Notes to Consolidated Financial Statements

Note 1 – Organization and Summary of Significant Accounting Policies

Nature of Business – Felix Energy Holdings II, LLC (the Company), a Delaware Limited Liability Company (LLC), was formed on August 28, 2015, for the purpose of acquiring, developing and operating oil and gas properties in the Permian Basin. As an LLC, the amount at risk for each individual member is limited to the amount of capital contributed to the LLC, and unless otherwise noted, the individual member’s liability for indebtedness of an LLC is limited to the member’s actual capital contribution.

In June 2017, the Company was conveyed to Felix Investments Holdings II, LLC (HoldCo). HoldCo is directly and indirectly owned 100% by Felix Energy Investments II, LLC (Investments). Prior to this conveyance, the Company was owned by Investments (99.9%) and Felix Energy II, Inc. (0.01%), a C Corporation, which was wholly owned by Investments.

The Company has the following wholly owned subsidiaries:

Basis of Presentation – The Company follows accounting standards established by the Financial Accounting Standards Board (FASB). The FASB sets accounting principles generally accepted in the United States of America (GAAP) to ensure consistent reporting of the Company’s financial condition, results of operations and cash flows. References to GAAP issued by the FASB in these footnotes are to the FASB Accounting Standards Codification (ASC or Codification).

Principles of Consolidation – The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries. In preparing the consolidated financial statements, all inter-company accounts and transactions have been eliminated.

Use of Estimates – The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of expenses during the reporting period. Actual results could differ from those estimates. Significant judgments and estimates include: estimates related to the oil and gas reserves held by the Company which directly impact the depletion calculation and fair value of the oil and gas properties, assignment of fair value and allocation of purchase price in connection with business combinations, valuation of derivative instruments, accrued revenue and related receivables and accrued liabilities.

Felix Energy Holdings II, LLC

Notes to Consolidated Financial Statements

Note 1 – Organization and Summary of Significant Accounting Policies (continued)

Cash and Restricted Cash – Cash and cash equivalents include cash on hand, amounts held in banks and highly liquid investments purchased with an original maturity of three months or less.

Accounts Receivable – The Company’s accounts receivable are generated from oil and gas sales and from joint interest owners on properties that the Company operates. The Company’s oil and gas receivables are typically collected within one to two months.

The Company accrues an allowance on a receivable when, based on the judgment of management, it is probable that a receivable will not be collected and the amount of any allowance may be reasonably estimated. For receivables from joint-interest owners, the Company usually has the ability to withhold future revenue disbursements to satisfy the outstanding balance. No allowance for bad debts has been recorded at December 31, 2018, or 2017.

Inventory – Inventory consists of pipe and supplies maintained to support the Company’s water and midstream infrastructure and is stated at the lower of cost (determined on a specific identification basis) or market. Management reviews inventory for items which are slow moving, damaged, or obsolete to provide for a valuation reserve. No reserve has been deemed necessary as of December 31, 2018, and 2017.

Oil and Gas Properties – The Company accounts for its oil and gas operations using the successful efforts method of accounting. Under this method, all costs associated with property acquisitions, successful exploratory wells and all development wells are capitalized, including interest on capital costs associated with the development of oil and gas properties during drilling and completion. Items charged to expense generally include geological and geophysical costs, costs of unsuccessful exploratory wells, delay rentals, and oil and gas production costs. Capitalized costs of proved leasehold costs are depleted on a field-by-field basis using the units-of-production method based upon total proved oil and gas reserves. Other capitalized costs of producing properties are depleted based on proved developed reserves. All wells in process as of December 31, 2018 and 2017 are expected to be completed within the next 12 months. Depletion expense for the years ended December 31, 2018, 2017, and 2016 was $78.5 million, $39.6 million, and $4.9 million, respectively.

The Company assesses its proved oil and gas properties for impairment whenever events or circumstances indicate that the carrying value of the assets may not be recoverable. The impairment test compares undiscounted future net cash flows to the assets’ net book value. If the net capitalized costs exceed future net cash flows, then the cost of the property is written down to the estimated fair value. Fair value for oil and natural gas properties is generally determined based on an analysis of discounted future net cash flows adjusted for certain risk factors. There were no impairments of proved oil and gas properties during the years ended December 31, 2018, 2017, or 2016.

