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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

 

(Mark One)

 

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

 

For the quarterly period ended March 31, 2013

 

OR

 

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

 

For the transition period from                     to

 

Commission File Number 333-183815

 

 

EP Energy LLC

(Exact Name of Registrant as Specified in Its Charter)

 

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Delaware		45-4871021
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)
1001 Louisiana Street Houston, Texas		77002
(Address of Principal Executive Offices)		(Zip Code)

 

Telephone Number: (713) 997-1200

Internet Website: www.epenergy.com

 

 

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

 

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

 

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

 

Large accelerated filer  o		Accelerated filer  o
Non-accelerated filer  x		Smaller reporting company  o
(Do not check if a smaller reporting company)

 

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

 

 

Table of Contents

 

EP ENERGY LLC

TABLE OF CONTENTS

 

Caption			Page
	PART I — FINANCIAL INFORMATION
Item 1.	Financial Statements		2
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		24
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		34
Item 4.	Controls and Procedures		35
	PART II — OTHER INFORMATION
Item 1.	Legal Proceedings		35
Item 1A.	Risk Factors		35
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		35
Item 3.	Defaults Upon Senior Securities		35
Item 4.	Mine Safety Disclosures		35
Item 5.	Other Information		35
Item 6.	Exhibits		36
Signatures			37

 

Below is a list of terms that are common to our industry and used throughout this document:

 

/d	=	per day
Bbl	=	Barrel
Boe	=	barrel of oil equivalent
CBM	=	Coal bed methane
Mboe	=	thousand barrels of oil equivalent
MBbls	=	thousand barrels
Mcf	=	thousand cubic feet
MMBtu	=	million British thermal units
MMcf	=	million cubic feet
NGL	=	natural gas liquids
TBtu	=	trillion British thermal units

 

When we refer to oil and natural gas in “equivalents,” we are doing so to compare quantities of oil with quantities of natural gas or to express these different commodities in a common unit. In calculating equivalents, we use a generally recognized standard in which one Bbl of oil is equal to six Mcf of natural gas. Also, when we refer to cubic feet measurements, all measurements are at a pressure of 14.73 pounds per square inch.

 

When we refer to “us”, “we”, “our”, “ours”, “the company” or “EP Energy”, we are describing EP Energy and/or our subsidiaries.

 

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CAUTIONARY STATEMENTS FOR PURPOSES OF THE “SAFE HARBOR” PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

 

We have made statements in this document that constitute forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements include information concerning possible or assumed future results of operations. The words “believe,” “expect,” “estimate,” “anticipate” and similar expressions will generally identify forward-looking statements. These statements may relate to information or assumptions about:

 

·                   capital and other expenditures;

 

·                   financing plans;

 

·                   capital structure;

 

·                   liquidity and cash flow;

 

·                   pending legal proceedings, claims and governmental proceedings, including environmental matters;

 

·                   future economic and operating performance;

 

·                   operating income;

 

·                   management’s plans; and

 

·                   goals and objectives for future operations.

 

Forward-looking statements are subject to risks and uncertainties. While we believe the assumptions or bases underlying the forward-looking statements are reasonable and are made in good faith, we caution that assumed facts or bases almost always vary from actual results, and these variances can be material, depending upon the circumstances. We cannot assure you that the statements of expectation or belief contained in our forward-looking statements will result or be achieved or accomplished. Important factors that could cause actual results to differ materially from estimates or projections contained in our forward-looking statements are described in our 2012 Annual Report on Form 10-K. There have been no material changes to the risk factors described in the Form 10-K.

 

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PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

EP ENERGY LLC
CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In millions)

(Unaudited)

 

		Successor				Predecessor
		Quarter ended March 31,				Quarter ended  March 31,
		2013				2012
Operating Revenues
Oil and condensate		$	280			$	209
Natural gas		159				182
NGL		19				17
Financial derivatives		(131		)		76
Total operating revenues		327				484
Operating expenses
Transportation costs		29				25
Lease operating expense		64				62
General and administrative		63				44
Depreciation, depletion and amortization		149				201
Ceiling test charges		—				62
Exploration expense		14				—
Taxes, other than income taxes		31				28
Total operating expenses		350				422
Operating (loss) income		(23		)		62
Earnings (loss) from unconsolidated affiliates		2				(3		)
Other income		1				1
Loss on extinguishment of debt		(1		)		—
Interest expense		(84		)		(4		)
(Loss) income before income taxes		(105		)		56
Income tax expense		1				41
Net (loss) income		$	(106	)		$	15

 

See accompanying notes.

 

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EP ENERGY LLC
CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME

(In millions)

(Unaudited)

 

		Successor				Predecessor
		Quarter ended March 31,				Quarter ended  March 31,
		2013				2012
Net (loss) income		$	(106	)		$	15
Cash flow hedging activities:
Reclassification adjustment (1)		—				2
Comprehensive (loss) income		$	(106	)		$	17

(1)              Reclassification adjustment is stated net of tax. Taxes recognized for the predecessor period are $1 million.

