UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

x
Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the quarterly period ended June 30, 2011
 
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 001-14039


 
CALLON PETROLEUM COMPANY
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction
of incorporation or organization)
64-0844345
(I.R.S. Employer
Identification No.)
   
200 North Canal Street
Natchez, Mississippi
(Address of principal executive offices)
 
 39120
(Zip Code)

601-442-1601
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x
 
No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes x
 
No ¨

Indicate by check mark whether the registrant is a larger accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definition of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ¨
Accelerated filer x
   
Non-accelerated filer ¨
Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨
 
No x

As of August 2, 2011 there were outstanding 39,381,693 shares of the Registrant’s common stock, par value $0.01 per share.

 
 

 

Table of Contents
Part I. Financial Information
 
   
Item 1. Financial Statements
 
   
3
   
4
   
5
   
6
   
15
   
27
   
27
   
Part II.  Other Information
 
   
28
   
28
   
28
   
28
   
28
   
28
   
29
   












 
2

 

Part 1.  Financial Information
Item 1.  Financial Statements

Callon Petroleum Company
Consolidated Balance Sheets
(in thousands, except share data)

   
June 30, 2011
   
December 31, 2010
 
ASSETS
 
(Unaudited)
       
Current assets:
           
   Cash and cash equivalents
  $ 52,018     $ 17,436  
   Accounts receivable
    19,024       10,728  
   Fair market value of derivatives
    1,704       -  
   Other current assets
    1,610       2,180  
      Total current assets
    74,356       30,344  
                 
Oil and gas properties, full-cost accounting method:
               
   Evaluated properties
    1,361,534       1,316,677  
   Less accumulated depreciation, depletion and amortization
    (1,182,317 )     (1,155,915 )
      Net oil and gas properties
    179,217       160,762  
   Unevaluated properties excluded from amortization
    6,889       8,106  
      Total oil and gas properties
    186,106       168,868  
                 
Other property and equipment, net
    11,480       3,370  
Restricted investments
    4,414       4,044  
Investment in Medusa Spar LLC
    10,213       10,424  
Other assets, net
    2,225       1,276  
      Total assets
  $ 288,794     $ 218,326  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current liabilities:
               
  Accounts payable and accrued liabilities
  $ 25,069     $ 17,702  
  Asset retirement obligations
    1,538       2,822  
   Fair market value of derivatives
    600       937  
      Total current liabilities
    27,207       21,461  
                 
13% Senior Notes
               
   Principal outstanding
    106,961       137,961  
   Deferred credit, net of accumulated amortization of $11,551 and $3,964, respectively
    19,956       27,543  
       Total 13% Senior Notes
    126,917       165,504  
                 
Asset retirement obligations
    12,825       13,103  
Other long-term liabilities
    3,845       2,448  
      Total liabilities
    170,794       202,516  
                 
Stockholders' equity:
               
  Preferred Stock, $.01 par value, 2,500,000 shares authorized;
    -       -  
  Common Stock, $.01 par value, 60,000,000 shares authorized; 39,368,473 and 28,984,125
    shares outstanding at June 30, 2011 and December 31, 2010, respectively
    394       290  
  Capital in excess of par value
    322,939       248,160  
  Other comprehensive loss
    (5,310 )     (8,560 )
  Retained earnings (deficit)
    (200,023 )     (224,080 )
       Total stockholders' equity
    118,000       15,810  
       Total liabilities and stockholders' equity
  $ 288,794     $ 218,326  

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

 
3

 

Callon Petroleum Company
Consolidated Statements of Operations (Unaudited)
(in thousands, except per share data)

   
Three-Months Ended June 30,
   
Six-Months Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
Operating revenues:
 
 
         
 
       
  Oil sales
  $ 29,087     $ 15,901     $ 47,891     $ 32,564  
  Gas sales
    7,747       5,668       14,392       12,390  
      Total operating revenues
    36,834       21,569       62,283       44,954  
                                 
Operating expenses:
                               
  Lease operating expenses
    5,299       4,031       10,344       8,679  
  Depreciation, depletion and amortization
    12,952       7,042       22,728       13,855  
  General and administrative
    3,799       4,411       8,023       8,715  
  Accretion expense
    583       622       1,198       1,202  
  Acquisition expense
    -       -       -       -  
     Total operating expenses
    22,633       16,106       42,293       32,451  
  Income from operations
    14,201       5,463       19,990       12,503  
                                 
  Other (income) expenses:
                               
  Interest expense
    2,698       3,198       6,190       6,792  
  (Gain) loss on early extinguishment of debt
    -       339       (1,942 )     339  
  Gain on acquired assets (See Note 10)
    (3,688 )     -       (3,688 )     -  
  Other (income) expense
    (425 )     (111 )     (253 )     (472 )
     Total other (income) expenses
    (1,415 )     3,426       307       6,659  
                                 
  Income before income taxes
    15,616       2,037       19,683       5,844  
  Income tax expense
    (3,972 )     -       (3,972 )     -  
  Income before equity in earnings of Medusa Spar LLC
    19,588       2,037       23,655       5,844  
  Equity in earnings of Medusa Spar LLC
    289       93       386       209  
  Net income available to common shares
  $ 19,877     $ 2,130     $ 24,041     $ 6,053  
                                 
  Net income per common share:
                               
    Basic
  $ 0.51     $ 0.07     $ 0.66     $ 0.21  
    Diluted
  $ 0.50     $ 0.07     $ 0.65     $ 0.21  
                                 
  Shares used in computing net income per common share:
                               
    Basic
    39,225       28,762       36,485       28,750  
    Diluted
    39,844       29,583       37,191       29,406  


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

 
4

 

Callon Petroleum Company
Consolidated Statements of Cash Flows (Unaudited)
(in thousands)

   
Six-Months Ended June 30,
 
   
2011
   
2010
 
Cash flows from operating activities:
           
Net income
  $ 24,041     $ 6,053  
Adjustments to reconcile net income to
               
cash provided by operating activities:
               
      Depreciation, depletion and amortization
    23,203       14,245  
      Accretion expense
    1,198       1,202  
      Gain on acquired assets
    (3,688 )     -  
      Amortization of non-cash debt related items
    218       221  
      Amortization of deferred credit
    (1,583 )     (1,796 )
      Non-cash (gain) loss on early extinguishment of debt
    (1,942 )     179  
      Equity in earnings of Medusa Spar LLC
    (386 )     (209 )
      Deferred income tax expense
    8,186       2,021  
      Deferred income tax asset valuation allowance
    (12,158 )     (2,021 )
      Non-cash derivative income due to hedge ineffectiveness
    (33 )     -  
      Non-cash charge related to compensation plans
    1,239       2,049  
      Payments to settle asset retirement obligations
    (1,288 )     (180 )
      Changes in current assets and liabilities
               
         Accounts receivable
    (7,909 )     53,362  
         Other current assets
    573       658  
         Current liabilities
    1,353       (921 )
      Change in gas balancing receivable
    186       285  
      Change in gas balancing payable
    (52 )     (249 )
      Change in other long-term liabilities
    100       (115 )
      Change in other assets, net
    (300 )     (780 )
         Cash provided by operating activities
    30,958       74,004  
                 
Cash flows from investing activities:
               
   Capital expenditures
    (42,018 )     (19,987 )
   Investment in restricted assets for plugging and abandonment
    (75 )     (300 )
   Proceeds from sale of mineral interest and equipment
    6,417       -  
   Distribution from Medusa Spar LLC
    597       818  
         Cash used in investing activities
    (35,079 )     (19,469 )
                 
Cash flows from financing activities:
               
   Payments on senior secured credit facility
    -       (10,000 )
   Redemption of remaining 9.75% senior notes
    -       (16,052 )
   Redemption of 13% senior notes
    (35,062 )     -  
   Proceeds from exercise of employee stock options
    -       5  
   Issuance of common stock
    73,765       -  
         Cash provided by (used in) financing activities
    38,703       (26,047 )
                 
Net change in cash and cash equivalents
    34,582       28,488  
Cash and cash equivalents:
               
    Balance, beginning of period
    17,436       3,635  
    Less: Cash held by subsidiary deconsolidated at January 1, 2010
    -       (311 )
    Balance, end of period
  $ 52,018     $ 31,812  

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




 
5

 
Callon Petroleum Company
Notes to the Consolidated Financial Statements
(all amounts in thousands, except per-share and per-hedge data)



INDEX TO THE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note 1 - Description of Business and Basis of Presentation

Description of Business

Callon Petroleum Company has been engaged in the exploration, development, acquisition and production of oil and gas properties since 1950.  The Company was incorporated under the laws of the state of Delaware in 1994 and succeeded to the business of a publicly traded limited partnership, a joint venture with a consortium of European investors and an independent energy company partially owned by a member of current management.  As used herein, the “Company,” “Callon,” “we,” “us,” and “our” refer to Callon Petroleum Company and its predecessors and subsidiaries unless the context requires otherwise.