Felix Energy Holdings II, LLC

Notes to Consolidated Financial Statements

Note 1 – Organization and Summary of Significant Accounting Policies (continued)

Unproved properties are assessed periodically on a project-by-project basis to determine whether an impairment has occurred. Management’s assessment includes consideration of the results of exploration activities, commodity price outlooks, planned future sales, or expiration of all or a portion of such projects which impact the amount and timing of impairment provisions. Sales proceeds from unproved oil and gas properties are credited to related costs of the prospect sold until all such costs are recovered and then to net gain or loss on sales of unproved oil and gas properties. Management determined there were no impairments of unproved oil and gas properties during the years ended December 31, 2018, 2017, or 2016.

Gains and losses arising from sales of oil and gas properties are included in income. However, a partial sale of proved properties within an existing field that does not significantly affect the unit-of-production depletion rate will be accounted for as a normal retirement with no gain or loss recognized. The sale of a partial interest within a proved property is accounted for as a recovery of cost. The partial sale of unproved property is accounted for as a recovery of cost when there is uncertainty of the ultimate recovery of the cost applicable to the interest retained.

Water Facilities and Disposal Systems – Water facilities and disposal systems consist of disposal wells and facilities and source water ponds and pits. Amounts are recorded at cost and depreciated using the straight-line method. The estimated useful lives are as follows:

Water facilities and disposal systems comprise the following:

Costs incurred for construction of produced water disposal assets in progress and not operational are initially included in construction in progress. No depreciation is recorded for these assets as they have not been placed in operations.

Felix Energy Holdings II, LLC

Notes to Consolidated Financial Statements

Note 1 – Organization and Summary of Significant Accounting Policies (continued)

Midstream Facilities – Midstream facilities include gathering system assets, primarily pipelines and well connections, which service the Company’s wells. Amounts are recorded at cost and depreciated using the units-of-production method consistent with the Company’s producing oil and gas properties.

Midstream facilities comprise the following:

Costs incurred for construction of midstream facilities in progress and not operational are initially included in construction in progress. No depreciation is recorded for these assets as they have not been placed in operations.

Other Property and Equipment – Other property and equipment consists of office furniture and fixtures, leasehold improvements, and computer hardware and software. Other property and equipment is recorded at cost and depreciated using the straight-line method over 3 to 5 years.

Prepaid Drilling Costs – Cash payments are made to operators in advance of drilling and completion work on oil and gas properties that the Company has a working interest in but does not operate. As work occurs on these properties, the balance is reduced and moved to oil and gas properties.

Accounts Payable and Accrued Liabilities – Costs to drill, complete, and operate oil and gas properties are included in accounts payable when invoiced. Costs incurred for which an invoice has not yet been received are included in accrued liabilities and are based on management’s estimate of amounts expected to be paid.

Accrued liabilities comprise the following:

Felix Energy Holdings II, LLC

Notes to Consolidated Financial Statements

Note 1 – Organization and Summary of Significant Accounting Policies (continued)

Revenues Payable – Revenue payable represents amounts collected from purchasers for oil and gas sales which are due to other revenue interest owners. Generally, the Company is required to remit amounts due under these liabilities within 60 days of the end of the month in which the related production occurs. Revenues in suspense are also included in revenue payable.

Derivative Instruments – The Company uses derivative contracts to reduce the risk associated with commodity price changes associated with its future oil and natural gas production, typically fixed-price swaps and floating basis swaps. The Company’s derivative instruments are measured at fair value and recorded on the consolidated balance sheets as an asset or a liability. Changes in the fair value and realized gains and losses are recorded in Loss on derivative instruments in the consolidated statements of income.

Revenue Recognition – The Company follows the sales method of accounting for its oil and gas sales whereby it recognizes revenue, net of royalties, on all oil and gas sold to purchasers at the time the oil and gas is produced and sold.

