NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(unaudited)
Note 1 Summary of Operations
Foothills Resources, Inc. (Foothills), a Nevada corporation, and its subsidiaries are collectively referred to herein as the Company. The Company is a growth-oriented independent energy company engaged in the acquisition, exploration, exploitation and development of oil and natural gas properties. The Company currently holds interests in properties in the Texas Gulf Coast area, in the Eel River Basin in northern California, and in the Anadarko Basin in southwest Oklahoma.
The Company took its current form on April 6, 2006, when Brasada California, Inc. (Brasada) merged with and into an acquisition subsidiary of Foothills. Brasada was formed on December 29, 2005 as Brasada Resources LLC, a Delaware limited liability company, and converted to a Delaware corporation on February 28, 2006. Following the merger, Brasada changed its name to Foothills California, Inc. (Foothills California) and is now a wholly owned operating subsidiary of Foothills. This transaction was accounted for as a reverse takeover of the Company by Foothills California. The Company adopted the assets, management, business operations and business plan of Foothills California. The financial statements of the Company prior to the merger were eliminated at consolidation.
These financial statements have been prepared by the Company without audit, and include all adjustments (which consist solely of normal recurring adjustments) which, in the opinion of management, are necessary for a fair presentation of financial position and results of operations. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted, although the Company believes that the disclosures are adequate to make the information presented not misleading. It is suggested that these financial statements be read in conjunction with the Companys audited financial statements and the notes thereto for the year ended December 31, 2006.
Note 2 New Accounting Pronouncements
During February 2007, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159), which permits all entities to choose, at specified election dates, to measure eligible items at fair value. SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value, and thereby mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The statement also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for
similar types of assets and liabilities. SFAS 159 is effective as of the beginning of an entitys first fiscal year that begins after November 15, 2007. The Company is evaluating the impact that this statement will have on its financial statements.
In September 2006, the FASB issued SFAS No. 158, Employers Accounting for Defined Benefit Plans and Other Postretirement Plans (SFAS 158). The statement requires employers to recognize any overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in their financial statements. Unrealized components of net periodic benefit costs are reflected in other comprehensive income, net of tax. SFAS 158 requires recognition of the funded status and related disclosures as of the end of the fiscal year ending after December 15, 2006. Adoption of this statement had no impact on the Companys financial position or results of operations.
10
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is continuing to assess the potential impacts this statement might have on its consolidated financial statements and related footnotes.
During September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 108. This Bulletin provides the Staffs views on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. The guidance in SAB No. 108 is effective for financial statements of fiscal years ending after November 15, 2006. Adoption of this guidance did not impact the Companys financial statements.
In July 2006, the FASB issued Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109, to clarify certain aspects of accounting for uncertain tax positions, including issues related to the recognition and measurement of those tax positions. This interpretation is effective for fiscal years beginning after December 15, 2006. Adoption of this statement had no impact on the Companys financial position or results of operations.
In March 2006, the FASB issued SFAS No.156, Accounting for Servicing of Financial Assets (SFAS 156), which requires all separately recognized servicing assets and servicing liabilities be initially measured at fair value. SFAS 156 permits, but does not require, the subsequent measurement of servicing assets and servicing liabilities at fair value. Adoption is required as of the beginning of the first fiscal year that begins after September 15, 2006. The adoption of SFAS 156 did not have a material effect on the Companys consolidated financial position, results of operations or cash flows.
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140 (SFAS 155). SFAS 155 clarifies certain issues relating to embedded derivatives and beneficial interests in securitized financial assets. The provisions of SFAS 155 are effective for all financial instruments acquired or issued after fiscal years beginning after September 15, 2006. Adoption of this statement had no impact on the Companys financial position or results of operations.
Note 3 Asset Retirement Obligation
The following table sets forth a reconciliation of the beginning and ending asset retirement obligation for the nine months ended September 30, 2007 (in thousands):
|
|
|
Asset retirement obligation, beginning of period
|
$ 570
|
|
Accretion expense
|
33
|
|
|
|
|
Asset retirement obligation, end of period
|
$ 603
|
|
11
Note 4 Long-term Debt
Long-term debt at September 30, 2007 and December 31, 2006 consisted of the following (in thousands):
|
|
|
|
|
|
September
30, 2007
|
|
December 31, 2006
|
|
|
|
|
|
|
Secured promissory note
|
$ 42,500
|
|
$ 42,500
|
|
Less: unamortized discount
|
(7,678
|
)
|
(10,325
|
)
|
|
34,822
|
|
32,175
|
|
Less: current portion
|
(5,398
|
)
|
(2,509
|
)
|
|
|
|
|
|
|
$ 29,424
|
|
$ 29,666
|
|
To finance a portion of the acquisition of certain producing properties in the Texas Gulf Coast area (the Texas Acquisition) in 2006, the Company executed a credit agreement (the Credit Agreement) with a financial institution (the Lender), whereby the Company may borrow funds under a credit facility in an amount not to exceed $42,500,000 (the Facility). As of September 30, 2007, $42,500,000 was outstanding under the Facility.
