Talos Energy - 10-Q quarterly report FY2019 Q1

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2019

OR

For the transition period from          to

Commission File Number: 001-38497

Talos Energy Inc.

(Exact Name of Registrant as Specified in its Charter)

Registrant’s telephone number, including area code: (713) 328-3000

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  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ☒    No  ☐

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

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

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

Securities registered pursuant to Section 12(b) of the Act:

As of May 2, 2019, the registrant had 54,155,805 shares of common stock, $0.01 par value per share, outstanding.

TABLE OF CONTENTS

GLOSSARY

Barrel or Bbl. One stock tank barrel, or 42 United States gallons liquid volume.

Boe. One barrel of oil equivalent determined using the ratio of six Mcf of natural gas to one barrel of crude oil or condensate.

Btu. British thermal unit, which is the heat required to raise the temperature of a one-pound mass of water one degree Fahrenheit.

Completion. The installation of permanent equipment for the production of oil or natural gas.

Deepwater. Water depths of more than 600 feet.

Field. An area consisting of a single reservoir or multiple reservoirs all grouped on or related to the same individual geological structural feature or stratigraphic condition.

Gross acres or gross wells. The total acres or wells in which the Company owns a working interest.

MBbls. One thousand barrels of crude oil or other liquid hydrocarbons.

MBblpd. One thousand barrels of crude oil or other liquid hydrocarbons per day.

MBoe. One thousand barrels of oil equivalent.

MBoepd. One thousand barrels of oil equivalent per day.

Mcf. One thousand cubic feet of natural gas.

Mcfpd. One thousand cubic feet of natural gas per day.

MMBtu. One million Btus.

MMcf. One million cubic feet of natural gas.

MMcfpd. One million cubic feet of natural gas per day.

NGL. Natural gas liquid. Hydrocarbons which can be extracted from wet natural gas and become liquid under various combinations of increasing pressure and lower temperature. NGLs consist primarily of ethane, propane, butane and natural gasoline.

NYMEX. The New York Mercantile Exchange.

Proved reserves. Proved reserves are those quantities of oil and natural gas, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible from a given date forward, from known reservoirs and under existing economic conditions, operating methods and government regulations prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation. The project to extract the hydrocarbons must have commenced or the operator must be reasonably certain that it will commence the project within a reasonable time.

Proved undeveloped reserves. In general, proved 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. The Securities and Exchange Commission provides a complete definition of undeveloped oil and gas reserves in Rule 4-10(a)(31) of Regulation S-X.

SEC. The Securities and Exchange Commission.

SEC pricing. The unweighted average first-day-of-the-month commodity price for crude oil or natural gas for the prior twelve months, adjusted by lease for market differentials (quality, transportation, fees, energy content, and regional price differentials). The Securities and Exchange Commission provides a complete definition of prices in “Modernization of Oil and Gas Reporting” (Final Rule, Release Nos. 33-8995; 34-59192).

Working interest. The operating interest that gives the owner the right to drill, produce and conduct operating activities on the property and a share of production.

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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

The information in this report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements, other than statements of historical fact included in this report, regarding our strategy, future operations, financial position, estimated revenues and losses, projected costs, prospects, plans and objectives of management are forward-looking statements. When used in this report, the words “could,” “believe,” “anticipate,” “intend,” “estimate,” “expect,” “project,” “forecast,” “may”, “objective,” “plan” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. These forward-looking statements are based on our current expectations and assumptions about future events and are based on currently available information as to the outcome and timing of future events. These forward-looking statements are based on management’s current belief, based on currently available information, as to the outcome and timing of future events. Forward-looking statements may include statements about:

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We caution you that these forward-looking statements are subject to numerous risks and uncertainties, most of which are difficult to predict and many of which are beyond our control. These risks include, but are not limited to, commodity price volatility, inflation, lack of availability of drilling and production equipment and services, environmental risks, failure to find, acquire or gain access to other discoveries and prospects or to successfully develop and produce from our current discoveries and prospects, geologic risk, drilling and other operating risks, well control risk, regulatory changes, the uncertainty inherent in estimating reserves and in projecting future rates of production, cash flow and access to capital, the timing of development expenditures, potential adverse reactions or competitive responses to the business combination between Talos Energy LLC and Stone Energy Corporation, the possibility that the anticipated benefits of such business combination are not realized when expected or at all, including as a result of the impact of, or problems arising from, the integration of the two companies, and the other risks discussed in “Part I, Item 1A. Risk Factors” of Talos Energy Inc.’s Annual Report for the year ended December 31, 2018.

Reserve engineering is a process of estimating underground accumulations of oil, natural gas and NGLs that cannot be measured in an exact way. The accuracy of any reserve estimate depends on the quality of available data, the interpretation of such data and price and cost assumptions made by reserve engineers. In addition, the results of drilling, testing and production activities may justify upward or downward revisions of estimates that were made previously. If significant, such revisions would change the schedule of any further production and development drilling. Accordingly, reserve estimates may differ significantly from the quantities of oil, natural gas and NGLs that are ultimately recovered.

Should one or more of the risks or uncertainties described herein occur, or should underlying assumptions prove incorrect, our actual results and plans could differ materially from those expressed in any forward-looking statements. All forward-looking statements, expressed or implied, included in this report are expressly qualified in their entirety by this cautionary statement. This cautionary statement should also be considered in connection with any subsequent written or oral forward-looking statements that we or persons acting on our behalf may issue. Except as otherwise required by applicable law, we disclaim any duty to update any forward-looking statements, all of which are expressly qualified by the statements in this section, to reflect events or circumstances after the date of this report.

