage to our properties and the property of others.
We may not have enough insurance to cover all of the risks we face, which could result in significant financial exposure.
We maintain insurance coverage against some, but not all, potential losses in order to protect against the risks we face. We may elect not to carry insurance if our management believes that the cost of insurance is excessive relative to the risks presented. If an event occurs that is not covered, or not fully covered, by insurance, it could harm our financial condition, results of operations and cash flows. In addition, we cannot fully insure against pollution and environmental risks.
We cannot control activities on properties we do not operate. Failure to fund capital expenditure requirements may result in reduction or forfeiture of our interests in some of our non-operated projects.
We do not operate some of the properties in which we have an interest and we have limited ability to exercise influence over operations for these properties or their associated costs. As of December 31, 2006, approximately 37.6% of our oil and natural gas properties, based on pre-tax PV10% value, were operated by other companies. Our dependence on the operator and other working interest owners for these projects and our limited ability to influence operations and associated costs could materially adversely affect the realization of our targeted return on capital in drilling or acquisition activities and our targeted production growth rate. The success and timing of drilling, development and exploitation activities on properties operated by others depend on a number of factors that are beyond our control, including the operator’s expertise and financial resources, approval of other participants for drilling wells and utilization of technology.
When we are not the majority owner or operator of a particular oil or natural gas project, we may have no control over the timing or amount of capital expenditures associated with such project. If we are not willing or able to fund our capital expenditures relating to such projects when required by the majority owner or operator, our interests in these projects may be reduced or forfeited.
Our future operating results may fluctuate and significant declines in them would limit our ability to invest in projects.
Our future operating results may fluctuate significantly depending upon a number of factors, including:
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industry conditions;
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prices of oil and natural gas;
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rates of drilling success;
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capital availability;
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rates of production from completed wells; and
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the timing and amount of capital expenditures.
This variability could cause our business, financial condition and results of operations to suffer. In addition, any failure or delay in the realization of expected cash flows from operating activities could limit our ability to invest and participate in economically attractive projects.
Our hedging activities may prevent us from benefiting from price increases and may expose us to other risks.
In an attempt to reduce our sensitivity to energy price volatility and in particular to downward price movements, we enter into hedging arrangements with respect to a portion of expected production, such as the use of derivative contracts that generally result in a range of minimum and maximum price limits or a fixed price over a specified time period.
Our hedging activities expose us to the risk of financial loss in certain circumstances. For example, if we do not produce our oil and natural gas reserves at rates equivalent to our derivative position, we would be required to satisfy our obligations under those derivative contracts on potentially unfavorable terms without the ability to offset that risk through sales of comparable quantities of our own production. This situation occurred during portions of 2000, due in part to our sale of certain producing reserves in mid- 1999 and reduced our cash flow in 2000 by approximately $1.0 million. Additionally, because the terms of our derivative contracts are based on assumptions and estimates of numerous factors such as cost of production and pipeline and other transportation and marketing costs to delivery points, substantial differences between the prices we receive pursuant to our derivative contracts and our actual results could harm our anticipated profit margins and our ability to manage the risk associated with fluctuations in oil and natural gas prices. We also could be financially harmed if the counter parties to our derivative contracts prove unable or unwilling to perform their obligations under such contracts. Additionally, in the past, some of our derivative contracts required us to deliver cash collateral or other assurances of performance to the counter parties if our payment obligations exceeded certain levels. Future collateral requirements are uncertain but will depend on arrangements with our counter parties and highly volatile oil and natural gas prices.
We face significant competition and many of our competitors have resources in excess of our available resources.
We operate in the highly competitive areas of oil and natural gas exploration, exploitation, acquisition and production. We face intense competition from a large number of independent, technology-driven companies as well as both major and other independent oil and natural gas companies in a number of areas such as:
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seeking to acquire desirable producing properties or new leases for future exploration;
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marketing our oil and natural gas production; and
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seeking to acquire the equipment and expertise necessary to operate and develop those properties.
Many of our competitors have financial and other resources substantially in excess of those available to us. This highly competitive environment could harm our business.
We are subject to various governmental regulations and environmental risks that may cause us to incur substantial costs.
From time to time, in varying degrees, political developments and federal and state laws and regulations affect our operations. In particular, price controls, taxes and other laws relating to the oil and natural gas industry, changes in these laws and changes in administrative regulations have affected and in the future could affect oil and natural gas production, operations and economics. We cannot predict how agencies or courts will interpret existing laws and regulations or the effect of these adoptions and interpretations may have on our business or financial condition.
Our business is subject to laws and regulations promulgated by federal, state and local authorities, including the FERC, the EPA, the Texas Railroad Commission, the TCEQ, the Oklahoma Corporation Commission, the Louisiana Department of Natural Resources, the Industrial Commission of North Dakota, the Wyoming Oil and Gas Conservation Commission and the Montana Board of Oil and Gas Conversation, relating to the exploration for, and the development, production and marketing of, oil and natural gas, as well as safety matters. Legal requirements are frequently changed and subject to interpretation and we are unable to predict the ultimate cost of compliance with these requirements or their effect on our operations. We may be required to make significant expenditures to comply with governmental laws and regulations.
Our operations are subject to complex federal, state and local environmental laws and regulations, including CERCLA, RCRA, OPA and the Clean Water Act. Environmental laws and regulations change frequently, and the implementation of new, or the modification of existing, laws or regulations could harm us. The discharge of oil, natural gas or other pollutants into the air, soil or water may give rise to significant liabilities on our part to the government and third parties and may require us to incur substantial costs of remediation.
We depend on our key management personnel and technical experts and the loss any of these individuals could adversely affect our business.
If we lose the services of our key management personnel or technical experts or are unable to attract additional qualified personnel, our business, financial condition, results of operations, development efforts and ability to grow could suffer. We have assembled a team of geologists, geophysicists and engineers who have considerable experience in applying 3-D seismic imaging technology to explore for and to develop oil and natural gas. We depend upon the knowledge, skill and experience of these experts to provide 3-D seismic imaging and to assist us in reducing the risks associated with our participation in oil and natural gas exploration and development projects. In addition, the success of our business depends, to a significant extent, upon the abilities and continued efforts of our management, particularly Ben M. Brigham, our Chief Executive Officer, President and Chairman of the Board. We have an employment agreement with Mr. Brigham, but do not have an employment agreement with any of our other employees.
The market price of our stock is volatile.
The trading price of our common stock and the price at which we may sell securities in the future are subject to large fluctuations in response to any of the following:
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limited trading volume in our stock;
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changes in government regulations;
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quarterly variations in operating results;
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our involvement in litigation;
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general market conditions;
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the prices of oil and natural gas;
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announcements by us and our competitors;
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our liquidity;
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our ability to raise additional funds; and
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other events.
Our stock price may decline when our financial results decline or when events occur that are adverse to us or our industry.
You can expect the market price of our common stock to decline when our financial results decline or otherwise fail to meet the expectations of the financial community or the investing public or at any other time when events actually or potentially adverse to us or the oil and natural gas industry occur. Our common stock price may decline to a price below the price you paid to purchase your shares of common stock.
We do not intend to pay any dividends on our common stock.
We anticipate that we will retain all future earnings and other cash resources for the future operation and development of our business. Accordingly, we do not intend to declare or pay any cash dividends on our common stock in the foreseeable future. Payment of any future dividends will be at the discretion of our board of directors after taking into account many factors, including our operating results, financial condition, current and anticipated cash needs and plans for expansion.
Our shares that are eligible for future sale may have an adverse effect on the price of our common stock.
Sales of substantial amounts of common stock, or a perception that such sales could occur, could adversely affect the market price of our common stock and could impair our ability to raise capital through the sale of our equity securities. At December 31, 2006, one of our stockholders, together with its affiliates, owned 16.7% of our outstanding common stock.
Certain of our affiliates control a substantial portion of our outstanding common stock, which may affect your vote as a stockholder.
Our directors, executive officers and 10% or greater stockholders, and certain of their affiliates, beneficially own a substantial portion of our outstanding common stock. Accordingly, these stockholders, as a group, may be able to control the outcome of stockholder votes, including votes concerning the election of directors, the adoption or amendment of provisions in our certificate of incorporation or bylaws, and the approval of mergers and other significant corporate transactions. The existence of these levels of ownership concentrated in a few persons makes it unlikely that any other holder of our common stock may be able to affect our management or direction. These factors may also have the effect of delaying or preventing a change in our management or voting control.
Certain anti-takeover provisions may adversely affect your rights as a stockholder.
Our certificate of incorporation authorizes our Board of Directors to issue up to 10 million shares of preferred stock without stockholder approval and to set the rights, preferences and other designations, including voting rights, of those shares as the Board of Directors may determine. In addition, our Series A preferred stock, our senior credit agreement and our subordinated credit agreement contain terms restricting our ability to enter into change of control transactions, including requirements to redeem or repay our outstanding Series A preferred stock, the amounts borrowed under our senior credit agreement and the amounts borrowed under our subordinated credit agreement upon a change in control. These provisions, alone or in combination with the other matters described in the preceding paragraph may discourage transactions involving actual or potential changes in our control, including transactions that otherwise could involve payment of a premium over prevailing market prices to holders of our common stock. We are also subject to provisions of the Delaware General Corporation Law that may make some business combinations more difficult.
Forward-Looking Statements
This report and the documents incorporated by reference in this annual report on Form 10-K contain forward-looking statements within the meaning of the federal securities laws.
These forward-looking statements include, among others, the following:
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our growth strategies;
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our ability to successfully and economically explore for and develop oil and gas resources;
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anticipated trends in our business;
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our future results of operations;
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our liquidity and ability to finance our exploration and development activities;
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market conditions in the oil and gas industry;
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our ability to make and integrate acquisitions; and
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the impact of governmental regulation.
Forward-looking statements are typically identified by use of terms such as “may,” “will,” “expect,” “anticipate,” “estimate” and similar words, although some forward-looking statements may be expressed differently.
You should be aware that our actual results could differ materially from those contained in the forward-looking statements. You should consider carefully the statements in this “Item 1A. Risk Factors” and other sections of this report, which describe factors that could cause our actual results to differ from those set forth in the forward-looking statements.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
Historically, our exploration and development activities have been focused primarily in the Onshore Gulf Coast, the Anadarko Basin in the Texas Panhandle and western Oklahoma and West Texas. We focus our activity in provinces where we believe technology and the knowledge of our technical staff can be effectively used to maximize our return on invested capital by reducing drilling risk and enhancing our ability to grow reserves and production volumes. We also regularly evaluate opportunities to expand our activities to areas that may offer attractive exploration and development potential, with a particular interest in those plays that complement our current exploration, development and production activities. Recent expansion initiatives include our acquisition of acreage in the Powder River Basin of Wyoming and the Williston Basin of North Dakota and Montana. In 2006, we drilled two horizontal wells on our Powder River Basin acreage and three horizontal wells on our North Dakota Williston Basin acreage. We view these as early investments, which we hope will generate drilling inventory and potential reserves in future years. During 2006, we invested a total of $32.1 million in land, G&G and drilling in the Williston Basin and Powder River Basin. To support our efforts in these new operating areas as well as to evaluate other opportunities in the Rocky Mountains, we opened a small one person satellite office in Denver, Colorado during December 2006. Additionally, we have implemented joint ventures with two operators in Southern Louisiana, which we view as a logical extension of our onshore Texas Gulf Coast activities. During 2006, we drilled a total of eight wells with our two joint venture partners in South Louisiana, spending a total of $17.5 million in the area during 2006.
For the three-year period ended December 31, 2006, we completed 116 gross wells (59.9 net) in 132 attempts for a completion rate of 88%. We also had three exploration wells and three development wells that were completing and one development well that was drilling as of December 31, 2006. For 2007, we plan to spend approximately $91.2 million to drill seven exploration wells and 15 development wells, to drill and complete wells that were in progress at December 31, 2006 and for other development activities. We also plan to spend $11.2 million on land and seismic and $11.5 million for capitalized costs.. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Capital Commitments - Capital Expenditures.” The following is a summary of our properties by major province as of December 31, 2006, unless otherwise noted.
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(a)
Includes the Powder River Basin in Wyoming and the Williston Basin in North Dakota and Montana .
(b)
The standardized measure for our proved reserves at December 31, 2006, was $302.7 million. See “- Reconciliation of Standardized Measure to Pre-tax PV10%” for a definition of pre-tax PV10% and a reconciliation of our standardized measure to our pre-tax PV10% value.
Onshore Gulf Coast Province
Our Onshore Gulf Coast province is a high potential, multi-pay province that lends itself to 3-D seismic exploration due to its substantial structural and stratigraphic complexity. In addition, certain sand reservoirs display seismic “bright spots,” which can be direct hydrocarbon indicators and can result in greatly reduced drilling risk. However, “bright spots” are not always reliable as direct hydrocarbon indicators and do not generally assess reservoir productivity. We believe our established 3-D seismic exploration approach, combined with our exploration staff’s extensive experience and accumulated knowledge base in this province, provides us with significant competitive advantages.
Key operating trends within this province include the Vicksburg trend in Brooks County, Texas and the Frio trend in and around Matagorda County, Texas. In addition, during the first quarter 2006 we announced joint ventures with two operators to explore for oil and natural gas in Southern Louisiana. We view Southern Louisiana as a logical extension of our current activities in the onshore Texas Gulf Coast. As such, Southern Louisiana operations have been consolidated within our Onshore Gulf Coast province.
Over the three year period ended December 31, 2006, approximately 57% of our total capital expenditures for drilling, land and seismic were allocated to our Onshore Gulf Coast province, where we completed 45 gross wells (31.8 net) in attempts for a completion rate of 83%.
During 2006, we completed 12 gross wells (9.1 net) in 17 attempts for a completion rate of 71% in this province. Five of the completed wells were exploration wells and seven were development wells. We also had one exploration well and one development well that were completing and one development well that was drilling as of December 31, 2006. We operated 80% of the wells that we drilled in this province during 2006. For 2006, we spent $86.7 million on drilling, land and seismic in our Onshore Gulf Coast province. Approximately 40% of the drilling, land and seismic was allocated to the Vicksburg, 38% to the Frio, 20% to Southern Louisiana, and 2% to other areas in the province.
For 2007, we currently plan to spend a total of $64.5 million in our Onshore Gulf Coast province. Approximately $61.6 million of this spending has been allocated to drilling, with the remaining $2.9 million allocated to capital spending for land and seismic activities. We plan to drill seven development wells and spend approximately $48.9 million on development drilling capital. We also plan to drill two exploration wells and spend $12.7 million on exploration drilling capital.
Vicksburg Trend
Our Vicksburg activity is focused principally in Brooks County, Texas, in our Home Run, Triple Crown, and Floyd Fields. We discovered these fields in 1999, 2001 and 2002, respectively. In 2006, we successfully completed all five of our development drilling wells spud in 2006 including three in the Triple Crown Field, one in the Home Run Field and one in the Floyd Field. Total drilling, land and seismic capital expended in the Vicksburg during 2006 was $34.7 million.
