Epsilon Energy Ltd.

08/12/2022 | Press release | Distributed by Public on 08/12/2022 04:01

Quarterly Report for Quarter Ending June 30, 2022 (Form 10-Q)

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2022

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: 001-38770

EPSILON ENERGY LTD.

(Exact name of registrant as specified in its charter)

Alberta, Canada

98-1476367

(State or other jurisdiction of incorporation or organization)

(I.R.S Employer Identification No.)

16945 Northchase Drive, Suite 1610

Houston, Texas77060

(281) 670-0002

(Address of principal executive offices including zip code and

telephone number, including area code)

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

Title of each class

Trading Symbol

Name of each exchange on which registered

Common Shares, no par value

EPSN

NASDAQ Global Market

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

Yes No

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).

Yes No

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

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

Emerging growth company

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

Yes No

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

Yes No

As of August 11, 2022, there were 22,975,512 Common Shares outstanding.

Table of Contents

Table of Contents

Contents

FORWARD-LOOKING STATEMENTS

4

PART I-FINANCIAL INFORMATION

5

ITEM 1. FINANCIAL STATEMENTS

5

Unaudited Condensed Consolidated Balance Sheets

5

Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income (Loss)

6

Unaudited Condensed Consolidated Statements of Changes in Shareholders' Equity

7

Unaudited Condensed Consolidated Statements of Cash Flows

9

Notes to the Unaudited Condensed Consolidated Financial Statements

10

1.

Description of Business

10

2.

Basis of Preparation

10

Interim Financial Statements

10

Principles of Consolidation

10

Use of Estimates

10

Recently Issued Accounting Standards

10

3.

Cash, Cash Equivalents, and Restricted Cash

11

4.

Property and Equipment

12

Property Impairment

12

5.

Revolving Line of Credit

12

6.

Shareholders' Equity

13

7.

Revenue Recognition

17

8.

Income Taxes

19

9.

Commitments and Contingencies

19

Litigation

19

10.

Net Income Per Share

20

11.

Operating Segments

21

12.

Risk Management Activities

23

Commodity Price Risks

23

Commodity Derivative Contracts

23

13.

Asset Retirement Obligations

25

14.

Fair Value Measurements

25

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

26

Overview

26

Business Strategy

26

Operational Highlights

26

Non-GAAP Financial Measures-Adjusted EBITDA

27

Net Operating Revenues

29

Operating Costs

30

Depletion, Depreciation, Amortization and Accretion ("DD&A")

30

General and Administrative

31

Interest Expense

31

(Loss)Gain on Commodity Contracts

32

OtherIncome (Expense)

