-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, RRT/NOwxdWZsm7upTj/kR2P6ktThL92kLxkI7V3asalY0YgdRJSh9XXzGJTXKda8 U6myWkt6f58m0DG4eyl/zA== /in/edgar/work/0000821699-00-500002/0000821699-00-500002.txt : 20001116 0000821699-00-500002.hdr.sgml : 20001116 ACCESSION NUMBER: 0000821699-00-500002 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20000930 FILED AS OF DATE: 20001114 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SOUTHWEST ROYALTIES INC CENTRAL INDEX KEY: 0000821699 STANDARD INDUSTRIAL CLASSIFICATION: [1311 ] IRS NUMBER: 751917432 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-23701 FILM NUMBER: 769087 BUSINESS ADDRESS: STREET 1: 407 N BIG SPRING STREET SUITE 300 CITY: MIDLAND STATE: TX ZIP: 79701 BUSINESS PHONE: 9156869927 MAIL ADDRESS: STREET 1: 407 N BIG SPRING STREET SUITE 300 CITY: MIDLAND STATE: TX ZIP: 79701 10-Q 1 s10q1.txt 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q (Mark One) X Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 30, 2000 or ? Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from __________ to __________ Commission file number: 000-23701 SOUTHWEST ROYALTIES, INC. SOUTHWEST ROYALTIES (Exact Name of Registrant as HOLDINGS, INC. Specified in Its Charter) (Exact Name of Registrant as Specified in Its Charter) Delaware Delaware (State or Other Jurisdiction of (State or Other Jurisdiction of Incorporation or Organization) Incorporation or Organization) 75-1917432 75-2724264 (I.R.S. Employer (I.R.S. Employer Identification Number) Identification Number) 407 North Big Spring, Suite 300 Midland, Texas 79701 (Address of Principal Executive Offices) (Zip Code) (915) 686-9927 Registrants' Telephone Number, Including Area Code: Not Applicable (Former name, former address and former fiscal year, if changed since last report) Indicate by check 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 X No ___ Number of shares of common stock outstanding as of September 30, 2000 for Southwest Royalties, Inc 100. Number of shares of common and redeemable common stock outstanding as of September 30, 2000 for Southwest Royalties Holdings, Inc 1,075,534. SOUTHWEST ROYALTIES, INC. SOUTHWEST ROYALTIES HOLDINGS, INC. TABLE OF CONTENTS PART I - FINANCIAL INFORMATION Page Item 1. Consolidated Financial Statements Consolidated Balance Sheets as of September 30, 2000 (unaudited) and December 31, 1999 3 Consolidated Statements of Operations for the three and nine months ended September 30, 2000 and 1999 (unaudited) 5 Consolidated Statements of Cash Flows for the three and nine months ended September 30, 2000 and 1999 (unaudited) 7 Notes to Consolidated Financial Statements 9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 22 Item 3. Quantitative and Qualitative Disclosures About Market Risk 26 PART II - OTHER INFORMATION Item 6. Reports on Form 8-K and Exhibits 28 PART I - FINANCIAL INFORMATION ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except per share data) September 30,December 31, 2000 1999 ----------------------- (unaudited) ASSETS - --------------------------------------------------------- Current assets Cash and cash equivalents $ 17,630 $ 16,983 Restricted cash 5,943 10,003 Accounts receivable, net of allowance of $558 and $440, respectively 10,716 7,134 Receivables from related parties 1,664 836 Other current assets 2,355 1,179 ------- ------- Total current assets 38,308 36,135 ------- ------- Oil and gas properties, using the full cost method of accounting Proved 200,036 193,319 Unproved 1,588 2,059 ------- ------- 201,624 195,378 Less accumulated depletion, depreciation and amortization 130,554 126,742 ------- ------- Oil and gas properties, net 71,070 68,636 ------- ------- Rental property, net 130,001 128,685 ------- ------- Rental property - construction in progress 5,391 3,984 ------- ------- Other property and equipment, net 4,692 4,841 ------- ------- Other assets Real estate investments 3,024 3,644 Deferred debt costs, net of accumulated amortization of $4,908 and $2,005, respectively 7,762 13,816 Noncompete covenants, net of accumulated amortization of $784 and $563, respectively 820 1,041 Other, net 1,315 1,385 ------- ------- Total other assets 12,921 19,886 ------- ------- Total assets $262,383 $ 262,167 ======= ======= (continued) SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (continued) (in thousands, except per share data) September 30,December 31, 2000 1999 --------- ----------- (unaudited) LIABILITIES, MINORITY INTEREST, REDEEMABLE COMMON STOCK AND STOCKHOLDERS' DEFICIT - --------------------------------------------------------- Current liabilities Current maturities of long-term debt $ 23,174 $ 40,277 Accounts payable 5,713 6,011 Accounts payable to related parties 884 867 Accrued expenses 6,462 5,896 Accrued interest payable 7,772 4,774 ------- ------- Total current liabilities 44,005 57,825 ------- ------- Long-term debt 312,098 306,806 ------- ------- Other long-term liabilities 1,671 1,220 ------- ------- Minority interest - 8 ------- ------- Redeemable common stock of subsidiary - 1,228 ------- ------- Redeemable common stock - 129,046 shares issued 8,290 8,290 ------- ------- Stockholders' deficit Preferred stock - $1 par value; 5,000,000 shares authorized; none issued - - Common stock - $.10 par value; 5,000,000 shares authorized; 1,161,037 issued at September 30, 2000 and December 31, 1999 116 116 Additional paid-in capital 2,196 2,196 Accumulated deficit (101,259) (110,784) Note receivable from an officer and stockholder (1,624) (1,648) Less: treasury stock - at cost; 214,549 shares at September 30, 2000 and 214,215 at December 31, 1999 (3,110) (3,090) ------- ------- Total stockholders' deficit (103,681) (113,210) ------- ------- Total liabilities, minority interest, redeemable common stock and stockholders' deficit $262,383 $ 262,167 ======= ======= The accompanying notes are an integral part of these consolidated financial statements. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) (unaudited) Three months ended Nine months ended September 30, September 30, ------------------ ----------------- 2000 1999 2000 1999 ------ ------ ------ ------ Operating revenues Oil and gas $14,955 $ 8,115 $39,297 $21,169 Real estate 7,933 7,985 23,391 23,936 Other 118 599 291 1,107 ------ ------ ------ ------ Total operating revenues 23,006 16,699 62,979 46,212 ------ ------ ------ ------ Operating expenses Oil and gas production 3,969 2,871 11,152 8,502 Real estate 4,558 4,741 13,714 13,493 General and administrative, net of related party management and administrative fees of $798, $934, $2,467 and $2,625, respectively 1,242 651 3,243 2,132 Depreciation, depletion and amortization 2,644 1,837 7,825 7,123 Other 165 120 754 579 ------ ------ ------ ------ Total operating expenses 12,578 10,220 36,688 31,829 ------ ------ ------ ------ Operating income 10,428 6,479 26,291 14,383 ------ ------ ------ ------ Other income (expense) Interest and dividend income 327 269 841 681 Interest expense (10,922) (10,277) (32,398) (31,340) Other 405 286 1,030 431 ------ ------ ------ ------ (10,190) (9,722) (30,527) (30,228) ------ ------ ------ ------ (continued) SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (continued) (in thousands, except per share data) (unaudited) Three months ended Nine months ended September 30, September 30, ----------------- ----------------- 2000 1999 2000 1999 ------ ----- ----- ----- Income (Loss) before income taxes, minority interest, equity loss and extraordinary item $ 238 $ (3,243) $ (4,236) $(15,845) Income tax benefit (provision) - - - - - --------- --------- --------- --------- Income (Loss) before minority interest, equity loss and extraordinary item 238 (3,243) (4,236) (15,845) Minority interest in subsidiaries, net of tax (33) (67) 1,139 - Equity in loss in subsidiary and partnerships, net of tax - - - (931) --------- --------- --------- --------- Income (Loss) before extraordinary item 205 (3,310) (3,097) (16,776) Extraordinary gain (loss) from early extinguishment of debt (1,374) (5) 12,622 (1,598) --------- --------- --------- --------- Net income (loss) $ (1,169) $ (3,315) $ 9,525 $(18,374) ========= ========= ========= ========= Income (Loss) per common share before extraordinary item $ .19 $ (3.08) $ (2.88) $ (15.60) Extraordinary gain (loss) from early extinguishment of debt (1.27) (.01) 11.74 (1.49) --------- --------- --------- --------- Income (loss) per common share $ (1.08) $ (3.09) $ 8.86 $ (17.09) ========= ========= ========= ========= Weighted average shares outstanding 1,075,868 1,075,868 1,075,868 1,075,868 ========= ========= ========= ========= The accompanying notes are an integral part of these consolidated financial statements SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited) Three months ended Nine months ended September 30, September 30, ----------------- ----------------- 2000 1999 2000 1999 ------ ----- ----- ----- Cash flows from operating activities Net income (loss) $(1,169) $(3,315) $ 9,525 $(18,374) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation, depletion and amortization 