During 2006, we operated all of our Vicksburg drilling, and the working interests we retained in our Vicksburg wells was higher than our historic average as our joint venture participant elected to take a more passive role in the development of the field. Rather than participating in the drilling of the wells with a paying working interest, our joint venture participant elected to receive a reversionary, or back-in working interest, based on certain payout thresholds in all of the 2006 Vicksburg wells. We continue to have discussions with our joint venture participant about other exploratory joint venture opportunities in the area and expect to continue to expand our activities in the trend.
Early in 2006, we successfully completed the Triple Crown Field Sullivan C-32 and Home Run Field Palmer 3S #2, which were carryover wells from the 2005 drilling program, at approximately 1.7 MMcfe per day and 2.3 MMcfe per day, respectively. Thereafter, we completed the Home Run Field Palmer #11 and Triple Crown Field Dawson #3, which produced at initial rates of approximately 5.3 MMcfe per day and 4.7 MMcfe per day, respectively. In August, we completed the Triple Crown Field Dawson #4 well from the 9800’ sands at an initial rate of approximately 3.0 MMcfe per day.
In September, we successfully completed the Triple Crown Field Sullivan, which came on-line at approximately 9.5 MMcfe per day. We encountered four pay zones and are currently producing only out of the deepest zone, the Dawson sand. Our plans are to commingle the remaining three zones after flowing tubing pressures from the Dawson sand subside. The remaining 61 feet of apparent pay includes, from shallowest to deepest, the Brigham, 9800’ and Loma Blanca sands. Production from the Dawson sand indicates the potential for further reserve growth in the Vicksburg, as this is the first well to be completed to sales from this zone.
Also in September, we commenced drilling the Floyd Field Sullivan C-33, an offset to our highly productive Sullivan #10. The Sullivan C-33 was brought on line in January 2007 at a rate of approximately 6.1 MMcf of natural gas and 570 barrels of oil per day (9.5 MMcfe per day). Subsequently, other pay intervals were brought on line and production increased to 10.6 MMcfe per day.
During 2007, we plan to operate a drilling rig on a continuous basis in the Vicksburg. In mid-January, we spud the Dawson #1S, the first of five consecutive Vicksburg wells we expect to drill in 2007. The Dawson #1S is a sidetrack of the previously drilled Dawson #1 and is an east offset to the aforementioned Sullivan. Based on mud logs and wireline logs, the Dawson #1S appears to have encountered roughly comparable 9800’ and Loma Blanca pay to that found in the offsetting wells. We retained a 100% working and 75% net revenue interest in the Dawson #1S. Following the Dawson #1S, we plan to drill the Sullivan C-35 in our Triple Crown Field. This well will test a number of upper Vicksburg pay intervals, and has the potential to prove up significant and additional locations and reserves. We expect the Sullivan C-35 to be followed by the Sullivan #14, which is also a well that could prove up additional development locations in our Triple Crown Field. Following the Sullivan #14, Brigham plans to commence the Sullivan #15, a significant development well in our Home Run Field. The Sullivan #15 appears to be located in a structurally high location at various Lower Vicksburg intervals, and could potentially prove up significant additional locations and reserves. We expect to retain a 100% working interest in the Sullivan #15 subject to a 66% back-in at 350% payout.
During 2007, we plan to spend $33.0 million to drill five development wells, to drill and complete wells that were in progress at December 31, 2006 and for other development activities. We expect to retain an average initial working interest of 100% in these wells. We also expect to spend $1.6 million on land and seismic.
Since 1999, we have drilled 35 Vicksburg wells, and we have completed 33 of those tests. We believe we have a multi-year inventory of drilling locations in our Home Run, Triple Crown and Floyd Fault Block Fields, and we expect to add to this inventory in 2007.
Frio Trend
During 2006, we drilled seven wells that targeted the Frio, including four exploratory and three development wells. Drilling, land and seismic capital expenditures for 2006 totaled $32.4 million.
The Sartwelle #4 was completed in the middle Frio and encountered 22 feet of apparent pay in a fault block that is estimated to be 320 acres. Production commenced in April 2006 at approximately 2.6 MMcfe per day. The Trull B #3 encountered 36 feet of apparent pay in various Frio intervals and was brought on-line in June 2006 at 2.8 MMcfe per day.
Our State Tract #109 tested what has been mapped as a 500 acre complex in the lower Frio and encountered 60 feet of apparent Lower Frio pay, with an additional 73 feet of potential pay that will likely be tested at a later date. This exploratory well initially flowed at approximately 2.4 MMcfe per day, but experienced a decline in production and began producing some sand. As a consequence, a frac pac was put in place to enhance production and to limit sand production. Subsequent to the frac pac, the well produced approximately 500 Mcfe per day, with additional potential pay remaining behind pipe for future completion.
In December 2006, we commenced drilling our high potential Frio exploratory test, the Green Ranch #1. In January 2007, after encountering poor sand quality, the well was plugged and abandoned.
In 2007, we currently plan to spend $ 7.7 million to drill one exploration well, to drill and complete wells that were in progress at December 31, 2006 and for other development activities.
Southern Louisiana Trend
In February 2006, we announced two new joint ventures to explore and develop 3-D delineated projects that target the Miocene and upper Oligocene trends located in South Louisiana. We view these projects as a logical extension of our activities in the onshore Texas Gulf Coast. In Southern Louisiana, we will utilize our geophysical, geological and operational expertise to explore for and develop potential Oligocene and Miocene reservoirs directly on trend to that of the Texas Gulf Coast Frio. During 2006, we drilled eight wells in the area with drilling, land and seismic expenditures totaling $17.5 million.
In our Bayou Postillion Project, which is located in Iberia Parish, Louisiana, we operated the drilling of the Cotten Land Corp. #1, with a 41% after casing point working interest. The Cotten Land Corp. #1 encountered 34 feet of apparent pay in a Miocene objective approximately 324 feet high to a down dip producer. The well put on line in September 2006 at an initial rate of approximately 10.1 MMcfe per day and in March 2007 was producing at a rate of approximately 15 MMcfe per day.
In August 2006, we participated in drilling an offset to the Cotten Land #1, the Marie Snyder #1, which found 40 feet of apparent pay. We retain a 13% working interest in the well, which is in the process of being completed.
On December 31, 2006, we spud our Cotton Land #3, which is our second development well in Bayou Postillion. We successfully production tested the Cotten Land #3, which encountered approximately 80 feet of apparent net pay in two intervals. The Cotten Land #3 was tested from the lowest 30 feet of pay at a production rate of 12.9 MMcf of natural gas and 48 barrels of oil per day with strong pressures. Based on the minimal pressure differences between the flowing and shut in tubing pressures, we expect to produce the well at an initial rate between 15 MMcfe and 20 MMcfe per day. Approximately 50 feet of shallower pay will remain behind pipe for future completion. Brigham operates the Cotten Land #3 with an approximate 47% working interest.
During the second quarter 2007, we plan to commence the Cotten Land #2, which is expected to test an apparent new fault block adjacent to the fault block in which Brigham drilled the Cotten Land #1 well. The unrisked reserve potential of this apparent fault block is estimated at approximately 4 to 12 Bcfe. Following the Cotten Land #2, Brigham plans to commence the Cotten Land #4, offsetting Brigham’s previously drilled Cotten Land #1 discovery.
In our Mystic Bayou Project located in St. Martin Parish, Louisiana, we identified at least three apparent fault blocks to test, all three of which we expect to encounter a Miocene objective structurally high to two wells that have combined to produce over 50 Bcfe to date. In November 2006, we commenced drilling of the Williams Land Company #1 on the first of the three prospective fault blocks. In December 2006, the well was plugged and abandoned after encountering tight and wet pay. The remaining two apparent fault blocks remain in inventory, one of which may be drilled in 2007 depending on the post-drill analysis of the Williams Land Company #1 dry hole. In addition, a number of shallow and deeper prospects and leads have been identified in the Mystic Bayou Project.
In 2007, we plan to spend a total of $19.4 million to drill two development wells, one exploration well, to complete wells in progress and for other development activities. We also expected to spend $1.7 million in land and seismic.
Anadarko Basin Province
The Anadarko Basin is located in the Texas Panhandle and Western Oklahoma. We believe this prolific natural gas producing province offers a combination of relatively lower risk exploration and development opportunities in shallower horizons, as well as higher risk, but higher reserve potential opportunities in the deeper sections that have been relatively under explored.
We believe our drilling program in the Anadarko Basin generally provides us with longer life reserves and helps to balance our drilling program in our prolific, but generally shorter reserve life, Onshore Gulf Coast province.
The stratigraphic and structural objectives in the Anadarko Basin can provide excellent targets for 3-D seismic imaging. In addition, drilling economics in the Anadarko Basin are enhanced by the multi-pay nature of many of the prospects, with secondary or tertiary targets serving as either incremental value or as alternatives if the primary target zone is not productive. Our recent activity has been focused primarily in the Hunton trend, Springer Channel and Springer Bar trends and the Granite Wash trend.
During 2006, we drilled ten development and three exploration wells. Of the $51.7 million that we spent on this province in 2006, approximately 69% was allocated to the Hunton trend, 18% was allocated to the Granite Wash trend, 5% was allocated to the Springer trends and 8% to other Anadarko Basin projects. Of our capital spent in the Hunton in 2006, $13.7 million was spent in 2006 to acquire 177 square miles of high resolution 3-D seismic data and land over a portion of Wheeler County, Texas, which includes our Mills Ranch Field as well as ten Hunton exploration prospects.
During 2007, we expect to spend $14.0 million to drill four exploration wells, complete wells that were in progress and on other activities. We also expect to spend $4.4 million on net land and seismic.
Hunton Trend
In January 2006, we commenced operations on a re-entry and sidetrack of the previously drilled Mills Ranch 99 #1S. The Mills Ranch 99 #1S2 reentered and sidetracked out of the Mills Ranch 99 #1S borehole at a depth of approximately 17,000 feet. We subsequently directionally drilled to a depth of approximately 21,000 feet to test the Hunton in what we determined to be in an adjacent fault block and encountered 125 feet of apparent pay. The well came on-line at approximately 6.0 MMcfe per day and in January 2007 was producing at a rate of approximately 1.8 MMcfe per day.
In March 2006, we commenced the drilling of the Mills Ranch #1-96, a development well on the westernmost end of the Mills Ranch field. The well was drilled to a depth of approximately 25,000 feet and offsets our Mills Ranch #1-97 well, which since December 2000 has produced approximately 6 Bcfe and is expected to ultimately produce approximately 15 Bcfe. Completion of the well was delayed due to operational complexities, primarily related to a mixed stream of water and gas from two different producing zones. The water bearing zone was isolated and production was tested from the Viola, the deepest producing interval in the well, which came on line at 8.3 MMcfe per day and then decreased to 3.0 MMcfe per day. We are preparing to perforate and stimulate the upper Chimney Hill, Haragan and Henryhouse Hunton intervals, which appear to be comparable pay intervals to the Mills Ranch #1-97 well discussed above. After production is established in the Hunton pay intervals, we expect to commingle these intervals with the Viola producing interval. We operate the Mills Ranch #1-96 with an appropriate 68% working interest.
In June 2006, a tubing leak developed in our Mills Ranch 98-2 well. In July 2006, we commenced operations to pull the tubing and remediate the well, but had difficulties in fishing the tubing out of the well. Subsequent to fishing the tubing, we discovered the casing was parted. After further remediation was unsuccessful, it was determined that the best course of action was to sidetrack the well at a later date. As a result, a kick-off plug was set. Prior to developing the tubing leak, the well was producing approximately 3.3 MMcfe per day.
Granite Wash Trend
In February 2006, we commenced the Hobart 59-2, which upon completion came on-line at approximately 3.4 MMcfe per day. Although no additional wells in our 4,000 acre contiguous held by production acreage block were drilled in 2006 or are scheduled for 2007, with strong commodity prices, we could accelerate our Granite Wash drilling program in 2007. Assuming 40 acre spacing, approximately 82 additional locations could be drilled to fully develop our acreage.
Rocky Mountains Province
Powder River Basin
In February 2006, we signed a letter of intent to acquire a 50% working interest in an unconventional shale play in the Powder River Basin of Wyoming. Vertical wells in the area, which date as far back as 1951, targeted shales approximately 175 feet thick at a depth of about 7,500 feet. Approximately 18 of these wells were completed in the targeted shale and produced between 8 to 189 barrels of oil per day. Given the historical results, we believe the application of horizontal drilling technology and / or advanced fracture stimulation could significantly increase the productivity of the shale zone. To earn a 50% working interest in approximately 54,000 net acres that our joint venture partners had accumulated in the play, we carried the drilling and completion costs of the first two wells for our partners and also paid the first $1 million of incremental land acquisition costs. The vast majority of our obligations to carry our partners for drilling, completion and land acquisition costs were fulfilled in 2006. As of December 31, 2006, we hold a total of over approximately 120,000 gross and 60,000 net acres in the play, located primarily in Niobrara County, Wyoming.
Our first well in the play, the Krejci Federal 29#3H, was spud at the end of July 2006. We are currently conducting varied and extensive production tests to evaluate the effectiveness of different completion methodologies. Initially, we tested only the last 219 feet of the approximate 1,600 foot lateral, which was not cased. Subsequent to fracture stimulation and hook up to a rod pump, the Krejci was producing between 120 and 160 barrels of oil per day from the outer 219 feet of the lateral. In late December, we began operations to test the innermost 1,381 foot cased portion of the well. We perforated and fractured stimulated three different intervals in this portion of the well bore and the well produce significant volumes of load water and between 50 and 90 barrels of oil per day. We drilled out the temporary plug to commingle production and installed a submersible pump. Pump problems, however, have prevented us from obtaining a stabilized rate. We expect to reinstall a submersible pump or install a more conventional rod pump.
We are currently in the process of completing our second well in the area, the Mills Trust #1-12. The well was drilled to a vertical depth of approximately 7,600 feet and then a 1,300 foot lateral was drilled. Casing was set on the first feet of the lateral. The outermost 415 feet of the lateral was left uncased. We fracture stimulated the outer 415 feet of the lateral and installed pumping equipment. After stimulation, the well produced approximately 120 barrels of load water and barrels of oil, with 400 to 500 barrels of load water remaining to be recovered. Subsequent to testing the open hole section, Brigham will production test the remaining 885 feet of the lateral which is currently behind production casing. Subsequent to completion testing in this part of the well bore, we will test the innermost 885 feet of the well bore.
In 2006, we spent $9.5 million in the Powder River Basin to complete the two aforementioned horizontal wells, to drill two other unsuccessful shallow vertical exploration wells targeting other primary objectives and to acquire land and seismic data. Beginning in March, we currently plan on committing a rig full time to the development of our Mowry acreage. In 2007, we anticipate spending approximately $14.5 million to drill eight wells, to acquire additional acreage and conduct additional seismic delineation testing.
Williston Basin
On November 1, 2005, we spent approximately $4.6 million to acquire a 100% working interest in approximately 46,000 net acres in McKenzie and Williams Counties in North Dakota. Since then, we have acquired significant additional acreage, and as of December 31, 2006 we had approximately 120,000 gross and net acres under lease. Of this acreage, approximately 55,000 net acres are in North Dakota, with approximately 65,000 net acres in Roosevelt and Sheridan Counties, Montana.