The Company’s properties and operations are geographically concentrated onshore in Louisiana and Texas and the offshore waters of the Gulf of Mexico.

Basis of Presentation

These interim financial statements of the Company have been prepared in accordance with (1) accounting principles generally accepted in the United States (“US GAAP”), (2) the Securities and Exchange Commission’s instructions to Quarterly Report on Form 10-Q and (3) Rule 10-01 of Regulation S-X, and should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. The balance sheet at December 31, 2010 has been derived from the audited financial statements at that date.

In the opinion of management, the accompanying unaudited consolidated financial statements reflect all adjustments (including normal recurring adjustments) necessary to present fairly the Company's financial position, the results of its operations and its cash flows for the periods indicated.  Operating results for the periods presented are not necessarily indicative of the results that may be expected for the year ended December 31, 2011.

Unless otherwise indicated, all amounts contained in the notes to the consolidated financial statements are presented in thousands, with the exception of years, per-share and per-hedge amounts.


 
6

 
Callon Petroleum Company
Notes to the Consolidated Financial Statements
(all amounts in thousands, except per-share and per-hedge data)


 
 
Note 2 - Earnings per Share

The following table sets forth the computation of basic and diluted earnings per share:

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
(a) Net income
  $ 19,877     $ 2,130     $ 24,041     $ 6,053  
                                 
(b) Weighted average shares outstanding
    39,225       28,762       36,485       28,750  
      Dilutive impact of stock options
    22       196       24       117  
      Dilutive impact of restricted stock
    597       625       682       539  
                                 
(c) Weighted average shares outstanding
                               
         for diluted net income per share
    39,844       29,583       37,191       29,406  
                                 
Basic net income per share (a/b)
  $ 0.51     $ 0.07     $ 0.66     $ 0.21  
Diluted net income per share (a/c)
  $ 0.50     $ 0.07     $ 0.65     $ 0.21  
                                 
The following were excluded from the diluted EPS calculation because their effect would be anti-dilutive:
 
                                 
Stock options
    67       147       67       177  
Warrants
    0       365       0       365  
Restricted stock
    675       179       675       179  



Note 3 - Comprehensive Income

The components of comprehensive income, net of related taxes, are as follows:

   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Net income
  $ 19,877     $ 2,130     $ 24,041     $ 6,053  
Other comprehensive income:
                               
     Change in fair value of derivatives
    5,209       1,260       3,250       1,451  
Total comprehensive income
  $ 25,086     $ 3,390     $ 27,291     $ 7,504  


 
7

 
Callon Petroleum Company
Notes to the Consolidated Financial Statements
(all amounts in thousands, except per-share and per-hedge data)


Note 4 – Borrowings

The Company’s borrowings consisted of the following at:

 
 
June 30, 2011
   
December 31, 2010
 
Principal components:
           
     Credit Facility
  $ -     $ -  
     13% Senior Notes due 2016, principal
    106,961       137,961  
          Total principal outstanding
    106,961       137,961  
                 
Non-cash components:
               
     13% Senior Notes due 2016 unamortized deferred credit
    19,956       27,543  
          Total carrying value
  $ 126,917     $ 165,504  


Senior Secured Revolving Credit Facility (the “Credit Facility”)

In January 2010, the Company amended its Credit Facility agreement to include Regions Bank as the sole arranger and administrative agent. The third amended and restated Credit Facility, which matures on September 25, 2012, provides for a $100,000 facility. Amounts borrowed under the Credit Facility may not exceed a borrowing base which is reviewed and re-determined on a semi-annual basis using second and fourth quarter financial results and reserve information available at the time of the redetermination.  During the second quarter of 2011, the Bank completed its borrowing base redetermination, which resulted in a 50% increase in the borrowing base from $30,000 at December 31, 2010 to $45,000 at June 30, 2011.  As of June 30, 2011, the interest rate on the facility was 3%, defined in the amended agreement as the London Interbank Offered Rate (“LIBOR”), with a minimum of 0.5%, plus a tiered rate ranging from 2.5% to 3.0%, which is based on the amount drawn on the facility.  In addition, the credit facility carries a commitment fee of 0.5% per annum on the unused portion of the borrowing base, which is payable quarterly.

13% Senior Notes due 2016 (“Senior Notes”) and Deferred Credit

During the fourth quarter of 2009, the Company exchanged approximately 92% of the principal amount, or $183,948, of the Company’s 9.75% Senior Notes (“Old Notes”) for $137,961 of Senior Notes.  The exchange resulted in a 25% reduction in the principal amount of the Old Notes, and included a 3.25% increase in the coupon rate from 9.75% to 13%.  In addition, holders of the tendered notes received 3,794 shares of common stock and 311 shares of Convertible Preferred Stock which was valued on November 24, 2009 in the amount of $11,527 and recorded as an increase to stockholders’ equity.  On December 31, 2009, each share of the Convertible Preferred Stock was automatically converted into 10 shares of common stock.  The Senior Notes’ 13% interest coupon is payable on the last day of each quarter.  Certain of the Company’s subsidiaries guarantee the Company’s obligations under the Senior Notes.  The subsidiary guarantors are 100% owned, all of the guarantees are full and unconditional and joint and several, the parent company has no independent assets or operations and any subsidiaries of the parent company other than the subsidiary guarantors are minor.

 
8

 
Callon Petroleum Company
Notes to the Consolidated Financial Statements
(all amounts in thousands, except per-share and per-hedge data)



Upon issuing the Senior Notes in 2009, the Company reduced the carrying amount of the Old Notes by the fair value of the common and preferred stock issued in the amount of $11,527.  The $31,507 difference between the adjusted carrying amount of the Old Notes and the principal of the Senior Notes was recorded as a deferred credit, which is being amortized as a reduction of interest expense over the life of the Senior Notes at an 8.5% effective interest rate.  The following table summarizes the Company’s deferred credit balance:
Gross Carrying Amount
   
Accumulated Amortization at June 30, 2011(1)
   
Carrying Value at June 30, 2011
   
Amortization Recorded during 2011 as a Reduction of Interest Expense(1)
   
Estimated Amortization
Expected to be
Recorded during the Remainder of 2011
 
$ 31,507     $ 11,551     $ 19,956     $ 1,583     $ 1,572  

(1)
Amortization recorded during 2011 excludes $6,004 of accelerated amortization related to the March 2011 early redemption of $31,000 principal of notes discussed below, which is recorded in the Statement of Operations as a component of the “Gain on early extinguishment of debt.”  Accumulated Amortization at June 30, 2011 includes the $6,004 of accelerated amortization.

On March 19, 2011, using a portion of the proceeds from the Company’s recent equity offering discussed in Note 7, the Company redeemed Senior Notes with a carrying value of $37,004, including $6,004 of the Notes’ deferred credit, in exchange for $35,062, comprised of the $31,000 principal of the notes, the $4,030 call premium and $32 of redemption expenses, which resulted in a $1,942 net gain on the early extinguishment of debt.

Restrictive Covenants

The Indenture governing our Senior Notes and the Company’s Credit Facility contains various covenants including restrictions on additional indebtedness and payment of cash dividends. In addition, Callon’s Credit Facility contains covenants for maintenance of certain financial ratios.  The Company was in compliance with these covenants at June 30, 2011.

Note 5 - Derivative Instruments and Hedging Activities

Objectives and Strategies for Using Derivative Instruments

The Company is exposed to fluctuations in crude oil and natural gas prices on its production. Consequently, the Company believes it is prudent to manage the variability in cash flows on a portion of its crude oil and natural gas production. The Company utilizes primarily collars and swap derivative financial instruments to manage fluctuations in cash flows resulting from changes in commodity prices.  The Company does not use these instruments for speculative purposes.

Counterparty Risk

The use of derivative transactions exposes the Company to counterparty credit risk, or the risk that a counterparty will be unable to meet its commitments. To reduce the Company’s risk in this area, counterparties to the Company’s commodity derivative instruments include a large, well-known financial institution and a large, well-known oil and gas company.  The Company monitors counterparty creditworthiness on an ongoing basis; however, it cannot predict sudden changes in counterparties’ creditworthiness. In addition, even if such changes are not sudden, the Company may be limited in its ability to mitigate an increase in counterparty credit risk. Should one of these counterparties not perform, the Company may not realize the benefit of some of its derivative instruments under lower commodity prices.
     
The Company executes commodity derivative transactions under master agreements that have netting provisions that provide for offsetting payables against receivables. In general, if a party to a derivative transaction incurs an event of default, as defined in the applicable agreement, the other party will have the right to terminate the arrangement or demand the posting of collateral, which may involve cash, letters of credit or property.