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TALOS ENERGY INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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TALOS ENERGY INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per common share amounts)

(Unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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TALOS ENERGY INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)

(In thousands, except share amounts)

(Unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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TALOS ENERGY INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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TALOS ENERGY INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2019

(Unaudited)

Note 1 — Formation and Basis of Presentation

Formation and Nature of Business

Talos Energy Inc. (“Talos,” the “Company,” “we,” “us” or “our”) is a technically driven independent exploration and production company focused on safely and efficiently maximizing cash flows and long-term value through our operations, currently in the United States (“U.S.”) Gulf of Mexico and offshore Mexico. As one of the largest public independent producers in the U.S. Gulf of Mexico, we leverage decades of geology, geophysics and offshore operations expertise towards the acquisition, exploration, exploitation and development of deep and shallow water assets in key geological trends that are present in many offshore basins around the world. Our activities offshore Mexico provide high impact exploration opportunities in an oil rich emerging basin.

Talos was formed in connection with the business combination between Talos Energy LLC and Stone Energy Corporation (“Stone”) that occurred on May 10, 2018, pursuant to which Talos Energy LLC and Stone became indirect wholly-owned subsidiaries of Talos Energy Inc.

Talos Energy LLC

Talos Energy LLC was formed in 2011 and commenced commercial operations on February 6, 2013. Prior to February 6, 2013, Talos Energy LLC had incurred certain general and administrative expenses associated with the start-up of its operations.  

On February 3, 2012, Talos Energy LLC completed a transaction with certain funds and other alternative investment vehicles managed by Apollo Management VII, L.P. and Apollo Commodities Management, L.P., with respect to Series I (“Apollo Funds”), and entities controlled by or affiliated with Riverstone Energy Partners V, L.P. (“Riverstone Funds”) and members of management pursuant to which the Talos Energy LLC received a private equity capital commitment.

Stone Combination

On May 10, 2018 (the “Closing Date”), the Company consummated the transactions contemplated by that certain Transaction Agreement, dated as of November 21, 2017 (the “Transaction Agreement”), pursuant to which, among other items, each of Stone, Talos Production LLC and Talos Energy LLC became wholly-owned subsidiaries of the Company (the “Stone Combination”). Concurrently with the consummation of the Transaction Agreement, the Company consummated the transactions contemplated by that certain Exchange Agreement, dated as of November 21, 2017 (the “Exchange Agreement”) pursuant to which (i) the Apollo Funds and Riverstone Funds contributed $102.0 million in aggregate principal amount of 9.75% Senior Notes due 2022 (“9.75% Senior Notes”) issued by Talos Production LLC and Talos Production Finance, Inc. (together, “Talos Issuers”) to the Company in exchange for an aggregate of 2,874,049 shares of Talos common stock; (ii) the holders of second lien bridge loans (“11.00% Bridge Loans”) exchanged such 11.00% Bridge Loans for $172.0 million aggregate principal amount of 11.00% Second-Priority Senior Secured Notes due 2022 of the Talos Issuers (“11.00% Senior Secured Notes”) and (iii) certain holders of 7.50% Senior Secured Notes due 2022 issued by Stone (“7.50% Stone Senior Notes”) exchanged such notes for $137.4 million aggregate principal amount of 11.00% Senior Secured Notes. Prior to the Closing Date, the Company did not conduct any material activities other than those incident to its formation and the matters contemplated by the Transaction Agreement. See Note 2 – Acquisitions for further details regarding the Stone Combination.

Substantially concurrent therewith, the Company consummated an exchange offer and consent solicitation, pursuant to which other holders of the 7.50% Stone Senior Notes exchanged their 7.50% Stone Senior Notes for 11.00% Senior Secured Notes and a cash payment. Approximately $81.5 million in aggregate principal amount of the 7.50% Stone Senior Notes were validly tendered, and approximately $6.1 million in aggregate principal amount of 7.50% Stone Senior Notes remained outstanding as of the Closing Date.

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Basis of Presentation and Consolidation

The condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, certain information and disclosures normally included in complete financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. All intercompany transactions have been eliminated. The unaudited financial statements reflect all adjustments which are of a normal, recurring nature and are necessary to fairly present the financial position, results of operations and cash flows for the interim periods. The results for any interim period are not necessarily indicative of the expected results for the entire year. The Company has evaluated subsequent events through the date the condensed consolidated financial statements were issued. The unaudited financial statements and related notes included in this Quarterly Report on Form 10-Q (this “Quarterly Report”) should be read in conjunction with the Company’s audited Consolidated Financial Statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018 (our “2018 Annual Report”).

Talos Energy LLC was considered the accounting acquirer in the Stone Combination under GAAP. Accordingly, the historical financial and operating data of Talos Energy Inc., which covers periods prior to the Closing Date, reflects the assets, liabilities and results of operations of Talos Energy LLC and does not reflect the assets, liabilities and results of operations of Stone. For the periods prior to May 10, 2018, the Company retrospectively adjusted its Statements of Changes in Stockholders’ Equity and the weighted average shares used in determining earnings per share to reflect the number of shares Talos Energy LLC received in the Stone Combination. Beginning on May 10, 2018, common stock is presented to reflect the legal capital of Talos Energy Inc.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements, the reported amounts of revenues and expenses during the reporting periods and the reported amounts of proved oil and natural gas reserves. Actual results could differ from those estimates.

The Company has one reportable segment, exploration and production of oil and natural gas. Substantially all of the Company’s proved reserves and production sales are related to the Company’s operations in the U.S.