The Bakken is an unconventional oil play at a depth of approximately 10,500 feet. Within a 324 square mile area of Richland County, Montana, approximately 227 Bakken wells have generated average initial production rates of approximately 345 barrels of oil per day, average cumulative production to date of approximately 112,000 barrels of oil per well, and estimated ultimate recoveries of approximately 376,000 barrels of oil per well based on data compiled from external sources.
Our current drilling activities are approximately 25 miles east of the ongoing Bakken activity in Richland County, Montana. Our original three well program consisted of wells approximately 10,600 feet deep with single long laterals of approximately 8,000 feet. In 2006, we spent $22.7 million on drilling, land and seismic. Approximately $17.5 million was allocated to the drilling of three pilot wells in North Dakota.
The first well, the Field 18-19 1-H, was spud in May 2006 and subsequent to stimulation and installation of a rod pump, came on-line at approximately 200 barrels of oil per day. By December 2006, the well appeared to have stabilized at between and 70 barrels of oil per day. Our second well, the Mracheck 15-22 1-H, was hooked up to a rod pump prior to stimulation and recently was producing approximately 30 barrels of oil per day. A fracture stimulation of the well is planned for this spring. The third well, the Erickson 8-17 1-H, was fracture stimulated and initially produced at approximately 200 barrels of oil per day, but quickly declined to a rate of approximately 45 barrels of oil per day. Frac sand was apparently inhibiting production. In January 2007 we commenced operations to clean out the lateral and hook the well up to a rod pump for further production testing. After cleaning out the lateral, the well produced up to 227 barrels of oil per day and then declined to 82 barrels per day.
In 2007, we anticipate spending approximately $2.6 million to complete wells in progress and acquire land and seismic. We are currently evaluating the feasibility of drilling a tri-lateral well on our North Dakota acreage, but will monitor activity by other operators in the areas either currently drilling or planning to drill tri-laterals. Depending on the drilling success that other operators have in the vicinity of our North Dakota acreage, we may commence a tri-lateral, dual lateral or single lateral well during the second half of 2007. In addition, we may form an area of mutual interest around a portion of our substantial Montana acreage position and bring in a joint venture participant to potentially recoup a portion of our costs, fund a seismic shoot, and fund a portion of our drilling and completion costs, in order to accelerate activity over some of our acreage.
West Texas and Other Province
The Permian Basin of West Texas and Eastern New Mexico is a predominantly oil producing province with generally longer life reserves than that of our onshore Gulf Coast. Our drilling activity in our West Texas province has been focused primarily in various carbonate reservoirs, including the Canyon Reef and Fusselman formations of the Horseshoe Atoll trend, the Canyon Reef of the Eastern Shelf, the Wolfcamp and Devonian section of New Mexico, and the Mississippian Reef of the Hardeman Basin, at depths ranging from 7,000 to 13,000 feet.
Over the past three years, approximately 3% of our total capital expenditures for drilling, land and seismic have been allocated to our West Texas province where we have completed five gross wells (3.8 net) in eight attempts for a completion rate of 63%.
During 2006, we completed two gross wells (0.9 net) in three attempts for a completion rate of 67%. All three of these wells were exploration wells, with two of the three operated by a private operator. The Pink Floyd and Pink Champagne wells in the Canyon Reef play came on-line at approximately 100 and 65 Bopd, respectively.
For 2007, we currently plan to spend approximately $2.4 million on drilling, land and seismic.
3-D Seismic Exploration
We have accumulated 3-D seismic data covering approximately 11,337 square miles (7.3 million acres) in ten states. We typically acquire 3-D seismic data in and around existing producing fields where we can benefit from the imaging of producing analog wells. These 3-D defined analogs, combined with our experience in drilling 731 wells, the majority of which were imaged utilizing our 3-D seismic data and interpretation, provide us with a knowledge base to evaluate other potential geologic trends, 3-D seismic projects within these trends and prospective 3-D delineated drilling locations. Through our experience in the early and mid 1990’s, we developed an expertise in the selection of geologic trends that we believe are best suited for 3-D seismic exploration. We have used the experience that we have gained within our core trends to enhance the quality of subsequent projects in the same trend and other analogous trends to help lower finding and development costs, compress project cycle times and enhance our return on capital.
Over the last 16 years, we have accumulated substantial experience exploring with 3-D seismic in a wide range of reservoir types and geologic trapping mechanisms. In addition, we typically acquire digital databases for integration on our computer-aided exploration workstations, including digital land grids, well information, log curves, production information, geologic studies, geologic top databases and existing 2-D seismic data. We use our knowledge base, local geological expertise and digital databases integrated with 3-D seismic data to create maps of producing and potentially productive reservoirs. As such, we believe our 3-D generated maps are more accurate than previous reservoir maps (which generally are based on subsurface geological information and 2-D seismic surveys), enabling us to more precisely evaluate recoverable reserves and the economic feasibility of projects and drilling locations.
Historically, we have acquired most of our raw 3-D seismic data using seismic acquisition vendors on either a proprietary basis or through alliances affording the alliance members the exclusive right to interpret and use data for extended periods of time. In addition, we have participated in non-proprietary group shoots of 3-D seismic data (commonly referred to as “spec data”) when we believe the expected full cycle project economics could not justify the acquisition of proprietary data. Further, we have exchanged certain interests in some of our non-core proprietary seismic data to gain access to additional 3-D seismic data. In most of our proprietary 3-D data acquisitions and alliances, we have selected the sites of projects, primarily guided by our knowledge and experience in the core provinces we explore, established and monitored the seismic parameters of each project for which seismic data was acquired, and typically selected the equipment that was used.
Combining our geologic and geophysical expertise with a sophisticated land effort, we manage the majority of our projects from conception through 3-D acquisition, processing and interpretation and leasing. In addition, we manage the negotiation and drafting of virtually all of our geophysical exploration agreements, resulting in reduced contract risk and more consistent deal terms. Because we generate most of our projects, we can often control the size of the working interest that we retain as well as the selection of the operator and the non-operating participants.
During 2004, we added approximately 655 square miles of 3-D seismic data to our corporate database. Of this total, we acquired approximately 57 square miles of non-proprietary and 101 square miles of new proprietary 3-D seismic data in our Alamo project located in the Frio trend of the Upper Texas Gulf Coast. We sold a working interest in Alamo to an industry participant on a promoted basis and retained a 75% working interest in the project. Also included in the 3-D seismic data that we added to our corporate database in 2004 were approximately 120 square miles of new proprietary data we acquired in our General Lee project, which is located in the Frio trend of the Upper Texas Gulf Coast. We sold a working interest in General Lee to an industry participant on a promoted basis and retained a 75% working interest.
During 2005, we added approximately 247 square miles of 3-D seismic data to our corporate database. All 247 square miles of 3-D seismic data acquired were non-proprietary to us. Included in the 3-D seismic data that we added to our corporate database in 2005 was approximately 80 square miles of data in our Mudflats project located in the Frio trend along the Lower Texas Gulf Coast. We retained a 100% working interest in our Mudflats project.
During 2006, we added approximately 637 square miles of 3-D seismic data to our corporate database. Approximately 225 square miles of 3-D seismic data was acquired on a proprietary basis and the remaining 412 square miles was acquired on a non-proprietary basis. Included in the 3-D seismic data that we added to our corporate database in 2006 was approximately 177 square miles of data from our proprietary Laker project, which is in the Hunton trend of our Anadarko Basin. We retained a 100% working interest in our Laker project.
See “- Onshore Gulf Coast Province,” “- Anadarko Basin Province,” “- Rocky Mountains Province,” “- West Texas and Other Province,” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Capital Commitments - Capital Expenditures” for additional discussion regarding our seismic capital expenditures.
Title to Properties
We believe we have satisfactory title, in all material respects, to substantially all of our producing properties in accordance with standards generally accepted in the oil and natural gas industry. Our properties are subject to royalty interests, standard liens incident to operating agreements, liens for current taxes and other burdens, which we believe do not materially interfere with the use of or affect the value of such properties. Substantially all of our proved oil and natural gas properties are pledged as collateral under first and second liens for borrowings under our senior credit agreement. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Senior Credit Agreement” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - 9 5/8% Senior Notes due 2014.”
Oil and Natural Gas Reserves
Our estimated total net proved reserves of oil and natural gas as of December 31, 2006, 2005 and 2004, pre-tax PV10% value, standardized measure and the estimated future development cost attributable to these reserves as of those dates were as follows.
(a)
See “- Reconciliation of Standardized Measure to Pre-tax PV10%” for a definition of pre-tax PV10% and a reconciliation of our standardized measure to our pre-tax PV10% value.
(b)
These base prices were adjusted to reflect applicable transportation and quality differentials on a well-by-well basis to arrive at realized sales prices used to estimate our reserves at these dates.
The reserve estimates reflected above were prepared by Cawley, Gillespie & Associates, Inc., our independent petroleum consultants, and are part of reports on our oil and natural gas properties prepared by them.
In accordance with applicable requirements of the Securities and Exchange Commission (SEC), estimates of our net proved reserves and future net revenues are made using sales prices estimated to be in effect as of the date of such reserve estimates and are held constant throughout the life of the properties (except to the extent a contract specifically provides for escalation). Estimated quantities of net proved reserves and future net revenues there from are affected by oil and natural gas prices, which have fluctuated widely in recent years. There are numerous uncertainties inherent in estimating oil and natural gas reserves and their estimated values, including many factors beyond our control. The reserve data set forth in the Cawley, Gillespie & Associates, Inc. report represents only estimates. Reservoir engineering is a subjective process of estimating underground accumulations of oil and natural gas that cannot be measured in an exact manner. The accuracy of any reserve estimate is a function of the quality of available data and of engineering and geologic interpretation and judgment. As a result, estimates of different engineers, including those used by us, may vary. In addition, estimates of reserves are subject to revision based upon actual production, results of future development and exploration activities, prevailing oil and natural gas prices, operating costs and other factors. The revisions may be material. Accordingly, reserve estimates are often different from the quantities of oil and natural gas that are ultimately recovered and are highly dependent upon the accuracy of the assumptions upon which they are based. Our estimated net proved reserves, included in our Security and Exchange Commission filings, have not been filed with or included in reports to any other federal agency. See “Item 1A. Risk Factors - Although our oil and gas reserve data is independently estimated, these estimates may still prove to be inaccurate.”
Estimates with respect to net proved reserves that may be developed and produced in the future are often based upon volumetric calculations and upon analogy to similar types of reserves rather than actual production history. Estimates based on these methods are generally less reliable than those based on actual production history. Subsequent evaluation of the same reserves based upon production history will result in variations in the estimated reserves that may be substantial.
Reconciliation of Standardized Measure to Pre-tax PV10%
Pre-tax PV10% is the estimated present value of the future net revenues from our proved oil and natural gas reserves before income taxes discounted using a 10% discount rate. Pre-tax PV10% is considered a non-GAAP financial measure under SEC regulations because it does not include the effects of future income taxes, as is required in computing the standardized measure of discounted future net cash flows. We believe that pre-tax PV10% is an important measure that can be used to evaluate the relative significance of our oil and natural gas properties and that pre-tax PV10% is widely used by security analysts and investors when evaluating oil and natural gas companies. Because many factors that are unique to each individual company impact the amount of future income taxes to be paid, the use of a pre-tax measure provides greater comparability of assets when evaluating companies. We believe that most other companies in the oil and natural gas industry calculate pre-tax PV10% on the same basis. Pre-tax PV10% is computed on the same basis as the standardized measure of discounted future net cash flows but without deducting income taxes. The table below provides a reconciliation of our standardized measure of discounted future net cash flows to our pre-tax PV10% value.
Drilling Activities
We drilled, or participated in the drilling of, the following wells during the periods indicated.
__________
(a)
Excludes three (1.9 net) exploratory and two (0.8 net) development wells that are completing and one (0.4 net) development was that was drilling.
(b)
Includes two (1.0 net) development wells that commenced drilling in 2005 and was completed productive in 2006.
(c)
Includes one (1.0 net) exploratory well that commenced drilling in 2004 and were completed productive in 2005.
We do not own drilling rigs and all of our drilling activities have been conducted by independent contractors or by industry participant operators under standard drilling contracts.
Productive Wells and Acreage
Productive Wells
The following table sets forth our ownership interest at December 31, 2006 in productive oil and natural gas wells in the areas indicated. Wells are classified as oil or natural gas according to their predominant production stream. Gross wells are the total number of producing wells in which we have an interest, and net wells are determined by multiplying gross wells by our average working interest.
Productive wells consist of producing wells and wells capable of production, including wells waiting on pipeline connection. Wells that are completed in more than one producing horizon are counted as one well. Of the gross wells reported above, two had multiple completions.
Acreage
Undeveloped acreage includes leased acres on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and natural gas, regardless of whether or not such acreage contains proved reserves. The following table sets forth the approximate developed and undeveloped acreage that we held a leasehold interest in at December 31, 2006.
(a)
Does not include acreage for which assignments have not been received.
In addition, as of December 31, 2006, we had 2,442 gross and 1,824 net mineral acres.
All of our leases for undeveloped acreage summarized in the preceding table will expire at the end of their respective primary terms unless we renew the existing leases, we establish production from the acreage, or some other “savings clause” is exercised. The following table sets forth the minimum remaining lease terms for our gross and net undeveloped acreage.
In addition, as of December 31, 2006, we had lease options and rights of first refusal to acquire additional acres. The following table sets forth the expiration year of our options and right of first refusal agreements and our gross and net acres associated with those options and agreements.
Volumes, Prices and Production Costs
The following table sets forth our production volumes, the average prices we received before hedging, the average prices we received including hedging settlement gains (losses), the average price we received including hedging settlement and unrealized gains (losses) and average production costs associated with our sale of oil and natural gas for the periods indicated. On October 1, 2006, we de-designated all derivatives that were previously classified as cash flow hedges and as a result, we will mark-to-market these derivatives in future periods. In addition, all future derivatives will be undesignated and therefore subject to mark-to-market accounting. The mark-to-market accounting requires that we record both derivative settlement and unrealized gains (losses) to the consolidated statement of operations within a single income statement line item. We have elected to include both derivative settlements and unrealized gains (losses) within revenue. As such, unrealized gains (losses) on derivatives will no longer be included within either other comprehensive income or other income (expense) and will therefore be reflected in revenue. Prior periods for which unrealized gains (losses) have been included in other comprehensive income or other income (expense) are indicated with “NA” in the table on the next page.
Item 3.
Item 3. Legal Proceedings
We are, from time to time, party to certain lawsuits and claims arising in the ordinary course of business. While the outcome of lawsuits and claims cannot be predicted with certainty, management does not expect these matters to have a materially adverse effect on our financial condition, results of operations or cash flows.
As of December 31, 2006, there are no known environmental or other regulatory matters related to our operations that are reasonably expected to result in a material liability to us. Compliance with environmental laws and regulations has not had, and is not expected to have, a material adverse effect on our capital expenditures.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matter was submitted to a vote of our security holders during the fourth quarter of 2006.