2,644 1,837 7,825 7,123 Noncash interest expense 2,314 1,708 7,492 4,218 Extraordinary (gain) loss from early extinguishment of debt 1,374 5 (12,622) 1,598 Gain on sale of assets (208) (194) (456) (196) Equity (income) loss of subsidiary and partnerships - - - 187 Impairment of equity investment - - - 744 Other noncash items 153 77 492 839 Amortization of lease commissions 41 - 145 - - Bad debt expense 100 127 240 226 Minority interest (income) loss of subsidiary 33 67 (1,139) - Changes in operating assets and liabilities - Accounts receivable (2,178) (498) (4,664) (1,432) Other current assets (736) 197 (1,205) (123) Accounts payable and accrued expenses 2,153 1,374 (195) 703 Changes in restricted cash 2,744 - 4,956 - Accrued interest payable 3,202 5,386 2,998 5,133 ------ ------ ------ ------ Net cash provided by operating activities 10,467 6,771 13,392 646 ------ ------ ------ ------ Cash flows from investing activities Proceeds from sale of oil and gas properties 162 328 498 5,533 Purchase of oil and gas properties (2,934) (1,670) (6,744) (2,454) Purchase of other property and equipment and rental property (2,120) (1,940) (6,419) (4,413) Purchase of other assets (586) (106) (622) (563) Proceeds from sale of real estate investments 410 17 1,053 631 Proceeds from sale of other assets 27 24 46 366 Proceeds from sale of other property equipment and rental property 7 2,268 87 3,336 Purchase of real estate investments - - - (30) (continued) SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) (in thousands) (unaudited) Three months ended Nine months ended September 30, September 30, ----------------- ----------------- 2000 1999 2000 1999 ------ ----- ----- ----- Change in restricted cash $ (61) $ (500) $ (896) $ 408 Other 8 7 24 23 ------ ------ ------ ------ Net cash provided by (used in) investing activities (5,087) (1,572) (12,973) 2,837 ------ ------ ------ ------ Cash flows from financing activities Proceeds from borrowings 54,403 2,576 75,922 105,816 Payments on debt (51,893) (2,315) (75,655) (98,393) Increase (decrease) in other long-term liabilities (2) 4 (47) (28) Deferred debt cost (1,264) (5) (1,395) (4,078) Refund of debt issue costs 1,500 - 1,500 - Dividends paid to minority interest owners (30) (30) (90) (91) Prepayment penalty on early extinguishment of debt - - - (875) Purchase of minority interest of subsidiary (8) - (8) - Other - (1) 1 3 ------ ------ ------ ------ Net cash provided by financing activities 2,706 229 228 2,354 ------ ------ ------ ------ Net increase in unrestricted cash and cash equivalents 8,086 5,428 647 5,837 Unrestricted cash and cash equivalents - beginning of period 9,544 14,210 16,983 13,801 ------ ------ ------ ------ Unrestricted cash and cash equivalents - end of period $17,630 $19,638 $17,630 $19,638 ====== ====== ====== ====== Non-cash investing and financing activities Deferred debt cost incurred $ 1,000 $ - $ 1,000 $ - Increase in other long-term liabilities associated with deferred debt costs $ 500 $ - $ 500 $ - Increase in accrued expenses associated with deferred debt costs $ 500 $ - $ 500 $ - Supplemental disclosures of cash flow information Interest paid $ 5,693 $ 3,185 $21,908 $21,989 The accompanying notes are an integral part of these consolidated financial statements SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Summary of Significant Accounting Policies Business Southwest Royalties Holdings, Inc. ("SRH"), a Delaware corporation was formed in June 1997 to serve as a holding company for Southwest Royalties Inc. ("Southwest"), Basic Energy Service, Inc. ("Basic") and Midland Red Oak Realty, Inc. ("Red Oak") (collectively, the "Company"). Each shareholder of Southwest was issued one share in SRH for each share of Southwest stock held. Prior to the formation of SRH, Red Oak and Basic were subsidiaries of Southwest. Southwest paid a dividend of the shares it owned in Red Oak and Basic to SRH. After the formation of SRH, Southwest and Red Oak became subsidiaries of SRH and, as of July 1, 1997, Basic was deconsolidated. In May 2000, Basic changed its name from Sierra Well Services, Inc. Southwest is principally involved in the business of oil and gas development and production as well as organizing and serving as managing general partner for various public and private limited partnerships engaged in oil and gas acquisitions, exploration, development and production. Southwest is also the general partner of Southwest Partners II and III, which own common stock in Basic. Southwest sells its oil and gas production to a variety of purchasers, with the prices it receives being dependent upon oil and gas commodity prices. Red Oak is principally involved in real estate investment and development. Basic is principally involved in the business of oil and gas well services. Principles of Consolidation The consolidated financial statements include the accounts of SRH and its subsidiaries. As of September 30, 2000, the Company owned approximately 100% of Southwest, 81% of Red Oak and 100% of Blue Heel. Blue Heel is a subsidiary of Southwest. Effective July 1, 1997, Basic was deconsolidated and is accounted for using the equity method. Effective November 1999, TPI was liquidated. Effective August 2000, Midland Southwest Software ("MSS") a software subsidiary was merged into Southwest. The consolidated financial statements include the Company's proportionate share of the assets, liabilities, income and expenses of oil and gas limited partnerships for which it serves as managing general partner. The Company accounts for its investments in Southwest Partners II and III using the equity method, as the Company exercises significant influence over the operations of these partnerships. All significant intercompany transactions have been eliminated. Estimates and Uncertainties Preparation of the accompanying consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash and Cash Equivalents The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. In addition, the Company maintains its excess cash in several interest bearing accounts in various financial institutions. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Restricted Cash Restricted cash represents amounts required to be reserved in separate accounts by financial lenders. The interest sinking fund is cash set aside to pay interest on 10.5% Senior Notes. Effective August 17, 2000, with the refinancing of the Revolving Line of Credit, the interest sinking fund is no longer required to be maintained. Restricted cash accounts have been established for the following purposes (in thousands): September 30,December 31, 2000 1999 ---- ---- Cash bonds - Red Oak $ - $ 35 Certificate of Deposits - Red Oak 118 112 Tenant security deposits - Red Oak 528 512 Capital expenditures account - Red Oak 1,448 552 Tax and insurance reserve - Red Oak 2,533 2,465 Lockbox - Red Oak 278 439 Customer service reserve - Red Oak 8 10 Interest reserve - Red Oak 281 - Escrow fund - Southwest 749 627 Interest sinking - Southwest - 5,251 ----- ------ $ 5,943 $ 10,003 ===== ====== Real Estate Revenue Recognition The Company leases offices and retail shopping centers under noncancelable operating leases. The Company reports base rental revenue for financial statement purposes straight-line over the terms of the respective leases. Accrued straight-line rents represent the amount that straight-line rental revenue exceeds rents collected in accordance with the lease agreements. Management, considering current information and events regarding the tenants' ability to fulfill their lease obligations, considers accrued straight-line rents to be impaired if it is probable that the Company will be unable to collect all rents due according to the contractual lease terms. If accrued straight-line rents associated with a tenant are considered to be impaired, the amount of the impairment is measured based on the present value of expected future cash flows. Impairment losses, if any, are recorded through a loss on the write-off of assets. Cash receipts on impaired accrued straight-line rents are applied to reduce the remaining outstanding balance and as rental revenue, thereafter. Some leases provide for percentage rents based on the tenant's revenue. Percentage rents are accrued monthly based on prior experience or current tenant financial information. Some leases require tenants to reimburse the Company for certain expenses of operating the property. Concentrations of Credit Risk The Company is subject to credit risk through oil and gas trade receivables and real estate lease receivables. Although a substantial portion of its customers' ability to pay is dependent upon conditions in the oil and gas industry as well as general economic conditions, credit risk is reduced due to a large customer base. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Commodity Hedging and Derivative Financial Instruments The Company has only limited involvement with derivative financial instruments and generally does not use them for trading purposes. They are used to manage commodity price risks. The Company is exposed to credit losses in the event of nonperformance by the counter-parties to its commodity hedges. The Company anticipates, however, that such counter- parties will be able to fully satisfy their obligations under the contracts. The Company does not obtain collateral or other security to support financial instruments subject to credit risk but monitors the credit standing of the counter-parties. The derivative financial instruments that the Company accounts for as hedging contracts must meet the following criteria: the underlying asset must expose the Company to price risk that is not offset in another asset or liability, the hedging contract must reduce that price risk, and the instrument must be designated as a hedge at the inception of the contract and throughout the contract period. In order to qualify as a hedge, there must be clear correlation between changes in the fair value of the financial instrument and the fair value of the underlying asset such that changes in the market value of the financial instrument will be offset by the effect of price changes on the exposed items. Premiums paid for commodity option contracts which qualify as hedges are amortized to oil and gas sales over the term of the agreements. Unamortized premiums are included in other assets in the consolidated balance sheet. Amounts receivable or payable under the commodity option contracts are accrued as an increase or decrease in oil and gas sales for the applicable periods. Oil and Gas Properties All of the Company's oil and gas properties are located in the United States and are accounted for at cost under the full cost method. Under this method, all productive and nonproductive costs incurred in connection with the acquisition, exploration and development of oil and gas reserves are capitalized. No gain or loss is recognized on the sale of oil and gas properties unless nonrecognition would significantly alter the relationship between capitalized costs and remaining proved reserves for the affected amortization base. When gain or loss is not recognized, the amortization base is reduced by the amount of sales proceeds. Net capitalized costs of oil and gas properties, including the estimated future costs to develop proved reserves, are amortized using the units of revenue method, whereby the provision is computed on the basis of current gross revenues from production in relation to future gross revenues, based on current prices, from estimated production of proved oil and gas reserves. Should the net capitalized costs net of related deferred income taxes exceed the estimated present value of oil and gas reserves discounted at 10% and adjusted for related income taxes, such excess costs would be charged to expense in the Consolidated Statements of Operations. As of September 30, 2000, no write down of the capitalized costs of oil and gas properties was deemed necessary. It is reasonably possible that the estimates of anticipated future gross revenues, the remaining estimated economic life of the product, or both could change significantly in the near term due to the fluctuation of oil and gas prices or production. Depletion estimates would also be affected by such changes. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Property and Equipment Rental property and other property and equipment is stated at cost. Repairs and maintenance are charged to expense as incurred, with additions and improvements being capitalized. Upon sale or other retirement of depreciable property, the cost and accumulated depreciation are removed from the related accounts and any gain or loss is reflected in the Consolidated Statements of Operations. Depreciation is provided on the straight-line method based on the estimated useful lives of the depreciable assets as follows: Building and improvements 20 to 30 years Rental property and improvements 5 to 30 years Leasehold improvements 2 to 10 years Machinery and equipment 3 to 5 years Furniture and fixtures 3 to 5 years Equipment under capital lease 3 to 5 years Rental Property - Construction in Progress All costs associated with construction in progress are capitalized and subject to depreciation when each project is completed. Interest is capitalized for construction in progress. The capitalized interest is recorded as part of the asset to which it relates and is amortized over the assets useful life. In 2000 and 1999, no interest costs were capitalized. Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of In accordance with the provisions of SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, the Company reviews its long-lived assets, excluding oil and gas properties accounted for using the full cost method of accounting, and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. In this circumstance, the Company recognizes an impairment loss for the amount by which the carrying amount of the asset exceeds the estimated fair value of the asset. Deferred Debt Costs The Company capitalizes certain costs incurred in connection with issuing debt. These costs are being amortized to interest expense on the straight-line method over the term of the related debt. Gas Balancing The Company utilizes the sales method of accounting for over or under deliveries of natural gas. Under this method, the Company recognizes sales revenue on all natural gas sold. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Income Taxes Deferred tax assets and liabilities are recognized for the estimated future tax effects attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rate is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced, if necessary, by a valuation allowance for the amount of tax benefits that may not be realized. SRH and its eligible subsidiaries file a consolidated U.S. federal income tax return. Basic (through June 30, 1997) and Red Oak are consolidated for financial reporting purposes, but beginning January 1, 1996, were not eligible to be included in the consolidated U.S. federal income tax return. Separate provisions for income taxes have been determined for these entities. Reclassifications Certain reclassifications have been made to the 1999 amounts to conform to the 2000 presentation. Derivative Instruments and Hedging Activities In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133 "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133") which established standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. It establishes conditions under which a derivative may be designated as a hedge, and establishes standards for reporting changes in the fair value of a derivative. SFAS 133, as amended by SFAS 137, is required to be implemented for all fiscal quarters of all fiscal years beginning after June 15, 2000. Early adoption is permitted. Management has initiated the evaluation of the possible effects of SFAS 133 on the Company and continues to study the implications. Income (loss) per share Basic net income (loss) per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. The computation of diluted net income (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that would then share in the earnings of the entity. For 2000 and 1999, the computation of diluted net income (loss) per share was antidilutive; therefore, the amounts reported for basic and diluted net income (loss) per share were the same. Noncompete covenants Noncompete covenants are carried at cost less accumulated amortization. The covenants are being amortized over their contractual lives, generally three to five years. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Interim Financial Statements In the opinion of management, the unaudited consolidated financial statements of the Company as of September 30, 2000 and 1999 include all adjustments and accruals, consisting only of normal recurring accrual adjustments, which are necessary for a fair presentation of the results for the interim periods. These interim results are not necessarily indicative of results for a full year. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted in this Report pursuant to the rules and regulations of the Securities and Exchange Commission. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the 1999 Form 10-K of the Company. 2. Liquidity The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. SRH has a highly leveraged capital structure with, approximately, $34.1 million of cash interest and $23.2 million of principal due within the next twelve months. Management is currently in the process of renegotiating the terms of SRH's various obligations with its note holders and/or attempting to seek new lenders or equity investors. Additionally, management would consider disposing of certain assets in order to meet its obligations. There can be no assurance that SRH's continuing debt restructuring efforts will be successful or that the note holders will agree to a course of action consistent with SRH's requirements in restructuring the obligations. Even if such agreement is reached, it may require approval of additional note holders, or possibly, agreements of other creditors of SRH, none of which is assured. Furthermore, there can be no assurance that the sales of assets can be successfully accomplished on terms acceptable to SRH. Under current circumstances, SRH's ability to continue as a going concern depends upon its ability to (1) successfully restructure its 10.5% Senior Notes and other obligations or obtain additional financing as may be required, (2) maintain compliance with all debt covenants, (3) generate sufficient cash flow to meet its obligations on a timely basis, and (4) achieve satisfactory levels of future earnings. If SRH is unsuccessful in its efforts, it may be unable to meet its debt obligations, making it necessary to undertake such other actions as may be appropriate to preserve asset values. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) 3. Commitments and Contingencies The Company is subject to extensive federal, state and local environmental laws and regulations. These laws, which are constantly changing, regulate the discharge of materials into the environment and may require the Company to remove or mitigate the environmental effects of the disposal or release of petroleum or chemical substances at various sites. Environmental expenditures are expensed or capitalized depending on their future economic benefit. Expenditures that relate to an existing condition caused by past operations and that have no future economic benefits are expensed. Liabilities for expenditures of a noncapital nature are expensed when environmental assessment and/or remediation is probable and the costs can be reasonably estimated. Management recognizes a financial exposure that may require future expenditures presently existing for oil and gas properties and other operations. Other long-term liabilities at September 30, 2000 include approximately $663,000 for estimated future remedial actions and cleanup costs. As of September 30, 2000, the Company has not been fined, cited or notified of any environmental violations which would have a material adverse effect upon capital expenditures, earnings or the competitive position in the oil and gas industry. However, management does recognize that by the very nature of its business, significant costs could be incurred to bring the Company into total compliance. The amount of such future expenditures is not readily determinable due to several factors, including the unknown magnitude of possible contaminations, the unknown timing and extent of the corrective actions which may be required, the determination of the Company's liability in proportion to other responsible parties and the extent to which such expenditures are recoverable from insurance or indemnifications from prior owners of the Company's properties. It is reasonably possible this estimate could change materially in the near term. In the normal course of its business, the Company is subject to pending or threatened legal actions; in the opinion of management, any such matters will be resolved without material effect on the Company's operations, cash flows or financial position. 4. Commodity Hedging and Derivative Financial Instruments The Company, from time to time, uses option contracts to mitigate the volatility of price changes on commodities the Company produces and sells, as well as, to lock in prices to protect the economics related to certain capital projects. On December 30, 1999, Southwest entered into a basket revenue protection agreement, which provides the Company with an oil and gas revenue floor. The contract is for the period January 1, 2000 through December 31, 2000. The agreement is to be calculated on a calendar year quarter as disclosed in the following table based on NYMEX Natural Gas and NYMEX Crude Oil: Notional Volumes Strike Prices ------------------------- ----------------------------- Crude Natural Crude Natural Minimum Oil (bbl) Gas (MMBtu) Oil Gas Boe Revenue ---------- ----------- ----- ------- ---- -------- Quarter 1 269,254 976,676 $ 21.12 $ 1.91 $ 28.76 $7,552,096 Quarter 2 263,058 910,325 $ 18.88 $ 1.92 $ 26.56 $6,714,359 Quarter 3 257,206 857,728 $ 18.00 $ 1.97 $ 25.88 $6,319,432 Quarter 4 251,914 813,400 $ 18.00 $ 2.20 $ 26.80 $6,323,932 Payments shall be made no later than five business days, after each quarterly floating price is determinable by NYMEX. The cost of the floor was approximately $638,000 and is amortized monthly as a reduction of oil and gas revenues. The carrying value of the floor is approximately $150,000 at September 30, 2000. The market value was approximately $160,000 at September 30, 2000. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) On September 6, 2000, Southwest entered into a floor option, which provides the Company with a crude oil price floor. The contract is for the period January 1, 2001 through December 31, 2001. The option is for a notional amount of 1,100 BBls of oil a day at a floor price of $25, based on NYMEX Light Sweet Crude. The agreement is to be calculated on a monthly basis, with payments to be made no later than five business days, after calculating period. The cost of the floor was approximately $466,000. Carrying value approximates market value at September 30, 2000. 5. Long-term Debt Long-term debt consists of the following (in thousands): September 30,December 31, 2000 1999 ----- ----- 10.5% Senior Notes, interest payable semi-annually due October 15, 2004, net of discount of $995 and $1,487, respectively $122,690 $160,598 Revolving Loan Facility with variable rate interest, due August 2003. Collateralized by oil and gas properties. 50,000 35,000 Variable Rate Notes Payables: Notes payable due July 2001, accrued interest due and payable monthly at 7.1%, per annum with additional 1% payable in cash or additional notes. Net of discount of $444 and $944, respectively 17,518 15,883 Notes payable due December 2001, accrued interest due and payable monthly at 7.1%, per annum with additional 1.5% payable in cash or additional notes. Net of discount of $1,556 and $2,556, respectively 30,482 25,298 Notes payable due July 2002, interest at 8.5% minimum per annum, accrued interest due and payable monthly. Net of discount of $2,906 and $4,229, respectively 104,841 101,835 Other 9,741 8,469 ------- ------- 335,272 347,083 Less current maturities 23,174 40,277 ------- ------- $312,098 $306,806 ======= ======= SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) 10.5% Senior Notes In October 1997, the Company issued $200 million aggregate principal amount of 10.5% Senior Notes due October 15, 2004 (the "Notes"). The Notes were sold at a discount and interest is payable April 15 and October 15 of each year, commencing April 15, 1998. The Notes are general unsecured senior obligations of the Company and rank equally in right of payment with all other senior indebtedness of the Company and senior in right of payment of all existing future subordinated indebtedness of the issuer. Net proceeds from the issuance of the Notes were used primarily to repay existing debt of approximately $84 million, purchase oil and gas properties for approximately $72 million, purchase additional stock in Red Oak for approximately $10 million, invest $1.7 million in an affiliate, with the remaining balance used for working capital. The Indenture imposes certain limitations on the ability of the Company and its restricted subsidiaries to, among other things, incur additional indebtedness or issue disqualified capital stock, make payments in respect to capital stock, enter into transactions with affiliates, incur liens, sell assets, change the nature of its business, merge or consolidate with any other person and sell, lease, transfer or otherwise dispose of substantially all of its properties or assets. The indenture requires the issuer to repurchase notes under certain circumstances with the excess cash of certain asset sales. The limitations are subject to a number of important qualifications and exceptions. The issuer must report to the Trustee on compliance with such limitations on a quarterly basis. Revolving Loan Facility In December 1999, Southwest entered into a Revolving Loan Facility with Bank One Texas, N.A., which provided a borrowing base of $50 million with a maturity date of December 29, 2000. Funds from the Revolving Loan Facility may be used for working capital and other general corporate purposes, including the repurchase of a portion of Southwest's outstanding 10.5% Senior Notes due 2004. Advances on the Revolving Loan Facility bear interest at the option of Southwest, based on the prime rate of Bank One Texas, N.A. (8.5% at December 31, 1999) plus one fourth of one percent (.25%), when the borrowing base usage is equal to or greater than 80% or zero percent (0%) when the borrowing base usage is less than 80% or, a Eurodollar rate (substantially equal to the London InterBank Offered Rate ("LIBOR")) plus 1.25% up to 2.0% based on the borrowing base usage percentage. The Revolving Loan Facility is secured by no less than 85% of Southwest's oil and gas properties. As of December 31, 1999 Southwest had drawn $35.0 million. The remaining $15.0 million was drawn in January 2000. The Revolving Loan Facility imposes certain limitations on the ability of Southwest to, among other things, incur additional indebtedness or issue disqualified capital stock, make payments in respect to capital stock, enter into transactions with affiliates, incur liens, sell assets, change the nature of its business, merge or consolidate with any other person and sell, lease, transfer or otherwise dispose of substantially all of its properties or assets. The Revolving Loan Facility required Southwest to establish a sinking fund account with an initial deposit of $3.5 million. Southwest is to transfer monthly one-twelfth of the annual interest payments on the 10.5% Senior Notes beginning December 31, 1999 into this sinking fund account for the purpose of making interest payments on the 10.5% Senior Notes. Effective August 17, 2000, this Revolving Loan Facility was refinanced with a new lender under the Amended and Restated Loan and Security Agreement. The new lender continues to impose limitations on Southwest business operations, however, the sinking fund requirement was eliminated. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) Southwest Royalties, Inc., a wholly owned subsidiary of Southwest Royalties Holdings, Inc. successfully completed a refinancing of their Revolving Loan Facility in the amount of $50.0 million on August 17, 2000 with a new lender. The Amended and Restated Loan and Security Agreement allows for a prime rate of interest (based on the new lenders prime rates) plus one and one-half percent (1.5%). Southwest was able to extend the due date from December 29, 2000 to August 17, 2003. Southwest, in recording the refinancing of the Revolving Loan Facility, recorded an extraordinary loss from early extinquishment of debt in the amount of approximately $1.4 million. Variable Rate Notes Payable In June 1998, MRO N Cross, Inc., a wholly owned subsidiary of Red Oak negotiated two notes payable in the amount of $13.5 million, net of a $2 million discount, and $2.5 million. The $13.5 million note was used for the acquisition of rental property in the amount of $12.9 million with the remaining $600,000 to be used for capital improvements to the rental property purchased. The $2.5 million note is reserved for capital improvements to the rental property purchased of which $2.4 million has been utilized as of September 30, 2000. The notes are collateralized by the property purchased. In December 1998, MRO Commercial, Inc., a wholly owned subsidiary of Red Oak negotiated two notes payable in the amount of $21.7 million, net of a $4 million discount, and $9.7 million. The $21.7 million note was used for the acquisition of a retail shopping center and the funding of various escrow balances. The $9.7 million note is for capital improvements to the rental property purchased of which $5.8 million has been utilized as of September 30, 2000. The notes are collateralized by the property purchased. In June 1999, MRO Southwest, Inc., a wholly owned subsidiary of Red Oak negotiated two notes payable in the amount of $97.5 million and $8.0 million, net of discounts of $5.3 million. Borrowings for both notes accrue interest in arrears at a rate per annum equal to the greater of 8.6% or LIBOR plus 360 basis points. The interest rate includes a servicing fee of .10%. Approximately $91.4 million of the $97.5 million note was used to retire existing debt on properties contributed to MRO Southwest by Red Oak, $1.5 million was deposited into various restricted cash accounts and the remaining proceeds were used for general corporate purposes. The $8.0 million note is for capital improvements to rental property and $5.0 million has been utilized as of September 30, 2000. The notes are collateralized by the properties owned by MRO Southwest. The notes impose certain restrictive covenants including restrictions on the incurrence of additional indebtedness, dissolution, termination or liquidation of all or substantially all of the assets, changes in the legal structure of the assets, making any loans or advances to any third party and commingling its assets with the assets of any of its affiliates or of any other person or entity. Extinguishment of Debt In June 1999, MRO Southwest repaid certain notes payable with proceeds from the aforementioned Variable Note Payable issued in June of 1999. Prepayment penalties and the remaining unamortized deferred debt costs associated with these notes resulted in an extraordinary charge of $1,598 million or $(1.49) per share. Since there is no recorded income tax benefits on continuing operations there is no income tax benefits recorded on the extraordinary loss. SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) In December of 1999, Southwest purchased approximately 19%, or approximately $37.9 million original face amount, of its 10.5% Senior Notes with the proceeds from the aforementioned Revolving Loan facility. Southwest paid approximately $22.0 million, including all fees, to purchase the 10.5% Senior Notes and wrote off approximately $980,000 of deferred loan issue costs and approximately $349,000 of the original issue discount to recognize a $14.5 million extraordinary gain on the purchase of the Notes. Southwest has not recorded any income tax benefits on continuing operations and therefore there is no income tax expense recognized on the extraordinary gain. The extraordinary gain per share is approximately $13.48. In January of 2000, Southwest purchased approximately 19%, or approximately $38.4 million original face amount, of its 10.5% Senior Notes with the proceeds from the aforementioned Revolving Loan facility. Southwest paid approximately $23.0 million, including all fees, to purchase the 10.5% Senior Notes and wrote off approximately $980,000 of deferred loan issue costs and approximately $349,000 of the original issue discount to recognize a $14.1 million extraordinary gain on the purchase of the Notes. Southwest has not recorded any income tax provisions on continuing operations and therefore there is no income tax expense recognized on the extraordinary gain. The extraordinary gain per share is approximately $13.01. On August 17, 2000, Southwest refinanced their Revolving Loan Facility and recorded an extraordinary loss from early extinguishment of debt in the amount of approximately $1.4 million. Southwest has not recorded any income tax provisions on continuing operations and therefore, there is no income tax benefit recognized on the extraordinary loss. The extraordinary loss per share is approximately $(1.27). Aggregate maturities of all long-term debt as of December 31, 1999 are as follows (in thousands): 2000 $ 40,277 2001 41,412 2002 101,926 2003 391 2004 160,680 Thereafter 2,397 ------- $347,083 ======= Aggregate maturities of all long-term debt as of September 30, 2000 are as follows (in thousands): For the twelve months ended -------------- September 30, 2001 $ 23,174 September 30, 2002 135,802 September 30, 2003 52,282 September 30, 2004 45 September 30, 2005 123,098 Thereafter 871 ------- $335,272 ======= SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) 6. Lines of Business The Company operates in two major segments: Oil and Gas Activities (oil and gas acquisition, development, exploration and production, as well as organizing and serving as managing general partner for various public and private limited partnerships engaged in oil and gas development and production) and Real Estate Investment and Management (owns and manages retail shopping centers and office buildings). Other items include eliminations, manufacturing, computer service and the holding Company. Three months ended Nine months ended September 30, September 30, ------------------ ----------------- 2000 1999 2000 1999 ----- ----- ----- ----- (in thousands) (in thousands) (unaudited) (unaudited) Operating Revenue Oil and gas $ 14,965 $ 8,644 $39,326 $21,726 Real estate 7,933 7,985 23,391 23,936 Other and eliminations 108 70 262 550 ------- ------ ------ ------ $ 23,006 $16,699 $62,979 $46,212 ======= ====== ====== ====== Operating profit (loss) Oil and gas $ 9,074 $ 4,752 $22,351 $ 8,425 Real estate 1,785 1,699 4,918 5,918 Other and eliminations (431) 28 (978) 40 ------- ------ ------ ------ $ 10,428 $ 6,479 $26,291 $14,383 ======= ====== ====== ====== Interest Expense Oil and gas $ 5,528 $ 5,629 $16,837 $16,757 Real Estate 5,404 4,663 15,592 14,702 Other and eliminations (10) (15) (31) (119) ------- ------ ------ ------ $ 10,922 $10,277 $32,398 $31,340 ======= ====== ====== ====== Depreciation, depletion and amortization Oil and gas $ 1,394 $ 697 $ 4,161 $ 3,676 Real Estate 1,222 1,127 3,555 3,349 Other and eliminations 28 13 109 98 ------- ------ ------ ------ $ 2,644 $ 1,837 $ 7,825 $ 7,123 ======= ====== ====== ====== Capital expenditures Oil and gas properties $ 2,934 $ 1,670 $ 6,744 $ 2,454 Oil and gas, other 162 73 294 229 Real Estate 1,957 1,793 6,046 3,927 Other and eliminations 1 74 79 257 ------- ------ ------ ------ $ 5,054 $ 3,610 $13,163 $ 6,867 ======= ====== ====== ====== SOUTHWEST ROYALTIES HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (continued) September 30, December 31, 2000 1999 ---------- ---------- Identifiable assets Oil and gas $ 111,481 $ 115,520 Real estate 151,667 150,269 Other and eliminations (765) (3,622) ------- ------- $ 262,383 $ 262,167 ======= ======= 7. Related Party Transactions Southwest is the managing general partner for several public and private oil and gas limited partnerships, with an officer of Southwest also serving as a general partner for certain of the limited partnerships. As is usual in the oil and gas industry, the operator is paid an amount for administrative overhead attributable to operating such properties and management fees attributable to serving as managing general partner. As provided for in the partnership agreements, such amounts paid by the partnerships to Southwest approximated $798,000 and $934,000 for the three months ended September 30, 2000 and 1999 respectively and $2,467,000 and $2,625,000 for the nine months ended September 30, 2000 and 1999. In addition, Southwest and certain officers and employees may have an interest in some of the partnership properties. An affiliate of the company performs various oilfield services for limited partnerships managed by Southwest. Such services aggregated $57,000 and $105,000 for the three months ended September 30, 2000 and 1999 and $241,000 and $245,000 for the nine months ended September 30, 2000 and 1999. The same affiliate performed services for Southwest that aggregated approximately $62,000 and $76,000, for the three months ended September 30, 2000 and 1999 and $210,000 and $210,000 for the nine months ended September 30, 2000 and 1999. In August 2000, Southwest made a prepayment to the affiliate in the amount of $975,000 for oil and gas services to be provided in the future. On August 11, 2000, Southwest invested $100,000 in a Web-based company through a Private Placement Offering. Southwest holds 200,000 shares of Series A Preferred Stock. The President of the Web-based company is the brother of H.H. Wommack, III, President of Southwest. 8. Subsequent Events On October 11, 2000, Southwest entered into a floor option, which provides the Company with a crude oil price floor. The contract is for the period January 1, 2001 through December 31, 2001. The option is for a notional amount of 500 BBls of oil a day at a floor price of $27, based on NYMEX Light Sweet Crude. The cost of the floor was approximately $224,000. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General Southwest Royalties Holdings, Inc., a Delaware corporation, was formed in 1997 to serve as a holding company for Southwest Royalties, Inc., Basic Energy Services, Inc. and Midland Red Oak Realty, Inc. SRH is an independent oil and gas company engaged in the acquisition, development and production of oil and gas properties, primarily in the Permian Basin of West Texas and southeastern New Mexico, through its wholly-owned subsidiary, Southwest. Since 1983, Southwest has grown primarily through selective acquisitions of producing oil and gas properties, both directly and through the oil and gas partnerships it manages. SRH also participates in the well servicing industry through its affiliate, Basic, and owns and manages real estate properties through its subsidiary, Red Oak. In May 2000, Basic changed its name from Sierra Well Service, Inc. Results of Operations Three months and nine months ended September 30, 2000 compared to three months and nine months September 30, 1999 The following table summarizes production volumes, average sales prices and period to period comparisons for the Company's oil and gas operations, including the effect on revenues, for the periods indicated: Three months ended Nine months ended September 30, September 30, ------------------- ------------------- 2000 1999 2000 1999 ----- ----- ----- ----- (in thousands) (in thousands) (unaudited) (unaudited) Production volumes: Oil and condensate (MBbls) 312 325 928 1,013 Natural gas (MMcf) 1,213 1,056 3,605 3,195 Average sales prices: Oil and condensate (per Bbl) 30.36 $ 17.42 $ 27.85 $ 14.47 Natural gas (per Mcf) 4.37 $ 2.27 $ 3.64 $ 2.01 Revenues. Revenues for the Company increased 38% to $23.0 million for the three months ended September 30, 2000 and 36% to $63.0 million for the nine months ended September 30, 2000, as compared to $16.7 million and $46.2 million for the same periods in 1999. Oil and gas revenues increased 84% to $15.0 million for the three months ended September 30, 2000 and 86% to $39.3 million for the nine months ended September 30, 2000, as compared to $8.1 million and $21.2 million for the same periods in 1999. The increase in oil and gas revenue is due primarily to increases in oil and gas prices. Oil and gas production increased 2%, to 5,590 BOEPD for the three months ended September 30, 2000 and decreased 1%, or approximately 82 BOEPD, to 5,580 BOEPD for the nine months ended September 30, 2000 as compared to the same periods in 1999. In an ongoing effort to increase the Company's cash position and/or reduce the number of high operating expense properties in its oil and gas portfolio, management has sold oil and gas properties for approximately $498,000 and $5.5 million in the nine months ended September 30, 2000 and 1999, respectively. The increase in production for the three months ended September 30, 2000 represented an increase of approximately 7% net of a decline from oil and gas property sales of approximately 5% or 280 BOEPD. The decrease in production for the nine months ended September 30, 2000 is primarily due to oil and gas property sales which resulted in production declines of approximately 359 BOEPD, or approximately 6% and is partially offset by increased production of approximately 5% or 277 BOEPD on the remaining oil and gas properties. Real estate revenues decreased 1% to $7.9 million for the three months ended September 30, 2000 and 2% to $23.4 million for the nine months ended September 30, 2000, as compared to $8.0 million and $23.9 million for the same periods in 1999. Operating Expenses. Operating expenses, before general and administrative expense, impairment of oil and gas properties and depreciation, depletion and amortization, increased 12% to $8.7 million for the three months ended September 30, 2000 and 13% to $25.6 million for the nine months ended September 30, 2000, as compared to $7.7 million and $22.6 million for the same periods in 1999. Oil and gas operating expense increased approximately 38% to $4.0 million for the three months ended September 30, 2000 and approximately 31% to $11.2 million for the nine months ended September 30, 2000, as compared to $2.9 million and $8.5 million for the same periods in 1999. The increase in oil and gas operating expenses for the three and nine months periods ended September 30, 2000 is due primarily to increased production taxes, associated with the 84% and 86% increase in oil and gas revenue as discussed above, and increased workover expense and repairs associated with bringing wells back on line, which were deemed uneconomical due to depressed oil and gas prices experienced during a portion of the nine months ended September 30, 1999. The average operating expense increased 34% to $7.72 per BOE for the three months ended September 30, 2000 and 32% to $7.29 per BOE for the nine months ended September 30, 2000 from $5.73 and $5.50 per BOE for the same periods in 1999. Real estate operating expense decreased 4% to $4.6 million for the three months ended September 30, 2000 and increased 1% to $13.7 million for the nine months ended September 30, 2000, as compared to $4.7 million and $13.5 million for the same periods in 1999. General and Administrative ("G&A") Expense. G&A expense for the Company increased 91% to $1.2 million for the three months ended September 30, 2000 and approximately 52% to $3.2 million for the nine months ended September 30, 2000, as compared to $651,000 and $2.1 million for the same periods in 1999. Oil and gas G&A expense increased 63% to $528,000 for the three months ended September 30, 2000 and 48% to $1.7 million for the nine months ended September 30, 2000, as compared to $324,000 and $1.1 million for the same periods in 1999. Oil and gas G&A expense per BOE increased 58% to $1.03 for the three months ended September 30, 2000 and 45% to $1.09 per BOE for the nine months ended September 30, 2000, as compared to $.65 per BOE and $.73 per BOE for the same periods in 1999. The increase in oil and gas G&A expense for the three months ended September 30, 2000 is due primarily to salary increases, bonuses, and certain health insurance claims pertaining to the Company's partially self insured insurance structure as well as legal and professional fees associated with managements evaluation of corporate strategies and options for dealing with its highly leverage structure. Increases in oil and gas G&A expense for the nine months ended September 30, 2000 are primarily due to salary increases, bonuses, and certain