Unless otherwise indicated or the context otherwise requires, references in this Quarterly Report to “Talos,”  the “Company,” “we,” “us,” or “our” refer to Talos Energy Inc. and its wholly-owned subsidiaries.

Recently Adopted Accounting Standards

Leases. In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Codification (“ASC”) 2016-02, Leases (“Topic 842”) requiring an entity to recognize a right-of-use asset representing the right to use an underlying asset for the lease term and a lease liability representing the obligation associated with future lease payments for virtually all leases. The pattern of expense recognition in the income statement is dependent on lease classification as finance or operating. A lease is defined as a contract, or part of a contract, that conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration. However, Topic 842 does not apply to leases of mineral rights.

On January 1, 2019, the Company adopted Topic 842, using the modified retrospective approach, which does not require an adjustment to comparative-period financial statements. As such, results for reporting periods beginning January 1, 2019 are presented in accordance with Topic 842, while prior period amounts are reported in accordance with previous lease accounting treatment. The Company elected the package of practical expedients permitted under the transition guidance within the new standard, which, among other items, allowed Talos not to reassess whether expired or existing contracts, including land easements, contain a lease or reassess the classification and indirect costs associated with existing or expired leases. On the January 1, 2019 adoption date, the Company recorded a right-of-use asset of approximately $7.3 million and corresponding lease liability of $16.9 million representing the present value of its future operating lease payments. Upon the adoption of Topic 842, lease incentives are presented as a reduction to the right-of-use asset resulting in the difference between the right-of-use asset and lease liability. Adoption of this standard did not require an adjustment to retained earnings and did not impact the condensed consolidated statements of operations, condensed consolidated statements of cash flows or condensed consolidated statements of changes in stockholders’ equity. See Note 4 – Leases for further information.

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Note 2 — Acquisitions

Asset Acquisitions

Each of the acquisitions below qualified as an asset acquisition that requires, among other items, that the cost of the assets acquired and liabilities assumed be recognized on the balance sheet by allocating the asset cost on a relative fair value basis. The fair value measurements of the oil and natural gas properties acquired and asset retirement obligations assumed were derived utilizing an income approach and based, in part, on significant inputs not observable in the market. These inputs represent Level 3 measurements in the fair value hierarchy and include, but are not limited to, estimates of reserves, future operating and development costs, future commodity prices, estimated future cash flows and appropriate discount rates. These inputs required significant judgments and estimates by the Company’s management at the time of the valuation. Transaction costs incurred on an asset acquisition are capitalized as a component of the assets acquired and any contingent consideration is recognized as the contingency is resolved.

Acquisition of Gunflint Field

On January 11, 2019, the Company completed the acquisition of an approximate 9.6% non-operated working interest in the Gunflint Field located in the Mississippi Canyon area (the “Gunflint Acquisition”) from Samson Offshore Mapleleaf, LLC for $29.6 million ($27.9 million after customary purchase price adjustments).

The following table presents the allocation of the purchase price to the assets acquired and liabilities assumed, based on their relative fair values, on January 11, 2019 (in thousands):

Acquisition of Whistler Energy II, LLC

On August 31, 2018, the Company completed the acquisition of all the issued and outstanding membership interests of Whistler Energy II, LLC (“Whistler”) from Whistler Energy II Holdco, LLC, an affiliate of Apollo Funds (the “Whistler Acquisition”), for $52.6 million ($14.8 million, net of $37.8 million of cash acquired). The $37.8 million of cash acquired consists of $30.8 million of cash collateral posted by Whistler released by third party surety companies at closing and $7.0 million of cash on hand for working capital purposes. Through the acquisition, the Company acquired and assumed all of Whistler’s oil and natural gas assets and the associated asset retirement obligations for interests located in Green Canyon Block 18, Green Canyon Block 69 and Ewing Bank Block 988, including a fixed production platform on Green Canyon Block 18.

The following table presents the allocation of the purchase price to the assets acquired and liabilities assumed, based on their relative fair values, on August 31, 2018 (in thousands):

Business Combinations

Acquisitions qualifying as a business combination are accounted for under the acquisition method of accounting, which requires, among other items, that assets acquired and liabilities assumed be recognized on the condensed consolidated balance sheet at their fair values as of the acquisition date. The fair value measurements of the oil and natural gas properties acquired and asset retirement obligations assumed were derived utilizing an income approach and based, in part, on significant inputs not observable in the market. These inputs represent Level 3 measurements in the fair value hierarchy and include, but are not limited to, estimates of reserves, future operating and development costs, future commodity prices, estimated future cash flows and appropriate discount rates. These inputs required significant judgments and estimates at the time of the valuation.

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Combination between Talos Energy LLC and Stone Energy Corporation

On May 10, 2018, the Company consummated the transactions contemplated by the Transaction Agreement and the Exchange Agreement, pursuant to which, among other things, Talos Energy LLC and Stone became wholly-owned subsidiaries of the Company. The combination was executed as an all-stock transaction whereby the former stakeholders of Talos Energy LLC held approximately 63% of the Company’s outstanding common stock and the former stockholders of Stone held approximately 37% of the Company’s outstanding common stock as of the Closing Date.

The purchase price of $732.0 million is based on the closing price of Stone common stock and common warrants immediately prior to closing. The following table summarizes the purchase price (in thousands, except per share data):

While the Company has substantially completed the determination of the fair values of the assets acquired and liabilities assumed, the Company is still finalizing the fair value analysis related to oil and natural gas properties acquired by Stone prior to the Closing Date. The Company anticipates finalizing the determination of the fair values by May 10, 2019.