Executive Officers of the Registrant
Pursuant to Instruction 3 to Item 401(b) of the Regulation S-K and General Instruction G(3) to Form 10-K, the following information is included in Part I of this report. The following are our executive officers as of March 5, 2007.
Ben M. “Bud” Brigham has served as our Chief Executive Officer, President and Chairman of the Board since we were founded in 1990. From 1984 to 1990, Mr. Brigham served as an exploration geophysicist with Rosewood Resources, an independent oil and gas exploration and production company. Mr. Brigham began his career in Houston as a seismic data processing geophysicist for Western Geophysical, Inc. a provider of 3-D seismic services, after earning his B.S. in Geophysics from the University of Texas at Austin. Mr. Brigham is the brother of David T. Brigham, Executive Vice President - Land and Administration.
Eugene B. Shepherd, Jr. has served as Executive Vice President and Chief Financial Officer since October 2003, and previously served as Chief Financial Officer from June 2002 to October 2003. Mr. Shepherd has approximately 24 years of financial and operational experience in the energy industry. Prior to joining us, Mr. Shepherd served as Integrated Energy Managing Director for the investment banking division of ABN AMRO Bank, where he executed merger and acquisition advisory, capital markets and syndicated loan transactions for energy companies. Prior to joining ABN AMRO, Mr. Shepherd spent fourteen years as an investment banker for Prudential Securities Incorporated, Stephens Inc. and Merrill Lynch Capital Markets. Mr. Shepherd worked as a petroleum engineer for over four years for both Amoco Production Company and the Railroad Commission of Texas. He holds a B.S. in Petroleum Engineering and an MBA, both from the University of Texas at Austin.
David T. Brigham joined us in 1992 and has served as a Director since May 2003 and as Executive Vice President - Land and Administration since June 2002. Mr. Brigham served as Senior Vice President - Land and Administration from March 2001 to June 2002, Vice President - Land and Administration from February 1998 to March 2001, as Vice President - Land and Legal from 1994 until February 1998 and as Corporate Secretary from February 1998 to September 2002. From 1987 to 1992, Mr. Brigham worked as an attorney in the energy section with Worsham, Forsythe, Sampels & Wooldridge. For a brief period of time before attending law school, Mr. Brigham was a landman for Wagner & Brown Oil and Gas Producers, an independent oil and gas exploration and production company. Mr. Brigham holds a B.B.A. in Petroleum Land Management from the University of Texas and a J.D. from Texas Tech School of Law. Mr. Brigham is the brother of Ben M. Brigham, Chief Executive Officer, President and Chairman of the Board.
A. Lance Langford joined us in 1995 as Manager of Operations and served as Vice President - Operations from January 1997 to March 2001, served as Senior Vice President - Operations from March 2001 to September 2003 and has served as Executive Vice President - Operations since September 2003. From 1987 to 1995, Mr. Langford served in various engineering capacities with Meridian Oil Inc., handling a variety of reservoir, production and drilling responsibilities. Mr. Langford holds a B.S. in Petroleum Engineering from Texas Tech University.
Jeffery E. Larson joined us in 1997 and was Vice President - Exploration from August 1999 to March 2001, Senior Vice President - Exploration from March 2001 to September 2003 and has served as Executive Vice President - Exploration since September 2003. Prior to joining us, Mr. Larson was an explorationist in the Offshore Department of Burlington Resources, a large independent exploration company, where he was responsible for generating exploration and development drilling opportunities. Mr. Larson worked at Burlington from 1990 to 1997 in various roles of responsibility. Prior to Burlington, Mr. Larson spent five years at Exxon as a Production Geologist and Research Scientist. He holds a B.S. in Earth Science from St. Cloud State University in Minnesota and a M.S. in Geology from the University of Montana.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Price Range of Common Stock, Performance Graph, and Dividend Policy
Our common stock commenced trading on the NASDAQ Global Market (formerly the NASDAQ National Market) on May 8, 1997 under the symbol “BEXP.” The following table sets forth the high and low intra-day sales prices per share of our common stock for the periods indicated on the NASDAQ Global Market for the periods indicated. The sales information below reflects inter-dealer prices, without retail mark-ups, mark-downs or commissions and may not necessarily represent actual transactions.
The closing market price of our common stock on March 5, 2007 was $5.30 per share. As of March 5, 2007, there were an estimated 181 record owners of our common stock.
No dividends have been declared or paid on our common stock to date. We intend to retain all future earnings for the development of our business. Our senior credit agreement, Senior Notes, and Series A preferred stock restrict our ability to pay dividends on our common stock.
We are obligated to pay dividends on our Series A preferred stock. At our option, these dividends were paid in kind through the issuance of additional shares of preferred stock in lieu of cash at a rate of 8% per annum through September 2005. Since October 2005, all dividends related to our series A preferred stock have been and are required to be paid in cash at a rate of 6% per annum. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Mandatorily Redeemable Preferred Stock.”
Securities Authorized for Issuance under Equity Compensation Plans
The following table includes information regarding our equity compensation plans as of the year ended December 31, 2006.
____________
(a)
Does not include 391,367 shares of restricted stock issued and outstanding at December 31, 2006.
Issuer Purchases of Equity Securities
In 2006, we elected to allow employees to deliver shares of vested restricted stock with a fair market value equal to their federal, state and local tax withholding amounts on the date of issue in lieu of cash payment.
Item 6.
Item 6. Selected Consolidated Financial Data
This section presents our selected consolidated financial data and should be read in conjunction with “Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Statements in the following discussion may be forward-looking and involve risk and uncertainty. The following discussion should be read in conjunction with our Consolidated Financial Statements and Notes hereto.
Sources of Our Revenues
We derive our revenues from the sale of oil and natural gas that is produced from our properties. Revenues are a function of the volume produced and the prevailing market prices at the time of sale.
To achieve more predictable cash flows and to reduce our exposure to downward price fluctuations, we utilize derivative instruments to hedge future sales prices on a portion of our oil and natural gas production. Our current strategy is to hedge up to 90% of our proved developed producing (PDP) volumes for the upcoming 12 months and 80% of our PDP for the remaining period. The use of certain types of derivative instruments may prevent us from realizing the benefit of upward price movements. See “Item 1A. Risk Factors - Our hedging activities may prevent us from benefiting from price increases and may expose us to other risks.”
Components of Our Cost Structure
Production Costs are the day-to-day costs we incur to bring hydrocarbons out of the ground and to the market combined with the daily costs we incur to maintain our producing properties. This includes lease operating expenses and production taxes.
-
Lease operating expenses are generally comprised of several components including the cost of labor and supervision to operate our wells and related equipment; repairs and maintenance; related materials, supplies, fuel, and supplies utilized in operating our wells and related equipment and facilities; insurance applicable to our wells and related facilities and equipment. Lease operating expenses also include the cost for expensed workovers. Lease operating expenses are driven in part by the type of commodity produced, the level of workover activity and the geographical location of the properties. Oil is inherently more expensive to produce than natural gas.
-
Lease operating expenses also include ad valorem taxes, which are imposed by local taxing authorities such as school districts, cities, and counties or boroughs. The amount of tax we pay is based on a percent of value of the property assessed or determined by the taxing authority on an annual basis. When oil and natural gas prices rise, the value of our underlying property interests increase, which results in higher ad valorem taxes.
-
In the U.S. there are a variety of state and federal taxes levied on the production of oil and natural gas. These are commonly grouped together and referred to as production taxes. The majority of our production tax expense is based on a percent of gross value realized at the wellhead at the time the production is sold or removed from the lease. As a result, our production tax expense increases when oil and gas prices rise.
-
Historically, taxing authorities have occasionally encouraged the oil and natural gas industry to explore for new oil and natural gas reserves, or to develop high cost reserves, through reduced tax rates or tax credits. These incentives have been narrow in scope and short-lived. A small number of our wells have qualified for reduced production taxes because they were discoveries based on the use of 3-D seismic or they are high cost wells.
Depreciation, Depletion and Amortization is the systematic expensing of the capital costs incurred to acquire, explore and develop oil and natural gas. As a full cost company, we capitalize all direct costs associated with our exploration and development efforts, including a portion of our interest and certain general and administrative costs, and apportion these costs to each unit of production sold through depletion expense. Generally, if reserve quantities are revised up or down, our depletion rate per unit of production will change inversely. When the depreciable base increases or decreases, the depletion rate will move in the same direction.
Asset Retirement Accretion Expense is the systematic, monthly accretion of future abandonment costs of tangible assets such as wells, service assets, pipelines, and other facilities.
General and Administrative Expense is our overhead, and includes payroll and benefits for our corporate staff, costs of maintaining our headquarters, managing our production and development operations and legal compliance. We capitalize general and administrative costs directly related to our exploration and development activities.
Interest. We rely on our Senior Notes, our Series A preferred stock and our senior credit facility to fund our short-term liquidity (working capital) and a portion of our long-term financing needs. We pay a fixed interest rate on both the Senior Notes and the preferred stock, but the interest rate that we pay on our senior credit facility correlates to both fluctuations in interest rates and to the extent that our cash flows from operations do not exceed our spending. We expect to continue to incur interest expense as we continue to grow. We capitalize interest directly related to our unevaluated properties and certain properties under development, which are not being amortized.
Income Taxes. We are generally subject to a 35% federal income tax rate. For income tax purposes, we are allowed deductions for accelerated depreciation, depletion, intangible drilling costs, and state taxes. Through 2006, all of our income taxes were deferred.
Capital Commitments
Our primary needs for cash are to fund our capital expenditure program, our working capital obligations and for the repayment of contractual obligations. In the future, cash will also be required to fund our capital expenditures for the exploration and development of properties necessary to offset the inherent declines in production and proven reserves that are typical in an extractive industry like ours. Future success in growing reserves and production will be highly dependent on our access to cost effective capital resources and our success in economically finding and producing additional oil and natural gas reserves. Funding for our exploration and development of oil and natural gas activities and the repayment of our contractual obligations may be provided by any combination of cash flow from operations, cash on our balance sheet, the unused committed borrowing capacity under our senior credit agreement, reimbursements of prior land and seismic costs by third parties who participate in our projects, and the sale of interests in projects and properties or alternative financing sources as discussed in “- Contractual Obligations” and “- Liquidity and Capital Resources.” Cash flows from operations and the unused committed borrowing capacity under our senior credit agreement fund our working capital obligations. We believe that cash on hand, net cash provided by operating activities, and the unused committed borrowing capacity under our senior credit agreement will fund our future financial obligations and liquidity.
Capital Expenditures
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. Our capital expenditure program includes the following:
•
cost of acquiring and maintaining our lease acreage position and our seismic resources;
•
cost of drilling and completing new oil and natural gas wells;
•
cost of installing new production infrastructure;
•
cost of maintaining, repairing and enhancing existing oil and natural gas wells;
•
cost related to plugging and abandoning unproductive or uneconomic wells; and,
•
indirect costs related to our exploration activities, including payroll and other expenses attributable to our exploration professional staff.
Our budgeted capital expenditures for 2007 are as follows:
The capital that funds our drilling activities is allocated to individual prospects based on the value potential of a prospect, as measured by a risked net present value analysis. We start each year with a budget and re-evaluate this budget monthly. The primary factors that impact this value creation measure include forecasted commodity prices, drilling and completion costs, and a prospect’s risked reserve size and risked initial producing rate. Other factors that are also monitored throughout the year that influence the amount and timing of all our planned expenditures include the level of production from our existing oil and natural gas properties, the availability of drilling and completion services, and the success and resulting production of our newly drilled wells. The outcome of our monthly analysis results in a reprioritization of our exploration and development drilling schedule to ensure that we are optimizing our capital expenditure plan.
Over the past three years, we have spent approximately $301.4 million to drill 53 exploratory wells and 86 developments wells. For 2007, we currently plan to spend approximately $91.2 million to drill seven exploratory wells with an average working interest of 62% and to drill 15 development wells with an average working interest of 65%. We believe that we possess a multi-year inventory of exploratory drilling prospects, the majority of which have been internally generated by our staff. We expect that we will continue to emphasize our prospect generation and drilling strategy as our primary means of creating value for our stockholders.
To support our prospect generation activities, we allocate a portion of our capital expenditures to land and seismic. Over the past three years, we have spent $64.3 million on land and seismic activities. For 2007, we expect to spend approximately $11.2 million or 10% of our total planned capital expenditures on land and seismic activities.
Additionally, we currently plan to capitalize approximately $11.5 million of our forecasted general and administrative cost and forecasted interest in 2007.
The final determination with respect to our 2007 budgeted expenditures will depend on a number of factors, including:
•
commodity prices;
•
production from our existing producing wells;
•
the results of our current exploration and development drilling efforts;
•
economic and industry conditions at the time of drilling, including the availability of drilling and completion equipment; and
•
the availability of more economically attractive prospects.
There can be no assurance that the budgeted wells will, if drilled, encounter commercial quantities of oil or natural gas.
For a more in depth discussion of our 2006 capital expenditures see “Item 2. Properties.”
Contractual Obligations
The following schedule summarizes our known contractual cash obligations at December 31, 2006 and the effect these obligations are expected to have on our future cash flow and liquidity.
____________
(a)
Senior Note interest calculated assuming $123.4 million of Senior Notes outstanding and an interest rate of 9.625%. The payments are made in May and November until its maturity in May 2014.
(b)
Senior credit agreement interest calculated assuming $25.9 million outstanding under our senior credit agreement, an interest rate of 6.57% and the agreement matures in June 2010. This interest rate assumes that we utilize approximately 24% of the available borrowing base during the period and a Eurodollar rate of 5.32% plus a margin of 1.25%. The Eurodollar rate used for the calculation is the one month Eurodollar rate on December 29, 2006. The amount of interest that we pay on amounts borrowed under our senior credit agreement will fluctuate over time as borrowings increase or decrease, as the applicable Eurodollar rate increases and decreases and as the applicable interest rate increases or decreases. See “Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Management Opinion Concerning Derivative Instruments
We use derivative instruments to manage exposure to commodity prices and interest rate risks. Our objectives for holding derivatives are to achieve a relatively consistent level of cash flow to support a portion of our planned capital spending. Our use of derivative instruments for hedging activities could materially affect our results of operations in particular quarterly or annual periods since such instruments can limit our ability to benefit from favorable price movements. We do not enter into derivative instruments for trading purposes.
Fair Value of Derivative Contracts
Prior to October 1, 2006, our derivatives were classified as either cash flow hedges or were undesignated. Cash flow hedges were valued quarterly and adjustments to the fair value of the contract prior to settlement were recorded to stockholders’ equity in other comprehensive income. Upon settlement, the gain (loss) on the cash flow hedge was recorded to revenue. Any unrealized gains (losses) for the ineffective portion of cash flow hedges were recorded to other income (expense). For undesignated hedges, both the changes in the fair market value of derivatives prior to settlement and the gains (losses) on the settlement of contracts were recorded to other income (expense).