 
9

 
Callon Petroleum Company
Notes to the Consolidated Financial Statements
(all amounts in thousands, except per-share and per-hedge data)



Settlements and Financial Statement Presentation

Settlements of the Company’s oil and gas collar derivative contracts are based on the difference between the contract price or prices specified in the derivative instrument and a New York Mercantile Exchange (“NYMEX”) price.  The estimated fair value of these collar contracts is based upon closing exchange prices on NYMEX and the time value of options.  See Note 6, “Fair Value Measurements.”

The Company’s derivative contracts are designated as cash flow hedges, and are recorded at fair market value with the changes in fair value recorded net of tax through other comprehensive income (loss) (“OCI”) in stockholders’ equity. The cash settlements on contracts for future production are recorded as an increase or decrease in oil and gas sales.  Both changes in fair value and cash settlements of ineffective derivative contracts are recognized as derivative expense (income) and are included in Other (income) expense within the Company’s consolidated statements of operations.

Listed in the table below are the outstanding oil and gas derivative contracts as of June 30, 2011:

Product
Product Type
 
Volumes per Month
 
Quantity Type
 
Average Floor Price per Hedge
   
Average Ceiling Price per Hedge
 
Period
                         
Oil
Collar
    10  
Bbls
  $ 75.00     $ 101.85  
July11 - Dec11
Oil
Collar
    5  
Bbls
    80.00       102.00  
July11 - Dec11
Oil
Collar
    10  
Bbls
    75.00       94.50  
July11 - Dec11
Oil
Collar
    15  
Bbls
    90.00       122.00  
July11 - Dec11
Oil
Collar
    25  
Bbls
    90.00       122.00  
Jan12 - Dec12
Oil
Collar
    25  
Bbls
    95.00       125.00  
Jan12 - Dec12

The tables below present the effect of the Company’s derivative financial instruments on the consolidated statements of operations as an increase (decrease) to oil and gas sales for the effective portion and as an increase (decrease) to other (income) expense for the ineffective portion and amounts excluded from effectiveness testing:

   
Three-Months ended
June 30,
   
Six-Months ended
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Amount of gain (loss) reclassified from OCI into income (effective portion)
  $ (350 )   $ 224     $ (449 )   $ 240  
Amount of gain (loss) recognized in income (ineffective portion and
   amount excluded from effectiveness testing)
    59       -       18       -  

Note 6 - Fair Value Measurements

The fair value hierarchy outlined in the relevant accounting guidance gives the highest priority to Level 1 inputs, which consist of unadjusted quoted prices for identical instruments in active markets. Level 2 inputs consist of quoted prices for similar instruments. Level 3 valuations are derived from inputs that are significant and unobservable, and these valuations have the lowest priority.

Fair Value of Financial Instruments

 Cash, Cash Equivalents, Short-Term Investments. The carrying amounts for these instruments approximate fair value due to the short-term nature or maturity of the instruments.
 
Debt. The Company’s debt is recorded at the carrying amount on its Consolidated Balance Sheet.  The fair value of Callon’s fixed-rate debt is based upon estimates provided by an independent investment banking firm. The carrying amount of floating-rate debt approximates fair value because the interest rates are variable and reflective of market rates.

 
10

 
Callon Petroleum Company
Notes to the Consolidated Financial Statements
(all amounts in thousands, except per-share and per-hedge data)



The following table summarizes the respective carrying and fair values at:
 
 
 
 
June 30, 2011
   
December 31, 2010
 
   
Carrying Value
   
Fair Value
   
Carrying Value
   
Fair Value
 
                         
13% Senior Notes due 2016 (1)
  $ 126,917     $ 112,844     $ 165,504     $ 140,030  
                                 
 
(1) Fair value is calculated only in relation to the $106,961 and $137,961 principal outstanding of the 13% Senior Notes at the dates indicated above, respectively.  The remaining $19,956 and $27,543, respectively, which the Company has recorded as a deferred credit, is excluded from the fair value calculation, and will be recognized in earnings as a reduction of interest expense over the remaining amortization period.  See Note 4 for additional information.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

Certain assets and liabilities are reported at fair value on a recurring basis (unless otherwise noted below) in Callon’s Consolidated Balance Sheets. The following methods and assumptions were used to estimate the fair values:

 Commodity Derivative Instruments. Callon’s derivative policy allows for commodity derivative instruments to consist of collars and natural gas and crude oil basis swaps.  As disclosed in Note 5, the Company’s hedge portfolio includes only collar contracts.  The fair value of these derivatives is calculated using a valuation model that utilizes market-corroborated inputs that are observable over the term of the derivative contract, and the values are corroborated by quotes obtained from counterparties to the agreements. The Company’s fair value calculations also incorporate an estimate of the counterparties’ default risk for derivative assets and an estimate of the Company’s default risk for derivative liabilities.  The Company believes that these inputs primarily fall within Level 2 of the fair-value hierarchy based on the wide availability of quoted market prices for similar commodity derivative contracts.  For additional information, see Note 5.

The following tables present the Company’s liabilities measured at fair value on a recurring basis for each hierarchy level:

As of June 30, 2011
Balance Sheet Presentation
 
Level 1
   
Level 2
   
Level 3
   
Total
 
Assets
                         
Derivative financial instruments - current
Fair market value of derivatives
  $ -     $ 1,704     $ -     $ 1,704  
Derivative financial instruments - non-current
Other assets, net
    -       1,243       -       1,243  
                                   
Liabilities
                                 
Derivative financial instruments - current
Fair market value of derivatives
  $ -     $ 600     $ -     $ 600  
Derivative financial instruments - non-current
Other long-term liabilities
    -       -       -       -  
Total
    $ -     $ 2,347     $ -     $ 2,347  
                                   
As of December 31, 2010
Balance Sheet Presentation
 
Level 1
   
Level 2
   
Level 3
   
Total
 
Assets
                                 
Derivative financial instruments - current
Fair market value of derivatives
  $ -     $ -     $ -     $ -  
Derivative financial instruments - non-current
Other assets, net
    -       -       -       -  
                                   
Liabilities
                                 
Derivative financial instruments - current
Fair market value of derivatives
  $ -     $ 937     $ -     $ 937  
Derivative financial instruments - non-current
Other long-term liabilities
    -       -       -       -  
Total
    $ -     $ (937 )   $ -     $ (937 )

The derivative fair values above are based on analysis of each contract. Derivative liabilities with the same counterparty are presented here on a gross basis, even where the legal right of offset exists.

 
11

 
Callon Petroleum Company
Notes to the Consolidated Financial Statements
(all amounts in thousands, except per-share and per-hedge data)



Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

Certain assets and liabilities are reported at fair value on a nonrecurring basis in Callon’s Consolidated Balance Sheet. The following methods and assumptions were used to estimate the fair values:

Asset Retirement Obligations Incurred in Current Period. Callon estimates the fair value of AROs based on discounted cash flow projections using numerous estimates, assumptions and judgments regarding such factors as (1) the existence of a legal obligation for an ARO, (2) amounts and timing of settlements, (3) the credit-adjusted risk-free rate to be used and (4) inflation rates. AROs incurred through June 30, 2011, including upward revisions of $219, were Level 3 fair value measurements.  See Note 9, Asset Retirement Obligations, which provides a summary of changes in the ARO liability.

Project wind-down assets acquired. See Note 10 for additional information regarding the Entrada project assets acquired through a wind-down agreement with Callon’s former joint interest partner on the project.  During the second quarter of 2011, Callon acquired 100% of the rights to all remaining assets related to the Entrada project, which primarily consisted of surplus equipment not used during the Entrada project.  As Callon is required to measure the assets acquired at fair value, Callon estimated each asset’s fair value based on several factors including (1) historical prices received for assets sold, (2) the similarity of unsold assets to those previously sold and the sales prices for those similar assets, (3) the number of market participants expected to have an interest in the assets, (4) the degree to which the asset has been customized and would require modification by a purchaser for use, and (5) the nature of the asset being held for sale (i.e. whether the asset is highly specialized, built-for-purpose, etc.).  Values assigned to equipment sold prior to the June 30 reporting date and for which the exit price, as defined by US GAAP, became readily determinable, represent Level 2 fair value measurements and represents $3,954 of the total $11,349 acquired through the agreement.  The remaining $7,395 of Entrada assets represent Level 3 fair value measurements based on the limited ability of market pricing information for either identical or similar items.  Certain assets were assigned $0 values in instances where the fair value was indeterminable due to the built-for-purpose or highly specialized nature of the assets.  Also as a result of this Agreement, the Company assumed liabilities, which consisted of a deferred tax liability associated with the basis difference of the equipment, which was valued at $3,972, and represents a level 3 fair value measurement.  

Note 7 – Equity Transactions

During February, 2011, the Company received $73,765 in net proceeds through the public offering of 10,100 shares of its common stock, which included the issuance of 1,100 shares pursuant to the underwriters’ over-allotment option.  As discussed in Note 4, the Company used a portion of the proceeds to redeem $31,000 principal or 22% of its Senior Notes.  The remaining proceeds are intended for general corporate purposes including the accelerated development of the Company’s Permian Basin properties and for potential acquisitions.