The following table presents the preliminary allocation of the purchase price to the assets acquired and liabilities assumed, based on their fair values on May 10, 2018 and March 31, 2019, including the associated measurement period adjustments (in thousands):

Revenue and net income attributable to the assets acquired in the Stone Combination during the three months ended March 31, 2019 was $102.6 million and $49.3 million, respectively.

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Pro Forma Financial Information (Unaudited)

The following supplemental pro forma information (in thousands, except per common share amounts), presents the condensed consolidated statements of operations for the three months ended March 31, 2019 and 2018 as if the Stone Combination had occurred on January 1, 2018. The unaudited pro forma information was derived from historical combined statements of operations of the Company and Stone and adjusted to include (i) depletion and accretion expense applied to the adjusted basis of the oil and natural gas properties acquired, (ii) interest expense to reflect the debt transactions contemplated by the Exchange Agreement and (iii) general and administrative expense adjusted for transaction related costs incurred. This information does not purport to be indicative of results of operations that would have occurred had the Stone Combination occurred on January 1, 2018, nor is such information indicative of any expected future results of operations.

Note 3 — Property, Plant and Equipment

Proved Properties. The Company’s interests in proved oil and natural gas properties are located primarily in the U.S. Gulf of Mexico deep and shallow waters. The Company follows the full cost method of accounting for its oil and natural gas exploration and development activities.

At March 31, 2019, the Company’s ceiling test computation of its U.S. oil and natural gas properties was based on SEC pricing of $67.60 per Bbl of oil, $3.00 per Mcf of natural gas and $30.24 per Bbl of NGLs. During the three months ended March 31, 2019 and 2018, the Company’s ceiling test computation did not result in a write-down of its U.S. oil and natural gas properties.

Unproved Properties. Unproved capitalized costs of oil and natural gas properties excluded from amortization relate to unevaluated properties associated with acquisitions, leases awarded in the U.S. Gulf of Mexico federal lease sales, certain geological and geophysical costs, costs associated with certain exploratory wells in progress and capitalized interest. Unproved properties also include costs associated with the two blocks (Block 2 and Block 7) awarded on September 4, 2015 to the Company together with Sierra Oil & Gas S. de R.L de C.V. (“Sierra”) and Premier Oil Plc (“Premier,” and together with the Company and Sierra), the (“Consortium”), located in the shallow waters off the coast of Mexico’s Veracruz and Tabasco states, by the National Hydrocarbons Commission (“CNH”), Mexico’s upstream regulator. During any period in which unproved properties are assessed as proved or impaired, the associated costs are transferred to the full cost pool and are subject to amortization.

In September 2018, the Company entered into a transaction (the “Hokchi Cross Assignment”) with Hokchi Energy, S.A. de C.V. (“Hokchi”), a subsidiary of Pan American Energy (“PAE”), to cross assign 25% participation interests (“PIs”) in Block 2 and Block 31. The Company’s assignment of a 25% PI in Block 2 to Hokchi closed on December 21, 2018, and Hokchi has assumed operator responsibilities with respect to Block 2. Hokchi’s assignment of Block 31 to the Company will be completed upon final approval by the CNH. In addition, Premier exercised its option to reduce its PI in Block 2 to zero and assign a 5% PI to each of Sierra and the Company. Upon completion of the Hokchi Cross Assignment, the Company will own a 25% PI in each of Block 2 and Block 31, and Hokchi will be the operator of both blocks.

Capitalized Overhead. General and administrative expense in the Company’s financial statements is reflected net of capitalized overhead. The Company capitalizes overhead costs directly related to exploration, acquisition and development activities. Capitalized overhead for the three months ended March 31, 2019 and 2018, was $6.6 million and $3.0 million, respectively.

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Asset Retirement Obligations

The discounted asset retirement obligations included “Current portion of asset retirement obligations” and “Asset retirement obligations” on the condensed consolidated balance sheets and the changes to that liability during the three months ended March 31, 2019 were as follows (in thousands):

Note 4 — Leases

The Company enters into service contracts and other contractual arrangements for the use of office space, drilling, completion and abandonment equipment (e.g. drilling rigs, etc.), production related equipment (i.e. compressors, etc.) and other equipment from third-party lessors to support its operations. The Company’s leasing activities as a lessor are negligible. At inception, contracts are reviewed to determine whether the agreement contains a lease. Contracts are considered a lease when the arrangement either explicitly or implicitly conveys the right to control the use of the identified property, plant or equipment for a period of time in exchange for consideration. In order to obtain control, the lessee must obtain substantially all of the economic benefits for the use of the identified asset and have the right to direct the use of the identified asset. To the extent an arrangement is determined to include a lease, it is classified as either an operating or a finance lease, which dictates the pattern of expense recognition in the income statement. The Company has elected to not apply the recognition requirements of Topic 842 to leases with durations of twelve months or less (i.e. short-term).

Upon commencement of a lease, a right-of-use asset and corresponding lease liability are recorded on the consolidated balance sheet for all leases, regardless of classification. The right-of-use asset is initially measured as the lease liability adjusted for any payments made prior to commencement, including any initial direct costs incurred and incentives received. Lease liabilities are initially measured at the present value of future minimum lease payments, excluding variable lease payments, over the lease term. Variable lease payments include changes in index rates, mobilization and demobilization costs related to oil and gas equipment and certain reimbursable costs associated with office and building leases are recognized when incurred. The discount rate used to determine present value is the rate implicit in the lease unless the rate cannot be determined, in which case the incremental borrowing rate is used. The incremental borrowing rate reflects the estimated rate of interest the Company would pay to borrow over a similar term an amount equal to the lease payments on a collateralized basis in a similar economic environment.