On October 1, 2006, we de-designated all cash flow hedges. In addition, all future hedges will be undesignated. At the end of each quarter, our derivatives will be marked-to-market to reflect the current fair value and both derivative settlements and unrealized gains (losses) will be recorded on the consolidated statement of operations. We elected to include all derivative settlement and unrealized gains (losses) within revenue and will therefore no longer included those amounts within other income (expense).
The fair values of our derivative contracts are determined based on counterparties’ estimates and valuation models. We did not change our valuation methodology during the year ended December 31, 2006. The following table reconciles the changes that occurred in the fair values of our open derivative contracts during 2006.
Based upon the market prices at December 31, 2006, we expect to transfer approximately $891,060 of the gain included on our balance sheet in accumulated other comprehensive income (loss) to earnings during the next twelve months when transactions actually occur.
Derivative Instruments and Hedging Activities
Our primary commodity market risk exposure is to changes in the prices that we receive for our oil and natural gas production. The market prices for oil and natural gas have been highly volatile and are likely to continue to be highly volatile in the future. As such, we employ established policies and procedures to manage our exposure to fluctuations in the sales prices we receive for our oil and natural gas production via using derivative instruments.
While the use of derivative instruments limits the downside risk of adverse price movements, their use may also limit future revenues from favorable price movements. Moreover, our derivative contracts generally do not apply to all of our production and thus provide only partial price protection against declines in commodity prices. We expect that the amount of our derivative contracts will vary from time to time.
During 2006, we were party to natural gas costless collars, natural gas three-way costless collars, natural gas basis swaps, oil costless collars, oil three-way costless collars and interest rate swaps. See “Notes to the Consolidated Financial Statements - Note 11” for additional information regarding our derivative contracts.
We use costless collars to establish floor (purchased put option) and ceiling price (written call option) on our anticipated future oil and natural gas production. We receive no net premiums when we enter into these option arrangements. These contracts are settled monthly. When the settlement price for a period is above the ceiling price (written call option), we pay our counterparty. When the settlement price for a period is below the floor price (purchased put option), our counterparty is required to pay us. Prior to October 1, 2006, we designated these instruments as cash flow hedges as they were designed to achieve a more predictable cash flow, as well as reduce our exposure to price volatility.
A three-way costless collar consists of a costless collar (purchased put option and written call option) plus a put (written put) sold by us with a price below the floor price (purchased put option) of the costless collar. We receive no net premiums when we enter into these option arrangements. These contracts are settled monthly. The written put requires us to make a payment to our counterparty if the settlement price for a period is below the written put price. Combining the costless collar (purchased put option and written call option) with the written put results in us being entitled to a net payment equal to the difference between the floor price (purchased put option) of the costless collar and the written put price if the settlement price is equal to or less than the written put price. If the settlement price is greater than the written put price, the result is the same as it would have been with a costless collar. This strategy enables us to increase the floor and the ceiling price of the collar beyond the range of a traditional costless collar while offsetting the associated cost with the sale of the written put. Prior to October 1, 2006, the costless collar portion of the three-way was designated as a cash flow hedge while the written put was undesignated.
Natural gas derivative transactions are generally settled based upon the average reported settlement prices on the NYMEX for the last three trading days of a particular contract month. Oil derivative transactions are generally settled based on the average reported settlement prices on the NYMEX for each trading day of a particular calendar month.
The following table reflects our open derivative contracts at December 31, 2006, the associated volumes and the corresponding weighted average NYMEX reference price.
The following table reflects commodity derivative contracts entered into subsequent to December 31, 2006, the associated volumes and the corresponding weighted average NYMEX reference price.
Starting October 1, 2006, Brigham de-designated all derivatives that were previously designated as cash flow hedges and will mark-to-market all derivatives in future periods. At the end of each period, the derivatives will be marked-to-market to reflect the current fair value and the realized and unrealized gains or losses will be recorded on the consolidated statement of operations rather than as a component of other comprehensive income.
Interest Rate Risk
At December 31, 2006, we had $159.4 million of debt, of which $133.5 million was fixed rate debt. Our fixed rate debt consists of our $123.4 million Senior Notes and $10.1 million in Series A preferred stock. The remaining $25.9 million of debt we had outstanding at December 31, 2006, was floating rate debt, which consisted of debt outstanding under our senior credit agreement.
The interest rate that we pay on amounts borrowed under our senior credit agreement is derived from the Eurodollar rate and a margin that is applied to the Eurodollar rate. This calculation was performed using the one month Eurodollar rate on December 29, 2006 which was 5.32%. The margin that we pay is based upon the percentage of our available borrowing base that we utilize at the beginning of the quarter. At December 31, 2006, the borrowing base for our senior credit agreement was $110 million. Since the amount that we had borrowed under our senior credit at December 31, 2006 was $25.9 million, we were utilizing approximately 24% of our available borrowing base. At this level of borrowing, our senior credit agreement requires us to pay a margin of 1.25%, thus the interest rate that we would be required to pay on the amounts borrowed under our senior credit facility would be 6.57%. A 10% increase in the Eurodollar rate would equal approximately 53 basis points. Such an increase in the Eurodollar rate would change our annual interest expense by approximately $138,000, assuming borrowed amounts under our senior credit facility remain at $25.9 million.
We are required to pay the dividends on our Series A preferred stock in cash at a rate of 6% per annum. The fair value of the Series A mandatorily redeemable preferred stock at December 31, 2006 was approximately $8.8 million.
Item 8.
Item 8. Financial Statements and Supplementary Data
Our Consolidated Financial Statements required by this item are included on the pages immediately following the Index to Financial Statements appearing on page .
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
On June 15, 2006, our audit committee engaged KPMG LLP as our independent registered public accounting firm for the fiscal year ending December 31, 2006 and dismissed PricewaterhouseCoopers LLP, our previous independent registered public accounting firm. Information regarding this change in independent auditors was included in our report on Form 8-K dated June 15, 2006. There have been no other changes in accountants nor any disagreements with accountants.
During the fiscal years ended December 31, 2005 and 2004, and through June 15, 2006, there were no disagreements with PricewaterhouseCoopers LLP on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedures, which, if not resolved to their satisfaction, would have caused them to make reference thereto in its reports on the consolidated financial statements for such years.
The PricewaterhouseCoopers LLP reports on our consolidated financial statements and our subsidiaries as of and for the years ended December 31, 2005 and 2004, did not contain an adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope, or accounting principles.
Item 9A.
Item 9A. Controls and Procedures
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
As of December 31, 2006, our management, including our principal executive officer and principal financial officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon and as of the date of the evaluation, our principal executive officer and our principal financial officer concluded that the design and operation of our disclosure controls and procedures were effective at a reasonable assurance level.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). 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. Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our evaluation under the framework in Internal Control - Integrated Framework issued by the COSO, our management concluded that our internal control over financial reporting was effective as of December 31, 2006.
Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which is included herein.
Changes in Internal Control over Financial Reporting
There has been no change in our internal control over financial reporting during the fourth quarter of 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
The information required by this item is incorporated by reference to information under the caption “Proposal One - Election of Directors”, the information under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” and the information under the caption “Corporate Governance - Code of Business Conducted and Ethics” in our 2007 Proxy Statement for our annual meeting of stockholders to be held on Thursday, May 31, 2007. The 2007 Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days subsequent to December 31, 2006.
Pursuant to Item 401(b) of Regulation S-K, the information required by this item with respect to Brigham’s executive officers is set forth in Part I of this report.
Item 11.
Item 11. Executive Compensation
The information required by this item is incorporated herein by reference to the 2007 Proxy Statement, which will be filed with the Securities and Exchange Commission not later than 120 days subsequent to December 31, 2006.
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 the 2007 Proxy Statement, which will be filed with the Securities and Exchange Commission not later than 120 days subsequent to December 31, 2006. See “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities,” which sets forth certain information with respect to our equity compensation plans.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
The information required by this item is incorporated herein by reference to the 2007 Proxy Statement, which will be filed with the Securities and Exchange Commission not later than 120 days subsequent to December 31, 2006.
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by this item is incorporated herein by reference to the 2007 Proxy Statement, which will be filed with the Securities and Exchange Commission not later than 120 days subsequent to December 31, 2006.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a)
1. Consolidated Financial Statements: See Index to Financial Statements on page.
2. No schedules are required.
3. Exhibits:
The exhibits listed in the accompanying Index to Exhibits are filed or incorporated by reference as part of the annual report.
GLOSSARY OF OIL AND GAS TERMS
The following are abbreviations and definitions of certain terms commonly used in the oil and gas industry and in this report. The definitions of proved developed reserves, proved reserves and proved undeveloped reserves have been abbreviated from the applicable definitions contained in Rule 4-10(a)(2-4) of Regulation S-X.
3-D seismic. The method by which a three dimensional image of the earth’s subsurface is created through the interpretation of reflection seismic data collected over surface grid. 3-D seismic surveys allow for a more detailed understanding of the subsurface than do conventional surveys and contribute significantly to field appraisal, development and production.
Bbl. One stock tank barrel, or 42 U.S. gallons liquid volume, used herein in reference to oil or other liquid hydrocarbons.
Bcfe. One billion cubic feet of natural gas equivalent. In reference to natural gas, natural gas equivalents are determined using the ratio of 6 Mcf of natural gas to 1 Bbl of oil, condensate or natural gas liquids.
Completion. The installation of permanent equipment for the production of oil or natural gas. Completion of the well does not necessarily mean the well will be profitable.
Completion Rate. The number of wells on which production casing has been run for a completion attempt as a percentage of the number of wells drilled.
Developed Acreage. The number of acres which are allocated or assignable to producing wells or wells capable of production.
Development Well. A well drilled within the proved area of an oil or natural gas reservoir to the depth of a stratigraphic horizon known to be productive.
Dry Well. A well found to be incapable of producing either oil or natural gas in sufficient quantities to justify completion of an oil or gas well.
Exploratory Well. A well drilled to find and produce oil or natural gas in an unproved area, to find a new reservoir in a field previously found to be productive of oil or gas in another reservoir, or to extend a known reservoir.
Fault. A break in the rocks along which there has been movement of one side relative to the other side.
Fault Block. A body of rocks bounded by one or more faults.
Gross Acres or Gross Wells. The total acres or wells, as the case may be, in which we have a working interest.
Lease Operating Expenses. The expenses, usually recurring, which pay for operating the wells and equipment on a producing lease.
MBbl. One thousand barrels of oil or other liquid hydrocarbons.
Mcf. One thousand cubic feet of natural gas.
MMBbl. One million barrels of oil or other liquid hydrocarbons.
Mcfe. One thousand cubic feet of natural gas equivalents.
MMBtu. One million Btu, or British Thermal Units. One British Thermal Unit is the quantity of heat required to raise the temperature of one pound of water by one degree Fahrenheit.
MMcf. One million cubic feet of natural gas.
MMcfe. One million cubic feet of natural gas equivalents.
MMcfe/d. MMcfe per day.
Net Acres or Net Wells. Gross acres or wells multiplied, in each case, by the percentage working interest we own.
Net Production. Production that we own less royalties and production due others.
Oil. Crude oil, condensate or other liquid hydrocarbons.
Operator. The individual or company responsible for the exploration, development, and production of an oil or gas well or lease.
Pay. The vertical thickness of an oil and gas producing zone. Pay can be measured as either gross pay, including non-productive zones or net pay, including only zones that appear to be productive based upon logs and test data.
Pre-tax PV10%. The pre-tax present value of estimated future revenues to be generated from the production of proved reserves calculated in accordance with Securities and Exchange Commission guidelines, net of estimated production and future development costs, using prices and costs as of the date of estimation without future escalation, without giving effect to non-property related expenses such as general and administrative expenses, debt service and depreciation, depletion and amortization, and discounted using an annual discount rate of 10%.
Proved Developed Reserves. Reserves that can be expected to be recovered through existing wells with existing equipment and operating methods.
Proved Reserves. The estimated quantities of crude oil, natural gas and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions.
Proved Undeveloped Reserves. Reserves that are expected to be recovered from new wells on undrilled acreage or from existing wells where a relatively major expenditure is required for recompletion.
Royalty. An interest in an oil and gas lease that gives the owner of the interest the right to receive a portion of the production from the leased acreage (or of the proceeds of the sale thereof), but generally does not require the owner to pay any portion of the costs of drilling or operating the wells on the leased acreage. Royalties may be either landowner’s royalties, which are reserved by the owner of the leased acreage at the time the lease is granted, or overriding royalties, which are usually reserved by an owner of the leasehold in connection with a transfer to a subsequent owner.
Spud. Start drilling a new well (or restart).
Standardized Measure. The after-tax present value of estimated future revenues to be generated from the production of proved reserves calculated in accordance with Securities and Exchange Commission guidelines, net of estimated production and future development costs, using prices and costs as of the date of estimation without future escalation, without giving effect to non-property related expenses such as general and administrative expenses, debt service and depreciation, depletion and amortization, and discounted using an annual discount rate of 10%.
Trend. A geographical area that has been known to contain certain types of combinations of reservoir rock, sealing rock and trap types containing commercial amounts of hydrocarbons.
Working Interest. An interest in an oil and gas lease that gives the owner of the interest the right to drill for and produce oil and natural gas on the leased acreage and requires the owner to pay a share of the costs of drilling and production operations.
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, hereunder duly authorized, as of March 6, 2007.
Pursuant to the requirements of the Securities Exchange Act of 1934, the following persons on behalf of the Registrant and in the capacity indicated have signed this report below as of March 6, 2007.
/s/ BEN M. BRIGHAM
Chief Executive Officer, President and Chairman of
Ben M. Brigham
the Board (Principal Executive Officer)
/s/ EUGENE B. SHEPHERD, JR.
Executive Vice President and Chief Financial
Eugene B. Shepherd, Jr.
Officer (Principal Financial and Accounting Officer)
/s/ DAVID T. BRIGHAM
Executive Vice President - Land and
David T. Brigham
Administration and Director
/s/ HAROLD D. CARTER
Director
Harold D. Carter
/s/ STEPHEN C. HURLEY
Director
Stephen C. Hurley
/s/ STEPHEN P. REYNOLDS
Director
Stephen P. Reynolds
/s/ HOBART A. SMITH
Director
Hobart A. Smith
/s/ STEVEN A. WEBSTER
Director
Steven A. Webster
/s/ R. GRAHAM WHALING
Director
R. Graham Whaling
BRIGHAM EXPLORATION COMPANY
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Brigham Exploration Company:
We have audited the accompanying consolidated balance sheet of Brigham Exploration Company and subsidiaries as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Brigham Exploration Company and subsidiaries as of December 31, 2006, and the results of their operations and their cash flows for the year then ended, in conformity with U.S. generally accepted accounting principles.
As discussed in note 1 to the consolidated financial statements, the Company changed its method of accounting for share-based payments effective January 1, 2006 in connection with the adoption of Statement of Financial Accounting Standards No. 123R, Share-Based Payment.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Brigham Exploration Company’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 6, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
KPMG LLP
Dallas, Texas
March 6,
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Brigham Exploration Company:
We have audited management's assessment, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, that Brigham Exploration Company maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Brigham Exploration Company'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 Brigham Exploration Company maintained effective internal control over financial reporting as of December 31, 2006 is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Brigham Exploration Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Brigham Exploration Company and subsidiaries as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended, and our report dated March 6, 2007 expressed an unqualified opinion on those consolidated financial statements.