health insurance claims pertaining to the Company's partially self insured insurance structure. Real estate G&A expense decreased 5% to $368,000 for the three months ended September 30, 2000 and increased 6% to $1.2 million for the nine months ended September 30, 2000, as compared to $388,000 and $1.1 million for the same periods in 1999. Depreciation, Depletion and Amortization ("DD&A") Expense. DD&A expense for the Company increased 44% to $2.6 million for the three months ended September 30, 2000 and 10% to $7.8 million for the nine months ended September 30, 2000, as compared to $1.8 million and $7.1 million for the same periods in 1999. Oil and gas DD&A increased 100% to $1.4 million for the three months ended September 30, 2000 and 13% to $4.2 million for the nine months ended September 30, 2000, as compared to $697,000 and $3.7 million for the same periods in 1999. Oil and gas depletion expense on a BOE basis, increased 112% to $2.47 per BOE for the three months ended September 30, 2000 and 16% to $2.49 per BOE for the nine months ended September 30, 2000, as compared to $1.16 per BOE and $2.14 per BOE for the same periods in 1999. The increase is due to higher and more stable commodity prices experienced during the three and nine months ended September 30, 2000 as compared to the same periods in 1999 and an increase in the Company's oil and gas property basis due to acquisitions and developmental drilling performed in late 1999 and throughout 2000. Real estate DD&A expense increased 8% to $1.2 million for the three months ended September 30, 2000 and increased 6% to $3.6 million for the nine months ended September 30, 2000, as compared to $1.1 million and $3.3 million for the same periods in 1999. The increase in DD&A expense for the three and nine months ended September 30, 2000 is due to the impact of capitalized improvements. Interest Expense. Interest expense for the Company increased 6% to 10.9 million for the three months ended September 30, 2000 and 3% to and $32.4 million for the nine months ended September 30, 2000, as compared to $10.3 million and $31.3 million for the same periods in 1999. Oil and gas interest expense decreased 2% to $5.5 million for the three months ended September 30, 2000 and remained unchanged at $16.8 million for the nine months ended September 30, 2000, as compared to $5.6 million and $16.8 million for the same periods in 1999. Real estate interest expense increased 16% to $5.4 million for the three months ended September 30, 2000 and 6% to $15.6 million for the nine months ended September 30, 2000, as compared to $4.7 million and $14.7 million for the same periods in 1999. The increase in interest expense for the three and nine months ended September 30, 2000 is due to increased borrowings to fund capital improvements and working capital. Equity Loss in Partnership. The Company's direct and indirect investment in Basic upon recording its portion of Basic's losses for the three months ended March 31, 1999 was reduced to zero. Therefore, according to General Accepted Accounting Principles, the equity method was suspended. The Company did not record their ownership percentage of Basic's losses for the nine months ended September 30, 2000. If Basic subsequently begins to report net income, the Company will resume applying the equity method only after its share of net income equals the share of net losses not recognized during the period the equity method is suspended. Net Income (Loss). Due to the factors described above, net (loss) for the Company decreased 65% to $1.2 million for the three months ended September 30, 2000 and 152% to net income of $9.5 million for the nine months ended September 30, 2000, as compared to a net loss of $3.3 million and $18.4 million for the same periods in 1999. Oil and gas net income increased 558% to $2.5 million for the three months ended September 30, 2000 and 336% to $19.0 million for the nine months ended September 30, 2000, as compared to a net loss of $538,000 and $8.0 million for the same periods in 1999. Included in the oil and gas net income for the three months ended September 30, 2000, is an extraordinary loss of $1.4 million from early extinguishment of debt. Included in oil and gas net income for the nine months ended September 30, 2000 is an extraordinary gain of approximately $12.7 million. The extraordinary gain is comprised of a gain associated with the repurchase of approximately 19% of the original issue, $200 million face 10.5% Senior Notes issued in October 1997, of approximately $14.1 million and a loss of approximately $1.4 million associated with the early extinguishment of debt upon the refinancing of the Company's Revolving Loan Facility in the amount of $50.0 million on August 17, 2000 with a new lender. Real estate net losses increased 24% to $3.2 million for the three months ended September 30, 2000 and decreased 1% to $9.5 million for the nine months ended September 30, 2000 as compared $2.5 million and $9.6 million for the same periods in 1999. Liquidity and Capital Resources Management is constantly monitoring the Company's cash position and its ability to meet its financial obligations as they become due, and in this effort, is exploring various strategies for addressing its current and future liquidity needs. During 1999 and 1998, for instance, Southwest sold $5.6 million and $5.7 million, respectively, of oil and gas properties in an ongoing effort to decrease its production costs and improve its cash position. In December 31, 1999 the Company also negotiated a $50 million Revolving Line Facility with BankOne Texas, N.A. the proceeds of which were used to purchase in December 1999 and January 2000, approximately $76.3 million of the 10.5% Senior Notes due 2004. On August 17, 2000, the Company refinanced the Revolving Loan Facility with a new lender and extended the maturity date out until August 17, 2003. As of September 30, 2000, the Company's consolidated cash balance was approximately $23.6 million, of which $17.6 million was unrestricted. SRH financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of liabilities that might be necessary should SRH be unable to continue as a going concern. SRH has a highly leveraged capital structure with, approximately, $34.1 million of cash interest and $23.2 million of principal due within the next twelve months. Management is currently in the process of renegotiating the terms of SRH's various obligations with its note holders and/or attempting to seek new lenders or equity investors. Additionally, management would consider disposing of certain assets in order to meet its obligations. There can be no assurance that SRH's continuing debt restructuring efforts will be successful or that the note holders will agree to a course of action consistent with SRH's requirements in restructuring the obligations. Even if such agreement is reached, it may require approval of additional note holders, or possibly, agreements of other creditors of SRH, none of which is assured. Furthermore, there can be no assurance that the sales of assets can be successfully accomplished on terms acceptable to SRH. Under current circumstances, SRH's ability to continue as a going concern depends upon its ability to (1) successfully restructure its 10.5% Senior Notes and other obligations or obtain additional financing as may be required, (2) maintain compliance with all debt covenants, (3) generate sufficient cash flow to meet its obligations on a timely basis, and (4) achieve satisfactory levels of future earnings. If SRH is unsuccessful in its efforts, it may be unable to meet its debt obligations, making it necessary to undertake such other actions as may be appropriate to preserve asset values. Net Cash Provided by Operating Activities Net cash provided by operating activities was $10.5 million and $13.4 million for the three and nine months ended September 30, 2000, respectively, as compared to net cash provided by operating activities of $6.8 million and $646,000 for the same periods in 1999. The increase in cash provided by operating activities, is primarily attributable to increased oil and gas commodity prices. Net Cash Provided by (Used in) Investing Activities Net cash provided by (used in) investing activities by the Company were $(5.1) million and $(13.0) million for the three and nine months ended September 30, 2000, as compared to net cash provided by (used in) investing activities of $(1.6) million and $2.8 million for the comparable periods in 1999. Purchase of oil and gas properties as well as capital improvements to Real Estate holdings were the primary uses of funds in 2000. Oil and gas property sales were the primary source of funds in 1999 while Real Estate investment sales were the primary source of funds in 2000. SRH has tentatively budgeted $3.0 million, for the remainder of 2000, in capital expenditures at Southwest for oil and gas development projects. This budget is subject to change based on financial strategies currently being developed, including hedging strategies, divestitures and debt restructuring, as well as the level of oil and gas prices in the future. Net Cash Provided by Financing Activities. Net cash provided by the Company's financing activities was $2.7 million and $228,000 for the three and nine months ended September 30, 2000 and $229,000 and $2.4 million for the same periods in 1999, respectively. For the three months ended September 30, 2000, proceeds from borrowings were $54.4 million and were primarily used to refinance Southwest's Revolving Loan Facility and fund capital improvements and working capital at Red Oak. For the nine months ended September 30, 2000, proceeds from borrowings were $75.9 million and were primarily used to fund the buy back of a portion of the 10.5% Senior notes due 2004, as well as refinance Southwest's Revolving Loan Facility and fund capital improvements and working capital at Red Oak. Other Issues The information included in "Other Issues" in Item 7 of SHR's 1999 Form 10-K regarding Information Systems for the year 2000 is incorporated herein by reference. As of September 30, 2000, there have been no material changes in SRH's Year 2000 disclosure. Item 3. Quantitative and Qualitative Disclosures About Market Risk The following quantitative and qualitative information is provided about financial instruments to which the Company is a party as of September 30, 2000, and from which the Company may incur future earnings gains or losses from changes in market interest rates or commodity prices. Quantitative Disclosures Interest rate sensitivity. The following table provides information about the Company's debt obligations, which are sensitive to changes in interest rates. The table presents cash maturities by expected maturity dates together with the weighted average interest rates expected to be paid on the debt, given current contractual terms and market conditions. For fixed rate debt, the weighted average interest rate represents the contractual fixed rates that the Company is obligated to periodically pay on the debt; for variable rate debt, the average interest rate represents the average rates being paid on the debt at September 30, 2000. As of September 30, 2000 2001 2002 2003 2004 2005Thereafter Total Fair Value ---- ---- ---- ---- -------------- ----- - ---------- Total Debt maturities $23,174 $ 135,802 $ 52,282 $45 $123,098 $ 871 $ 335,272 $ 314,004 Fixed rate debt $4,044 $ 428 $ 698 $19 $122,707 $ 871 $ 128,767 $ 107,499 Weighted average interest rate 10.48% 10.48% 10.48% 10.48% 10.48% 8.04% Variable rate debt $19,130 $ 135,374 $ 51,584 $26 $ 391 $ - $ 206,505 $206,505 Average interest rate 10.43% 10.43% 10.97% 10.50% 10.50% - -% Commodity price sensitivity. See Notes 1 and 4 of Notes to Consolidated Financial Statements included in "Item 1. Consolidated Financial Statements" for a description of the accounting procedures followed by SRH relative to hedge derivative financial instruments and for specific information regarding the terms of the Company's derivative financial instrument which is sensitive to changes in natural gas and crude oil commodity prices. On December 30, 1999, Southwest entered into a basket revenue protection agreement, which provides the Company with an oil and gas revenue floor. The contract is for the period January 1, 2000 through December 31, 2000. The agreement is to be calculated on a calendar year quarter as disclosed in the following table based on NYMEX Natural Gas and NYMEX Crude Oil: Notional Volumes Strike Prices ------------------------- ----------------------------- Crude Natural Crude Natural Minimum Oil (bbl) Gas (MMBtu) Oil Gas Boe Revenue ---------- ----------- ----- ------- ---- -------- Quarter 1 269,254 976,676 $ 21.12 $ 1.91 $ 28.76 $7,552,096 Quarter 2 263,058 910,325 $ 18.88 $ 1.92 $ 26.56 $6,714,359 Quarter 3 257,206 857,728 $ 18.00 $ 1.97 $ 25.88 $6,319,432 Quarter 4 251,914 813,400 $ 18.00 $ 2.20 $ 26.80 $6,323,932 Payments shall be made no later than five business days, after each quarterly floating price is determinable by NYMEX. The cost of the floor was approximately $638,000 and is amortized monthly as a reduction of oil and gas revenues. The carrying value of the floor is approximately $150,000 at September 30, 2000. On September 6, 2000, Southwest entered into a floor option, which provides the Company with a crude oil revenue floor. The contract period begins on January 1, 2001 ending on December 31, 2001. The option is for a notional amount of 1,100 BBls of oil a day at a floor price of $25. The agreement is to be calculated on a monthly basis, with payments to be made no later than five business days, after calculating period. The cost of the floor was approximately $466,000. Qualitative Disclosures Non-derivative financial instruments. The Company is a borrower under fixed rate and variable rate debt instruments that give rise to interest rate risk. The Company's objective in borrowing under fixed or variable rate debt is to satisfy capital requirements while minimizing the Company's costs of capital. To realize its objectives, the Company borrows under fixed and variable rate debt instruments, based on the availability of capital and market conditions. See Note 5 of Notes to Consolidated Financial Statement included in "Item 1. Consolidated Financial Statements" for a discussion relative to the Company's debt instruments. Derivative financial instruments. Revenues from the Company's operations are highly dependent on the price of oil and gas. The markets for oil and natural gas are volatile and prices for oil and gas are subject to wide fluctuations in response to relatively minor changes in the supply of and demand for oil and gas and a variety of additional factors that are beyond SRH's control. These factors include the level of consumer demand, weather conditions, domestic and foreign governmental regulations, market uncertainty, the price and availability of alternative fuels, political conditions in the Middle East, foreign imports and overall economic conditions. It is impossible for SRH to predict future oil and gas prices with any certainty. In order to reduce the Company's exposure to oil and gas price risks, from time to time the Company enters into commodity price derivative contracts to hedge commodity price risks. As of September 30, 2000, the Company's primary risk exposures associated with financial instruments to which it is a party include natural gas and crude oil price volatility and interest rate volatility. The Company's primary risk exposures associated with financial instruments have not changed significantly since December 31, 1999. PART II - OTHER INFORMATION ITEM 6. REPORTS ON FORM 8K AND EXHIBITS Reports on Form 8-K None. Exhibits The following instruments and documents are included as Exhibits to this Report. Exhibits incorporated by reference are so indicated by parenthetical information. Exhibit Number Description -------------- ------------ 27* Financial Data Schedule. * Filed herewith. SIGNATURES SOUTHWEST ROYALTIES, INC. Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized. SOUTHWEST ROYALTIES, INC. By: /s/ H. H. Wommack, III --------------------------------------- H.H. Wommack, III, Chairman, President, Chief Executive Officer, and Director Date: November 14, 2000 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE --------- ----- ---- /s/ H.H. Wommack, III --------------------------- H. H. Wommack, III Chairman/President/ Chief Executive Officer November 14, 2000 /s/ Bill E. Coggin --------------------------- Bill E. Coggin Vice President/Chief Financial Officer November 14, 2000 /s/ H. Allen Corey --------------------------- H. Allen Corey Director/Secretary November 14, 2000 SIGNATURES SOUTHWEST ROYALTIES HOLDINGS, INC. Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized. SOUTHWEST ROYALTIES HOLDINGS, INC. By: /s/ H. H. Wommack, III --------------------------------------- H.H. Wommack, III, Chairman, President, Chief Executive Officer, and Director Date: November 14, 2000 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE --------- ----- ----- /s/ H.H. Wommack, III --------------------------- H. H. Wommack, III Chairman/President/ Chief Executive Officer November 14, 2000 /s/ Bill E. Coggin --------------------------- Bill E. Coggin Vice President/Chief Financial Officer November 14, 2000 /s/ H. Allen Corey --------------------------- H. Allen Corey Director/Secretary November 14, 2000 EX-27 2 fds.frm
5 This sechdule contains summary financial information extracted from the Balance Sheet at September 30, 2000 (Unaudited) and the Statement of Operations for the Nine Months Ended September 30, 2000 (Unaudited) and is qualified in its entirety by reference to such financial statements. 1 9-MOS Jan-01-2000 Dec-31-2000 Sep-30-2000 23,573,000 0 12,938,000 558,000 262,000 38,308,000 357,354,000 146,200,000 262,383,000 44,005,000 335,272,000 8,290,000 0 116,000 (103,797,000) 262,383,000 62,979,000 62,979,000 25,620,000 36,688,000 1,030,000 0 32,398,000 (4,236,000) 0 (3,097,000) 0 12,622,000 0 9,525,000 8.86 8.86
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