The Facility will terminate and all amounts borrowed under the Facility will be due and payable on September 7, 2010. The interest rate on the Facility was initially LIBOR plus 700 basis points, and was increased by 100 basis points on each of September 22, 2006, October 23, 2006 and November 22, 2006 when the Company did not satisfy a requirement of the credit agreement to raise an additional $5,000,000 in equity capital on or before those dates. The interest rate at September 30, 2007 was 15.2%. The Company is required to make quarterly interest and principal payments on the Facility equal to the adjusted net cash flow attributable to the properties acquired in the Texas Acquisition. The Facility is secured by liens and security interests on substantially all of the assets of the Company, including 100% of the Companys oil and gas reserves, and prohibits any dividends on or
redemptions of Foothills capital stock.
The terms of the Facility require the Company to maintain certain covenants. As of September 30, 2007, the Company was in compliance with all of the financial covenants.
The Company issued to an affiliate of the Lender a warrant to purchase 3,000,000 shares of its common stock for five years at an exercise price of $2.75 per share. In addition, the Company conveyed to the Lender a 5% overriding royalty interest in all oil and gas leases associated with the Texas Acquisition, but excluding new exploration projects relating to other formations on these properties, to the extent they are distinct from operations included in the Lenders approved plan of development and the related engineering report for the Texas Acquisition and are funded through equity capital. The fair values of the warrant and the overriding royalty interest amounted to an aggregate of $11,426,000. This amount was recorded as debt issue discount, which is being amortized using the interest method.
Note 5 Stockholders Equity
Registration rights payments
The purchasers of units consisting of shares of common stock and warrants issued by Foothills in private placement financings in 2006 have registration rights, pursuant to which the Company agreed to register for resale the shares of common stock and the shares of common stock issuable upon exercise of the warrants. In the event that the registration statements are not declared effective by the Securities and Exchange Commission (SEC) by specified dates, the Company is required to pay liquidated damages to the purchasers.
12
The purchasers of 17,142,857 units issued in April 2006 are entitled to liquidated damages in the amount of 1% per month of the purchase price for each unit, payable each month that the registration statement is not declared effective following the mandatory effective date (January 28, 2007). The total amount recorded at September 30, 2007 for these liquidated damages was $322,000. Amounts payable as liquidated damages cease when the shares can be sold under Rule 144 of the Securities Act of 1933, as amended. The Company has determined that liquidated damages ceased on April 6, 2007 as to a minimum of 16,192,613 units, and that liquidated damages ceased on July 6, 2007 as to the remaining units.
The purchasers of an aggregate of 10,093,804 units issued in September 2006 are entitled to liquidated damages in the amount of 1% per month of the purchase price for each unit, payable each month that the registration statement is not declared effective following the applicable mandatory effective dates (March 7, 2007 for 10,000,000 units and March 28, 2007 for the remaining 93,804 units). The total amount recorded at September 30, 2007 for these liquidated damages was $1,573,000. The investors in the September 2006 private placement financing have the right to take the liquidated damages either in cash or in shares of Foothills common stock, at their election. If the Company fails to pay the cash payment to an investor entitled thereto by the due date, the Company will pay interest thereon at a rate of 12% per annum (or such lesser maximum amount that is permitted to be paid by
applicable law) to such investor, accruing daily from the date such liquidated damages are due until such amounts, plus all such interest thereon, are paid in full. The total amount of liquidated damages will not exceed 10% of the purchase price for the units or $2,271,000.
The Company filed the required registration statement but the registration statement has not yet become effective. As a result, the Company had incurred the obligation to pay a total of approximately $1,895,000 in liquidated damages as of September 30, 2007, which amount has been recorded as liquidated damages expense in the consolidated statement of operations.
Stock-based employee compensation plan
Foothills 2006 and 2007 Equity Incentive Plans (the Plans) enable the Company to provide equity-based incentives through grants or awards to present and future employees, directors, consultants and other third party service providers. Foothills Board of Directors reserved an aggregate total of 7,000,000 shares of Foothills common stock for issuance under the Plans. The compensation committee of the Board administers the Plans. The Plans authorize the grant to participants of nonqualified stock options, incentive stock options, restricted stock awards, restricted stock units, performance grants intended to comply with Section 162(m) of the Internal Revenue Code, as amended, and stock appreciation rights. Generally, options are granted at prices equal to the fair value of the stock at the date of grant, expire not later than 10 years from the date of grant, and
vest ratably over a three-year period following the date of grant. From time to time, options with differing terms have been granted, as approved by the Board of Directors.
The estimated fair value of the options granted during the nine months ended September 30, 2007 was calculated using a Black Scholes Merton option pricing model (Black Scholes). The following schedule reflects the various assumptions included in this model as it relates to the valuation of options:
|
|
|
Risk free interest rate
|
4.6 5.2
|
%
|
Expected volatility
|
85 116
|
%
|
Weighted-average volatility
|
102
|
%
|
Dividend yield
|
0
|
%
|
Expected years until exercise
|
0.5 3.0
|
|
13
The Black Scholes model incorporates assumptions to value stock-based awards. The risk-free rate of interest for periods within the expected term of the option was based on a zero-coupon U.S. government instrument over the expected term of the equity instrument. Because Foothills common stock has limited trading history, expected volatility was based on the historical volatility of a representative stock with characteristics similar to the Company. The Company has limited historical experience upon which to base estimates of employee option exercise timing (expected term) within the valuation model, and utilized estimates for the expected term based on criteria required by SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123R).
Option activity under the Plans during the nine months ended September 30, 2007 was as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Shares
|
|
|
Weighted
Average
Exercise
Price
|
|
Weighted
Average
Remaining
Contractual
Term In
Years
|
|
Aggregate
Intrinsic
Value
|
Outstanding at January 1, 2007
|
|
1,790,000
|
|
|
$
|
1.53
|
|
|
|
|
|
Granted
|
|
95,000
|
|
|
|
1.19
|
|
|
|
|
|
Exercised
|
|
-
|
|
|
|
-
|
|
|
|
|
|
Forfeited
|
|
-
|
|
|
|
-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding at September 30, 2007
|
|
1,885,000
|
|
|
$
|
1.52
|
|
8.7
|
|
$
|
216,000
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercisable at September 30, 2007
|
|
948,750
|
|
|
$
|
1.61
|
|
8.7
|
|
$
|
108,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock-based compensation for the three and nine months ended September 30, 2007 totaling $104,000 and $356,000, respectively, has been recognized as a component of general and administrative expenses in the accompanying consolidated financial statements. The weighted-average grant-date fair value of options granted during the nine months ended September 30, 2007 was $0.83. As of September 30, 2007, $736,000 of total unrecognized compensation cost related to stock options is expected to be recognized over a weighted-average period of approximately 2.6 years. The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the closing stock price on the last trading day of September 2007 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders
exercised their options on September 30, 2007. The amount of aggregate intrinsic value will change based on the fair market value of the Companys stock. As of September 30, 2007, 5,115,000 shares were available for future grants under the Plans. No stock options were exercised during the nine months ended September 30, 2007.
14
Note 6 Derivative Instruments and Price Risk Management Activities
The Company has entered into derivative contracts to manage its exposure to commodity price risk. These derivative contracts, which are placed with a major financial institution that the Company believes is a minimal credit risk, currently consist only of swaps. The oil prices upon which the commodity derivative contracts are based reflect various market indices that have a high degree of historical correlation with actual prices received by the Company for its oil production. Swaps are designed to fix the price of anticipated sales of future production. The Company entered into most of the contracts at the time it acquired certain operated oil and gas property interests as a means to reduce the future price volatility on its sales of oil production, as well as to achieve a more predictable cash flow from its oil and gas properties. The Company has designated its price hedging instruments
as cash flow hedges in accordance with SFAS No. 133. The Company recognizes gains or losses on settlement of its hedging instruments in oil and gas revenues, and changes in their fair value as a component of other comprehensive income, net of deferred taxes. For the three and nine months ended September 30, 2007 and 2006, the Company recognized the following pre-tax gains and losses due to realized settlements of its price hedging contracts (in thousands):
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
|
2007
|
|
2006
|
|
2007
|
|
2006
|
|
Recognized gains (losses) on settlement of hedging instruments
|
$(118)
|
|
$ 37
|
|
$ 518
|
|
$ 37
|
|
Accumulated other comprehensive income included an unrealized loss of $1,890,000 as of September 30, 2007 and an unrealized gain of $1,595,000 as of December 31, 2006 on the Companys cash flow hedges. As of September 30, 2007, the Company anticipates that $948,000 of unrealized losses, net of deferred taxes of zero, will be reclassified into earnings within the next 12 months. Irrespective of the unrealized gains or losses reflected in other comprehensive income, the ultimate impact to net income over the life of the hedges will reflect the actual settlement values. No cash flow hedges were determined to be ineffective during 2007. Further details relating to the Companys hedging activities are as follows:
Hedging contracts held as of September 30, 2007 were as follows:
Contract
Period
and
Type
|
|
Total
Volume
|
|
NYMEX
Swap
Price
|
|
Fair
Value
(in
thousands)
|
|
|
|
|
|
|
|
|
|
Crude oil contracts (barrels)
|
|
|
|
|
|
|
|
Swap contracts:
|
|
|
|
|
|
|
|
October 2007 December 2007
|
|
37,353
|
|
$
|
71.69
|
|
$
|
(314)
|
|
January 2008 December 2008
|
|
148,994
|
|
71.01
|
|
(783)
|
|
January 2009 December 2009
|
|
135,041
|
|
69.41
|
|
(516)
|
|
January 2010 September 2010
|
|
74,206
|
|
68.00
|
|
(277)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
(1,890)
|
|
|
|
|
|
|
|
|
|
|
|
15