KPMG LLP
Dallas, Texas
March 6,
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of Brigham Exploration Company:
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Brigham Exploration Company and its subsidiaries at December 31, 2005, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. 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 of these statements 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
s/s PricewaterhouseCoopers LLP
Houston, Texas
February 27, 2006
BRIGHAM EXPLORATION COMPANY
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
The accompanying notes are an integral part of these consolidated financial statements.
BRIGHAM EXPLORATION COMPANY
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
BRIGHAM EXPLORATION COMPANY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
BRIGHAM EXPLORATION COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
BRIGHAM EXPLORATION COMPANY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Nature of Operations
Brigham Exploration Company is a Delaware corporation formed on February 25, 1997 for the purpose of exchanging its common stock for the common stock of Brigham, Inc. and the partnership interests of Brigham Oil & Gas, L.P. (the “Partnership”). Hereinafter, Brigham Exploration Company and the Partnership are collectively referred to as “Brigham.” Brigham, Inc. is a Nevada corporation whose only asset is its ownership interest in the Partnership. The Partnership was formed in May 1992 to explore and develop onshore domestic oil and natural gas properties using 3-D seismic imaging and other advanced technologies. Since its inception, the Partnership has focused its exploration and development of oil and natural gas properties primarily in the onshore Texas Gulf Coast, the Anadarko Basin, the Rocky Mountains and West Texas.
2. Summary of Significant Accounting Policies
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates relate to proved oil and natural gas reserve volumes and the future development costs, estimates relating to certain oil and natural gas revenues and expenses and deferred income taxes. Actual results may differ from those estimates.
Principles of Consolidation
The accompanying financial statements include the accounts of Brigham and its wholly owned subsidiaries, and its proportionate share of assets, liabilities and income and expenses of the limited partnerships in which Brigham, or any of its subsidiaries has a participating interest. All significant intercompany accounts and transactions have been eliminated.
Cash and Cash Equivalents
Brigham considers all highly liquid financial instruments with an original maturity of three months or less to be cash equivalents.
Property and Equipment
Brigham uses the full cost method of accounting for oil and natural gas properties. Under this method, all acquisition, exploration and development costs, including certain payroll, asset retirement costs, other internal costs, and interest incurred for the purpose of finding oil and natural gas reserves, are capitalized. Internal costs capitalized are directly attributable to acquisition, exploration and development activities and do not include costs related to production, general corporate overhead or similar activities. Costs associated with production and general corporate activities are expensed in the period incurred.
Proceeds from the sale of oil and natural gas properties are applied to reduce the capitalized costs of oil and natural gas properties unless the sale would significantly alter the relationship between capitalized costs and proved reserves, in which case a gain or loss is recognized.
Capitalized costs associated with impaired properties and capitalized costs related to properties having proved reserves, plus the estimated future development costs, asset retirement costs under Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (SFAS 143) are amortized using the unit-of-production method based on proved reserves. Capitalized costs of oil and natural gas properties, net of accumulated amortization and deferred income taxes, are limited to the total of estimated future net cash flows from proved oil and natural gas reserves, discounted at ten percent, plus the cost of unevaluated properties. The estimated future net cash flows are determined using prices at the end of the year. Under certain specific conditions, companies my elect to use subsequent prices for determining the estimated future net cash flows. Brigham has elected to use subsequent pricing for this purpose. There are many factors, including global events that may influence the production, processing, marketing and the price of oil and natural gas. A reduction in the valuation of oil and natural gas properties resulting from declining prices or production could adversely impact depletion rates and capitalized cost limitations. Capitalized costs associated with properties that have not been evaluated through drilling or seismic analysis, including exploration wells in progress at December 31, are excluded from the unit-of-production amortization. Exclusions are adjusted annually based on drilling results and interpretative analysis.
Other property and equipment, which primarily consists of 3-D seismic interpretation workstations, is depreciated on a straight-line basis over the estimated useful lives of the assets after considering salvage value. Estimated useful lives are as follows:
Betterments and major improvements that extend the useful lives are capitalized while expenditures for repairs and maintenance of a minor nature are expensed as incurred.
Asset Retirement Obligations
Brigham records the fair value of a liability for an asset retirement obligation in the period in which it is incurred and a corresponding increase in the carrying amount of the related long-lived asset. The liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. If the liability is settled for an amount other than the recorded amount, a gain or loss is recognized.
Revenue Recognition
Brigham recognizes revenues from the sale of oil using the sales method of accounting. Under this method, Brigham recognizes revenues when oil is delivered and title transfers.
Brigham recognizes revenues from the sale of natural gas using the entitlements method of accounting. Under this method, revenues are recognized based on Brigham’s entitled ownership percentage of sales of natural gas to purchasers. Gas imbalances occur when Brigham sells more or less than its entitled ownership percentage of total natural gas production. When Brigham receives less than its entitled share, a receivable is recorded. When Brigham receives more than its entitled share, a liability is recorded.
Derivative Instruments and Hedging Activities
Brigham uses derivative instruments to manage market risks resulting from fluctuations in the prices of oil and natural gas. Brigham periodically enters into derivative contracts, including price swaps, caps and floors, which require payments to (or receipts from) counterparties based on the differential between a fixed price and a variable price for a fixed quantity of oil or natural gas without the exchange of underlying volumes. The notional amounts of these financial instruments are based on expected production from existing wells.
At the inception of a derivative contract, Brigham historically designated the derivative as a cash flow hedge. For all derivatives designated as cash flow hedges, Brigham formally documented the relationship between the derivative contract and the hedged items, as well as the risk management objective for entering into the derivative contract. To be designated as a cash flow hedge transaction, the relationship between the derivative and the hedged items must be highly effective in achieving the offset of changes in cash flows attributable to the risk both at the inception of the derivative and on an ongoing basis. Brigham historically measured hedge effectiveness on a quarterly basis and hedge accounting would be discontinued prospectively if it is determined that the derivative is no longer effective in offsetting changes in the cash flows of the hedged item. Gains and losses deferred in accumulated other comprehensive income related to cash flow hedge derivatives that become ineffective remain unchanged until the related production is delivered. If Brigham determines that it is probable that a hedged forecasted transaction will not occur, deferred gains or losses on the derivative are recognized in earnings immediately. See Note 11 for a description of the derivative contracts which Brigham executes.
Derivatives, historically, were recorded on the balance sheet at fair value and changes in the fair value of derivatives were recorded each period in net income or other comprehensive income, depending on whether a derivative was designated as part of a hedge transaction and, if it was, depending on the type of hedge transaction. Brigham’s derivatives historically consisted primarily of cash flow hedge transactions in which Brigham was hedging the variability of cash flows related to a forecasted transaction. Period to period changes in the fair value of derivative instruments designated as cash flow hedges were reported in other comprehensive income and reclassified to net income in the periods in which the contracts are settled. The ineffective portion of the cash flow hedges was reflected in net income as an increase or decrease to other income (expense). Gains and losses on derivative instruments that did not qualify for hedge accounting were also recorded as an increase or decrease to other income (expense), in the period in which they occur. The resulting cash flows from derivatives are reported as cash flows from operating activities.
On October 1, 2006, Brigham de-designated all derivates that were previously classified as cash flow hedges and, in addition, Brigham has elected not to designate any additional derivative contracts as accounting hedges under SFAS No. 133. As such, all derivative positions are carried at their fair value on the consolidated balance sheet and are marked-to-market at the end of each period. Any realized and unrealized gains or losses are recorded as gain (loss) on derivatives, net, as an increase or decrease in revenue on the consolidated statement of operations rather than as a component of other comprehensive income or other income (expense).
Other Comprehensive Income (Loss)
Brigham follows the provisions of Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income,” which establishes standards for reporting comprehensive income. In addition to net income, comprehensive income includes all changes in equity during a period, except those resulting from investments and distributions to stockholders of Brigham.
The following table reflects the components of other comprehensive income (loss) for the years ended December 31, 2006, 2005 and 2004 (in thousands):
Stock Based Compensation
Effective January 1, 2006, Brigham adopted the provisions of SFAS 123R “Share Based Payment” for its stock based compensation plans. Brigham previously accounted for these plans under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” (APB 25) and related interpretations and disclosure requirements established by SFAS 123, “Accounting for Stock-Based Compensation.”
Under APB 25, Brigham recognized stock based compensation using the intrinsic value method and, thus, generally no compensation expense was recognized for stock options as they were generally granted at the market value on the date of grant. The pro forma effects on net income due to stock based compensation were disclosed in the notes to the consolidated financial statements. SFAS 123R eliminates the use of APB 25 and the intrinsic value method of accounting, and requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, based on the grant date fair value of those awards, in the financial statements over the requisite service period.
Income Taxes
Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using the tax rate in effect for the year in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates of deferred tax assets and liabilities is recognized in income in the year of the enacted rate change. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.
Deferred Loan Fees
Deferred loan fees incurred in connection with the issuance of debt are recorded on the balance sheet in other noncurrent assets. The debt issue costs are amortized to interest expense over the life of the debt using the straight-line method. The results obtained using the straight-line method are not materially different than those that would result from using the effective interest method.
Segment Information
All of Brigham’s oil and natural gas properties and related operations are located onshore in the United States and management has determined that Brigham has one reportable segment.
Treasury Stock
Treasury stock purchases are recorded at cost. Upon reissuance, the cost of treasury shares held is reduced by the average purchase price per share of the aggregate treasury shares held.
Mandatorily Redeemable Preferred Stock
The Mandatorily Redeemable Preferred Stock is presented in accordance with SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. SFAS 150 requires an issuer to classify certain financial instruments within its scope, such as mandatorily redeemable preferred stock, as liabilities (or assets in some circumstances). SFAS 150 defines a financial instrument as mandatorily redeemable if it embodies an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets at a specified or determinable date(s) or upon an event certain to occur. Brigham adopted this standard as required on July 1, 2003.
New Pronouncements
In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155 (SFAS 155) “Accounting for Certain Hybrid Instruments - an amendment of FASB Statements No. 133 and 140.” SFAS 155 amends SFAS 133 to permit fair value measurement for certain hybrid financial instruments that contain an embedded derivative, provides additional guidance on the applicability of SFAS 133 and SFAS 140 to certain financial instruments and subordinated concentrations of credit risk. SFAS 155 is effective for the first fiscal year that begins after September 15, 2006. This did not have any impact on Brigham’s consolidated financial statements.
In July 2006, the Financial Accounting Standards Board issued FASB Interpretation No. “Accounting for Uncertainty in Income Taxes--an Interpretation of FASB Statement 109” (FIN 48), which clarifies the accounting for uncertainty in tax positions taken or expected to be taken in a tax return, including issues relating to financial statement recognition and measurement. FIN 48 provides that the tax effects from an uncertain tax position can be recognized in the financial statements only if the position is “more-likely-than-not” of being sustained if the position were to be challenged by a taxing authority. The assessment of the tax position is based solely on the technical merits of the position, without regard to the likelihood that the tax position may be challenged. If an uncertain tax position meets the “more-likely-than-not” threshold, the largest amount of tax benefit that is greater than 50 percent likely of being recognized upon ultimate settlement with the taxing authority, is recorded. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company expects to recognize a liability of approximately $3.3 million as a result of adopting FIN 48.
In September 2006 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157 “Fair Value Measurements” (SFAS 157), which provides expanded guidance for using fair value to measure assets and liabilities. SFAS 157 establishes a hierarchy for data used to value assets and liabilities, and requires additional disclosures about the extent to which a company measures assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. Implementation of SFAS 157 is required on January 1, 2008. The Company is currently evaluating the impact of adopting SFAS 157 on the financial statements.
On September 29, 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(r)” (SFAS 158). The Statement requires the recognition of the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability on the balance sheet and the recognition of the changes of the funded status in the year in which the changes occur through comprehensive income. Implementation of SFAS 158 is required as of the end of the fiscal year ending after December 15, 2006. The adoption of SFAS 158 did not have an impact on the Company’s financial statements because the Company does not currently have any defined benefit pension or other postretirement benefit plans.
On September 13, 2006 the Securities Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 (SAB 108), which establishes an approach that requires quantification of financial statement errors based on the effects of the error on each of the company's financial statements and the related disclosures. SAB 108 requires the use of a balance sheet and an income statement approach to evaluate whether either of these approaches results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. The adoption of SAB 108 did not have an impact on the Company’s financial statements.
3. Property and Equipment
Property and equipment, at cost, are summarized as follows (in thousands):
Depletion expense is based on units-of-production. Production volumes used to determine depletion expense were 13,254 MMcfe for 2006 and 11,913 MMcfe for 2005.
Brigham capitalizes certain payroll and other internal costs directly attributable to acquisition, exploration and development activities as part of its investment in oil and natural gas properties over the periods benefited by these activities. Capitalized costs do not include any costs related to production, general corporate overhead, or similar activities. Capitalized costs are summarized as follows for the years ended December 31, 2006, 2005 and 2004 (in thousands):
The risk that the Company will experience a ceiling test writedown increases when oil and gas prices are depressed or if the Company has substantial downward revisions in its estimated proved reserves. Based on oil and gas prices in effect on December 29, 2006 ($5.475 per MMBtu for Henry Hub natural gas and $61.06 per barrel for West Texas Intermediate oil, adjusted for differentials), the unamortized cost of the Company's oil and gas properties exceeded the ceiling limit by $40.4 million, net of tax. However, subsequent to the end of the year, oil and natural gas prices increased, and on February 28, 2006, reached $7.205 per MMBtu for natural gas and $61.80 per barrel for oil. Utilizing these prices, the Company’s net capitalized costs of oil and natural gas properties would not have exceeded the ceiling limit. As a result of the increase in the ceiling limit using subsequent prices, the Company was not required to writedown the net capitalized costs of its oil and gas properties.
Undesignated hedges are excluded from the ceiling test calculation. The company de-designated its cash flow hedges effective October 1, 2006.
4. Senior Credit Facility, Senior Notes, and Senior Subordinated Notes
The following table reflects the outstanding balances of the senior credit facility, senior notes, and senior subordinated notes for the years ended December 31, 2006 and 2005:
Senior Credit Facility
During June 2005, Brigham amended and restated its senior credit facility to provide for revolving credit borrowings up to a maximum principal amount of $200 million at any one time outstanding. Borrowings under Brigham’s senior credit facility cannot exceed its borrowing base, which is determined at least semiannually. Brigham’s borrowing base under the amended and restated senior credit facility increased from $80 million to $90 million in November 2005. In conjunction with the issuance of the Senior Notes, the borrowing base was reset to $50 million. In November 2006, Brigham concluded the semi-annual redetermination process, which is described in further detail below, and at that time the borrowing base was reset to $110 million.