 

See accompanying notes.

 

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EP ENERGY LLC

CONDENSED CONSOLIDATED BALANCE SHEETS

(In millions)

(Unaudited)

 

		March 31, 2013			December 31, 2012
ASSETS
Current assets
Cash and cash equivalents		$	71		$	63
Accounts receivable
Customer, net of allowance of less than $1 in 2013 and 2012		248			226
Other, net of allowance of $1 for 2013 and 2012		16			21
Materials and supplies		23			22
Derivative instruments		30			108
Prepaid assets		39			20
Other		1			4
Total current assets		428			464
Property, plant and equipment, at cost
Oil and natural gas properties		7,952			7,533
Other property, plant and equipment		109			103
		8,061			7,636
Less accumulated depreciation, depletion and amortization		424			266
Total property, plant and equipment, net		7,637			7,370
Other assets
Investments in unconsolidated affiliates		220			226
Derivative instruments		67			88
Deferred income taxes		6			6
Unamortized debt issue cost		129			134
Other		12			5
		434			459
Total assets		$	8,499		$	8,293

 

See accompanying notes.

 

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EP ENERGY LLC

CONDENSED CONSOLIDATED BALANCE SHEETS

(In millions)

(Unaudited)

 

		March 31, 2013			December 31, 2012
LIABILITIES AND EQUITY
Current liabilities
Accounts payable
Trade		$	128		$	126
Other		359			358
Derivative instruments		70			17
Accrued taxes other than income		30			23
Accrued interest		108			57
Accrued taxes		17			19
Asset retirement obligations		10			10
Other accrued liabilities		19			48
Total current liabilities		741			658
Long-term debt		4,556			4,346
Other long-term liabilities
Derivative instruments		21			14
Asset retirement obligations		183			180
Other		12			10
Total non-current liabilities		4,772			4,550
Commitments and contingencies (Note 8)
Member’s equity		2,986			3,085
Total liabilities and equity		$	8,499		$	8,293

 

See accompanying notes.

 

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EP ENERGY LLC
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions)
(Unaudited)

 

		Successor				Predecessor
		Quarter ended March 31,				Quarter ended March 31,
		2013				2012
Cash flows from operating activities
Net (loss) income		$	(106	)		$	15
Adjustments to reconcile net (loss) income to net cash from operating activities
Depreciation, depletion and amortization		149				201
Deferred income tax expense		—				41
(Earnings) loss from unconsolidated affiliates, adjusted for cash distributions		6				11
Ceiling test charges		—				62
Loss on extinguishment of debt		1				—
Amortization of equity compensation expense		7				—
Non-cash portion of exploration expense		12				—
Amortization of debt issuance cost		5				—
Asset and liability changes
Accounts receivable		(18		)		25
Accounts payable		16				(19		)
Derivative instruments		159				6
Accrued interest		52				—
Other asset changes		(24		)		(3		)
Other liability changes		(25		)		(2		)
Net cash provided by operating activities		234				337
Cash flows from investing activities
Capital expenditures		(444		)		(410		)
Net proceeds from the sale of assets		10				5
Cash paid for acquisitions, net of cash acquired		—				(1		)
Net cash used in investing activities		(434		)		(406		)
Cash flows from financing activities
Proceeds from long term debt		390				175
Repayment of long term debt		(180		)		(65		)
Debt issuance costs		(2		)		—
Net cash provided by financing activities		208				110
Change in cash and cash equivalents		8				41
Cash and cash equivalents
Beginning of period		63				25
End of period		$	71			$	66

 

See accompanying notes

 

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EP ENERGY LLC

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

(In millions)

(Unaudited)

 

		Total Member’s Equity
Balance at December 31, 2012		$	3,085
Equity compensation expense		7
Net loss		(106		)
Balance at March 31, 2013		$	2,986

 

See accompanying notes.

 

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EP ENERGY LLC
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 

1. Basis of Presentation and Significant Accounting Policies

 

Basis of Presentation

 

EP Energy LLC (the successor and formerly known as Everest Acquisition LLC) was formed as a Delaware limited liability company on March 23, 2012 by Apollo Global Management LLC (Apollo) and other private equity investors (collectively, the Sponsors). On April 24, 2012, we issued approximately $2.75 billion in private placement notes.  Proceeds from these notes, along with other sources, were used by the Sponsors to acquire EP Energy Global LLC (formerly known as EP Energy Corporation and EP Energy, L.L.C. after its conversion into a Delaware limited liability company) and subsidiaries for approximately $7.2 billion on May 24, 2012, from El Paso Corporation (El Paso) following its merger with Kinder Morgan, Inc. (KMI). We are engaged in the exploration for and the acquisition, development, and production of oil, natural gas and NGL primarily in the United States, with international activities in Brazil. These entities constituted the oil and natural gas operations of El Paso prior to the Acquisition. Hereinafter, we refer to the transactions above as the Acquisition and the acquired entities are referred to as the predecessor for financial accounting and reporting purposes.