32

Capital Resources and Liquidity

32

Table of Contents

Cash Flow

32

Credit Agreement

33

Derivative Transactions

34

Contractual Obligations

34

Off-Balance Sheet Arrangements

34

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

35

Gathering System Revenue Risk

35

Interest Rate Risk

35

DerivativeContracts

35

ITEM 4. CONTROLS AND PROCEDURES

35

Disclosure Controls and Procedures

35

Changes in Internal Control Over Financial Reporting

36

Inherent Limitations on Effectiveness of Controls

36

PART II OTHER INFORMATION

36

ITEM 1. LEGAL PROCEEDINGS

36

ITEM 1A. RISK FACTORS

36

ITEM 2. UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS

37

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

37

ITEM 4. MINE SAFETY DISCLOSURES

37

ITEM 5. OTHER INFORMATION

37

ITEM 6. EXHIBITS

38

SIGNATURES

38

Table of Contents

FORWARD-LOOKING STATEMENTS

Certain statements contained in this report constitute forward-looking statements. The use of any of the words ''anticipate,'' ''continue,'' ''estimate,'' ''expect,'' ''may,'' ''will,'' ''project,'' ''should,'' ''believe,'' and similar expressions and statements relating to matters that are not historical facts constitute ''forward looking information'' within the meaning of applicable securities laws. These statements involve known and unknown risks, uncertainties and other factors that may cause actual results or events to differ materially from those anticipated. Such forward-looking statements are based on reasonable assumptions, but no assurance can be given that these expectations will prove to be correct and the forward-looking statements included in this report should not be unduly relied upon. These statements are made only as of the date of this report. All statements that address operating performance, events or developments that we expect or anticipate will occur in the future - including statements relating to natural gas and oil production rates, commodity prices for crude oil or natural gas, supply and demand for natural gas and oil; the estimated quantity of natural gas and oil reserves, including reserve life; future development and production costs, and statements expressing general views about future operating results - are forward-looking statements. Management believes that these forward-looking statements are reasonable as and when made. However, caution should be taken not to place undue reliance on any such forward-looking statements because such statements speak only as of the date when made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In addition, forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our present expectations or projections. These risks and uncertainties include, but are not limited to, those described in our Annual Report on Form 10-K for the year ended December 31, 2021, and those described from time to time in our future reports filed with the Securities and Exchange Commission.You should consider carefully the statements under Item 1A. Risk Factors included in our Annual Report on Form 10-K for the year ended December 31, 2021. Our Annual Report on Form 10-K for the year ended December 31, 2021 is available on our website at www.epsilonenergyltd.com.

4

Table of Contents

PART I-FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Balance Sheets

June 30,

December 31,

2022

2021

ASSETS

Current assets

Cash and cash equivalents

$

30,945,605

$

26,497,305

Accounts receivable

9,930,891

4,596,931

Fair value of derivatives

940,553

-

Other current assets

240,998

569,870

Total current assets

42,058,047

31,664,106

Non-current assets

Property and equipment:

Oil and gas properties, successful efforts method

Proved properties

145,697,537

138,032,413

Unproved properties

18,021,391

21,700,926

Accumulated depletion, depreciation, amortization and impairment

(105,047,754)

(102,480,972)

Total oil and gas properties, net

58,671,174

57,252,367

Gathering system

42,566,495

42,475,086

Accumulated depletion, depreciation, amortization and impairment

(33,995,327)

(33,443,949)

Total gathering system, net

8,571,168

9,031,137

Land

637,764

637,764

Buildings and other property and equipment, net

292,727

309,102

Total property and equipment, net

68,172,833

67,230,370

Other assets:

Restricted cash

569,407

568,118

Total non-current assets

68,742,240

67,798,488

Total assets

$

110,800,287

$

99,462,594

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities

Accounts payable trade

$

1,786,570

$

1,189,905

Gathering fees payable

1,052,168

963,546

Royalties payable

2,471,969

1,853,508

Income taxes payable

2,410,790

1,098,425

Accrued capital expenditures

224,179

1,016,830

Other accrued liabilities

834,779

1,098,127

Fair value of derivatives

-

239,824

Asset retirement obligations

-

85,207

Total current liabilities

8,780,455

7,545,372

Non-current liabilities

Asset retirement obligations

2,735,965

2,748,449

Deferred income taxes

10,224,766

9,905,440

Total non-current liabilities

12,960,731

12,653,889

Total liabilities

21,741,186

20,199,261

Commitments and contingencies (Note 9)

Shareholders' equity

Common shares, no par value, unlimited shares authorized and 23,356,453issued and 23,082,353 outstanding at June 30, 2022 and 24,202,218 issued and 23,668,203 shares outstanding at December 31, 2021

127,093,520

131,815,739

Treasury shares, 274,100 at June 30, 2022 and 534,015 at December 31, 2021

(1,646,823)

(2,423,007)

Additional paid-in capital

9,171,555

8,835,203

Accumulated deficit

(55,364,008)

(68,783,207)

Accumulated other comprehensive income

9,804,857

9,818,605

Total shareholders' equity

89,059,101

79,263,333

Total liabilities and shareholders' equity

$

110,800,287

$

99,462,594

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

5

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EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income (Loss)

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

Revenues from contracts with customers:

Gas, oil, NGL, and condensate revenue

$

17,915,836

$

5,238,754

$

29,395,161

$

11,677,909

Gas gathering and compression revenue

1,987,168

1,851,095

4,107,941

3,853,252

Total revenue

19,903,004

7,089,849

33,503,102

15,531,161

Operating costs and expenses:

Lease operating expenses

2,621,750

1,784,138

4,392,404

3,378,327

Gathering system operating expenses

171,495

173,547

330,706

364,494

Development geological and geophysical expenses

2,386

11,451

4,772

22,990

Depletion, depreciation, amortization, and accretion

1,803,739

1,646,094

3,192,958

3,328,954

Gain on sale of oil and gas properties

(221,642)