Brigham also extended the maturity of its senior credit facility from March 2009 to June 2010 and changed the interest rate that it pays on borrowings under the facility. Borrowings under the senior credit facility bear interest, at Brigham’s election, at a base rate (as the term is defined in the senior credit facility) or Eurodollar rate (5.32% at December 31, 2006), plus in each case an applicable margin that is reset quarterly (1.25% at December 31, 2006). The applicable interest rate margin varies from 0.0% to 0.5% in the case of borrowings based on the base rate (as the term is defined in the senior credit facility) and from 1.25% to 2.0% in the case of borrowings based on the Eurodollar rate, depending on percentage of the available borrowing base utilized. In addition, Brigham is required to pay a commitment fee on the unused portion of its borrowing base. The applicable commitment fee varies from 0.25% to 0.375%, depending on the percentage of the available borrowing base not utilized. Borrowings under the senior credit facility are collateralized by substantially all of Brigham’s oil and natural gas properties under first liens.
The senior credit facility contains various covenants, including among others restrictions on liens, restrictions on incurring other indebtedness, restrictions on mergers, restrictions on investments, and restrictions on hedging activity of a speculative nature or with counterparties having credit ratings below specified levels. The senior credit facility requires Brigham to maintain a current ratio (as defined) of at least 1 to 1 and an interest coverage ratio (as defined) of at least 3 to 1. At December 31, 2006, Brigham was in compliance with all covenants under the senior credit facility.
In April 2006, proceeds from the Senior Notes issuance were used to repay the $48.4 million balance outstanding under the senior credit agreement. As of December 31, 2006, Brigham had $25.9 million in borrowings outstanding under its senior credit facility.
Senior Subordinated Notes
In April 2006, Brigham used a portion of the net proceeds from the sale of the Senior Notes issuance to repay the $30 million in borrowings that were outstanding under the senior subordinated credit agreement. Subsequent to this repayment, Brigham terminated the senior subordinated credit agreement and the associated interest rate swap designated as a cash flow hedge.
Senior Notes
In April 2006, Brigham issued $125 million of 9 5/8% Senior Notes due in 2014 (the “Senior Notes”). The Senior Notes were priced at 98.629% of their face value to yield 9 7/8% and are fully and unconditionally guaranteed by Brigham Exploration and its wholly-owned subsidiaries, Brigham Inc. and Brigham Oil & Gas, L.P. (the “Guarantors”). The guarantees are joint and several. Brigham Exploration does not have any independent assets or operations and the aggregate assets and revenues of the subsidiaries not guaranteeing are less than 3% of the Company’s consolidated assets and revenues. As of December 31, 2006, Brigham had $123.4 million of senior notes outstanding, net of discount of $1.6 million.
The Senior Notes agreement contains various covenants, including among others restrictions on incurring other indebtedness, restrictions on liens, restrictions on the sale of assets, and restrictions on certain payments. The Senior Notes agreement requires Brigham to maintain a fixed charge coverage ratio (as defined) for the most recent four full fiscal quarters of at least 2.5 to 1. At December 31, 2006, Brigham was in compliance with all covenants under the Senior Notes agreement.
5. Preferred Stock
Series A Mandatorily Redeemable Preferred Stock
The following table reflects the outstanding shares of Series A mandatorily redeemable preferred stock and the activity related thereto for the years ended December 31, 2006 and 2005 (in thousands, except share amounts):
Brigham has designated 2,250,000 shares of preferred stock as Series A Preferred Stock. The Series A Preferred Stock has a par value of $0.01 per share and a stated value of $20 per share. The Series A Preferred Stock is cumulative and pays dividends quarterly at a rate of 6% per annum of the stated value if paid in cash or 8% per annum of the stated value if paid in kind (PIK) through the issuance of additional Series A Preferred Stock in lieu of cash. From issuance, through September 30, 2005, Brigham paid the dividends on the Series A preferred stock in kind through the issuance of additional shares of preferred stock at a rate of 8% per annum. Beginning on October 1, 2005, Brigham’s option to pay dividends in kind expired and Brigham was required to pay all dividend obligations related to the Series A preferred stock in cash at a rate of 6% per annum. The Series A Preferred Stock matures on October 31, 2010 and is redeemable at Brigham’s option at 100% or 101% of stated value (depending upon certain conditions) at anytime prior to maturity. The Series A Preferred Stock does not generally have any voting rights, except for certain approval rights and as required by law.
6. Issuance of Common Stock
In February 2005, Brigham filed a second universal shelf registration statement that allows Brigham to issue common stock, preferred stock, depositary shares, warrants, senior debt and subordinated debt up to an aggregate amount of $300 million.
In November 2005, Brigham issued 2,500,000 shares of Brigham common stock under its first universal shelf registration statement and received proceeds of approximately $28.2 million, net of underwriting commissions and other offering expenses. During July and August 2004, Brigham completed the sale of 2,598,500 shares of its common stock under the same universal shelf registration statement. Net proceeds from the stock sale were approximately $22.1 million.
7. Asset Retirement Obligations
Brigham has asset retirement obligations associated with the future plugging and abandonment of proved properties and related facilities. Prior to the adoption of SFAS 143, Brigham assumed salvage value approximated plugging and abandonment costs. As such, estimated salvage value was not excluded from depletion and plugging and abandonment costs were not accrued for over the life of the oil and gas properties. Under the provisions of SFAS 143, the fair value of a liability for an asset retirement obligation is recorded in the period in which it is incurred and a corresponding increase in the carrying amount of the related long-lived asset. The liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. If the liability is settled for an amount other than the recorded amount, a gain or loss is recognized.
Brigham has no assets that are legally restricted for purposes of settling asset retirement obligations. The following table summarizes Brigham’s asset retirement obligation transactions recorded in accordance with the provisions of SFAS 143 during the years ended December 31, 2006 and 2005 (in thousands):
8. Income Taxes
The income tax expense (benefit) consists of the following (in thousands):
The differences in income taxes provided and the amounts determined by applying the federal statutory tax rate to income before income taxes result from the following (in thousands):
The components of deferred income tax assets and liabilities are as follows (in thousands):
A deferred liability or asset is recognized for the estimated future tax effects attributable to (i) net operating loss carryforwards (“NOLs”) and (ii) existing temporary differences between book and taxable income. In 2006, Brigham recognized a current year net deferred federal tax liability of $12.3 million due to reversals of existing temporary differences between book and taxable income resulting mainly from capital expenditures. Brigham also recognized a current year net deferred state tax liability of $1.2 million, consisting of a $1.3 million new Texas franchise tax and miscellaneous deferred tax benefits of other states. At December 31, 2006, Brigham has capital loss carryforwards of approximately $175,000 that expire in 2007 on which Brigham has established a valuation allowance. In addition, Brigham has percentage depletion carryforwards of approximately $8.5 million on which Brigham has established a valuation allowance.
Brigham believes an Internal Revenue Code Sec. 382 ownership change may have occurred in March 2001 and in November 2005, as a result of a potential 50% change in ownership among its 5% shareholders over a three-year period. The limitations resulting from the March 2001 and November 2005 ownership changes approximate $5.2 million annually and $22 million annually, respectively, which can be increased by recognized Built-in-Gains over five years following the ownership change. Management believes that the limitations will not have a material impact on the utilization of its NOL’s because the maximum limitations to be utilized exceed total NOL’s affected by the limitations.
In May 2006, the state of Texas enacted legislation that replaces the taxable capital and earned surplus components of its franchise tax with a new franchise tax that is based on modified gross revenue. The new franchise tax (referred to as the “Margin Tax”) becomes effective beginning with the 2007 tax year. The current franchise tax remains in effect through the end of 2006. Within the context of generally accepted accounting principals in the United States, the Margin Tax is based on a measure of income and is thus accounted for in accordance with Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes” (SFAS 109). The provisions of SFAS 109 require recognition of the effects of the tax law change in the period of enactment. As discussed above, Brigham has recorded a deferred tax liability in the amount of $1.3 million to reflect the estimated impact of the adoption of the Margin Tax in 2006. The Margin Tax legislation contains significant inconsistencies in language describing the computation of the tax, which combined with unclear legislative intent preclude reliable interpretation of the law. The Texas Comptroller of public accounts (responsible for administering Texas tax laws) has issued guidance on calculating the Margin Tax that the Company has followed in determining the effects of the Margin Tax, even though the comptroller’s guidance differs in several respects from the text of the enacted law.
At December 31, 2006, Brigham had regular tax NOLs of approximately $116 milion available as a deduction against future taxable income. Additionally, Brigham has approximately $102.1 million of alternative minimum tax (“AMT”) NOLs. The NOLs expire from 2012 through 2026. The value of these NOLs depends on the ability of Brigham to generate taxable income. A summary of the NOLs follows (in thousands):
9. Net Income Available Per Common Share
Basic earnings per share are computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS is computed by dividing net income by the weighted average number of common shares and potential common shares outstanding (if dilutive) during each period. Potential common shares include stock options and restricted stock. The number of potential common shares outstanding relating to stock options and restricted stock is computed using the treasury stock method.
At December 31, 2006, 2005, and 2004, potential dilution of approximately 1.7 million, 330,000, and, 718,500 shares of common stock, respectively, related to mandatorily redeemable preferred stock and options were outstanding, but were not included in the computation of diluted income (loss) per share because the effect of these instruments would have been anti-dilutive.
10. Contingencies, Commitments and Factors Which May Affect Future Operations
Litigation
Brigham is, from time to time, party to certain lawsuits and claims arising in the ordinary course of business. While the outcome of lawsuits and claims cannot be predicted with certainty, management does not expect these matters to have a materially adverse effect on the financial condition, results of operations or cash flows of Brigham.
As of December 31, 2006, there are no known environmental or other regulatory matters related to Brigham’s operations that are reasonably expected to result in a material liability to Brigham. Compliance with environmental laws and regulations has not had, and is not expected to have, a material adverse effect on Brigham’s financial position, results of operations or cash flows.
Operating Lease Commitments
Brigham leases office equipment and space under operating leases expiring at various dates. The noncancelable term of the leases for Brigham’s office space expires in 2012. The future minimum annual rental payments under the noncancelable terms of these leases at December 31, 2006 are as follows (in thousands):
Rental expense for the years ended December 31, 2006, 2005 and 2004 was approximately $651,000, $596,000, and $754,000, respectively.
Major Purchasers
The following purchasers accounted for 10% or more of Brigham’s oil and natural gas sales for the years ended December 31, 2006, 2005 and 2004:
Brigham believes that the loss of any individual purchaser would not have a long-term material adverse impact on its financial position or results of operations.
Factors Which May Affect Future Operations
Since Brigham’s major products are commodities, significant changes in the prices of oil and natural gas could have a significant impact on Brigham’s results of operations for any particular year.
11. Derivative Instruments and Hedging Activities
Brigham utilizes various commodity swap and option contracts to (i) reduce the effects of volatility in price changes on the oil and natural gas commodities it produces and sells, (ii) reduce commodity price risk and (iii) provide a base level of cash flow in order to assure it can execute at least a portion of its capital spending plans.
Brigham reports average oil and natural gas prices and revenues including the net results of hedging activities. On October 1, 2006, Brigham de-designated all derivates that were previously classified as cash flow hedges and, in addition, Brigham has elected not to designate any additional derivative contracts as accounting hedges under SFAS No. 133. Beginning on October 1, 2006, all derivative positions are carried at their fair value on the consolidated balance sheet and are marked-to-market at the end of each period. As such, the realized and unrealized gains or losses are recorded as gain (loss) on derivatives, net, as an increase or decrease in revenue on the consolidated statement of operations rather than as a component of other comprehensive income. The following table sets forth Brigham’s oil and natural gas prices including and excluding the realized and unrealized hedging gains and losses and the increase or decrease in oil and natural gas revenues as a result of the hedging activities for the three year period ended December 31, 2006:
For the years ended December 31, 2006, 2005 and 2004, ineffectiveness associated with Brigham’s derivative contracts designated as cash flow hedges increased (decreased) earnings by approximately $3.2 million, $(0.7) million, and $0.7 million, respectively. Effective October 1, 2006, Brigham de-designated all existing cash flow hedges. Subsequent derivative contracts are undesignated for accounting purposes. Brigham continues to designate derivative contracts as cash flow hedges for tax purposes.
Natural Gas and Crude Oil Derivative Contracts
Cash flow hedges
Prior to October 1, 2006, all derivative positions that qualified for hedge accounting were designated on the date Brigham entered into the contract as a hedge against the variability in cash flows associated with the forecasted sale of future oil and gas production. Brigham’s cash flow hedges consisted of costless collars (purchased put options and written call options). The costless collars are used to establish floor and ceiling prices on anticipated future oil and natural gas production. There were no net premiums paid or received when Brigham entered into these option agreements. The cash flow hedges were valued at the end of each period and adjustments to the fair value of the contract prior to settlement were recorded on the consolidated statement of stockholders’ equity as other comprehensive income. Upon settlement, the gain (loss) on the cash flow hedge was recorded as an increase or decrease in revenue on the consolidated statement of operations. Additionally, any unrealized gains (losses) relating to the ineffective portion of the cash flow hedges was recorded as an increase or decrease in other income (expense).
On October 1, 2006, Brigham de-designated all derivates that were previously classified as cash flow hedges and, in addition, Brigham has elected not to designate any additional derivative contracts as accounting hedges under SFAS No. 133. As such, all derivative positions are carried at their fair value on the consolidated balance sheet and are marked-to-market at the end of each period. Any realized and unrealized gains or losses are recorded as gain (loss) on derivatives, net, as an increase or decrease in revenue on the consolidated statement of operations rather than as a component of other comprehensive income or as other income (expense).
Derivative positions included written put options that were not designated as cash flow hedges and were reflected at fair value on the balance sheet. These positions were entered into in conjunction with a costless collar to offset the cost of other option positions that were designated as cash flow hedges. Historically, at each balance sheet date, the value of written put options not designated as cash flow hedges was adjusted to reflect current fair value and any realized and unrealized gains or losses were recorded as an increase or decrease in other income (expense). During the current year, any realized and unrealized gains or losses associated with the written put options was recorded as gain (loss) on derivatives, net, as an in increase or decrease in revenue on the consolidated statement of operations with any other undesignated derivatives. The following table provides a summary of the fair value of the written put options included in other current liabilities (in thousands):
The following table provides a summary of the impact on earnings from non-cash gains (losses) related to changes in the fair values of these derivative contracts for the three years ended December 31 (in thousands):
The following table reflects our open commodity derivative contracts at December 31, 2006, the associated volumes and the corresponding weighted average NYMEX reference price.
The following table reflects commodity derivative contracts entered subsequent to December 31, 2006, the associated volumes and the corresponding weighted average NYMEX reference price.
Interest rate swap
Periodically, Brigham may use interest rate swap contracts to adjust the proportion of its total debt that is subject to variable interest rates to fixed rates. Under such an interest rate swap contract, Brigham agrees to pay an amount equal to a specified fixed-rate of interest for a certain notional amount and receive in return an amount equal to a variable-rate. The notional amounts of the contract are not exchanged. No other cash payments are made unless the contract is terminated prior to maturity. Although no collateral is held or exchanged for the contract, the interest rate swap contract is entered into with a major financial institution with an investment grade credit rating in order to minimize Brigham’s counterparty credit risk. The interest rate swap contract is designated as cash flow hedges against changes in the amount of future cash flows associated with Brigham’s interest payments on variable-rate debt. The effect of this accounting on operating results is that interest expense on a portion of variable-rate debt being hedged is recorded based on fixed interest rates.