Acquisitions – In accordance with ASC Topic 805, Business Combinations, the Company determines whether an acquisition is a business combination, which requires that the assets acquired and liabilities assumed constitute a business. Each business combination is then accounted for by applying the acquisition method of accounting. If the assets acquired are not a business, the Company accounts for the transaction as an asset acquisition. Under both methods, purchase prices are allocated to acquired assets and assumed liabilities based on their estimated fair value at the time of the acquisition (adjusted for purchase price adjustments in business combinations). For transactions that are business combinations, the Company evaluates the existence of goodwill or intangibles. The excess, if any, of the purchase price over the net fair value amounts assigned to assets and acquired and liabilities assumed is recognized as goodwill. The Company capitalizes acquisition-related costs and fees associated with asset acquisitions and immediately expenses acquisition-related costs and fees associated with business combinations.

The Company estimates the fair values of assets acquired and liabilities assumed in acquisitions using various assumptions (all of which are Level 3 inputs within the fair value hierarchy). The most significant assumptions typically relate to the estimated fair values assigned to proved and unproved oil and natural gas properties. To estimate the fair values of the proved and unproved oil and natural gas properties, the Company develops estimates of oil, natural gas, and NGL reserves. Estimates of reserves are based on the quantities of oil, natural gas, and NGLs that geological and engineering data demonstrate, with reasonable certainty, to be recoverable in future years from known reservoirs under existing economic and operating conditions. Additionally, a risk factor is applied to reserves by reserve type based on industry standards. The Company estimates future prices to apply to the estimated net quantities of reserves based on the applicable ownership percentage acquired and estimates future operating and development costs to arrive at estimates of future net cash flows. The future net cash flows are discounted using a market-based weighted average cost of capital rate determined appropriate at the time of the acquisition.

Felix Energy Holdings II, LLC

Notes to Consolidated Financial Statements

Note 1 – Organization and Summary of Significant Accounting Policies (continued)

Income Taxes – The Company is an LLC. Accordingly, no provision for U.S. federal or state income taxes has been recorded as the income, deductions, expenses and credits of the Company are reported on the individual income tax returns of the Company’s member. The Company is, however, subject to the Texas margin tax due to its operation within the state of Texas. Amounts incurred under the Texas margin tax during the years ended December 31, 2018, 2017, and 2016 were immaterial, and no amounts were due as of December 31, 2018, and 2017.

The Company has not recorded any liabilities as of December 31, 2018 related to uncertain tax provisions. As of December 31, 2018, the Company made no provision for interest or penalties related to uncertain tax positions. The Company files income tax returns in the U.S. federal jurisdiction and various states. There are currently no federal or state income tax examinations underway for these jurisdictions.

Asset Retirement Obligations – The Company accounts for asset retirement obligations by recognizing the fair value of a liability for an asset retirement obligation in the period in which it is incurred, if a reasonable estimate of fair value can be made. The fair value of the liability is added to the carrying amount of the associated asset. This additional carrying amount is then depreciated over the life of the asset. The liability increases due to the passage of time based on the time value of money until the obligation is settled.

The Company’s asset retirement obligations relate primarily to the retirement of oil and gas properties and related equipment used at the wellsite. The following table summarizes the changes in the Company’s asset retirement obligations for the years ended December 31, 2018, and 2017:

Fair Value of Financial Instruments – The Company’s financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, revenues payable, derivative instruments, and long-term debt. The carrying value of the Company’s financial instruments approximate fair value due to their short maturities, interest rates that approximate market rates, or recurring fair value measurements (Note 6).

Concentrations of Credit Risk – The Company maintains cash balances at a financial institution that is insured by the Federal Deposit Insurance Corporation (FDIC) for amounts up to $250,000. At any point in time, the Company may have amounts on deposit that are in excess of federally insured limits.