 

The condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles as it applies to interim financial statements. Because this is an interim period report presented using a condensed format, it does not include all of the disclosures required by United States generally accepted accounting principles. You should read this quarterly report along with our 2012 Annual Report on Form 10-K, which contains a summary of significant accounting policies and other disclosures. The financial statements as of March 31, 2013 and for each of the successor and predecessor periods presented are unaudited. The consolidated balance sheet as of December 31, 2012 has been derived from the audited balance sheet filed in our 2012 Annual Report on Form 10-K.  In our opinion, all adjustments which are of a normal, recurring nature to fairly present these interim period results are reflected. The results for any interim period are not necessarily indicative of the expected results for the entire year. Our disclosures in this Form 10-Q are an update to those provided in our 2012 Annual Report on Form 10-K.  The predecessor period reflects reclassifications to conform to EP Energy LLC’s financial statement presentation.

 

Significant Accounting Policies

 

There were no changes in significant accounting policies as described in the 2012 Annual Report on Form 10-K and no material accounting pronouncements issued but not yet adopted as of March 31, 2013.

 

2. Acquisitions and Divestitures

 

Acquisitions. On May 24, 2012, the Sponsors acquired all of the equity of EP Energy Global LLC for approximately $7.2 billion. The Acquisition was funded with approximately $3.3 billion in equity contributions and the issuance of approximately $4.25 billion of debt. In conjunction with the sale, a portion of the proceeds were also used to repay approximately $960 million outstanding under predecessor’s revolving credit facility at that time. See Note 7 for an additional discussion of debt.

 

The purchase transaction was accounted for under the acquisition method of accounting which requires, among other items, that assets and liabilities assumed be recognized on the balance sheet at their fair values as of the Acquisition date. Our consolidated balance sheet presented as of March 31, 2013, reflects our purchase price allocation based on available information to specific assets and liabilities assumed based on estimates of fair values and costs. There was no goodwill associated with the transaction.

 

Allocation of purchase price		May 24, 2012
		(In millions)
Current assets		$	587
Non-current assets		446
Property, plant and equipment		6,897
Current liabilities		(420		)
Non-current liabilities		(297		)
Total purchase price		$	7,213

 

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The unaudited pro forma information below for the quarter ended March 31, 2012 has been derived from the historical, consolidated financial statements and has been prepared as though the Acquisition occurred on January 1, 2012. The unaudited pro forma information does not purport to represent what our results of operations would have been if the Acquisition had occurred on such date.

 

		Quarter ended  March 31,
		2012
		(In millions)
Operating Revenues		$	484
Net Income		60

 

Divestitures. During the quarter ended March 31, 2013, we received approximately $10 million for the sale of domestic oil and natural gas properties.  No gain or loss was recorded on this sale.

 

3. Ceiling Test Charges

 

Prior to the Acquisition, the predecessor used the full cost method of accounting.  Under this method of accounting, the predecessor conducted quarterly ceiling tests of capitalized costs in each of the full cost pools. During the predecessor period ended March 31, 2012, the predecessor recorded a non-cash ceiling test charge of approximately $62 million as a result of the decision to exit exploration and development activities in Egypt. The charge related to unevaluated costs in that country and included approximately $2 million related to equipment.

 

4. Income Taxes

 

Effective Tax Rate.  For the quarter ended March 31, 2013, the effective tax rate is less than one percent, significantly lower than the statutory rate primarily due to the conversion in 2012 to a limited liability company treated as a partnership for federal and state income tax purposes. We continue to be subject to foreign income taxes on our Brazil operations. Prior to the Acquisition, the predecessor was party to a tax accrual policy with El Paso whereby they filed U.S. and certain state returns on the predecessor’s behalf. For the predecessor period ended March 31, 2012, the effective tax rate was 73 percent, significantly higher than the statutory rate primarily due to the impact of a ceiling test charge that did not have a corresponding tax benefit.

 

5. Financial Instruments

 

The following table presents the carrying value and fair value of our financial instruments:

 

		March 31, 2013						December 31, 2012
		Carrying Amount			Fair Value			Carrying Amount			Fair Value
		(In millions)
Long-term debt		$	4,556		$	4,992		$	4,346		$	4,690
Derivative instruments		$	6		$	6		$	165		$	165

 

As of March 31, 2013 and December 31, 2012, the carrying amounts of cash and cash equivalents, accounts receivable and accounts payable represent fair value because of the short-term nature of these instruments. We hold long term debt obligations (see Note 7) with various terms. We estimated the fair value of debt (representing a Level 2 fair value measurement) primarily based on quoted market prices for the same or similar issuances, including consideration of our credit risk related to those instruments.