-

(221,642)

-

General and administrative expenses:

Stock based compensation expense

194,050

236,041

336,352

438,540

Other general and administrative expenses

1,465,143

2,048,300

2,636,275

3,375,461

Total operating costs and expenses

6,036,921

5,899,571

10,671,825

10,908,766

Operating income

13,866,083

1,190,278

22,831,277

4,622,395

Other income (expense):

Interest income

21,945

8,904

37,166

16,717

Interest expense

(745)

(22,345)

(16,064)

(49,418)

Gain (loss) on derivative contracts

776,994

(1,827,334)

(194,910)

(1,361,993)

Other (expense) income

(61,713)

(279)

(67,119)

1,663

Other income (expense), net

736,481

(1,841,054)

(240,927)

(1,393,031)

Net income (loss) before income tax expense

14,602,564

(650,776)

22,590,350

3,229,364

Income tax expense (benefit)

4,019,576

(165,751)

6,201,474

978,822

NET INCOME (LOSS)

$

10,582,988

$

(485,025)

$

16,388,876

$

2,250,542

Currency translation adjustments

(19,150)

242

(13,748)

(1,242)

NET COMPREHENSIVE INCOME (LOSS)

$

10,563,838

$

(484,783)

$

16,375,128

$

2,249,300

Net income (loss) per share, basic

$

0.45

$

(0.02)

$

0.69

$

0.09

Net income (loss) per share, diluted

$

0.44

$

(0.02)

$

0.69

$

0.09

Weighted average number of shares outstanding, basic

23,576,746

23,779,205

23,627,015

23,862,749

Weighted average number of shares outstanding, diluted

23,822,123

23,779,205

23,796,166

23,941,340

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

6

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EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Changes in Shareholders' Equity

Accumulated

Other

Total

Common Shares Issued

Treasury Shares

Additional

Comprehensive

Accumulated

Shareholders'

Shares

Amount

Shares

Amount

paid-in Capital

Income

Deficit

Equity

Balance at January 1, 2022

24,202,218

$

131,815,739

(534,015)

$

(2,423,007)

$

8,835,203

$

9,818,605

$

(68,783,207)

$

79,263,333

Net income

-

-

-

-

-

-

5,805,888

5,805,888

Dividends

-

-

-

-

-

-

(1,483,027)

(1,483,027)

Stock-based compensation expenses

-

-

-

-

142,302

-

-

142,302

Exercise of stock options

38,750

209,312

-

-

-

-

-

209,312

Retirement of treasury shares

(534,015)

(2,423,007)

534,015

2,423,007

-

-

-

-

Other comprehensive income

-

-

-

-

-

5,402

-

5,402

Balance at March 31, 2022

23,706,953

$

129,602,044

-

$

-

$

8,977,505

$

9,824,007

$

(64,460,346)

$

83,943,210

Net income

-

-

-

-

-

-

10,582,988

10,582,988

Dividends

-

-

-

-

-

-

(1,486,650)

(1,486,650)

Stock-based compensation expenses

-

-

-

-

194,050

-

-

194,050

Exercise of stock options

72,500

399,475

-

-

-

-

-

399,475

Buyback of common shares

-

-

(697,100)

(4,554,822)

-

-

-

(4,554,822)

Retirement of treasury shares

(423,000)

(2,907,999)

423,000

2,907,999

-

-

-

-

Other comprehensive loss

-

-

-

-

-

(19,150)

-

(19,150)

Balance at June 30, 2022

23,356,453

$

127,093,520

(274,100)

$

(1,646,823)

$

9,171,555

$

9,804,857

$

(55,364,008)

$

89,059,101

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

7

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Accumulated

Other

Total

Common Shares Issued

Treasury Shares

Additional

Comprehensive

Accumulated

Shareholders'

Shares

Amount

Shares

Amount

paid-in Capital

Income

Deficit

Equity

Balance at January 1, 2021

23,985,799

$

131,730,401

-

$

-

$

7,879,119

$

9,820,647

$

(80,410,724)

$

69,019,443

Net income

-

-

-

-

-

-

2,735,567

2,735,567

Stock-based compensation expenses

-

-

-

-

202,499

-

-

202,499

Buyback of common shares

-

-

(123,200)

(492,479)

-

-

-

(492,479)