Felix Energy Holdings II, LLC

Notes to Consolidated Financial Statements

Note 1 – Organization and Summary of Significant Accounting Policies (continued)

Recently Issued Accounting Pronouncements – In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers. The update clarifies the principles for revenue recognition and provides a common revenue standard across industries. The codification has been amended through additional ASUs and, as amended, requires companies to recognize revenue to depict the transfer of goods or services to customers in amounts that reflect the consideration to which the Company expects to be entitled in exchange for those goods or services. For nonpublic entities, the guidance is effective for annual reporting periods beginning after December 15, 2018. The Company does not expect the guidance to have a material impact on its financial statements.

In February 2016, the FASB issued ASU 2016-02, Leases. The FASB issued the guidance to increase the transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. This will be required for all leases that have a term longer than one year. For nonpublic entities, ASU 2016-02 is effective for annual reporting periods beginning after December 15, 2019. Early application of the standard is permitted upon issuance. The Company is in the process of evaluating the impact this standard will have on its financial statements.

Note 2 – Property Acquisitions

On June 7, 2016, the Company acquired oil and gas properties located in Ward and Winkler Counties, Texas from a third party for $220.2 million in cash. The effective date for the transaction was March 1, 2016, with purchase price adjustments calculated as of the closing date on June 7, 2016.

The acquisition was accounted for using the acquisition method under ASC 805, Business Combinations, which requires the acquired assets and assumed liabilities to be recorded at fair values as of the acquisition date. The following table summarizes the purchase price and estimated fair value of the assets acquired and liabilities assumed:

Felix Energy Holdings II, LLC

Notes to Consolidated Financial Statements

Note 2 – Property Acquisitions (continued)

The Company incurred fees of $2 million related to the change in operators and has included it in operator transfer fees in the accompanying consolidated statement of income for the year ended December 31, 2016. Other acquisition-related expenses were inconsequential and have been recognized in general and administrative expenses in the accompanying consolidated statement of income for the year ended December 31, 2016.

On October 10, 2016, the Company acquired oil and gas properties located in Winkler and Loving Counties, Texas from a third party for $40.9 million in cash. The effective date for the transaction was September 1, 2016, with purchase price adjustments calculated as of the closing date on October 10, 2016.

The acquisition was accounted for using the acquisition method under ASC 805, Business Combinations, which requires the acquired assets and assumed liabilities to be recorded at fair values as of the acquisition date. The following table summarizes the purchase price and estimated fair value of the assets acquired and liabilities assumed:

Note 3 – Property Dispositions

There were no significant property dispositions during the year ended December 31, 2018. In January 2017, the Company sold its entire interest in certain oil and gas properties located in Oklahoma to a related party for $42.0 million (net of transaction costs of $0.4 million). The properties had a carrying value of $22.2 million, resulting in a gain of $19.8 million included in the Company’s consolidated statement of income for the year ended December 31, 2017.

In August 2016, the Company sold its entire interest in certain unproved oil and gas properties to a third party for $61.6 million. The properties had a carrying value of $48.7 million, resulting in a gain of $12.9 million included in the Company’s consolidated statement of income for the year ended December 31, 2016.

Felix Energy Holdings II, LLC

Notes to Consolidated Financial Statements

Note 4 – Related Party Transactions

Short-Term Borrowing – The Unit Purchase Agreement between Investments and members of Investments allowed for additional funding up to $100 million. In March and May 2017, the Company received $20 million and $25 million, respectively, under this additional funding stipulation. Such amounts may be repaid under the terms of Investment’s LLC Agreement at 11% interest per annum. The outstanding amount of $45 million was repaid in August 2017, plus accrued interest of $1.3 million. The agreement was terminated when repaid.

HoldCo Note – In August 2017, HoldCo closed on $300 million of senior secured first lien notes due 2022 (the HoldCo Note). The $300 million facility includes a $100 million delay draw. The HoldCo Note is collateralized by substantially all of HoldCo’s assets and equity interests, which includes the equity of the Company. As of December 31, 2018, the Company has received $194.7 million sourced from the HoldCo Note and has classified the amounts as capital contributions.

The HoldCo Note accrues interest at LIBOR (London Interbank Offered Rate) plus 6.50%. Interest payments are made by the Company to HoldCo in the form of distributions. During the years ended December 31, 2018 and 2017, the Company made distributions of $17.4 million and $7.1 million, respectively, in connection with the interest.