 
12

 
Callon Petroleum Company
Notes to the Consolidated Financial Statements
(all amounts in thousands, except per-share and per-hedge data)



Note 8 - Income Taxes

The following table presents Callon’s net unrecognized tax benefits relating to its reported net losses and other temporary differences from operations:
   
June 30, 2011
   
December 31, 2010
 
Deferred tax asset:
           
   Federal net operating loss carryforward
  $ 74,305     $ 79,680  
   Statutory depletion carryforward
    6,997       6,140  
   Alternative minimum tax credit carryforward
    209       208  
   Asset retirement obligations
    3,482       4,018  
   Other
    14,195       16,807  
      Deferred tax asset before valuation allowance
    99,188       106,853  
   Less: Valuation allowance
    (74,583 )     (85,222 )
Total deferred tax asset
    24,605       21,631  
Deferred tax liability:
               
   Oil and gas properties
    24,605       21,631  
Total deferred tax liability
    24,605       21,631  
Net deferred tax asset
  $ -     $ -  

In assessing the realizability of deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized.  The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible.  The Company considers the scheduled expiration of deferred tax assets, projected future taxable income and tax planning strategies in making this assessment.  Following an impairment of oil and gas properties recorded during the fourth quarter of 2008, the Company remains in a three-year cumulative loss position as of June 30, 2011.  Accordingly, the Company continues to carry a full valuation allowance against its net deferred tax assets, which will affect the Company’s effective tax rate in future periods to the extent these deferred tax assets are recognized.

Note 9 - Asset Retirement Obligations

The following table summarizes the Company’s asset retirement obligations activity for the six-months ended
June 30, 2011:

Asset retirement obligations at January 1, 2011
  $ 15,925  
   Accretion expense
    1,198  
   Liabilities incurred
    17  
   Liabilities settled
    (2,356 )
   Revisions to estimate
    (421 )
Asset retirement obligations at end of period
    14,363  
   Less: current asset retirement obligations
    (1,538 )
Long-term asset retirement obligations at June 30, 2011
  $ 12,825  

Liabilities settled relate to properties sold during the period for which the related asset retirement obligations were assumed by the purchaser, and also includes individual properties, primarily located in the Gulf of Mexico, plugged and abandoned during the period.

Certain of the Company’s operating agreements require that assets be restricted for future abandonment obligations.  Amounts recorded on the Consolidated Balance Sheets as restricted investments were $4,520 at June 30, 2011 and included $106 recorded as current and $4,414 recorded as long-term at quarter end.  These investments include primarily U.S. Government securities, and are held in abandonment trusts dedicated to pay future abandonment costs for several of the Company’s oil and gas properties.



 
13

 
Callon Petroleum Company
Notes to the Consolidated Financial Statements
(all amounts in thousands, except per-share and per-hedge data)



Note 10 – Entrada Project Wind-down

Effective January 1, 2010 Callon Entrada Company (“CEC”), a variable interest entity, was deconsolidated from the Company’s consolidated financial statements because the Company no longer had the power to direct the activities that most significantly affected CEC’s economic performance, which was the liquidation of the surplus equipment related to the Entrada project.  During May 2011, the Company entered into a final project wind-down agreement (the “Agreement”) with CIECO Energy LLC (“CIECO”), its former joint interest partner in the Entrada deepwater project.  The Agreement, effective as of April 29, 2011, provided for the extinguishment of all existing agreements and commitments between the parties as it related to the past development of the Entrada project.  The Agreement included a formal extinguishment of the non-recourse credit agreement between CEC and CIECO and the assignment to CEC of CIECO’s 50% rights to the remaining assets including primarily the unsold, residual equipment and all engineering data related to the Entrada project.  When combined with CEC’s existing 50% ownership of these assets, this Agreement results in CEC’s full ownership of all remaining assets. Also, as a result of this Agreement, which included both the assignment of the rights to the Entrada assets and the proceeds from the ultimate sale of such assets, the Company gained the power to direct the activities related to the sale of the remaining assets, and therefore became the primary beneficiary of CEC.  Therefore, as Callon became its primary beneficiary, CEC was consolidated in the Company’s consolidated financial statements, effective April 29, 2011.

As discussed in Note 6, the Company estimated the fair values of the assets acquired to be $11,349 and liabilities assumed of CEC to be $3,972 as a result of this Agreement. The assets acquired consisted primarily of the Entrada surplus equipment and the liabilities assumed consisted of deferred tax liabilities associated with the basis difference of the equipment.  The total net assets acquired of approximately $7,377 were recorded as a $3,688 gain and $3,689 as an adjustment to the Company’s full cost pool of oil and gas properties.  The gain recognition was required as a result of the Company acquiring CIECO’s former 50% share of the assets and the full cost pool adjustment was required to reflect the Company’s 50% share of the assets held by the Company prior to the deconsolidation of the CEC subsidiary in 2010.  The gain of $3,688 increased the Company’s fully diluted earnings per share by $0.09 and $.10 for the three and six-months ended June 30, 2011.

With respect to the deferred tax liability, the Company utilized a portion of its deferred tax asset and recognized an income tax benefit equal to $3,972.  During the period from the acquisition date through June 30, 2011, the Company sold certain of the acquired assets for $3,658.  The remaining unsold assets are recorded on the Company’s balance sheet as $296 in Other current assets and $7,665 included in Other property and equipment, net. The Company is actively marketing these assets. Also in connection with this Agreement, CEC agreed to pay to CIECO approximately $438, which represented the net balance of joint interest billings due to CIECO and which had been previously accrued.  The agreement also included joint releases of each party from any further liabilities or obligations to the other party in connection with the Entrada project.


 
14

 
Management’s Discussion and Analysis of Financial Condition and Results of Operations

Special Note Regarding Forward Looking Statements

All statements, other than historical fact or present financial information, may be deemed to be forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements that address activities, outcomes and other matters that should or may occur in the future, including, without limitation, statements regarding the financial position, business strategy, production and reserve growth and other plans and objectives for our future operations, are forward-looking statements. Although we believe the expectations expressed in such forward-looking statements are based on reasonable assumptions, such statements are not guarantees of future performance. We have no obligation and make no undertaking to publicly update or revise any forward-looking statements, except as may be required by law.
 
Forward-looking statements include the items identified in the preceding paragraph, information concerning possible or assumed future results of operations and other statements in this Form 10-Q identified by words such as “anticipate,” “project,” “intend,” “estimate,” “expect,” “believe,” “predict,” “budget,” “projection,” “goal,” “plan,” “forecast,” “target” or similar expressions.

You should not place undue reliance on forward-looking statements. They are subject to known and unknown risks, uncertainties and other factors that may affect our operations, markets, products, services and prices and cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. In addition to any assumptions and other factors referred to specifically in connection with forward-looking statements, risks, uncertainties and factors that could cause our actual results to differ materially from those indicated in any forward-looking statement include, but are not limited to:

·      the timing and extent of changes in market conditions and prices for commodities (including regional basis differentials);
 
·      our ability to transport our production to the most favorable markets or at all;
 
·      the timing and extent of our success in discovering, developing, producing and estimating reserves;
 
·      our ability to fund our planned capital investments;
 
·      the impact of government regulation, including any increase in severance or similar taxes, legislation relating to hydraulic
 
fracturing, the climate and over-the-counter derivatives;
 
·      the costs and availability of oilfield personnel services and drilling supplies, raw materials, and equipment and services;
 
·      our future property acquisition or divestiture activities;
 
·      the effects of weather;
 
·      increased competition;
 
·      the financial impact of accounting regulations and critical accounting policies;
 
·      the comparative cost of alternative fuels;
 
·      conditions in capital markets, changes in interest rates and the ability of our lenders to provide us with funds as agreed;
 
·      credit risk relating to the risk of loss as a result of non-performance by our counterparties; and
 
·      any other factors listed in the reports we have filed and may file with the Securities and Exchange Commission (“SEC”).

We caution you that the forward-looking statements contained in this Form 10-Q are subject to all of the risks and uncertainties, many of which are beyond our control, incident to the exploration for and development, production and sale of oil and natural gas. These risks include, but are not limited to, the risks described in Item 1A our Annual Report on Form 10-K for the year ended December 31, 2010 (the “2010 Annual Report on Form 10-K”), and all quarterly reports on Form 10-Q filed subsequently thereto (“Form 10-Qs”).

Should one or more of the risks or uncertainties described above or elsewhere in our 2010 Annual Report on Form 10-K occur, or should underlying assumptions prove incorrect, our actual results and plans could differ materially from those expressed in any forward-looking statements. We specifically disclaim all responsibility to publicly update any information contained in a forward-looking statement or any forward-looking statement in its entirety and therefore disclaim any resulting liability for potentially related damages.