At March 31, 2006, Brigham had an interest rate swap contract to pay a fixed-rate of interest of 7.6% on $20.0 million notional amount of senior subordinated notes. The $20.0 million notional amount of the outstanding contract was to mature in March 2009. Brigham used the net proceeds from the Senior Notes offering to repay all amounts currently outstanding under its senior and subordinated credit agreements which totaled $78.4 million at the time the offering closed. Subsequent to this repayment, Brigham terminated the subordinated credit agreement and the associated interest rate swap. Upon termination of the interest rate swap, Brigham received $838,000 for the fair market value of the swap, which was recognized as gain (loss) on derivatives, net.
Fair values
The current asset and liability amounts represent the fair values expected to be included in the results of operations for the subsequent year. The fair value of derivative contracts is reflected on the balance sheet as detailed in the following schedule (in thousands):
12. Financial Instruments
Brigham’s non-derivative financial instruments include cash and cash equivalents, accounts receivable, accounts payable and long-term debt. The carrying amount of cash and cash equivalents, accounts receivable and accounts payable approximate fair value because of their immediate or short-term maturities. The carrying value of Brigham’s senior credit facility approximates its fair market value since it bears interest at floating market interest rates. The fair value of Brigham’s senior subordinated notes at December 31, 2006 and 2005 was zero and $29.4 million, respectively. The fair value of Brigham’s Senior Notes at December 31, 2006 and 2005 was $125.5 million and zero, respectively. The fair value of the Series A mandatorily redeemable preferred stock at December 31, 2006 and 2005 was approximately $8.8 million and $8.9 million, respectively.
Brigham’s accounts receivable relate to oil and natural gas sold to various industry companies, and amounts due from industry participants for expenditures made by Brigham on their behalf. Credit terms, typical of industry standards, are of a short-term nature and Brigham does not require collateral. Brigham’s accounts receivable at December 31, 2006 and 2005 do not represent significant credit risks as they are dispersed across many counterparties. Counterparties to Brigham’s oil and natural gas financial hedges are investment grade financial institutions.
13. Stock Based Compensation
Brigham adopted SFAS 123R using the modified prospective method. Under this transition method, compensation cost recognized includes the cost for all stock based compensation granted prior to, but not yet vested, as of January 1, 2006. This cost was based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. The cost for all stock based awards granted subsequent to January 1, 2006, was based on the grant date fair value that was estimated in accordance with the provisions of SFAS 123R. The maximum contractual life of stock based awards is seven years and the historical forfeiture rate used to estimate forfeitures prospectively is 14.5%. At adoption of SFAS 123R, Brigham elected to amortize newly issued and existing granted awards on a straight-line basis over the requisite service period including estimates of pre-vesting forfeiture rates. If actual forfeitures differ from the estimates, additional adjustments to compensation expense may be required in future periods. Unearned stock compensation recorded under APB 25 of $2.3 million was eliminated and additional paid-in capital was reduced by a like amount on the consolidated balance sheet and consolidated statements of stockholders’ equity, in accordance with SFAS 123R. Results for prior periods have not been restated.
The estimated fair value of the options granted during 2006 and prior periods was calculated using a Black-Scholes Merton option pricing model (Black-Scholes). The following table summarizes the weighted average assumptions used in the Black-Scholes model:
The Black-Scholes model incorporates assumptions to value stock based awards. The risk-free rate of interest for periods within the contractual life of the option is based on a zero-coupon U.S. government instrument over the contractual term of the equity instrument. Expected volatility is based on the historical volatility of Brigham’s stock for an equal period of the expected term. The expected life is determined using the contractual life and vesting term in accordance with the guidance in Staff Accounting Bulletin No. 107 for using the “simplified” method for “plain vanilla” options.
In November 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position No. FAS 123R-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards.” Brigham elected to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects of stock based compensation pursuant to SFAS 123R. The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (APIC pool) related to the tax effects of employee stock based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee stock based compensation awards that are outstanding upon adoption of SFAS 123R.
Prior to the adoption of SFAS 123R, Brigham presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Consolidated Statement of Cash Flows. SFAS 123R requires the cash flow resulting from the tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. Brigham did not have any excess tax benefits during 2006.
Had compensation cost for Brigham's stock options been determined based on the fair market value at the grant dates of the awards consistent with the methodology prescribed by SFAS 123, as amended by SFAS 148, Brigham's net income and net income per share for the years ended December 31, 2005 and 2004 would have been the pro forma amounts as indicated below (in thousands, except per share amounts):
Prior to January 1, 2006, Brigham’s stock compensation expense largely consisted of the amortization of unearned stock compensation due to unvested (restricted) stock, in accordance with APB 25. The following table summarizes the components of stock based compensation included in general and administrative expense (in thousands):
The adoption of SFAS 123R did not impact basic and diluted net income per share for the year ended December 31, 2006
Brigham provides an incentive plan for the issuance of stock options, stock appreciation rights, stock, restricted stock, cash or any combination of the foregoing. The objective of this plan is to provide incentive and reward key employees whose performance may have a significant impact on the success of Brigham. It is Brigham’s policy to use unissued shares of stock when stock options are exercised. The number of shares available under the plan is equal to the lesser of 5,915,414 or 15% of the total number of shares of common stock outstanding. At December 31, 2006, approximately 940,420 shares remain available for grant under the current incentive plan. The Compensation Committee of the Board of Directors determines the type of awards made to each participant and the terms, conditions and limitations applicable to each award. Except for one stock option grant, options granted subsequent to March 4, 1997 have an exercise price equal to the fair market value of Brigham’s common stock on the date of grant, vest over five years and have a contractual life of seven years.
Brigham also maintains a director stock option plan under which stock options are awarded to non-employee directors. Options granted under this plan have an exercise price equal to the fair market value of Brigham common stock on the date of grant and vest over five years. Stockholders have authorized the issuance of 430,000 shares to non-employee directors and approximately 2,300 remain available for grant under the director stock option plan.
The following table summarizes option activity under the incentive plans for each of the three years ended December 31, 2006:
The weighted-average grant-date fair value of share options granted during the years ended December 31, 2006, 2005, and 2004 was $3.33, $4.78, and $3.31, respectively. The total intrinsic value of options exercised during the years ended December 31, 2006, 2005 and 2004 was $401,667, $2.3 million, and $1.5 million, respectively
The following table summarizes information about stock options outstanding at December 31, 2006:
The aggregate intrinsic value of options outstanding and exercisable at December 31, 2006 was $3.5 million and $2.4 million, respectively. The aggregate intrinsic value represents the total pre-tax value (the difference between Brigham’s closing stock price on the last trading day of 2006 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on December 31, 2006. The amount of aggregate intrinsic value will change based on the fair market value of Brigham’s stock.
As of December 31, 2006 there was approximately $5.9 million of total unrecognized compensation expense related to unvested stock based compensation plans. This compensation expense is expected to be recognized, net of forfeitures, on a straight-line basis over the remaining vesting period of approximately 3.3 years.
Restricted Stock
During the years ended December 31, 2006 and 2005, Brigham issued 129,595 and 137,650, respectively, restricted shares of common stock as compensation to officers and employees of Brigham. The restricted shares vest over five years or cliff-vest at the end of five years. As of December 31, 2006, there was approximately $2.3 million of total unrecognized compensation expense related to unvested restricted stock. This compensation expense is expected to be recognized, net of forfeitures, over the remaining weighted average vesting period of approximately 2.3 years. Brigham had previously assumed a zero percent forfeiture rate for restricted stock. During 2006, stock compensation expense related to unvested restricted stock was adjusted to recognize actual forfeitures during the year as they occurred. Brigham has assumed a 6% weighted average forfeiture rate for restricted stock to be used prospectively at December 31, 2006. If actual forfeitures differ from the estimates, additional adjustments to compensation expense may be required in future periods.
The following table reflects the outstanding restricted stock awards and activity related thereto for the years ended December 31:
14. Employee Benefit Plans
Brigham has adopted a defined contribution 401(k) plan for substantially all of its employees. The plan provides for Brigham matching of employee contributions to the plan, at Brigham’s discretion. During 2006, 2005 and 2004, Brigham provided a base match equal to 25% of eligible employee contributions. Based on attainment of performance goals established at the beginning of each fiscal year, Brigham matched an additional 45%, 41%, and 25.25% of eligible employee contributions made during 2006, 2005 and 2004, respectively. Brigham contributed approximately $230,000, $303,000, and $204,000 to the 401(k) plan for the years ended December 31, 2006, 2005 and 2004, respectively, to match eligible contributions by employees
15. Related Party Transactions
During the years ended December 31, 2006, 2005, and 2004, Brigham incurred costs of approximately $4.1 million, $2.3 million and $2.9 million, respectively, in fees for land acquisition services performed by a company owned by a brother of Brigham’s Chairman, President and Chief Executive Officer and its Executive Vice President - Land and Administration. Other participants in Brigham’s 3-D seismic projects reimbursed Brigham for a portion of these amounts. At December 31, and 2005, Brigham had a liability recorded in accounts payable of approximately $300 and $25,000, respectively, related to services performed by this company.
Mr. Harold Carter, a director of Brigham, served as a consultant to Brigham on various aspects of its business and strategic issues. Fees paid for these services by Brigham were approximately $30,000 for each the years ended December 31, 2006, 2005, and 2004. Additional payments totaling approximately $12,000 were made during each of the years ended December 31, 2006, 2005, and 2004, for the reimbursement of certain expenses. At December 31, 2006 and 2005, there were no payables related to these services recorded by Brigham.
From time to time, in the normal course of business, Brigham has engaged a drilling company in which Mr. Steven Webster, one of Brigham’s current directors, owns stock and serves on the board of directors. There were no payments to the drilling company during 2006. Total payments to the drilling company during and 2004 were $3.5 million, and $3.5 million, respectively. Brigham did not owe the drilling company any amounts at December 31, 2006 and 2005. Brigham owed the drilling company approximately $0.7 million at December 31, 2004. At December 31, 2006, there were no short-term accounts receivable from Mr. Webster. At December 31, 2005, and 2004, Brigham had short-term accounts receivable from Mr. Webster of approximately $1,500 and $2,200, respectively. These receivables represent the director’s share of costs related to his working interest ownership in the Staubach #1, Burkhart #1R and Matthes-Huebner #1 wells that are operated by Brigham. Mr. Webster obtained his interest in these wells through an exploration and production company, Carrizo, that is not affiliated with Brigham. Mr. Webster was a co-founder of Carrizo and is currently chairman of Carrizo’s board of directors. At December 31, 2006, 2005, and 2004, Carrizo owed Brigham $71,000, $175,000, and $114,000, respectively, for exploration and production activities. Brigham had no accounts payable owed to Carrizo at December 31, 2006. Brigham owed Carrizo $20,000 and $0 at December 31, 2005 and 2004, respectively. Mr. Webster is also chairman of the board of directors for a well services company that Brigham made payments totaling approximately $1.1 million and $560,000 during 2006 and 2005. Brigham had no accounts payable owed to the well services company at December 31, 2006. Brigham owed the well services company approximately $43,000 at December 31, 2005.
From time to time, in the normal course of business, Brigham has engaged a service company in which Mr. Hobart Smith, one of Brigham’s current directors, owns stock and serves as a consultant. Total payments to the service company during 2006, and 2004 were $1.9 million, $1.2 million, and $1 million, respectively. At December 31, 2006, 2005, and 2004, Brigham owed the service company approximately $77,000, $61,000, and $132,000, respectively.
16. Supplemental Cash Flow Information
Supplemental cash flow information consists of the following (in thousands):
17. Other Assets and Liabilities
Other current assets consist of the following (in thousands):
Other current liabilities consist of the following (in thousands):
BRIGHAM EXPORATION COMPANY
SUPPLEMENTAL OIL AND GAS INFORMATION (UNAUDITED)
Oil and Natural Gas Exploration and Production Activities
Oil and natural gas sales reflect the market prices of net production sold or transferred with appropriate adjustments for royalties, net profits interest and other contractual provisions. Lease operating expenses include lifting costs incurred to operate and maintain productive wells and related equipment including such costs as operating labor, repairs and maintenance, materials, supplies and fuel consumed. Production taxes include production and severance taxes. Depletion of oil and natural gas properties relates to capitalized costs incurred in acquisition, exploration and development activities. Results of operations do not include interest expense and general corporate amounts.
Costs Incurred and Capitalized Costs
The costs incurred in oil and natural gas acquisition, exploration and development activities follow (in thousands):
Excluded costs for prospects are accumulated by year. Costs are reflected in the full cost pool as the drilling program is executed or as costs are evaluated and deemed impaired. Brigham anticipates these excluded costs will be included in the depletion computation over the next five years. Brigham is unable to predict the future impact on depletion rates. The following is a summary of capitalized costs (in thousands) excluded from depletion at December 31, 2006 by year incurred.
Oil and Natural Gas Reserves and Related Financial Data
Information with respect to Brigham’s oil and natural gas producing activities is presented in the following tables. Reserve quantities, as well as certain information regarding future production and discounted cash flows, were determined by Brigham’s independent petroleum consultants, Cawley, Gillespie and Associates, Inc.
Oil and Natural Gas Reserve Data
The following tables present Brigham’s independent petroleum consultants’ estimates of its proved oil and natural gas reserves. Brigham emphasizes reserves are approximates and are expected to change as additional information becomes available. Reservoir engineering is a subjective process of estimating underground accumulations of oil and natural gas that cannot be measured in an exact way, and the accuracy of any reserve estimate is a function of the quality of available data and of engineering and geological interpretation and judgment.
Proved reserves are estimated quantities of natural gas and crude oil, which geological and engineering data indicate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved developed reserves are proved reserves that can be expected to be recovered through existing wells with existing equipment and operating methods.
Standardized Measure of Discounted Future Net Cash Inflows and Changes Therein
The following table presents a standardized measure of discounted future net cash inflows (in thousands) relating to proved oil and natural gas reserves. Future cash flows were computed by applying year-end prices of oil and natural gas relating to Brigham’s proved reserves to the estimated year-end quantities of those reserves. Future price changes were considered only to the extent provided by contractual agreements in existence at year-end. Future production and development costs were computed by estimating those expenditures expected to occur in developing and producing the proved oil and natural gas reserves at the end of the year, based on year-end costs. Actual future cash inflows may vary considerably, and the standardized measure does not necessarily represent the fair value of Brigham’s oil and natural gas reserves.
Year-end spot prices were adjusted to reflect applicable transportation and quality differentials on a well-by-well basis to arrive at realized sales prices used to estimate Brigham’s reserves. The sales prices for Brigham’s reserve estimates were as follows:
Changes in the future net cash inflows discounted at 10% per annum follow (in thousands):
BRIGHAM EXPLORATION COMPANY
SUPPLEMENTAL QUARTERLY FINANCIAL INFORMATION
Quarterly Financial Data (Unaudited)
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*
Management contract or compensatory plan.
†
Filed herewith.