Other – During the year ended December 31, 2016, various expenses of the Company were paid by Felix Energy, LLC, a related party, and the Company was allocated $2.3 million as a result. The Company paid this amount and no amount was outstanding at December 31, 2016. No such expenses were paid by a related party in 2018 or 2017.

Refer to Note 3 regarding the Company’s sale of oil and gas properties to a related party.

Holdings Facility – In July 2016, the Company entered into a five-year, $500 million credit facility with a third party financial institution (the Holdings Facility). The borrowing base is redetermined periodically based on the Company’s proved reserves. As of December 31, 2018, the borrowing base had been increased to $800 million. Except in the case of a continuing event of default, amounts borrowed under the Holdings Facility are due on the maturity date of July 1, 2021.

Borrowings under the Holdings Facility bear interest at a variable interest rate based on the higher of (a) the prime rate set by the Holdings Facility’s administrative agent, (b) the Federal Funds Rate plus 0.50%, or (c) the rate for LIBOR loans for a one-month interest period plus 1% (Alternate Base Rate Loans). Interest is payable quarterly.

As of December 31, 2018, the Company had $567 million outstanding under the Holdings Facility, and the applicable interest rate was 5.06%.

Under the provisions of the Holdings Facility, the Company is subject to a number of restrictions and covenants, including maintaining a consolidated current ratio greater than 1.0 to 1.0 and a consolidated leverage ratio less than 4.0 to 1.0 The Company believes it was in compliance with all of the covenants under the Holdings Facility as of December 31, 2018.

Water Facility – In May 2017, the Company, through its wholly owned subsidiary, Felix Water, LLC, entered into a three-year, $50 million credit facility with a third party financial institution (the Water Facility). The borrowing base is redetermined periodically based on the Company’s produced water disposal properties. As of December 31, 2018, the borrowing base was $100 million. Except in the case of a continuing event of default, amounts borrowed under the Water Facility are due on the maturity date of May 20, 2020.

Felix Energy Holdings II, LLC

Notes to Consolidated Financial Statements

Note 5 – Long-Term Debt (continued)

Borrowings under the Water Facility bear interest at a variable rate equal to the higher of (a) the Prime Rate in effect on such day, (b) the Federal Funds Effective Rate in effect on such day plus 0.50%, or (c) the Adjusted LIBOR for a one-month interest period beginning on such day plus 1.00%. Interest is payable monthly.

As of December 31, 2018, the Company has $79.8 million outstanding under the Water Facility, and the applicable interest rate was 6.75%.

Under the provisions of the Water Facility, the Company is subject to a number of restrictions and covenants, including maintaining a current ratio greater than 1.0 to 1.0 and a leverage ratio less than 3.5 to 1.0 for Felix Water, LLC. The Company believes it was in compliance with all of the covenants under the Water Facility as of December 31, 2018.

Interest Expense – Interest expense consists of the following components:

The following table sets forth the Company’s outstanding derivative contracts as of December 31, 2017:

The following table discloses the Company’s derivative instruments as of December 31, 2018 and 2017. There were no outstanding derivative contracts during the year ended December 31, 2016.

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 1 – Organization and Summary of Significant Accounting Policies

Nature of Business – Felix Energy Holdings II, LLC (the Company), a Delaware Limited Liability Company (LLC), was formed on August 28, 2015, for the purpose of acquiring, developing and operating oil and gas properties in the Permian Basin. As an LLC, the amount at risk for each individual member is limited to the amount of capital contributed to the LLC, and unless otherwise noted, the individual member’s liability for indebtedness of an LLC is limited to the member’s actual capital contribution.

In June 2017, the Company was conveyed to Felix Investments Holdings II, LLC (HoldCo). HoldCo is directly and indirectly owned 100% by Felix Energy Investments II, LLC (Investments). Prior to this conveyance, the Company was owned by Investments (99.9%) and Felix Energy II, Inc. (0.01%), a C Corporation, which was wholly owned by Investments.