All forward-looking statements attributable to us are expressly qualified in their entirety by this cautionary statement.

 
15

 
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)


General

The following management’s discussion and analysis describes the principal factors affecting the Company’s results of operations, liquidity, capital resources and contractual cash obligations.  This discussion should be read in conjunction with the accompanying unaudited consolidated financial statements and our Annual Report, which include additional information about our business practices, significant accounting policies, risk factors, and the transactions that underlie our financial results. When appropriate, the Company also updates its risk factors in Part II, Item 1A of this filing.

Our website address is www.callon.com.  All of our filings with the SEC are available free of charge through our website as soon as reasonably practicable after we file them with, or furnish them to, the SEC.  Information on our website does not form part of this report on Form 10-Q.

We have been engaged in the exploration, development, acquisition and production of oil and gas properties since 1950. Prior to 2009, our operations were focused on exploration and production in the Gulf of Mexico.  Beginning in 2009 and continuing still, we are taking steps to change our operational focus to lower risk, onshore exploration and development activities.

Overview and Outlook

For the six-months ended June 30, 2011, we reported net income and fully diluted earnings per share of $24.0 million and $0.65, respectively, compared to net income and diluted earnings per share of $6.1 million and $0.21, respectively for the same period of 2010.  These results are discussed in greater detail within the “Results of Operations” section included below.  Key accomplishments to date in 2011 include:

 
·
Successfully completed a public offering of 10.1 million shares during February 2011 for which the Company received $73.8 million in net proceeds.  While approximately 47% of the proceeds were used to reduce the Company’s debt outstanding, the remaining proceeds will be used for general corporate purposes, to fund the Company’s development of its Permian Basin and other properties and would be available should the Company identify an attractive acquisition opportunity.

 
·
Redeemed during March 2011 $31 million of principal of the Senior Notes resulting in a net gain on the early extinguishment of debt of approximately $2.0 million.  This redemption reduced the principal of the Company’s debt outstanding by approximately 22% to $107 million, and will reduce future interest expense by approximately $3.2 million during 2011 and by $4.0 million for each full year through the Notes’ maturity in 2016.

 
·
Increased the Credit Facility borrowing base to $45 million, representing a $15 million or 50% increase over the previously approved $30 million borrowing base.  Simultaneously received a reduction in the Credit Facility’s interest rate from a minimum of 6% to 3%.

 
·
Increased production from our Permian Basin properties.  Production has increased approximately 100% since December 31, 2010 to approximately 1,100 net barrels of oil equivalent per day (“Boe/d”) from 550 Boe/d.

 
·
Executed an Agreement with our former joint interest partner to complete the wind-down of the Company’s previously abandoned deepwater Entrada Project.  Through the Agreement, the Company acquired rights to the remaining, unsold assets from the project.  Upon recording these assets in the Company’s consolidated financial statements, we recognized a gain of $3.7 million and a related income tax benefit of $4.0 million.


 
16

 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)


Our success in these areas allows us to continue executing on our strategy to shift our operational focus from the offshore Gulf of Mexico to developing longer life, lower risk onshore properties.  Our onshore properties along with the cash flows from our Gulf of Mexico operations have re-shaped our portfolio and outlook, and we believe we are positioned to continue diversifying our portfolio by building profitable growth opportunities onshore.  At December 31, 2010, our onshore properties represented 50% of our proved reserves, and we expect to increase this percentage throughout 2011 as we further develop our onshore assets.  Highlights of our onshore and deepwater development program include:

 
·
Onshore – Permian Basin

We currently own approximately 9,300 net acres in the Permian Basin, of which approximately 80% is prospective for the Wolfberry.  During the second quarter of 2011, we acquired approximately 480 net acres in Midland County located in proximity to our Carpe Diem field.  We operate substantially all of the production and development of these Permian assets, which are located in Crockett, Ector, Midland and Upton Counties, Texas.  As of December 31, 2010, the properties included an estimated 4.5 million barrels of oil equivalent (“MMBoe”) of proved reserves. Production from these properties has increased 100% since December 31, 2010 to approximately 1,100 net Boe/d from 49 gross wells compared to 550 net Boe/d produced from 33 gross wells.  The acreage has the remaining potential for an approximate 129 additional net wells based on 40-acre spacing.  

During the first six months of 2011, we fracture stimulated and placed on production 16 wells and have 10 wells awaiting fracture stimulation services.  We also drilled 16 wells during the first six months of 2011 at a total cost, including completion and facility costs, of approximately $37.6 million, which was included in our 2011 capital expenditures budget.  We now expect to drill approximately 36 total gross wells in 2011, down from 41 previously estimated wells due primarily to drilling wells deeper through the Atoka to define deeper potential within the Wolfberry interval.  We expect to fracture stimulate an additional 22 wells during the second half of the year under our fracture stimulation service agreement.   

 
·
Onshore – Shale Gas (Haynesville Shale)

We own a 69% working interest in a 624-acre unit in the heart of the Haynesville Shale play in Bossier Parish, Louisiana.   Our multi-year development plan for this property includes drilling and operating a total of seven horizontal wells, the first of which was placed on production in September 2010.  As of June 30, 2011, this well was producing 3,400 thousand cubic feet of natural gas equivalent per day.  We have no drilling obligations in our Haynesville Shale position, and currently plan to mobilize a rig to the area once natural gas prices warrant continued development of the remaining six planned gross horizontal wells.

 
·
Deepwater – Mississippi Canyon Blocks 538/582 (“Medusa”) and Garden Banks Block 341 (“Habanero”)

Our deepwater, legacy properties continue to play a key role in our transition to onshore operations by providing strong cash flows used to fund the development of our onshore properties.  Together, our two deepwater properties have produced approximately 245 MBoe equal to nearly 50% of the Company’s total year-to-date production in 2011.  Most of our Medusa’s eight wells continue to produce from their initial completions and, as of December 31, 2010, had 2.4 MMBoe of proved developed non-producing reserves that will be accessed by recompletions in the existing wells.  Another 1.2 MMBoe of proved undeveloped reserves will be developed by side tracking an existing well.  On March 29, 2011, the operator of our Medusa property successfully recompleted at a net cost to Callon of $0.1 million the A6 well from the T4-C zone to the T4-B zone, which increased production net to Callon from approximately 80 Boe/day to approximately 850 Boe/day.  Production from our offshore properties is approximately 80% oil, which in the present market offers favorable pricing in relation to gas.

While we are proud of the portfolio of assets we have built, we remain committed to strategic, onshore growth through attractive property acquisitions.  To this end, we have been actively evaluating various opportunities.

 
17

 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)




Liquidity and Capital Resources

Historically, our primary sources of capital have been cash flows from operations, borrowings from financial institutions and the sale of debt and equity securities.  Cash and cash equivalents increased by approximately $34.6 million during the six month period ended June 30, 2011 to $52.0 million compared to $17.4 million at December 31, 2010.  The increase in liquidity is primarily attributable to higher commodity oil prices, increased production levels and the receipt of $73.8 million from the previously discussed equity offering of 10.1 million shares of common stock offset by approximately $35 million used to repurchase $31 million principal of outstanding Senior Notes.

In January 2010, we amended our Senior Secured Credit Agreement to include Regions Bank as the sole arranger and administrative agent. The third amended and restated senior secured credit agreement (“the Credit Facility”) matures on September 25, 2012, and provides for a $100 million facility with a current borrowing base of $45 million as approved by Regions Bank in May 2011.  The current borrowing base represents a $15 million or 50% increase over the previous $30 million borrowing base.  As of June 30, 2011, the interest rate on the facility was 3%, though no amounts were outstanding under the amended facility as of June 30, 2011.  Simultaneous with the May 2011 increase in the borrowing base, Regions Bank also approved a reduction in the interest rate on the facility from the previous floor of 6% to 3%.  The rate is calculated as LIBOR, with a minimum of 0.5%, plus a tiered rate ranging from 2.5% to 3.0%, which is based on the amount drawn on the facility.  In addition, the Credit Facility which continues to carry a commitment fee of 0.5% per annum on the unused portion of the borrowing base, is payable quarterly.  We are in discussions with Regions Bank to syndicate this facility, which is expected to include an extension of the maturity beyond the September 25, 2012 date noted above.  Similarly, we expect that reserves growth related to our accelerated development of our Permian Basin properties could result in an additional increase in the borrowing base at syndication.

At June 30, 2011, we had approximately $107.0 million of 13% Senior Notes due 2016 outstanding with interest payable quarterly, a $31 million decrease from amounts outstanding at December 31, 2010 following the early redemption previously discussed.  The principal reduction in our Senior Notes will reduce 2011 interest expense by approximately $3.2 million and each full-year thereafter by approximately $4.0 million.

2011 Budget and Capital Expenditures.  For 2011, we designed a flexible capital expenditures spending program that can be funded from cash on hand, inclusive of the proceeds received from the previously discussed equity offering, and cash flows from operations.  This budget projects $107 million of capital expenditures and is primarily focused on the accelerated development of our Permian Basin oil properties including completion costs and the drilling of an estimated 36 wells.  This budget also includes all anticipated plugging and abandonment, capitalized interest and certain overhead costs related to acquiring, exploring and developing oil and gas properties.

In addition to cash on hand, should we identify an attractive strategic opportunity or acquisition, we currently have $45 million of borrowing capacity available under our Credit Facility.  We believe that our cash on hand and operating cash flows along with our Credit Facility, if needed, will be adequate to meet our capital, interest payments, and operating requirements for 2011.


 
18

 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)



Summary cash flow information is provided as follows:

Operating Activities.  For the six-months ended June 30, 2011, net cash provided by operating activities was $31.0 million, compared to $74.0 million for the same period in 2010.  Cash flows from operations in the first half of 2010 included a $44.8 million recoupment of royalties paid to the Bureau of Ocean Energy Management, Regulation and Enforcement (“BOEMRE;” formerly the Minerals Management Service), and related interest of $7.9 million.  Excluding this $52.7 million related to the BOEMRE royalty recoupment, cash flow provided by operating activities increased period-over-period by approximately 45% or $9.6 million primarily as a result of a 21% increase in the average realized sales price on an equivalent basis and a 14% increase in total production on an equivalent basis.

Investing Activities.  For the six-months ended June 30, 2011, net cash used in investing activities was $35.1 million as compared to $19.5 million for the same period in 2010. The $15.5 million increase in net cash used in investing activities is primarily attributable to an increase in capital expenditure spending, and relates to drilling activity on our Permian Basin acreage, which was partially offset by $6.4 million in proceeds received for the sale of certain mineral interests and assets acquired as part of the Entrada project wind-down agreement discussed below and in Note 10 of Item 1, Part 1 of this filing.

Financing Activities.  For the six-months ended June 30, 2011, net cash provided by financing activities was $38.7 million compared to cash used by financing activities of $26.0 million during the same period of 2010.  The 2011 net cash provided by financing activities included $73.8 million of net proceeds from an equity offering offset by approximately $35.1 million used to redeem a $31 million principal portion of our outstanding Senior Notes and to pay the $4.0 million call premium and other redemption expenses.  The 2010 expenditures related to the $10 million repayment of outstanding borrowings under the Credit Facility and the $16.0 million redemption of the Company’s remaining outstanding 9.75% Senior Notes.

Income Taxes

As a result of the impairment of oil and gas properties recorded in the fourth quarter of 2008, we incurred losses on an aggregate basis for the three-year period ended December 31, 2008.  Consequently, we concluded that it was more likely than not that we would not be able to utilize our deferred tax assets.  Accordingly, accounting rules required that we establish a full valuation allowance against our deferred tax asset at the end of that year.  At June 30, 2011, our net deferred tax asset was $74.6 million. During the current quarter, and consistent with previous profitable periods, we recognized no income tax expense by applying a portion of our net operating losses against current income, and simultaneously reversed a portion of the deferred tax valuation allowance equal to this benefit. As a result, we recognized no income tax expense in the income statement for the past two years as we continue to utilize our deferred tax assets to offset taxable income. We have reported earnings in 2009, 2010 and expect to have earnings for the full year of 2011. Based on our recent profitable operations, we are evaluating whether to reverse all or a portion of our valuation allowance.


 
19

 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)



Entrada Project Wind-down Agreement

Effective January 1, 2010 Callon Entrada Company (“CEC”), a variable interest entity, was deconsolidated from our consolidated financial statements because we no longer had the power to direct the activities that most significantly affected CEC’s economic performance, which was the liquidation of the surplus equipment related to the Entrada project.  During the second quarter of 2011, we entered into a final project wind-down agreement (the Agreement) with CIECO Energy LLC (“CIECO”), our former joint interest partner in the Entrada deepwater project.  The Agreement provides for the extinguishment of all existing agreements and commitments between the parties as it relates to the past development of the Entrada project.  The Agreement included a formal extinguishment of the non-recourse credit agreement between CEC and CIECO and the assignment to CEC of CIECO’s 50% rights to the remaining assets including primarily the unsold, residual equipment and all engineering data related to the Entrada project.  When combined with CEC’s existing 50% ownership of these assets, this Agreement results in CEC’s full ownership of all remaining assets. Also, as a result of this Agreement, which included both the assignment of the rights to the Entrada assets and the proceeds from the ultimate sale of such assets, we gained the power to direct the activities related to the sale of the remaining assets, and therefore became the primary beneficiary of CEC.  Therefore, as we became its primary beneficiary, CEC was included in our consolidated financial statements, effective April 29, 2011.

As discussed in Note 6, we estimated the fair values of the assets acquired to be $11.4 million and liabilities assumed of CEC to be $4.0 million as a result of this Agreement. The assets acquired consisted primarily of the Entrada surplus equipment and the liabilities assumed consisted of deferred tax liabilities associated with the basis difference of the equipment.  The total net assets acquired of approximately $7.4 million were recorded as a $3.7 million gain and $3.7 million as an adjustment to our full cost pool of oil and gas properties.  The gain recognition was required as a result of our acquiring CIECO’s former 50% share of the assets, and the full cost pool adjustment was required to reflect the 50% share of the assets we held prior to the deconsolidation of the CEC subsidiary in 2010.  The gain of $3.7 million increased our fully diluted earnings per share by $0.09 and $.10 for the three and six-months ended June 30, 2011.

With respect to the deferred tax liability, we utilized a portion of our deferred tax asset and recognized an income tax benefit equal to $4.0 million.  During the period from the acquisition date through June 30, 2011, we sold certain of the acquired assets for $3.7 million.  The remaining unsold assets are recorded on our balance sheet as $0.3 million in Other current assets and $7.7 million included in Other property and equipment, net. We are actively marketing these assets. Also in connection with this Agreement, CEC agreed to pay to CIECO approximately $0.4 million, which represented the net balance of joint interest billings due to CIECO and which had been previously accrued.  The agreement also included joint releases of each party from any further liabilities or obligations to the other party in connection with the Entrada project.


 
20

 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)


Results of Operations

The following tables set forth certain unaudited operating information with respect to the Company's oil and gas operations for the periods indicated:

   
Three-Months Ended June 30,
 
   
2011
   
2010
   
Change
   
% Change
 
Net production:
                       
  Oil (MBbls)
    275       215       60       28 %
  Gas (MMcf)
    1,388       1,085       303       28 %
  Total production (Mboe)
    506       396       110       28 %
  Average daily production (Boe)
    5,564       4,350       1,214       28 %
                                 
Average realized sales price (a):
                               
  Oil (Bbl)
  $ 105.75     $ 74.03     $ 31.72       43 %
  Gas (Mcf)
    5.58       5.22       0.36       7 %
  Total (Boe)
    72.75       54.49       18.26       34 %
                                 
Oil and gas revenues (in thousands):
                               
  Oil revenue
  $ 29,087     $ 15,901     $ 13,186       83 %
  Gas revenue
    7,747       5,668       2,079       37 %
  Total
  $ 36,834     $ 21,569     $ 15,265       71 %
                                 
Additional per Boe data:
                               
  Sales price
  $ 72.75     $ 54.49     $ 18.26       34 %
  Lease operating expense
    (10.47 )     (10.18 )     (0.29 )     3 %
  Operating margin
  $ 62.28     $ 44.31     $ 17.97       41 %
                                 
Other expenses per Boe:
                               
  Depletion, depreciation and amortization
  $ 25.58     $ 17.79     $ 7.79       44 %
  General and administrative
  $ 7.50     $ 11.14     $ (3.64 )     (33 )%
                                 
(a) Below is a reconciliation of the average NYMEX price to the average realized sales price:
 
                                 
Average NYMEX price per barrel of oil
  $ 102.56     $ 78.03     $ 24.53       31 %
  Basis differential and quality adjustments
    5.50       (2.88 )     8.38    
nm
 
  Transportation
    (1.04 )     (1.16 )     0.12       (10 )%
  Hedging
    (1.27 )     0.04       (1.31 )  
nm
 
Average realized price per barrel of oil
  $ 105.75     $ 74.03     $ 31.72       43 %
                                 
Average NYMEX price per Mcf of natural gas
  $ 4.37     $ 4.34       0.03       1 %
  Basis differential and quality adjustments
    1.21       0.70       0.51       73 %
  Hedging
    -       0.18       (0.18 )     100 %
Average realized price per Mcf of natural gas
  $ 5.58     $ 5.22     $ 0.36       7 %
                                 
nm – Not Meaningful
                               

   

 
21

 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)


   
Six-Months Ended June 30,
 
   
2011
   
2010
   
Change
   
% Change
 
Net production:
                       
  Oil (MBbls)
    476       438       38       9 %
  Gas (MMcf)
    2,730       2,252       478       21 %
  Total production (Mboe)
    931       813       117       14 %
  Average daily production (Boe)
    5,141       4,494       647       14 %
                                 
Average realized sales price (a):
                               
  Oil (Bbl)
  $ 100.71     $ 74.41     $ 26.30       35 %
  Gas (Mcf)
    5.27       5.50       (0.23 )     (4 )%
  Total (Boe)
    66.93       55.27       11.66       21 %
                                 
Oil and gas revenues (in thousands):
                               
  Oil revenue
  $ 47,891     $ 32,564     $ 15,327       47 %
  Gas revenue
    14,392       12,390       2,002       16 %
  Total
  $ 62,283     $ 44,954     $ 17,329       39 %
                                 
Additional per Boe data:
                               
  Sales price
  $ 66.93     $ 55.27     $ 11.66       21 %
  Lease operating expense
    (11.12 )     (10.67 )     (0.45 )     4 %
  Operating margin
  $ 55.81     $ 44.60     $ 11.21       25 %
                                 
Other expenses per Boe:
                               
  Depletion, depreciation and amortization
  $ 24.43     $ 17.03     $ 7.39       43 %
  General and administrative
  $ 8.62     $ 10.72     $ (2.10 )     (20 )%
                                 
(a) Below is a reconciliation of the average NYMEX price to the average realized sales price per barrel of oil:
         
                                 
Average NYMEX oil price
  $ 98.34     $ 78.37     $ 19.97       25 %
  Basis differential and quality adjustments
    4.48       (2.83 )     7.31       nm  
  Transportation
    (1.17 )     (1.16 )     (0.01 )     1 %
  Hedging
    (0.94 )     0.03       (0.97 )     nm  
Average realized oil price
  $ 100.71     $ 74.41     $ 26.30       35 %
                                 
Average NYMEX gas price
  $ 4.29     $ 4.69     $ (0.40 )     (9 )%
  Basis differential and quality adjustments
    0.98       0.73       0.25       34 %
  Hedging
    -       0.08       (0.08 )     (100 )%
Average realized gas price
  $ 5.27     $ 5.50     $ (0.23 )     (4 )%
                                 
 nm – Not Meaningful                                
 
 
 
 
22

 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)



Revenues

The following table is intended to reconcile the change in crude oil, natural gas and total revenue for the respective periods presented by reflecting the effect of changes in volume, changes in the underlying commodity prices and the impact of our hedge program.
 
Changes in Oil and Gas Production Revenues
                 
                   
   
Crude Oil
   
Natural Gas
   
Total
 
                   
Revenues for the three-months ended June 30, 2009
  $ 18,971     $ 6,054     $ 25,025  
                         
Volume increase (decrease)
    (3,458 )     (1,471 )     (4,929 )
Price increase (decrease)
    379       870       1,249  
Impact of hedges increase
    9       215       224  
Net increase (decrease) in 2010
    (3,070 )     (386 )     (3,456 )
                         
Revenues for the three-months ended June 30, 2010
  $ 15,901     $ 5,668     $ 21,569  
                         
Volume increase (decrease)
    4,460       1,579       6,039  
Price increase (decrease)
    9,076       500       9,575  
Impact of hedges increase
    (350 )     -       (350 )
Net increase (decrease) in 2011
    13,186       2,079       15,265  
                         
Revenues for the three-months ended June 30, 2011
  $ 29,087     $ 7,747     $ 36,834  
                         
                         
Changes in Oil and Gas Production Revenues
                       
                         
   
Crude Oil
   
Natural Gas
   
Total
 
                         
Revenues for the six-months ended June 30, 2009
  $ 34,923     $ 14,917     $ 49,840  
                         
Volume increase (decrease)
    (5,863 )     (3,255 )     (9,118 )
Price increase (decrease)
    3,495       497       3,992  
Impact of hedges increase
    9       231       240  
Net increase (decrease) in 2009
    (2,359 )     (2,527 )     (4,886 )
                         
Revenues for the six-months ended June 30, 2010
  $ 32,564     $ 12,390     $ 44,954  
                         
Volume increase (decrease)
    2,822       2,631       5,453  
Price increase (decrease)
    12,954       (629 )     12,325  
Impact of hedges increase
    (449 )     -       (449 )
Net increase (decrease) in 2010
    15,327       2,002       17,329  
                         
Revenues for the six-months ended June 30, 2011
  $ 47,891     $ 14,392     $ 62,283  
 

 
 
23

 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)



Total Revenue

Total oil and gas revenues of $36.8 million for the three-months ended June 30, 2011 increased $15.3 million or 71% from $21.6 million during the same period of 2010 principally driven by an increase in pricing on an equivalent unit basis combined with an increase in overall production.  Compared to the second quarter of 2010, and on an equivalent basis, the average price realized by the Company increased 34%, while overall production increased by 28%.  Production increases were primarily attributable to the Company’s accelerated development program in its Permian Basin properties, the addition of the Company’s Haynesville Shale gas well and due to a well recompletion at its Medusa offshore property.  Normal and expected declines in other legacy properties partially offset these increases.

For the six-months ended June 30, 2011, total oil and gas revenues of $62.3 million increased approximately $17.3 million or 39% from $45.0 million for the same period of 2010.  Compared to the first six months of 2010, total production on an equivalent basis increased by 14%, for the same reasons cited above, while the average realized price per Boe also increased by 21%.

Oil Revenue

Oil revenues increased $13.2 million or 83% to $29.1 million for the three-months ended June 30, 2011 compared to revenues of $15.9 million for the same period of 2010.  As noted above in conjunction with the overall increase in total revenue, both an increase in commodity prices and production resulted in the increase in oil revenue.   The average price realized increased 43% to $105.75 per barrel compared to $74.03 for the same period of 2010.  Similarly, production levels, for the reasons previously discussed, increased 28% to 275 thousand barrels (“MBbls”) during the second quarter of 2011 compared to production of 215 MBbls during the same period in 2010.

For the six-months ended June 30, 2011, oil revenues increased $15.3 million or 47% to $47.9 million compared to revenues of $32.6 million for the same period of 2010.  As previously mentioned, increases in both commodity prices and production contributed to the increase in revenue.  The average price realized increased 35% to $100.71 per barrel compared to $74.41 for the same period of 2010.  Similarly, production increased 9% to 476 MBbls during the first six months of 2011 compared to production of 438 MBbls during the same period in 2010.


Gas Revenue

Gas revenues of $7.7 million for the three-months ended June 30, 2011 increased 37% or $2.1 million compared to gas revenues of $5.7 million for the same period of 2010.  Gas production increased 28% during the second quarter of 2011 compared to the same quarter in 2010, primarily driven by production from our Haynesville Shale gas well, which was placed on production during September 2010, and due to the production from East Cameron #2 well, which was shut-in during the first quarter of 2010 for repairs and did not return to production until December 2010.  In addition to production increases, the average realized price increased 7% to $5.58 per thousand cubic feet of natural gas (“Mcf”) compared to an average realized price of $5.22 per Mcf for the corresponding period in 2010.

For the six-months ended June 30, 2011, gas revenues of $14.4 million increased 16% or $2.0 million when compared to gas revenues of $12.4 million for the same period of 2010.  The largest contributor to the six-month period-over-period increase was a 21% increase in production, the drivers of which are discussed above, partially offset by a 4% period-over-period decrease in the average realized gas sales price.


 
24

 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)



Expenses
   
Three-Months ended June 30,
 
   
2011
   
Per
Boe
   
2010
   
Per Boe
   
Year $ Change
   
Year % Change
   
Boe $ Change
   
Boe % Change
 
Lease operating expenses
  $ 5,299     $ 10.47     $ 4,031     $ 10.18     $ 1,268       31 %   $ 0.28       3 %
Depreciation, depletion and amortization
    12,952       25.58       7,042       17.79       5,910       84 %     7.79       44 %
General and administrative
    3,799       7.50       4,411       11.14       (612 )     (14 )%     (3.64 )     (33 )%
Accretion expense
    583       1.15       622       1.57       (39 )     (6 )%     (0.42 )     (27 )%

   
Six-Months ended June 30,
 
   
2011
   
Per
Boe
   
2010
   
Per Boe
   
Year $ Change
   
Year % Change
   
Boe $ Change
   
Boe % Change
 
Lease operating expenses
  $ 10,344     $ 11.12     $ 8,679     $ 10.67     $ 1,665       19 %   $ 0.45       4 %
Depreciation, depletion and amortization
    22,728       24.43       13,855       17.03       8,873       64 %     7.39       43 %
General and administrative
    8,023       8.62       8,715       10.72       (692 )     (8 )%     (2.10 )     (20 )%
Accretion expense
    1,198       1.29       1,202       1.48       (4 )  
<(1
)%     (0.19 )     (13 )%

Lease Operating Expenses

For the three-months ended June 30, 2011, lease operating expenses (“LOE”) increased by 31% or $1.3 million to $5.3 million compared to $4.0 million for the same period in 2010.  The significant growth in the number of wells now producing in our Permian Basin properties and our new Haynesville Shale well increased LOE approximately $1.0 million compared to the corresponding period of 2010.  Additionally, LOE increased approximately $0.2 million related to increased production from our Medusa A6 well following the previously discussed well recompletion and due to LOE at our East Cameron #2 well, which was shut-in for repairs during the first quarter of 2010 and returned to production during December 2010.  Higher severance taxes partially offset by a mix of lower LOE related primarily to our shelf properties resulted in the remaining $0.1 million increase in LOE.