Other comprehensive income

-

-

-

-

-

242

-

242

Balance at March 31, 2021

23,985,799

131,730,401

(123,200)

(492,479)

8,081,618

9,820,889

(77,675,157)

$

71,465,272

Net loss

-

-

-

-

-

-

(485,025)

(485,025)

Stock-based compensation expenses

-

-

-

-

236,041

-

-

236,041

Buyback of common shares

-

-

(141,015)

(568,989)

-

-

-

(568,989)

Other comprehensive loss

-

-

-

-

-

(1,484)

-

(1,484)

Balance at June 30, 2021

23,985,799

131,730,401

(264,215)

(1,061,468)

8,317,659

9,819,405

(78,160,182)

$

70,645,816

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

8

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EPSILON ENERGY LTD.

Unaudited Condensed Consolidated Statements of Cash Flows

Six months ended June 30,

2022

2021

Cash flows from operating activities:

Net income

$

16,388,876

$

2,250,542

Adjustments to reconcile net income to net cash provided by operating activities:

Depletion, depreciation, amortization, and accretion

3,192,958

3,328,954

Loss on derivative contracts

194,910

1,361,993

Gain on sale of oil and gas properties

(221,642)

-

Settlement paid on derivative contracts

(1,375,287)

(27,460)

Settlement of asset retirement obligation

(118,259)

(3,483)

Stock-based compensation expense

336,352

438,540

Deferred income tax expense

319,326

230,863

Changes in assets and liabilities:

Accounts receivable

(5,333,960)

388,912

Prepaid income taxes and other current assets

328,872

(12,476)

Accounts payable, royalties payable and other accrued liabilities

738,023

77,248

Income taxes payable

1,312,365

-

Net cash provided by operating activities

15,762,534

8,033,633

Cash flows from investing activities:

Additions to unproved oil and gas properties

(162,445)

(70,058)

Additions to proved oil and gas properties

(4,935,370)

(1,557,869)

Additions to gathering system properties

(82,855)

(79,419)

Additions to land, buildings and property and equipment

(1,234)

(5,745)

Proceeds from sale of oil and gas properties

200,000

-

Prepaid drilling costs

-

273

Net cash used in investing activities

(4,981,904)

(1,712,818)

Cash flows from financing activities:

Buyback of common shares

(3,956,403)

(1,061,468)

Exercise of stock options

608,787

-

Dividends

(2,969,677)

-

Net cash used in financing activities

(6,317,293)

(1,061,468)

Effect of currency rates on cash, cash equivalents and restricted cash

(13,748)

(1,242)

Increase in cash, cash equivalents and restricted cash

4,449,589

5,258,105

Cash, cash equivalents and restricted cash, beginning of period

27,065,423

13,836,771

Cash, cash equivalents and restricted cash, end of period

$

31,515,012

$

19,094,876

Supplemental cash flow disclosures:

Income taxes paid

$

4,566,000

$

1,074,025

Interest paid

$

33,885

$

27,073

Non-cash investing activities:

Change in unproved properties accrued in accounts payable and accrued liabilities

$

-

$

(65,000)

Change in proved properties accrued in accounts payable and accrued liabilities

$

(1,097,247)

$

805,443

Change in gathering system accrued in accounts payable and accrued liabilities

$

8,554

$

(8,915)

Change in prepaid drilling costs

$

-

$

979,358

Asset retirement obligation asset additions and adjustments

$

7,666

$

(29,853)

Non-cash financing activities:

Change in share buybacks accrued in accounts payable and accrued liabilities

$

598,419

$

-

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

9

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

1. Description of Business

Epsilon Energy Ltd. (the "Company" or "Epsilon" or "we") was incorporated under the laws of the Province of Alberta, Canada on March 14, 2005. On October 24, 2007, the Company became a publicly traded entity trading on the Toronto Stock Exchange ("TSX") in Canada. On February 14, 2019, Epsilon's registration statement on Form 10 was declared effective by the United States Securities and Exchange Commission and on February 19, 2019, the Company began trading in the United States on the NASDAQ Global Market under the trading symbol "EPSN." Effective as of the close of trading on March 15, 2019 Epsilon voluntarily delisted its common shares from the TSX. The Company is engaged in the acquisition, development, gathering and production of primarily natural gas reserves in the United States.