The Company has the following wholly owned subsidiaries:

Basis of Presentation – The Company follows accounting standards established by the Financial Accounting Standards Board (FASB). The FASB sets accounting principles generally accepted in the United States of America (GAAP) to ensure consistent reporting of the Company’s financial condition, results of operations and cash flows. References to GAAP issued by the FASB in these footnotes are to the FASB Accounting Standards Codification (ASC or Codification). The condensed interim financial information includes a note that the financial information does not represent complete financial statements and is to be read in conjunction with the entity’s latest audited annual financial statements. The Company believes the disclosures are adequate to make the information not misleading. In the opinion of management, all adjustments (consisting of only normal recurring accruals) considered necessary for a fair presentation for the period presented have been included.

Principles of Consolidation – The accompanying condensed consolidated financial statements include the accounts of the Company and its subsidiaries. In preparing the condensed consolidated financial statements, all inter-company accounts and transactions have been eliminated.

Use of Estimates – The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of expenses during the reporting period. Actual results could differ from those estimates. Significant judgments and estimates include: estimates related to the oil and gas reserves held by the Company which directly impact the depletion calculation and fair value of the oil and gas properties.

Cash, Cash Equivalents, and Restricted Cash – Cash and cash equivalents include cash on hand, amounts held in banks and highly liquid investments purchased with an original maturity of three months or less. Restricted cash consists of cash restricted for the purpose of the drilling and completion costs for five oil and gas wells pursuant to a farm-out agreement executed during the nine months ended September 30, 2019.

Felix Energy Holdings II, LLC

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 1 – Organization and Summary of Significant Accounting Policies (continued)

Accounts Receivable – The Company’s accounts receivable are generated from oil and gas sales and from joint interest owners on properties that the Company operates. The Company’s oil and gas receivables are typically collected within one to two months. No allowance for bad debts has been recorded at September 30, 2019.

Inventory – Inventory consists of pipe and supplies maintained to support the Company’s water and midstream infrastructure and is stated at the lower of cost (determined on a specific identification basis) or market. Management reviews inventory for items which are slow moving, damaged, or obsolete to provide for a valuation reserve. No reserve for excess or obsolete inventory has been deemed necessary as of September 30, 2019.

Oil and Gas Properties – The Company accounts for its oil and gas operations using the successful efforts method of accounting. Under this method, all costs associated with property acquisitions, successful exploratory wells, and all development wells are capitalized, including interest on capital costs associated with the development of oil and gas properties during drilling and completion. Items charged to expense generally include geological and geophysical costs, costs of unsuccessful exploratory wells, delay rentals, and oil and gas production costs. Capitalized costs of proved leasehold costs are depleted on a field-by-field basis using the units-of-production method based upon total proved oil and gas reserves. Other capitalized costs of producing properties are depleted based on proved developed reserves. All wells in process as of September 30, 2019 and 2018 are expected to be completed within the next 12 months. Depletion expense for the nine-month periods ended September 30, 2019 and 2018 was $133.9 million and $54.7 million, respectively.

The Company assesses its proved oil and gas properties for impairment whenever events or circumstances indicate that the carrying value of the assets may not be recoverable. The impairment test compares undiscounted future net cash flows to the assets’ net book value. If the net capitalized costs exceed future net cash flows, then the cost of the property is written down to the estimated fair value. Fair value for oil and natural gas properties is generally determined based on an analysis of discounted future net cash flows adjusted for certain risk factors. There were no impairments of proved oil and gas properties during the nine months ended September 30, 2019 and 2018.

Unproved properties are assessed periodically on a project-by-project basis to determine whether an impairment has occurred. Management’s assessment includes consideration of the results of exploration activities, commodity price outlooks, planned future sales, or expiration of all or a portion of such projects which impact the amount and timing of impairment provisions. Sales proceeds from unproved oil and gas properties are credited to related costs of the prospect sold until all such costs are recovered and then to net gain or loss on sales of unproved oil and gas properties. As of September 30, 2019, management determined there was no impairment of unproved properties.