The Company has elected to account for lease and non-lease components in its contracts as a single lease component for all asset classes. Lease agreements may include options to renew the lease, terminate the lease or purchase the underlying asset. The Company determines the lease term at lease commencement date as the non-cancelable period of the lease, including options to extend or terminate the lease when such an option is reasonably certain to be exercised. Factors used to assess reasonable certainty of rights to extend or terminate a lease include current and forecasted drillings plans, anticipated changes in development strategies, historical practice in extending similar contracts and current market conditions.

On August 2, 2016, the Company executed a seven-year lease agreement for the use of the Helix Producer 1 (“HP-1”), a dynamically positioned floating production facility that interconnects with the Phoenix Field through a production buoy. Under the terms of the agreement, the Company paid Helix a $49.0 million annual fixed demand charge for the first two years and $45.0 million thereafter.

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Prior to implementation, the agreement with Helix was accounted for as a capital lease under Topic 840. The Company initially recorded a capital lease asset and liability of $124.3 million on its consolidated balance sheet at lease inception. As the HP-1 is utilized in the Company’s oil and natural gas development activities, the capital lease asset was included within proved property and depleted as part of the full cost pool. As of December 31, 2018, the balance of the capital lease obligation on the consolidated balance sheet was $93.6 million, of which $14.1 million is included in other current liabilities and $79.5 million is included in other long-term liabilities. Upon adoption of Topic 842, the HP-1 capital lease was classified as a finance lease resulting in no change to the amounts recognized on the condensed consolidated balance sheet.

The Company has operating leases expiring at various dates, principally for office space, drilling rigs, compressors and other equipment necessary to support the Company’s operations. Operating leases are reflected as operating lease assets, current portion of operating lease liabilities and operating lease liabilities on the condensed consolidated balance sheet. The Company’s operating lease liabilities recognized on the balance sheet as of March 31, 2019 was $16.9 million. Costs associated with the Company’s operating leases are either expensed or capitalized depending on how the underlying asset is utilized.

Presented below are disclosures required by Topic 842. The amounts disclosed herein primarily represent costs associated with properties operated by the Company that are presented on a gross basis and do not reflect the Company’s net proportionate share of such amounts. A portion of these costs have been or will be billed to other working interest owners. The Company’s share of these costs are included in property and equipment, lease operating expense or general and administrative expense, as applicable. The components of lease cost were as follows (in thousands):

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The present value of the fixed lease payments recorded as the Company’s right-of-use asset and lability, adjusted for initial direct costs and incentives are as follows (in thousands):

Minimum future commitments by year for the Company’s leases as of March 31, 2019 are presented in the table below (in thousands). Such commitments are reflected at undiscounted values and are reconciled to the discounted present value recognized on the balance sheet.

Below is the table related to the disclosure of supplemental cash flow information related to leases for the three months ended March 31, 2019 (in thousands):

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Note 5 — Financial Instruments

The following table presents the carrying amounts and estimated fair values of financial instruments (in thousands): 

As of March 31, 2019 and December 31, 2018, the carrying amounts of cash and cash equivalents, restricted cash, accounts receivable and accounts payable approximate their fair values because of the short-term nature of these instruments.

11.00% Second-Priority Senior Secured Notes – due April 2022. The $390.9 million aggregate principal amount of 11.00% Senior Secured Notes are reported on the condensed consolidated balance sheet as of March 31, 2019 at their carrying value, net of original issue discount and deferred financing costs (see Note 6 – Debt). The fair value of the 11.00% Senior Secured Notes are estimated (representing a Level 1 fair value measurement) using quoted secondary market trading prices.

7.50% Senior Secured Notes – due May 2022. The $6.1 million aggregate principal amount of 7.50% Stone Senior Notes are reported on the condensed consolidated balance sheet as of March 31, 2019 at their carrying value (see Note 6 – Debt). The fair value of the 7.50% Stone Senior Notes are estimated (representing a Level 1 fair value measurement) using quoted secondary market trading prices.

Bank Credit Facility – due May 2022. In May 2018, in conjunction with the Stone Combination, the Company and Talos Production LLC, our wholly-owned subsidiary, executed a new bank credit facility with an initial borrowing base of $600.0 million (the “Bank Credit Facility”) which is reported on the condensed consolidated balance sheet as of March 31, 2019 at its carrying value net of deferred financing costs (see Note 6 – Debt). The fair value of the Bank Credit Facility is estimated based on the outstanding borrowings under the Bank Credit Facility since it is secured by the Company’s reserves and the interest rates are variable and reflective of market rates (representing a Level 2 fair value measurement).

Oil and natural gas derivatives. The Company attempts to mitigate a portion of its commodity price risk and stabilize cash flows associated with sales of oil and natural gas production through the use of oil and natural gas swaps and costless collars. Swaps are contracts where the Company either receives or pays depending on whether the oil or natural gas floating market price is above or below the contracted fixed price. Costless collars consist of a purchased put option and a sold call option with no net premiums paid to or received from counterparties. Collar contracts typically require payments by the Company if the NYMEX average closing price is above the ceiling price or payments to the Company if the NYMEX average closing price is below the floor price.