2. Basis of Preparation

Interim Financial Statements

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and with the appropriate rules and regulations of the SEC. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. All adjustments which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the interim periods presented have been included. The interim financial information and notes hereto should be read in conjunction with the Company's consolidated financial statements as of and for the year ended December 31, 2021. The results of operations for interim periods are not necessarily indicative of results to be expected for a full fiscal year.

Principles of Consolidation

The Company's unaudited condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Epsilon Energy USA, Inc. and its wholly owned subsidiaries, Epsilon Midstream, LLC, Dewey Energy GP, LLC, Dewey Energy Holdings, LLC, Epsilon Operating, LLC, and Altolisa Holdings, LLC. With regard to the gathering system, in which Epsilon owns an undivided interest in the asset, proportionate consolidation accounting is used. All inter-company transactions have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates pertain to proved natural gas and oil reserves and related cash flow estimates used in impairment tests of natural gas and oil, and gathering system properties, asset retirement obligations, accrued natural gas and oil revenues and operating expenses, accrued gathering system revenues and operating expenses, as well as the valuation of commodity derivative instruments. Actual results could differ from those estimates.

Recently Issued Accounting Standards

The Company, an emerging growth company ("EGC"), has elected to take advantage of the benefits of the extended transition period provided for in Section 7(a)(2)(B) of the Securities Act, for complying with new or revised accounting standards which allows the Company to defer adoption of certain accounting standards until those standards would otherwise apply to private companies.

In March 2020, the FASB issued ASU No. 2020-04 - Reference Rate Reform (Topic 848), codified as ASC 848 ("ASC 848"). This was followed by ASU No. 2021-01, Reference Rate Reform (Topic 848): Scope ("ASU 2021-01"), issued in January 2021. The purpose of ASC 848 is to provide optional guidance to ease the potential effects on financial

10

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

reporting of the market-wide migration away from Interbank Offered Rates ("IBORs") to alternative reference rates. ASC 848 applies only to contracts, hedging relationships, and other transactions that reference a reference rate expected to be discontinued because of reference rate reform. The guidance may be applied upon issuance of ASC 848 through December 31, 2022. We do not expect a material impact from the adoption of this ASU.

In June 2016 the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which removes the thresholds that companies apply to measure credit losses on financial instruments measured at amortized cost, such as loans, receivables, and held-to-maturity debt securities. Under current U.S. GAAP, companies generally recognize credit losses when it is probable that the loss has been incurred. The revised guidance will remove all recognition thresholds and will require companies to recognize an allowance for credit losses for the difference between the amortized cost basis of a financial instrument and the amount of amortized cost that the Company expects to collect over the instrument's contractual life. ASU 2016-13 is effective for fiscal years beginning after December 15, 2022, and interim periods within those fiscal years, and must be applied retrospectively. Early adoption is permitted. Epsilon will adopt ASU 2016-13 as of January 1, 2023.

In February 2016, the Financial Accounting Standards Board (the "FASB") issued Accounting Standards Update ("ASU") No. 2016-02, Leases (Topic 842), which will require lessees to recognize a right of use asset and a lease liability on their balance sheet for all leases, including operating leases, with a term of greater than 12 months. In July 2018, the FASB issued ASU 2018-11, which adds a transition option permitting entities to apply the provisions of the new standard at its adoption date instead of the earliest comparative period presented in the consolidated financial statements. Under this transition option, comparative reporting would not be required, and the provisions of the standard would be applied prospectively to leases in effect at the date of adoption.

The Company has determined its portfolio of leased assets and is completing its review of all related contracts to determine the impact the adoption will have on its consolidated financial statements and related disclosures. Upon adoption, the Company will recognize a right of use asset and lease liability for certain commitments related to office space that will be accounted for as an operating lease. To track these lease arrangements and facilitate compliance with this ASU, the Company is in the process of designing processes and internal controls.

The adoption of this ASU will increase asset and liability balances on the consolidated balance sheets due to the required recognition of a right of use asset and corresponding lease liabilities and will result in changes to the Company's existing accounting policies, business processes, and internal controls. The Company plans to elect the available package practical expedients provided in the standard and adopt Topic 842 as of January 1, 2022 at December 31, 2022 on its Form 10-K for the year ending December 31, 2022, using the optional transition method provided by ASU 2018-11 and continues to assess potential effects of the standard.