Felix Energy Holdings II, LLC

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 1 – Organization and Summary of Significant Accounting Policies (continued)

Water Facilities and Disposal Systems – Water facilities and disposal systems consist of disposal wells and facilities and source water ponds and pits. Amounts are recorded at cost and depreciated using the straight-line method. The estimated useful lives are as follows:

Water facilities and disposal systems comprise the following:

Costs incurred for construction of produced water disposal assets in progress and not operational are initially included in construction in progress. No depreciation is recorded for these assets as they have not been placed in operations.

Midstream Facilities – Midstream facilities include gathering system assets, primarily pipelines and well connections, which service the Company’s wells. Amounts are recorded at cost and depreciated using the units-of-production method consistent with the Company’s producing oil and gas properties.

Midstream facilities comprise the following:

Felix Energy Holdings II, LLC

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 1 – Organization and Summary of Significant Accounting Policies (continued)

Costs incurred for construction of midstream facilities in progress and not operational are initially included in construction in progress. No depreciation is recorded for these assets as they have not been placed in operations.

Accounts Payable and Accrued Liabilities – Costs to drill, complete and operate oil and gas properties are included in accounts payable when invoiced. Costs incurred for which an invoice has not yet been received are included in accrued liabilities and are based on management’s estimate of amounts expected to be paid.

Accrued liabilities consisted of the following as of the dates indicated below:

Derivative Instruments – The Company uses derivative contracts to reduce the risk associated with commodity price changes associated with its future oil and natural gas production, typically fixed-price swaps and floating basis swaps. The Company’s derivative instruments are measured at fair value and recorded on the condensed consolidated balance sheets as an asset or a liability. Changes in the fair value and realized gains and losses are recorded in (Gain) Loss on Derivative Instruments in the condensed consolidated statements of income.

Revenue Recognition – Effective January 1, 2019, the Company adopted ASU 2014-09, Revenue from Contracts with Customers. Revenue from the sale of oil, NGLs, and gas are recognized as the product is delivered to the customers’ custody transfer points and collectability is reasonably assured.

The Company fulfills the performance obligations under the customer contracts through daily delivery of oil, NGLs, and gas to the customers’ custody transfer points and revenues are recorded on a monthly basis. The prices received for oil, NGLs, and natural gas sales under the Company’s contracts are generally derived from stated market prices which are then adjusted to reflect deductions, including transportation, fractionation and processing. As a result, the revenues from the sale of oil, natural gas, and NGLs will decrease if market prices decline. The sales of oil, NGLs, and gas as presented on the condensed consolidated statements of income represent the Company’s share of revenues, net of royalties and excluding revenue interests owned by others. When selling oil, NGLs, and gas on behalf of royalty owners or working interest owners, the Company is acting as an agent and thus reports the revenue on a net basis. To the extent actual volumes and prices of oil and natural gas sales are unavailable for a given reporting period because of timing or information not received from third parties, the expected sales volumes and prices for those properties are estimated and recorded.

Felix Energy Holdings II, LLC

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 1 – Organization and Summary of Significant Accounting Policies (continued)

Revenue derived from the midstream assets are only transacted through the Company and its subsidiaries, and as such are eliminated during consolidation.

Income Taxes – The Company is an LLC. Accordingly, no provision for U.S. federal or state income taxes has been recorded as the income, deductions, expenses, and credits of the Company are reported on the individual income tax returns of the Company’s member. The Company is, however, subject to the Texas margin tax due to its operation within the state of Texas. Amounts incurred under the Texas margin tax during the period ended September 30, 2019 was immaterial, and no amounts were due as of September 30, 2019.

The Company has not recorded any liabilities as of September 30, 2019 related to uncertain tax provisions, and the Company made no provision for interest or penalties related to uncertain tax positions.

Asset Retirement Obligations – The Company accounts for asset retirement obligations by recognizing the fair value of a liability for an asset retirement obligation in the period in which it is incurred, if a reasonable estimate of fair value can be made. The fair value of the liability is added to the carrying amount of the associated asset. This additional carrying amount is then depreciated over the life of the asset. The liability increases due to the passage of time based on the time value of money until the obligation is settled.