 

Oil and natural gas derivative instruments.  We attempt to mitigate a portion of our commodity price risk and stabilize cash flows associated with forecasted sales of oil and natural gas production through the use of oil and natural gas swaps, basis swaps and option contracts. As of March 31, 2013 and December 31, 2012, we had total derivative contracts related to 34,075 MBbl and 34,232 MBbl of oil and 281 TBtu and 276 TBtu of natural gas, respectively. None of these contracts are designated as accounting hedges.

 

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Interest Rate Derivative Instruments . During July 2012, we entered into interest rate swaps with a notional amount of $600 million that are intended to reduce variable interest rate risk related to our LIBOR based loans. These interest rate derivative instruments started in November 2012 and extend through April 2017. For the quarter ended March 31, 2013 we recorded $1 million in interest expense related to the change in fair market value and cash settlements of our interest rate derivative instruments.

 

Fair Value Measurements.  We use various methods to determine the fair values of our financial instruments. The fair value of a financial instrument depends on a number of factors, including the availability of observable market data over the contractual term of the underlying instrument. We separate the fair values of our financial instruments into three levels (Levels 1, 2 and 3) based on our assessment of the availability of observable market data and the significance of non-observable data used to determine fair value.  As of March 31, 2013 and December 31, 2012, all of our financial instruments were classified as Level 2. Our assessment of an instrument within a level can change over time based on the maturity or liquidity of the instrument, which could result in a change in the classification of our financial instruments between other levels.

 

Financial Statement Presentation.   The following table presents the fair value associated with derivative financial instruments as of March 31, 2013 and December 31, 2012. All of our derivative instruments are subject to master netting arrangements which provide for the unconditional right of offset for all derivative assets and liabilities with a given counterparty in the event of default. We present assets and liabilities related to these instruments in our balance sheets as either current or non-current assets or liabilities based on their anticipated settlement date, net of the impact of master netting agreements.  On certain derivative contracts recorded as assets in the table below we are exposed to the risk that our counterparties may not perform.

 

		Level 2
		March 31, 2013			December 31, 2012
		(In millions)
Assets
Oil and natural gas derivative instruments		$	165		$	231
Interest rate derivative instruments		—			4
Impact of master netting arrangements		(68		)	(39		)
Total derivative assets (1)		97			196
Liabilities
Oil and natural gas derivative instruments		(157		)	(64		)
Interest rate derivative instruments		(2		)	(6		)
Impact of master netting arrangements		68			39
Total derivative liabilities (1)		(91		)	(31		)
Total		$	6		$	165

 

(1)   As of March 31, 2013 total derivative instruments include $30 million in current assets, $67 million in non-current assets, $70 million in current liabilities and $21 million in non-current liabilities on our balance sheet.  As of December 31, 2012 total derivative instruments include $108 million in current assets, $88 million in non-current assets, $17 million in current liabilities and $14 million in non-current liabilities on our balance sheet.

 

The following table presents realized and unrealized net gains and losses on financial oil and gas derivative instruments presented in operating revenues and dedesignated cash flow hedges of the predecessor included in accumulated other comprehensive income (in millions):

 

		Successor				Predecessor
		Quarter ended March 31,				Quarter ended March 31,
		2013				2012
Realized and unrealized (losses) gains		$	(131	)		$	76
Accumulated other comprehensive income		—				(3		)

 

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6.  Property, Plant, and Equipment

 

Unproved oil and natural gas properties .  As of December 31, 2012 and March 31, 2013, we had $2.3 billion and $2.0 billion of unproved oil and natural gas properties on our balance sheet primarily a result of the allocation of the purchase price in conjunction with the Acquisition. The reduction is largely attributable to transferring approximately $0.28 billion from unproved properties to proved properties.  As of March 31, 2013 we recorded $12 million of amortization of unproved leasehold costs in exploration expense in our income statement.  Suspended well costs were not material as of March 31, 2013.

 

Impairments Assessment .  Subsequent to the Acquisition, we applied the successful efforts method of accounting and evaluate capitalized costs related to proved properties at least annually or upon a triggering event to determine if impairment of such properties is necessary.  During the first quarter of 2013, no impairments of our oil and natural gas properties were recorded.  Forward commodity prices can play a significant role in determining impairments. Due to the current forecast of future natural gas prices and considering the significant amount of fair value allocated to our oil and natural gas properties in conjunction with the Acquisition, sustained lower oil and natural gas prices from present levels could result in an impairment of the carrying value of our proved properties in the future.

 

Asset Retirement Obligations.  We have legal asset retirement obligations associated with the retirement, replacement, or removal of our oil and natural gas wells and related infrastructure. We incur these obligations when production on those wells is exhausted, when we no longer plan to use them or when we abandon them. We accrue these obligations when we can estimate the timing and amount of their settlement. In estimating our liability, we utilize several assumptions, including a credit-adjusted risk-free rate of 7 percent and a projected inflation rate of 2.5 percent. The net asset retirement liability is reported on our balance sheet in other current and non-current liabilities.  Changes in the net liability from December 31, 2012 through March 31, 2013 were as follows:

 

		2013
		(In millions)
Net asset retirement liability at January 1		$	190
Liabilities settled		(1		)
Property sales		(1		)
Accretion expense		3
Liabilities incurred		2
Net asset retirement liability at March 31		$	193

 

Capitalized Interest.   Interest expense is reflected in our financial statements net of capitalized interest. Capitalized interest for the successor period ended March 31, 2013 was $5 million. Capitalized interest for the predecessor period ended March 31, 2012 was $3 million.