For the six-months ended June 30, 2011, lease operating expenses (“LOE”) increased by 19% or $1.7 million to $10.3 million compared to $8.7 million for the same period in 2010.  As discussed above, the significant growth in the number of wells now producing in our Permian Basin properties and our new Haynesville Shale well increased LOE approximately $1.4 million compared to the corresponding period of 2010.  Additionally, LOE increased approximately $0.5 million related to platform maintenance work at Medusa, the increased production from the Medusa A6 well following the previously discussed well recompletion and due to LOE at our East Cameron #2 well, which was shut-in for repairs during the first quarter of 2010 and returned to production during December 2010. Offsetting these increases was a mix of lower LOE related primarily to our shelf properties.

Depreciation, Depletion and Amortization

Depreciation, depletion and amortization (“DD&A”) for the three-months ended June 30, 2011 increased 44% per Boe to $25.58 per Boe compared to $17.79  per Boe for the same period of 2010.  Similarly, DD&A for the six-months ended June 30, 2011 increased 43% per Boe to $24.43 per Boe compared to $17.03 per Boe for the same period of 2010.  The additional DD&A relates primarily to costs associated with the Company’s strategic shift towards developing lower-risk, onshore reserves, which, on a unit-of-production basis, have higher development costs than those for our offshore reserves.

General and Administrative

For the three-months ended June 30, 2011, general and administrative (“G&A”) expenses of $3.8 million, net of amounts capitalized, decreased 14% or $0.6 million compared to $4.4 million for the same period of 2010.  Similarly, for the six-months ended June 30, 2011, G&A expenses of $8.0 million, net of amounts capitalized, decreased 8% or $0.7 million compared to $8.7 million for the same period of 2010.  Reduced legal expenses and lower employee-related costs were the primary drivers of the decrease.  These reductions were partially offset by a decline in the amounts of capitalized G&A recorded during the three and six-month periods of 2011 as compared to the same periods of 2010.


 
25

 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)



Accretion Expense

Accretion expense related to our asset retirement obligation decreased 6% and <1% for the three and six-months ended June 30, 2011, respectively, compared to the same periods of 2010.  Accretion expense correlates directionally with the Company’s asset retirement obligation (“ARO”).    At June 30, 2011, our asset retirement obligation of $14.4 million was only slightly lower than the $14.9 million ARO at June 30, 2010.  See Note 9 for additional information regarding the Company’s ARO.

Other Income and Expenses
   
Three-Months ended June 30,
 
   
2011
   
2010
   
$ Change
   
% Change
 
Interest expense
  $ 2,698     $ 3,198     $ (500 )     (16 )%
Gain on early extinguishment of debt, net
    -       339       (339 )     100 %
Gain on acquired assets
    (3,688 )     -       (3,688 )     100 %
Income tax benefit
    (3,972 )     -       (3,972 )     100 %

   
Six-Months ended June 30,
 
   
2011
   
2010
   
$ Change
   
% Change
 
Interest expense
  $ 6,190     $ 6,792     $ (602 )     (9 )%
Gain on early extinguishment of debt, net
    (1,942 )     339       (2,281 )  
nm
 
Gain on acquired assets
    (3,688 )     -       (3,688 )     100 %
Income tax benefit
    (3,972 )     -       (3,972 )     100 %

nm – Not Meaningful

Interest Expense

Interest expense on Callon’s debt obligations decreased 16% to $2.7 million for the three-months ended June 30, 2011 compared to $3.2 million for the same period of 2010.  Similarly, for the six-months ended June 30, 2010 interest expense decreased 9% to $6.2 million compared to $6.8 million.

The decreases relate primarily to the redemption of $31 million principal of 13% Senior Notes during March 2011.  This early redemption reduced interest expense by approximately $1.0 million and $1.1 million for the three and six-month periods, respectively, compared to the same periods of 2010.  Additionally, 2010 interest expense for the three and six-month periods ended June 30, 2010 included approximately $0.5 million and $0.1 million, respectively of interest expense related to the remaining outstanding $16.1 million of old 9.75% Senior Notes, which were redeemed on April 30, 2010 and were therefore not included in 2011 interest expense. Offsetting these declines in interest expense is a $0.4 million and $0.8 million decline in capitalized interest for the three and six-month periods ended June 30, 2011, respectively.  The reduction in capitalized interest relates to a lower balance year-over-year in average unevaluated oil and gas properties following the write-off earlier in 2011 of certain leases, primarily offshore, that the Company elected not to renew.  Further offsetting the declines discussed above are slight decreases in the deferred credit amortization recorded for the three and six-month periods ended June 30 2011, respectively compared to the same period of 2010.

Gain on Early Extinguishment of Debt

During March 2011, using a portion of the proceeds from the Company’s recent equity offering discussed in Note 7, the Company redeemed Senior Notes with a carrying value of $37 million, including $6.0 million of the Notes’ deferred credit, in exchange for $35.1 million, comprised of the $31 million principal of the notes, the $4.0 million call premium and miscellaneous redemption expenses, which resulted in a $1.9 million net gain on the early extinguishment of debt.

Gain on Acquired Assets & Income Tax Benefit

For information concerning the gain on acquired assets and the related income tax benefit, please refer to the discussions included in ”Entrada Project Wind-down Agreement” and in Note 10 included in Part I, Item 1 of this filing.

 
26

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Commodity Price Risk

The Company's revenues are derived from the sale of its crude oil and natural gas production.  The prices for oil and gas remain extremely volatile and sometimes experience large fluctuations as a result of relatively small changes in supply, weather conditions, economic conditions and government actions.  From time to time, the Company enters into derivative financial instruments to manage oil and gas price risk.

The Company may utilize fixed price “swaps,” which reduce the Company's exposure to decreases in commodity prices and limit the benefit the Company might otherwise have received from any increases in commodity prices.

The Company may utilize price "collars" to reduce the risk of changes in oil and gas prices.  Under these arrangements, no payments are due by either party as long as the applicable market price is above the floor price and below the ceiling price set in the collar.  If the price falls below the floor, the counter-party to the collar pays the difference to the Company, and if the price rises above the ceiling, the counter-party receives the difference from the Company.

Callon may purchase “puts” which reduce the Company’s exposure to decreases in oil and gas prices while allowing realization of the full benefit from any increases in oil and gas prices.  If the price falls below the floor, the counter-party pays the difference to the Company.

The Company enters into these various agreements from time to time to reduce the effects of volatile oil and gas prices and does not enter into derivative transactions for speculative purposes.  However, under certain circumstances some of the Company’s derivative positions may not be designated as hedges for accounting purposes.

See Note 5 to the Consolidated Financial Statements for a description of the Company's outstanding derivative contracts at the most recent reporting date.

Item 4. Controls and Procedures

Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to the issuer’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.  During the second quarter of 2011, the Company implemented a new financial system that encompasses financial reporting, the general ledger, land management, and other similar and related processes.  The new financial system was implemented to enhance the Company’s business and financial reporting processes.  The Company’s principal executive and principal financial officers have concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)) were effective as of June 30, 2011.


 
27

 

Part II.  Other Information

Item 1.  Legal Proceedings

Callon Petroleum Company is involved in various lawsuits incidental to our business. While the outcome of these lawsuits and proceedings cannot be predicted with certainty, it is the opinion of our management, based on current information and legal advice, that the ultimate disposition of these suits will not have a material effect on our financial position or results of operations.

Item 1A. Risk Factors

There have been no material changes with respect to the risk factors disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010.
 
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3.  Defaults Upon Senior Securities

None.

Item 4.  Removed and Reserved

Item 5.  Other Information

None.


 
28

 

Item 6.  Exhibits

Index of Exhibits

The following exhibits are filed as part of this Form 10-Q.

Exhibit
   
Number
 
Description


10.           Material Contracts

 
10.1
The Second Amendment to the Third Amended and Restated Credit Agreement dated May 9, 2011 among Callon Petroleum Company and Regions Bank (filed with the Company’s Form 10-Q for the period ended March 31, 2011).