The Company’s asset retirement obligations relate primarily to the retirement of oil and gas properties and related equipment used at the wellsite. The following table summarizes the changes in the Company’s asset retirement obligations for the nine months ended September 30, 2019.

Fair Value of Financial Instruments – The Company’s financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, revenues payable, derivative instruments, and long-term debt. The carrying value of the Company’s financial instruments approximate fair value due to their short maturities, interest rates that approximate market rates, or recurring fair value measurements.

Felix Energy Holdings II, LLC

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 1 – Organization and Summary of Significant Accounting Policies (continued)

Concentrations of Credit Risk – The Company maintains cash balances at a financial institution that is insured by the Federal Deposit Insurance Corporation (FDIC) for amounts up to $250,000. At any point in time, the Company may have amounts on deposit that are in excess of federally insured limits.

Concentrations of credit risk that arise from financials instruments exist for groups of customers or counterparties when they have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions described below.

The Company had certain customers whose revenue individually represented 10% or more of the Company’s total revenue as follows:

For the nine months ended September 30, 2019 and twelve months ended December 31, 2018, one customer accounted for 87% and two customers accounted for 89% of revenue, respectively.

Note 2 – Related Party Transactions

HoldCo Note – In August 2017, HoldCo closed on $300 million of senior secured first lien notes due 2022 (the HoldCo Note). The $300 million facility includes a $100 million delay draw which was amended on March 1, 2019 to extend the expiration to March 1, 2020. The HoldCo Note is collateralized by substantially all of HoldCo’s assets and equity interests, which includes the equity of the Company. As of December 31, 2018, the Company has received $194.7 million sourced from the HoldCo Note and has classified the amounts as capital contributions.

The HoldCo Note accrues interest at LIBOR (London Interbank Offered Rate) plus 6.50%. Interest payments are made by the Company to HoldCo in the form of distributions. During the nine-month period ended September 30, 2019, the Company made distributions of $19.7 million in connection with the interest, and received the $100 million delay draw that was treated as a capital contribution.

Holdings Facility – In July 2016, the Company entered into a five-year, $500 million credit facility with a third party financial institution (the Holdings Facility). The borrowing base is redetermined periodically based on the Company’s proved reserves. As of September 30, 2019, the borrowing base had been increased to $1,125 million. Except in the case of a continuing event of default, amounts borrowed under the Holdings Facility are due on the maturity date of July 1, 2021.

As of September 30, 2019, the Company had $788 million outstanding under the Holdings Facility, and the applicable interest rate was 4.5%.

Under the provisions of the Holdings Facility, the Company is subject to a number of restrictions and covenants, including maintaining a consolidated current ratio greater than 1.0 to 1.0 and a consolidated leverage ratio less than 4.0 to 1.0

The Company believes it was in compliance with all of the covenants under the Holdings Facility as of September 30, 2019.

Water Facility – In April 2019, Felix Water, LLC (“Water”) a wholly owned subsidiary of the Company, entered into a three-year, $150 million credit facility with a third party financial institution (the Water Facility). The borrowing base is redetermined periodically based on the Water’s produced water disposal properties. As of September 30, 2019, the borrowing base was $150 million. Except in the case of a continuing event of default, amounts borrowed under the Water Facility are due on the maturity date of April 23, 2022.

As of September 30, 2019, Water has $94.3 million outstanding under the Water Facility, and the applicable interest rate was 4.44%.

Felix Energy Holdings II, LLC

Notes to Condensed Consolidated Financial Statements (unaudited)

Note 3 – Long-Term Debt (continued)

Under the provisions of the Water Facility, Water is subject to a number of restrictions and covenants, including maintaining an interest coverage ratio greater than 2.75 to 1.0 and a leverage ratio less than 3.5 to 1.0 for Felix Water, LLC. The Company believes it was in compliance with all of the covenants under the Water Facility as of September 30, 2019.

Interest Expense – Interest expense consists of the following components: