Note 3. Acquisitions and Divestitures

Earthstone Energy Reverse Acquisition

On December 19, 2014, the Company and OVR closed the Exchange. In this transaction, OVR contributed to the Company the membership interests of its three wholly-owned subsidiaries, which included producing assets, undeveloped acreage and cash. OVR received approximately 9.124 million shares of newly issued common stock, $0.001 par value per share (the “Common Stock”), of the Company. The Exchange resulted in a change of control of the Company. The Exchange has been accounted in accordance with FASB ASC 805, as a reverse acquisition whereby Oak Valley is considered the acquirer for accounting purposes although Earthstone is the acquirer for legal purposes. ASC 805 also requires, that among other things, assets acquired and liabilities assumed to be measured at their acquisition date fair values. The results of operations from Earthstone’s legacy assets are reflected in the Company’s consolidated statement of operations beginning December 19, 2014.

An allocation of the purchase price was prepared using, among other things, the 2014 year-end reserve report prepared by Cawley, Gillespie and Associates, Inc. (“CG&A”) that was adjusted and re-priced by the Company’s reserve engineering staff back to the December 19, 2014 acquisition date.

The following table summarizes the consideration paid to acquire the legacy Earthstone net assets and the estimated values of those net assets (in thousands, except share and share price amounts):

Shares of Common Stock outstanding before the Exchange		1,734,988
Company director and officer restricted shares that vested in the Exchange		18,400
Shares of Common Stock issued in the Exchange		9,124,452
Total shares of Common Stock outstanding following the Exchange		10,877,840

Shares of Common Stock issued as consideration		1,753,388
Closing price of Common Stock ⁽¹⁾	$	19.08
Total purchase price	$	33,455
Estimated Fair Value of Liabilities Assumed:
Current liabilities	$	7,631
Long-term debt		7,000
Deferred tax liability ⁽²⁾		2,880
Asset retirement obligation		1,035
Amount attributable to liabilities assumed		18,546
Total purchase price plus liabilities assumed	$	52,001
Estimated Fair Value of Assets Acquired:
Cash ⁽³⁾	$	2,920
Other current assets		3,466
Proved oil and natural gas properties ^{(4) (5)}		21,813
Unproved oil and natural gas properties		5,524
Other non-current assets		745
Amount attributable to assets acquired	$	34,468
Goodwill ⁽⁶⁾	$	17,533

(1)

The share price used for the determination of the purchase price, was the adjusted closing price of the Common Stock on December 19, 2014.

(2)

This amount represents the recorded book value versus tax value difference in oil and natural gas properties and other net assets as of the date the Exchange on a tax effected basis of approximately 35%. The tax basis of the legacy Earthstone assets were not adjusted in the Exchange. As noted above, however, ASC 805 requires that the Company in a reverse acquisition record the legacy Earthstone net assets at fair value on the date of the Exchange; the fair value of the net assets was in excess of the tax basis and as such required the recognition of a deferred tax liability.

(3)

The components of cash flow in the Exchange transaction in which the legacy Earthstone assets were acquired was $7.1 million in notes payable and accrued interest that was paid in full in conjunction with the Exchange less the cash acquired of $2.9 million.

(4)

The weighted average commodity prices utilized in the determination of the fair value of oil and natural gas properties was $51.62 per barrel of oil and $4.58 per Mcf of natural gas after adjustments for transportation fees and regional price differentials.

(5)

The market assumptions as to future commodity prices, projections of estimated quantities of oil and natural gas reserves, expectations for timing and amount of future development and operating costs, projections of future rates of production, expected recovery rates and risk adjusted discount rates used by the Company to estimate the fair value of the oil and natural gas properties represent Level 3 inputs. For additional information on Level 3 inputs, see Note 6 Fair Value Adjustments.

(6)

Goodwill was determined to be the excess consideration exchanged over the fair value of the Company’s net assets on December 19, 2014. During the three months ended December 31, 2015, a decrease of $1.4 million was recorded to goodwill and reflect purchase price adjustments made to estimated items in the preliminary purchase price allocation. The goodwill recognized will not be deductible for tax purposes.

2014 Eagle Ford Acquisition Properties

Also on December 19, 2014, immediately following the Exchange, Flatonia Energy, LLC (“Flatonia”), Parallel Resource Partners, LLC (“Parallel”), and Sabine, closed the transactions contemplated by the Contribution Agreement by and among the Company, OVR, Sabine, OVO, Parallel, and Flatonia, whereby Parallel contributed 28.57% of the oil and natural gas property interests held by Flatonia, a wholly owned subsidiary of Parallel, in consideration for approximately 2.957 million shares of Common Stock (the “Contribution”). The assets subject to the Contribution Agreement were oil and natural gas property interests in producing wells and acreage in the Eagle Ford trend of Texas (the “2014 Eagle Ford Acquisition Properties”). One of the subsidiaries included in the Exchange is the operator of the 2014 Eagle Ford Acquisition Properties. The only relationship that Flatonia or Parallel had with this subsidiary or the Company prior to the transaction was that the subsidiary is the operator of the 2014 Eagle Ford Acquisition Properties. The Contribution was accounted for as a business combination in accordance ASC 805 which among other things requires the assets acquired and liabilities assumed to be measured and recorded at their fair values as of the acquisition date.

An allocation of the purchase price was prepared using, the 2014 year-end reserve report prepared by CG&A that was adjusted and re-priced by the Company’s reserve engineering staff back to December 19, 2014. During the three months ended December 31, 2015, the preliminary purchase price allocation was adjusted due to the completion of the 2014 Flatonia tax return, with respect to the deferred tax liability.

The following table summarizes the consideration paid to acquire the 2014 Eagle Ford Acquisition Properties and the estimated values of those net assets (in thousands, except share and share price amounts):

Shares of Common Stock issued as consideration in the Contribution		2,957,288
Closing price of Common Stock ⁽¹⁾	$	19.08
Total purchase price	$	56,425

Estimated Fair Value of Liabilities Assumed:
Deferred tax liability ⁽²⁾	$	1,547
Asset retirement obligation		173
Amount attributable to liabilities assumed		1,720
Total purchase price plus liabilities assumed	$	58,145

Estimated Fair Value of Assets Acquired:
Proved oil and natural gas properties ^{(3) (4)}	$	34,745
Unproved oil and natural gas properties		21,853
Amount attributable to assets acquired	$	56,598

Goodwill ⁽⁵⁾	$	1,547

(1)

The share price used for the determination of the purchase price, was the adjusted closing price of the Common Stock on December 19, 2014.

(2)

This amount represents the recorded book value to tax difference of the oil and natural gas properties as of the date of the closing of the Contribution Agreement on a tax effected basis of approximately 34%. As noted above, the Company received the net assets acquired at Flatonia’s carryover tax basis; however, ASC 805 requires assets acquired and liabilities assumed be measured at their fair values as of the acquisition date; the fair value of the 2014 Eagle Ford Acquisition Properties on December 19, 2014 was in excess of the tax basis and as such required the recognition of a deferred tax liability.

(3)

The weighted average commodity prices utilized in the determination of the fair value of oil and natural gas properties was $56.36 per barrel of oil and $3.36 per Mcf of natural gas after adjustments for transportation fees and regional price differentials.

(4)

(5)

Goodwill was determined as the excess consideration exchanged over the fair value of the 2014 Eagle Ford Acquisition Properties on December 19, 2014. During the fourth quarter of 2015 and due to the current commodity price environment, the Company determined that the goodwill balance was not recoverable and therefore fully impaired it, recording a goodwill impairment charge of $1.5 million. See Note 5 Asset Impairments.

The following unaudited pro forma combined condensed results of operations are provided for the years ended December 31, 2014 and 2013 as though the Exchange and Contribution had been completed as of January 1, 2013. These unaudited supplemental pro forma results of operations are provided for illustrative purposes only and do not purport to be indicative of the actual results that would have been achieved by the combined company for the periods presented or that may be achieved by the combined company in the future. The pro forma results of operations do not include any cost savings or other synergies that resulted, or may result, from the Exchange or Contribution or any estimated costs that will be incurred to integrate the legacy Earthstone net assets and the 2014 Eagle Ford Acquisition Properties. Future results may vary significantly from the results reflected in this unaudited pro forma financial information (in thousands, except per share amounts).

	Years ended December 31,
	2014		2013
	(Unaudited)
Revenue	$	85,633	$	66,450
Income before taxes	$	16,196	$	2,460
Net income available to Earthstone common stockholders	$	10,672	$	1,610
Pro forma net loss per common share:
Basic and diluted	$	0.77	$	0.12

The Company’s historical financial information was adjusted to give effect to the pro formas events that were directly attributable to the Exchange and the Contribution and were factually supportable. The unaudited pro forma consolidated results include the historical revenues and expenses of the assets acquired and liabilities assumed in the transactions noted above with the following adjustments:

Adjustments to recognize incremental depletion expense under the successful efforts method of accounting based on the fair value of the oil and natural gas properties and incremental accretion expense based on the asset retirement costs of the oil and natural gas properties acquired;

Eliminate historical interest expense for the legacy Earthstone debt that was retired;

Eliminate transaction costs and non-recurring charges directly related to the transactions that were included in the historical results of operations for Earthstone and OVR in the amount of $3.3 million. Transaction costs directly related to the transactions that do not have a continuing impact on the combined Company’s operating results have been excluded from the 2014 and 2013 pro forma earnings;

Adjustments to recognize pro forma income tax based on an assumed approximate 35% rate;

Adjustments to convert the full cost method financial statement of Earthstone to successful efforts financial statements which included adjusting exploration expense which would not have been capitalized under successful efforts method of accounting for oil and natural gas activities; and

Adjustment to eliminate the non-recurring deferred tax expense charge for the conversion of the Oak Valley subsidiaries from a non-taxable partnership to a taxable corporation.

2013 Eagle Ford Acquisition

In July 2013 and August 2013, the Company purchased producing wells and acreage in the Eagle Ford shale trend of South Texas for approximately $71.6 million and $15.1 million, respectively (the “2013 Eagle Ford Acquisition”). The 2013 Eagle Ford Acquisition was accounted for as a business combination in accordance with ASC Topic 805, which among other things, requires assets acquired and liabilities assumed to be measured at fair value as of the effective date of the acquisition. The effective date of the 2013 Eagle Ford Acquisition was January 1, 2013. The estimated fair value of the properties approximates the fair value of consideration, and as a result, no goodwill was recognized.

The following table summarizes the consideration paid to acquire the properties and the amounts of the assets acquired and liabilities assumed:

(In thousands)
Purchase price	$	86,687
Allocation of purchase price:
Proved properties ^{(1) (2)}	$	57,255
Unproved properties		30,041
Asset retirement obligations		(609	)
Total	$	86,687

(1)

The weighted average commodity prices utilized in the determination of the fair value of oil and natural gas properties was $99.32 per barrel of oil and $3.24 per Mcf of natural gas after adjustments for transportation fees and regional price differentials.

(2)

The following unaudited pro forma combined results of operations are provided for the year ended December 31, 2013 as if the 2013 Eagle Ford Acquisition had been completed as of January 1, 2013. The pro forma combined results of operations for the year ended December 31, 2013 have been prepared by adjusting historical results of the Company to include the historical results of the 2013 Eagle Ford Acquisition. These supplemental pro-forma results of operations are provided for illustrative purposes only and do not purport to be indicative of the actual results that would have been achieved by the combined company for the periods presented or that may be achieved by the combined company in the future. The pro forma results of operations do not include any cost savings or other synergies that resulted, or may result, from the Eagle Ford Acquisition or any estimated costs that will be incurred to integrate the 2013 Eagle Ford Acquisition. Future results may vary significantly from the results reflected in this unaudited pro forma financial information because of future events and transactions, as well as other factors.

The unaudited pro forma consolidated results include the Company’s historical financial information and the revenues and expenses of assets acquired and liabilities assumed in the 2013 Eagle Ford Acquisition (in thousands except share amounts):

	Year ended December 31,
	2013
	(Unaudited)
Revenue	$	48,291
Loss before taxes	$	(5,240	)
Net loss available to Earthstone common stockholders	$	(3,406	)
Pro forma net loss per common share:
Basic and diluted	$	(0.37	)

The Company’s historical financial information was adjusted to give effect to the pro formas events that were directly attributable to 2013 Eagle Ford Property acquisition and were factually supportable. The unaudited pro forma consolidated results include the historical revenues and expenses of the assets acquired and liabilities assumed in the transactions noted above with the following adjustments:

Eliminate transaction costs and non-recurring charges directly related to the transactions that were included in the historical results of operations for OVR in the amount of $1.1 million. Transaction costs directly related to the transactions that do not have a continuing impact on the Company’s operating results have been excluded from the 2013 pro forma earnings; and

Adjustments to recognize pro forma income tax based on an assumed approximately 35% rate.

The amount of revenue and net income from the 2013 Eagle Ford Acquisition included in the Company’s Consolidated Statements of Operations for the year ended December 31, 2013, was $9.5 million and $6.2 million, respectively.

Acquisition costs of $1.1 million, are included in General and administrative expense in the Consolidated Statements of Operations.

Other Acquisitions

In June 2015, the Company acquired a 50% operated interest in two gross Austin Chalk wells, which hold approximately 1,000 gross acres in southern Gonzales County, Texas. The acreage, acquired for future Eagle Ford development, is 100% held-by-production, with gross production as of the time of the acquisition of 44 barrels of oil equivalent per day (“BOEPD”) all of which was oil. Also during June 2015, the Company acquired additional acreage in northern Karnes County, Texas, increasing its total leasehold position to approximately 400 gross acres. The Company has a 33% working interest in the Karnes acreage. These two positions are adjacent to one another. The Company initiated drilling on the Karnes county acreage during the fourth quarter of 2015, with completions on four wells expected to occur during 2016. The Gonzales County acreage will provide for 13 gross Eagle Ford locations.

The following table summarizes the consideration paid to acquire the properties and the estimated fair values of the assets acquired and liabilities assumed (in thousands):

Purchase price	$	4,066

Estimated fair value of assets acquired:
Proved oil and natural gas properties	$	588
Unproved oil and natural gas properties		3,496
Total assets acquired	$	4,084

Estimated fair value of liabilities assumed:
Asset retirement obligations	$	13
Other liabilities		5
Total liabilities assumed	$	18
Consideration paid	$	4,066

Pro forma financial information, assuming the acquisition occurred at the beginning of each period presented, has not been presented because the effect on the Company’s results for each of those periods is not material. The results of the above acquisitions have been included in the Company’s consolidated financial statements since the date of each acquisition.

In June 2015, the Company acquired additional acreage and increased the Company’s working interest in wells in existing Bakken spacing units primarily located in the Banks Field of McKenzie County, North Dakota, for $1.4 million plus purchase price adjustments of $2.0 million for the revenues, net of production taxes and operating expenses and capital costs incurred for the existing wells. The acquisition included 164 net acres which allowed the Company to increase its working interest in approximately 41 producing wells and 21 wells that are in the drilling and completion phase.

In August 2015, the Company acquired a 33% working interest in approximately 1,650 gross acres, in Southern Gonzales County, Texas for $3.3 million. This acreage is anticipated to support 16 additional gross Eagle Ford locations.

Divestitures

In May 17, 2013, the Company sold undeveloped acreage and working interest in nine wells located in Guadalupe County, Texas, and Caldwell County, Texas for cash consideration of $0.5 million. The Company recorded a loss on sale of $0.1 million. The effective date of the sale was April 1, 2013.

On March 28, 2013, the Company sold undeveloped acreage in Harrison County, Texas, and the working interest in one well for cash consideration of one hundred dollars. The Company recorded a loss on sale of $0.1 million. The effective date of the sale was April 1, 2013.

In April 2015, the Company sold its Louisiana properties located primarily in DeSoto and Caddo Parishes, Louisiana, for cash consideration of $3.4 million. The Company recorded a gain of $1.6 million on the sale. The effective date of the transaction was March 1, 2015.