The Company has elected not to designate any of its derivative contracts for hedge accounting. Accordingly, commodity derivatives are recorded on the condensed consolidated balance sheets at fair value with settlements of such contracts, and changes in the unrealized fair value, recorded as “Price risk management activities income (expense)” on the condensed consolidated statements of operations in each period.

The following table presents the impact that derivatives, not qualifying as hedging instruments, had on the Company’s condensed consolidated statements of operations (in thousands):

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The following table reflects the contracted volumes and weighted average prices the Company will receive under its derivative contracts as of March 31, 2019:

Subsequent events. The following table reflects the contracted volumes and weighted average prices the Company will receive under its derivative contracts entered into subsequent to March 31, 2019, which are not reflected in the table above:

The Company’s commodity derivative instruments are measured at fair value based on third-party industry-standard models using various inputs substantially observable in active markets, including forward oil and natural gas price curves, and are therefore classified as Level 2 in the required fair value hierarchy for the periods presented. The following tables provide additional information related to financial instruments measured at fair value on a recurring basis (in thousands):

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Financial Statement Presentation. Derivatives are classified as either current or non-current assets or liabilities based on their anticipated settlement dates. Although the Company has master netting arrangements with its counterparties, the Company presents its derivative financial instruments on a gross basis on its condensed consolidated balance sheets. On derivative contracts recorded as assets in the table below, the Company is exposed to the risk that the counterparties may not perform. The following table presents the fair value of derivative financial instruments at March 31, 2019 and December 31, 2018 (in thousands):

Credit Risk. The Company is subject to the risk of loss on its financial instruments as a result of nonperformance by counterparties pursuant to the terms of their contractual obligations. The Company entered into International Swaps and Derivative Association agreements with counterparties to mitigate this risk. The Company also maintains credit policies with regard to its counterparties to minimize overall credit risk. The Company’s assets and liabilities from commodity price risk management activities at March 31, 2019 represent derivative instruments from nine counterparties; all of which are registered swap dealers that have an “investment grade” (minimum Standard & Poor’s rating of BBB- or better) credit rating, and seven of which are parties under the Company’s Bank Credit Facility. The Company enters into derivatives directly with these counterparties and, subject to the terms of the Company’s Bank Credit Facility, is not required to post collateral or other securities for credit risk in relation to the derivative activities. The Company is subject to the risk of loss on its financial instruments as a result of nonperformance by counterparties pursuant to the terms of their contractual obligations.

Note 6 — Debt

A summary of the detail comprising the Company’s debt and the related book values for the respective periods presented is as follows (in thousands):

11.00% Second-Priority Senior Secured Notes – due April 2022. The 11.00% Senior Secured Notes were issued pursuant to an indenture dated May 10, 2018. The 11.00% Senior Secured Notes mature April 3, 2022 and have interest payable semi-annually each April 15 and October 15. Prior to May 10, 2019, the Company may, at its option, redeem all or a portion of the 11.00% Senior Secured Notes at 100% of the principal amount plus accrued and unpaid interest and a make-whole premium. Thereafter, the Company may redeem all or a portion of the 11.00% Senior Secured Notes at redemption prices decreasing annually from 105.5% to 100.0% plus accrued and unpaid interest.

The indenture governing the 11.00% Senior Secured Notes applies certain limitations on the Company’s ability and the ability of its subsidiaries to, among other things, (i) incur additional indebtedness or issue certain preferred shares; (ii) pay dividends and make certain other restricted payments; (iii) create restrictions on the payment of dividends or other distributions to the Company from its restricted subsidiaries; (iv) create liens on certain assets to secure debt; (v) make certain investments; (vi) engage in sales of assets and subsidiary stock; (vii) transfer all or substantially all of its assets or enter into merger or consolidation transactions; and (viii) engage in transactions with affiliates. The 11.00% Senior Secured Notes contain customary quarterly and annual reporting, financial and administrative covenants. The Company was in compliance with all debt covenants at March 31, 2019.

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7.50% Senior Secured Notes – due May 2022.  The 7.50% Stone Senior Notes represent the remaining $6.1 million of long-term debt assumed in the Stone Combination that were not exchanged for 11.00% Senior Secured Notes and thus remain outstanding. As a result, substantially all of the restrictive covenants relating to the 7.50% Stone Senior Notes have been removed and collateral securing the 7.50% Stone Senior Notes has been released. The 7.50% Stone Senior Notes mature May 31, 2022 and have interest payable semi-annually each May 31 and November 30. Prior to May 31, 2020, the Company may, at its option, redeem all or a portion of the 7.50% Stone Senior Notes at 100% of the principal amount plus accrued and unpaid interest and a make-whole premium. Thereafter, the Company may redeem all or a portion of the 7.50% Stone Senior Notes at redemption prices decreasing annually from 105.625% to 100.0% plus accrued and unpaid interest.

Bank Credit Facility – due May 2022. The Company and Talos Production LLC, our wholly-owned subsidiary, executed the Bank Credit Facility in conjunction with the Stone Combination with a syndicate of financial institutions, with an initial borrowing base of $600.0 million. The Bank Credit Facility matures on May 10, 2022.  

The Bank Credit Facility bears interest based on the borrowing base usage, at the applicable London InterBank Offered Rate, plus applicable margins ranging from 2.75% to 3.75% or an alternate base rate, based on the federal funds effective rate plus applicable margins ranging from 1.75% to 2.75%. In addition, the Company is obligated to pay a commitment fee of 0.50% on the unfunded portion of the commitments under the Bank Credit Facility. The Bank Credit Facility has certain debt covenants, the most restrictive of which is that the Company must maintain a total debt to EBITDAX Ratio (as defined in the Bank Credit Facility) of no greater than 3.00 to 1.00 each quarter. The Company must also maintain a current ratio no less than 1.00 to 1.00 each quarter. According to the Bank Credit Facility, undrawn commitments are included in current assets in the current ratio calculation. The Bank Credit Facility is secured by substantially all of the oil and natural gas assets of the Company. The Bank Credit Facility is fully and unconditionally guaranteed by the Company and certain of its wholly-owned subsidiaries.