 

7. Long Term Debt

 

Listed below are our debt obligations as of March 31:

 

		Interest Rate		March 31, 2013
				(In millions)
$2.5 billion RBL credit facility - due May 24, 2017		Variable		$	315
$750 million term loan - due April 24, 2018 (1) (3)		Variable		742
$400 million senior secured term loan - due April 30, 2019 (2) (3)		Variable		399
$750 million senior secured note - due May 1, 2019 (3)		6.875%		750
$2.0 billion senior unsecured note - due May 1, 2020		9.375%		2,000
$350 million senior unsecured note - due September 1, 2022		7.75%		350
Total				$	4,556

(1)	The Term Loan was issued at 99 percent of par and carries a specified margin over the LIBOR of 4.00%, with a minimum LIBOR floor of 1.00%. As of March 31, 2013 the effective interest rate of the note was 5.00%. In May 2013, we entered into an agreement to reprice our term loan which will carry a specified margin over the LIBOR of 2.75%, with a minimum LIBOR floor of 0.75% over the remaining life of the term loan.
(2)	The Term Loan carries a specified margin over the LIBOR of 3.50%, with a minimum LIBOR floor of 1.00%.
(3)	The term loans and secured notes are secured by a second priority lien on all of the collateral securing the RBL credit facility, and effectively rank junior to any existing and future first lien secured indebtedness of the Company.

 

During the first quarter of 2013, we amortized $5 million of deferred financing costs in interest expense.  As of March 31, 2013 we have $129 million remaining in deferred financing costs.

 

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$2.5 Billion Reserve-based Loan (RBL). After completing our borrowing base redetermination in March 2013, we increased our $2 billion RBL credit facility to a $2.5 billion facility.  Under this RBL facility, we can borrow funds or issue letters of credit (LCs) and as of March 31, 2013, we had a $2.5 billion RBL borrowing base, $315 million of outstanding borrowings, and approximately $9 million of letters of credit issued, leaving $2.18 billion of remaining capacity. During the quarter ended March 31, 2013, we borrowed an additional $210 million under the RBL Facility.  As of May 8, 2013, we had $515 million of outstanding borrowings under our RBL Facility.

 

Our credit facility is collateralized by certain of our oil and natural gas properties and as noted has a borrowing base subject to semi-annual redetermination if there is a downward revision or a reduction of our oil and natural gas reserves due to future declines in commodity prices, performance revisions, sales of assets or otherwise, if certain other additional debt is incurred.  A reduction in our borrowing base could negatively impact our ability to borrow funds from such facilities in the future.  For a further discussion of our credit facility see our 2012 Annual Report on Form 10-K.

 

Guarantees.   Our obligations under the RBL, term loan, secured and unsecured notes are fully and unconditionally guaranteed, jointly and severally, by the Company’s present and future direct and indirect wholly owned material domestic subsidiaries. Our foreign wholly-owned subsidiaries are not guarantors. As of March 31, 2013, foreign subsidiaries that do not guarantee the unsecured notes held approximately 2% of our consolidated assets and had no outstanding indebtedness, excluding intercompany obligations. For the quarter ended March 31, 2013 these non-guarantor subsidiaries generated approximately 8% of our revenue including the impacts of financial derivative instruments. We have provided consolidating financial statements which include the separate results of our guarantor and non-guarantor subsidiaries in Note 12.

 

Restrictive Provisions/Covenants.   The availability of borrowings under our credit agreements and our ability to incur additional indebtedness is subject to various financial and non-financial covenants and restrictions. There have been no significant changes to our restrictive covenants, and as of March 31, 2013, we were in compliance with all of our debt covenants. For a further discussion of our credit facilities and restrictive covenants, see our 2012 Annual Report on Form 10-K.

 

8. Commitments and Contingencies

 

Legal Proceedings and Other Contingencies

 

We and our subsidiaries and affiliates are named defendants in numerous legal proceedings that arise in the ordinary course of our business. There are also other regulatory rules and orders in various stages of adoption, review and/or implementation. For each of these matters, we evaluate the merits of the case or claim, our exposure to the matter, possible legal or settlement strategies and the likelihood of an unfavorable outcome. If we determine that an unfavorable outcome is probable and can be estimated, we establish the necessary accruals. While the outcome of these matters cannot be predicted with certainty and there are still uncertainties related to the costs we may incur, based upon our evaluation and experience to date, we believe we have established appropriate reserves. It is possible, however, that new information or future developments could require us to reassess our potential exposure related to these matters and adjust our accruals accordingly, and these adjustments could be material. As of March 31, 2013, we had approximately $18 million accrued for all outstanding legal proceedings and other contingent matters, including a reserve related to an audit of sales and use taxes in the State of Texas.

 

Brazil Labor Claim.   In Brazil, one of our subsidiaries as well as a formerly affiliated party have been named in a lawsuit by a former contractor of the former affiliated party claiming entitlement to certain employee benefits under Brazilian law.  The case is currently pending before the 42 nd  Labor Court of the State of Rio de Janeiro. We are currently unable to estimate a range of reasonably possible loss, if any, primarily due to the early stages of the proceedings and the novelty of the legal claims being presented.

 

Sales Tax Audits. As a result of sales and use tax audits during 2010, the state of Texas has asserted additional taxes plus penalties and interest for the audit period 2001-2008 for two of our operating entities.  We are indemnified by KMI if and to the extent the ultimate outcomes exceed the reserves.  During 2012 we settled one of our Texas sales and use tax audits for $3 million, including fees. We are currently contesting the remaining assessment and the ultimate outcome is still uncertain. We believe amounts reserved are adequate.

 

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Environmental Matters

 

We are subject to existing federal, state and local laws and regulations governing environmental air, land and water quality.  The environmental laws and regulations to which we are subject also require us to remove or remedy the effect on the environment of the disposal or release of specified substances at current and former operating sites. As of March 31, 2013, we had accrued less than $1 million for related environmental remediation costs associated with onsite, offsite and groundwater technical studies and for related environmental legal costs. Our accrual represents a combination of two estimation methodologies. First, where the most likely outcome can be reasonably estimated, that cost has been accrued. Second, where the most likely outcome cannot be estimated, a range of costs is established and if no one amount in that range is more likely than any other, the lower end of the expected range has been accrued. Our exposure could be as high as $1 million.  Our environmental remediation projects are in various stages of completion. The liabilities we have recorded reflect our current estimates of amounts that we will expend to remediate these sites. However, depending on the stage of completion or assessment, the ultimate extent of contamination or remediation required may not be known. As additional assessments occur or remediation efforts continue, we may incur additional liabilities.

 

Climate Change and other Emissions .  The EPA and several state environmental agencies have adopted regulations to regulate greenhouse gas (GHG) emissions. Although the EPA has adopted a “tailoring” rule to regulate GHG emissions, at this time we do not expect a material impact to our existing operations. There have also been various legislative and regulatory proposals and final rules at the federal and state levels to address emissions from power plants and industrial boilers. Although such rules and proposals will generally favor the use of natural gas over other fossil fuels such as coal, it remains uncertain what regulations will ultimately be adopted and when they will be adopted. In addition, any regulations regulating GHG emissions would likely increase our costs of compliance by potentially delaying the receipt of permits and other regulatory approvals; requiring us to monitor emissions, install additional equipment or modify facilities to reduce GHG and other emissions; purchase emission credits; and utilize electric-driven compression at facilities to obtain regulatory permits and approvals in a timely manner .

 

Air Quality Regulations . In August 2010, the EPA finalized a rule that mandates emission reductions of hazardous air pollutants from reciprocating internal combustion engines that requires us to install emission controls on engines across our operations.  Certain amendments to this rule were finalized in January 2013. Engines subject to the regulations must comply by October 2013. We currently estimate to incur capital expenditures in 2013 to complete the required modifications and testing of less than $1 million.

 

In August 2012, EPA finalized New Source Performance Standard regulations to reduce various air pollutants from the oil and natural gas industry. These regulations will limit emissions from the hydraulic fracturing of certain natural gas wells and equipment including compressors, storage vessels and natural gas processing plants. EPA has recently proposed amendments to this rule, in part phasing in emission controls for storage vessels past current deadlines. We do not anticipate a material impact associated with compliance to these new requirements.

 

In the State of Utah we are currently obtaining or amending air quality permits for a number of small oil and natural gas production facilities. As part of this permitting process we anticipate the installation of tank emission controls that will require approximately $2 million capital expenditures starting in 2013 and extending through 2014.

 

Hydraulic Fracturing Regulations . We use hydraulic fracturing extensively in our operations. Various regulations have been adopted and proposed at the federal, state and local levels to regulate hydraulic fracturing operations. These regulations range from banning or substantially limiting hydraulic fracturing operations, requiring disclosure of the hydraulic fracturing fluids and requiring additional permits for the use, recycling and disposal of water used in such operations. In addition, various agencies, including the EPA, the Department of Interior and Department of Energy are reviewing changes in their regulations to address the environmental impacts of hydraulic fracturing operations. Until such regulations are implemented, it is uncertain what impact they might have on our operations.

 

Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) Matters. As part of our environmental remediation projects, we have received notice that we could be designated, or have been asked for information to determine whether we could be designated as a Potentially Responsible Party (PRP) with respect to the Casmalia Remediation site located in California under the CERCLA or state equivalents. As of March 31, 2013, we have estimated our share of the remediation costs at this site to be less than $1 million. Because the clean-up costs are estimates and are subject to revision as more information becomes available about the extent of remediation required, and in some cases we have asserted a defense to any liability, our estimates could change. Moreover, liability under the federal CERCLA statute may be joint and several, meaning that we could be required to pay in excess of our pro rata share of remediation costs. Our understanding of the financial strength of other PRPs has been considered, where appropriate, in estimating our liabilities. Accruals for these matters are included in the environmental reserve discussed above.

 

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It is possible that new information or future developments could require us to reassess our potential exposure related to environmental matters. We may incur significant costs and liabilities in order to comply with existing environmental laws and regulations. It is also possible that other developments, such as increasingly strict environmental laws, regulations, and orders of regulatory agencies, as well as claims for damages to property and the environment or injuries to employees and other persons resulting from our current or past operations, could result in substantial costs and liabilities in the future. As this information becomes available, or other relevant developments occur, we will adjust our accrual amounts accordingly. While there are still uncertainties related to the ultimate costs we may incur, based upon our evaluation and experience to date, we believe our reserves are adequate.

 

9. Long-Term Incentive Compensation

 

Our long term incentive (LTI) programs include a cash-based long term incentive program and certain long-term equity based programs established in conjunction with the Acquisition including Class A “matching units”, a “guaranteed cash bonus”, and management incentive units each of which are further described in our 2012 Annual Report on Form 10-K.  During the quarter ended March 31, 2013, we recorded approximately $13 million in expense related to all of these long-term incentive awards.  As of March 31, 2013, we had unrecognized compensation expense of $52 million related to our cash based long-term incentive awards, Class A “matching units”, and management incentive units.  We will recognize an additional $20 million related to these outstanding awards during the rest of 2013 and the remainder over the requisite service periods.  During April 2013 we granted additional cash-based LTI awards with a fair value of $21 million on the grant date that will be amortized on an accelerated basis over a three-year vesting period.

 

10. Investments in Unconsolidated Affiliates

 

We hold investments in two unconsolidated affiliates, Four Star Oil & Gas Company (Four Star) and Black Warrior Transmission Corporation, which we account for using the equity method of accounting. Our income statement reflects (i) our share of net earnings directly attributable to these unconsolidated affiliates, and (ii) other adjustments, such as the amortization of the excess of the carrying value of our investment relative to the underlying equity in the net assets of the entity. As of March 31, 2013 and December 31, 2012, our investment in unconsolidated affiliates was $220 million and $226 million, respectively. Included in these amounts was approximately $122 million and $125 million, respectively, related to the excess of the carrying value of our investment in Four Star relative to the underlying equity in its net assets.

 

Below is summarized financial information of the operating results of our unconsolidated affiliates.

 

		Successor				Predecessor
		Quarter ended March 31,				Quarter ended March 31,
		2013				2012
		(In millions)				(In millions)
Operating results:
Operating revenues		$	50			$	49
Operating expenses		34				37
Net income		9				7

 

We amortize the excess of our investment in Four Star over the underlying equity in its net assets using the unit-of-production method over the life of our estimate of Four Star’s oil and natural gas reserves which are predominantly natural gas reserves. Amortization of our investment for the successor period related to the quarter ended March 31, 2013 was $3 million. Amortization for the predecessor period related to the quarter ended March 31, 2012 was $8 million.  Four Star’s underlying reserves and production are predominantly natural gas. Changes in natural gas prices impact the fair value of our investment in Four Star, and sustained declines in natural gas prices could cause the fair value of our investment to decline which could require us to record an impairment of the carrying value of our investment in the future if that loss is determined to be other than temporary.

 

We received dividends from Four Star for the successor period ended March 31, 2013 and for the predecessor period ended March 31, 2012 of approximately $8 million, respectively.

 

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11. Related Party Transactions

 

Management Fee Agreement. We are subject to a management fee agreement with certain of our Sponsors for the provision of certain management consulting and advisory services which terminates on the twelve-year anniversary of the Acquisition date (May 24, 2012) if not terminated earlier by mutual agreement of the parties, or upon a change in control or specified initial public offering transaction. Under the agreement, we pay a non-refundable annual management fee of $25 million. For the quarter ended March 31, 2013, we recognized approximately $6 million in general and administrative expense related to management fees .

 

Affiliate Supply Agreement.  In November 2012, we entered into a supply agreement with an Apollo affiliate through October 2014 to provide certain fracturing materials for our Eagle Ford drilling operations.  As of March 31, 2013, we recorded approximately $21 million as capital expenditures for amounts provided under this agreement.

 

Related Party Transactions Prior to the Acquisition. Prior to the completion of the Acquisition, the predecessor entered into transactions during the ordinary course of conducting its business with affiliates of El Paso, primarily related to the sale, transportation and hedging of its oil, natural gas and NGL production. Additionally, El Paso billed the predecessor directly for certain general and administrative costs and allocated a portion of its general and administrative costs. The allocation was based on the estimated level of resources devoted to its operations and the relative size of its earnings before interest and taxes, gross property and payroll. These expenses were primarily related to management, legal, financial, tax, consultative, administrative and other services, including employee benefits, pension benefits, annual incentive bonuses, rent, insurance, and information technology. Prior to the Acquisition, El Paso also (i) billed the predecessor directly for compensation expense related to certain stock-based compensation awards granted directly to the predecessor’s employees, and allocated to the predecessor a proportionate share of El Paso’s corporate compensation expense (ii) filed consolidated U.S. federal and certain state tax returns which included the predecessor’s taxable income and (iii)  matched short-term cash surpluses and needs of our predecessor through its cash management program.   Other than continuing transition services agreements with KMI, all these agreements ceased on the date of the Acquisition.  The following table shows revenues and charges to/from affiliates for the following predecessor period:

 

		Predecessor
		Quarter ended March 31,
		2012
		(In millions)
Operating revenues		$	113
Operating expenses		28

 

12. Condensed Consolidating Financial Statements

 

As discussed in Note 7, our secured and unsecured notes are fully and unconditionally guaranteed, jointly and severally, by the Company’s present and future direct and indirect wholly-owned material domestic subsidiaries. Our foreign wholly-owned subsidiaries are not parties to the guarantees (the ‘‘Non-Guarantor Subsidiaries’’). The following reflects condensed consolidating financial information of the issuer, guarantor subsidiaries, non-guarantor subsidiaries, eliminating entries (to combine the entities) and consolidated results as of and for the same periods in our condensed consolidated financial statements presented herein.

 

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EP ENERGY LLC

CONDENSED CONSOLIDATING STATEMENT OF INCOME

FOR QUARTER ENDED MARCH 31, 2013

(In millions)

 

		Successor
		Issuer			Guarantor Subsidiaries			Non- Guarantor Subsidiaries			Eliminations			Consolidated
Operating Revenues
Oil and condensate		$	—		$	271		$	9		$	—		$	280
Natural gas		—			141			18			—			159
NGL		—			19			—			—			19
Financial derivatives		(131		)	—			—			—			(131		)
Total operating revenues		(131		)	431			27			—			327
Operating Expenses
Transportation costs		—			29			—			—			29
Lease operating expense		—			55			9			—			64
General and administrative		13			48			2			—			63
Depreciation, depletion and amortization		—			146			3			—			149
Exploration expense		—			14			—			—			14
Taxes, other than income taxes		—			28			3			—			31
Total operating expenses		13			320			17			—			350
Operating (loss) income		(144		)	111			10			—			(23		)
Earnings from unconsolidated affiliates		—			2			—			—			2
Other income		—			1			—			—			1
Loss on extinguishment of debt		(1		)	—			—			—			(1		)
Interest expense		(84		)	—			—			—			(84		)
(Loss) income before income taxes		(229		)	114			10			—			(105		)
Income tax expense		—			—			1			—			1
(Loss) income before earnings from consolidated subsidiaries		(229		)	114			9			—			(106		)
Earnings from consolidated subsidiaries		123			9			—			(132		)	—
Net (loss) income		$	(106	)	$	123		$	9		$	(132	)	$	(106	)

 

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EP ENERGY LLC

CONDENSED CONSOLIDATING STATEMENT OF INCOME

FOR QUARTER ENDED MARCH 31, 2012

(In millions)

 

		Predecessor
		Guarantor Subsidiaries			Non- Guarantor Subsidiaries			Eliminations			Consolidated
Operating Revenues
Oil and condensate		$	198		$	11		$	—		$	209
Natural gas		160			22			—			182
NGL		17			—			—			17
Financial derivatives		76			—			—			76
Total operating revenues		451			33			—			484
Operating Expenses
Transportation costs		25			—			—			25
Lease operating expense		51			11			—			62
General and administrative		40			4			—			44
Depreciation, depletion and amortization		193			8			—			201
Ceiling test charge		—			62			—			62
Taxes, other than income taxes		24			4			—			28
Total operating expenses		333			89			—			422
Operating (loss) income		118			(56		)	—			62
Loss from unconsolidated affiliates		(3		)	—			—			(3		)
Other income		—			1			—			1
Interest expense
Third party		(5		)	1			—			(4		)
Affiliated		1			(1		)	—			—
Income (loss) before income taxes		111			(55		)	—			56
Income tax expense		40			1			—			41
Income (loss) before earnings from consolidated subsidiaries		71			(56		)	—			15
Earnings from consolidated subsidiaries		(56		)	—			56			—
Net income		$	15		$	(56	)	$	56		$	15
Cash flow hedging activities:
Reclassification adjustments (1)		2			—			—			2
Comprehensive income		$	17		$	(56	)	$	56		$	17

 

(1)             Reclassification adjustment is stated net of tax. Taxes recognized for the predecessor period are $1 million.

 

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