The Bank Credit Facility provides for determination of the borrowing base based on the Company’s proved producing reserves and a portion of its proved undeveloped reserves. The borrowing base is redetermined by the lenders at least semi-annually during the second quarter and fourth quarter. On November 16, 2018 the borrowing base was increased from $600.0 million to $850.0 million. However, the Company elected to maintain the $600.0 million commitment based upon its current liquidity needs. The next redetermination is expected to occur during the second quarter of 2019.

As of March 31, 2019, the Company’s borrowing base was set at $600.0 million, of which no more than $200 million can be used as letters of credit. The amount the Company is able to borrow with respect to the borrowing base is subject to compliance with the financial covenants and other provisions of the Bank Credit Facility. On March 29, 2019, the Company repaid $25.0 million of the Bank Credit Facility. The Company was in compliance with all debt covenants at March 31, 2019. As of March 31, 2019, the Bank Credit Facility had approximately $309.8 million of undrawn commitments (taking into account $15.2 million letters of credit and $275.0 million drawn from the Bank Credit Facility).

Subsequent event. During April 2019, the Company borrowed $40.0 million for general corporate purposes.

Building Loan – due November 2030. In connection with the Stone Combination, the Company assumed Stone’s 4.20% term loan maturing on November 20, 2030 (the “Building Loan”). The Building Loan bears interest at a rate of 4.20% per annum and is to be repaid in 180 equal monthly installments of approximately $0.1 million. As of March 31, 2019, the outstanding balance under the Building Loan totaled $10.5 million. The Building Loan is collateralized by the Company’s two office buildings in Lafayette, Louisiana. Under the financial covenants of the Building Loan, the Company must maintain a ratio of EBITDA to Net Interest Expense of not less than 2.00 to 1.00. In addition, the Building Loan contains certain customary restrictions or requirements with respect to change of control and reporting responsibilities. The Company was in compliance with all covenants under the Building Loan as of March 31, 2019.

Note 7 — Employee Benefits Plans and Share-Based Compensation

Talos Energy Inc. Long Term Incentive Plan

Under the Talos Energy Inc. Long Term Incentive Plan (the “LTIP”), the Company may issue, subject to Board approval, grants of options, stock appreciation rights, restricted stock, restricted stock units, stock awards, dividend equivalents, other stock-based awards, cash awards, substitute awards or any combination of the foregoing to employees, directors and consultants. The LTIP authorizes the Company to grant awards of up to 5,415,576 shares of the Company’s common stock.

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Restricted Stock Units. During the three months ended March 31, 2019, the Company granted 673,617 RSUs under the LTIP to employees and non-employees. The following table summarizes RSU activity for the three months ended March 31, 2019:

Performance Stock Units. During the three months ended March 31, 2019, the Company granted 190,972 PSUs under the LTIP to employees. The following table summarizes PSU activity for the three months ended March 31, 2019:

The grant date fair value of the PSUs granted during the three months ended March 31, 2019, calculated using a Monte Carlo simulation, was $6.2 million. The following table summarizes the assumptions used to calculate the grant date fair value of the PSUs granted on March 5, 2019:

Share-based Compensation Expense, net

Share-based compensation expense is reflected as “General administrative expense,” net amounts capitalized to oil and gas properties in the consolidated statement of operations. Because of the non-cash nature of share-based compensation, the expensed portion of share-based compensation is added back to net income in arriving at net cash used in or provided by operating activities in the condensed consolidated statement of cash flows. For the three months ended March 31, 2019 and 2018, share-based compensation expense was $1.3 million and $0.3 million, net of $1.0 million and $0.2 million of capitalization, respectively.

Note 8 — Income Taxes

Prior to the Stone Combination in May of 2018, Talos Energy LLC was a partnership for U.S. federal income tax purposes and was not subject to U.S. federal income tax or state income tax (in most states) at the entity level. As such, Talos Energy LLC did not recognize U.S. federal income tax expense or state income tax expense in most states. Talos Energy LLC’s operations in the shallow waters off the coast of Mexico were conducted under a different legal form and are subject to foreign income taxes. 

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For the three months ended March 31, 2019, the Company recognized income tax benefit of $6.4 million for an effective tax rate of 5.48%. The difference between the Company’s effective tax rate of 5.48% and federal statutory income tax rate of 21% is primarily due to a reduction to the valuation allowance.  For the three months ended March 31, 2018, the Company’s effective tax rate differed from the federal statutory rate of 21% because the Company was not subject to U.S. federal or state taxation as a partnership and the Company’s Mexico operations did not incur a material income tax expense.

The Company evaluates and updates the estimated annual effective income tax rate on a quarterly basis based on current and forecasted operating results and tax laws. Consequently, based upon the mix and timing of the Company’s actual earnings compared to annual projections, the effective tax rate may vary quarterly and may make quarterly comparisons not meaningful. The quarterly income tax provision is generally comprised of tax expense on income or benefit on loss at the most recent estimated annual effective tax rate.  The tax effect of discrete items are recognized in the period in which they occur at the applicable statutory rate.

Deferred income tax assets and liabilities are recorded related to net operating losses and temporary differences between the book and tax basis of assets and liabilities expected to produce deductions and income in the future.  The realization of deferred tax assets depends on recognition of sufficient future taxable income in specific tax jurisdictions in which those temporary differences or net operating losses are deductible.  When assessing the need for a valuation allowance on deferred tax assets, the Company considers whether it is more likely than not that some portion or all of them will not be realized.  As of December 31, 2018, the Company had a valuation allowance related to federal, state and foreign deferred tax assets.

Note 9 — Loss Per Share

Basic earnings per share is computed by dividing net loss attributable to common stockholders by the weighted average number of shares of common stock outstanding during the period.  Except when the effect would be antidilutive, diluted earnings per share include the impact of RSUs, PSUs and outstanding warrants.

The following table presents the computation of basic and diluted earnings per share for Talos Energy Inc. (in thousands except for per share amounts):

For the periods prior to May 10, 2018, the Company retrospectively adjusted the weighted average shares used in determining earnings per share to reflect the number of shares Talos Energy LLC received in the Stone Combination. There is no impact for the three months ended March 31, 2018 on diluted earnings per common share from the RSUs, PSUs and outstanding warrants as these instruments did not exist throughout such periods.

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Note 10 — Related Party Transactions

Whistler Acquisition. On August 31, 2018, the Company acquired certain properties from Whistler Energy II Holdco, LLC, an affiliate of the Apollo Funds, for $52.6 million ($14.8 million net of $37.8 million of cash acquired). Included in current assets acquired as of March 31, 2019 is $1.1 million in receivables from an affiliate of the Apollo Funds to reimburse the Company for certain payments made or to be made post-closing. See additional details in Note 2 – Acquisitions.

Equity Registration Rights Agreement. On the Closing Date, the Company entered into a Registration Rights Agreement (the “Equity Registration Rights Agreement”) with each of the Apollo Funds, Riverstone Funds, Franklin Advisers, Inc. (“Franklin”) and MacKay Shields LLC (“MacKay Shields”) relating to the registered resale of the Company’s common stock owned by such parties as of Closing. The Company will bear all of the expenses incurred in connection with the offer and sale, while the Apollo Funds, Riverstone Funds, Franklin and MacKay Shields will be responsible for paying underwriting fees, discounts and commissions or similar charges.  Fees incurred by the Company in conjunction with the Equity Registration Rights Agreement were $0.6 million for the three months ended March 31, 2019.

Legal Fees. The Company has engaged the law firm Vinson & Elkins L.L.P. to provide legal services. An immediate family member of William S. Moss III, our Executive Vice President and General Counsel and one of the Company’s executive officers, is a partner at Vinson & Elkins L.L.P. For the three months ended March 31, 2019 and 2018, we incurred fees of approximately $1.1 million and $1.1 million, respectively, of which $1.6 million and $4.9 million were payable at each respective balance sheet date for legal services performed by Vinson & Elkins L.L.P.

Service Fee Agreement. Talos Energy LLC entered into service fee agreements with Apollo Funds and Riverstone Funds for the provision of certain management consulting and advisory services. Under each agreement, the Company paid a fee equal to the higher of (i) a certain percentage of earnings before interest, income taxes, depletion, depreciation and amortization and (ii) a fixed fee payable quarterly, provided, however, such fees did not exceed in each case $0.5 million, in aggregate, for any calendar year. For the three months ended March 31, 2019 and 2018, the Company incurred approximately nil and $0.1 million, respectively, for these services. These fees are recognized in “General and administrative expense” on the condensed consolidated statements of operations. In connection with the Stone Combination on May 10, 2018, the Service Fee Agreement was terminated.

Note 11 — Commitments and Contingencies

Performance Obligations

Regulations with respect to offshore operations govern, among other things, engineering and construction specifications for production facilities, safety procedures, plugging and abandonment of wells, removal of facilities and to guarantee the execution of the minimum work program under the Mexico production sharing contracts. As of March 31, 2019, the Company had secured performance bonds totaling approximately $649.0 million. As of March 31, 2019, the Company had $15.2 million in letters of credit issued under its Bank Credit Facility.

Legal Proceedings

The Company is named as a party in certain lawsuits and regulatory proceedings arising in the ordinary course of business. The Company does not expect that these matters, individually or in the aggregate, will have a material adverse effect on its financial condition.

Note 12 — Condensed Consolidating Financial Information

The Company owns no operating assets, has no operations independent of its subsidiaries and owns 100% of the Talos Issuers. The Talos Issuers issued 11.00% Senior Secured Notes on May 10, 2018, which are fully and unconditionally guaranteed, jointly and severally, by the Company and certain of its 100% owned subsidiaries (“Guarantors”) on a senior unsecured basis. Certain of the Company’s subsidiaries which are accounted for on a consolidated basis do not guarantee the 11.00% Senior Secured Notes (“Non-Guarantors”).

The following condensed consolidating financial information presents the financial information of the Company on an unconsolidated stand-alone basis and its combined subsidiary issuers, combined guarantor and combined non-guarantor subsidiaries as of and for the periods indicated. As described in Note 1 – Formation and Basis of Presentation, the Company retrospectively adjusted its consolidated equity to reflect the legal capital of the Company for all periods presented. Such financial information may not necessarily be indicative of the Company’s results of operations, cash flows or financial position had these subsidiaries operated as independent entities.

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TALOS ENERGY INC.

CONDENSED CONSOLIDATING BALANCE SHEET

AS OF MARCH 31, 2019

(In thousands)

(Unaudited)