3. Cash, Cash Equivalents, and Restricted Cash

Cash and cash equivalents include cash on hand and short term, highly liquid investments with original maturities of three months or less that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

Restricted cash consists of amounts deposited to back bonds or letters of credit for potential well liabilities. The Company presents restricted cash with cash and cash equivalents in the Consolidated Statements of Cash Flows.

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Notes to the Unaudited Condensed Consolidated Financial Statements

The following table provides a reconciliation of cash, cash equivalents and restricted cash reported in the Consolidated Balance Sheets to the total of the amounts in the Consolidated Statements of Cash Flows as of June 30, 2022 and December, 31 2021:

June 30,

December 31,

2022

2021

Cash and cash equivalents

$

30,945,605

$

26,497,305

Restricted cash included in other assets

569,407

568,118

Cash, cash equivalents and restricted cash in the statement of cash flows

$

31,515,012

$

27,065,423

4. Property and Equipment

The following table summarizes the Company's property and equipment as of June 30, 2022 and December 31, 2021:

June 30,

December 31,

2022

2021

Property and equipment:

Oil and gas properties, successful efforts method

Proved properties

$

145,697,537

$

138,032,413

Unproved properties

18,021,391

21,700,926

Accumulated depletion, depreciation, amortization and impairment

(105,047,754)

(102,480,972)

Total oil and gas properties, net

58,671,174

57,252,367

Gathering system

42,566,495

42,475,086

Accumulated depletion, depreciation, amortization and impairment

(33,995,327)

(33,443,949)

Total gathering system, net

8,571,168

9,031,137

Land

637,764

637,764

Buildings and other property and equipment, net

292,727

309,102

Total property and equipment, net

$

68,172,833

$

67,230,370

Property Impairment

Epsilon performs a quantitative impairment test quarterly or whenever events or changes in circumstances indicate that an asset group's carrying amount may not be recoverable, over proved properties using the published NYMEX forward prices, timing, methods and other assumptions consistent with historical periods. When indicators of impairment are present, GAAP requires that the Company first compares expected future undiscounted cash flows by asset group to their respective carrying values. If the carrying amount exceeds the estimated undiscounted future cash flows, a reduction of the carrying amount of the oil and natural gas properties to their estimated fair values is required, which is determined based on discounted cash flow techniques using significant assumptions including projected revenues, future commodity prices, and a market-specific weighted average cost of capital which are affected by expectations about future market and economic conditions. During the three and six months ended June 30, 2022 and 2021, no impairment was required.

5. Revolving Line of Credit

The Company has a senior secured revolving credit facility ("Facility") which includes a total commitment of up to $100 million. The current borrowing base is $14 million, which is subject to semi-annual redetermination. There are currently no borrowings under the Facility. If Epsilon decided to access the Facility, depending on the level of borrowing, the Company might need to increase its hedging activity. Borrowings from the Facility may be used for the acquisition and development of oil and gas properties, investments in cash flow generating assets complimentary to the production of oil and gas, and for letters of credit and other general corporate purposes. Upon each advance, interest is charged at the highest of a) rate of LIBOR plus an applicable margin (2.75%-3.75% based on the percent of the line of credit utilized), b) the Prime Rate, or c) the sum of the Federal Funds Rate plus 0.5%.

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Notes to the Unaudited Condensed Consolidated Financial Statements

Effective April 6, 2021, the agreement was amended to extend the maturity date to March 1, 2024. In addition, the agreement was amended to include a Benchmark Replacement definition and transition plan to be used at such time when the LIBOR rate is discontinued.

On August 2, 2022, the borrowing base of $14 million was reaffirmed until the next periodic redetermination of the borrowing base.

The lender under the Credit Facility has a first priority security interest in the tangible and intangible assets, including the gathering system, of Epsilon Energy USA, Inc. to secure any outstanding amounts under the agreement. Under the terms of the agreement, the Company must maintain the following covenants:

Interest coverage ratio greater than 3 based on income adjusted for interest, taxes and non-cash amounts.

Current ratio, adjusted for line of credit amounts used and available and non-cash amounts, greater than 1.

Leverage ratio less than 3.0 based on income adjusted for interest, taxes and non-cash amounts.

The Company was in compliance with the financial covenants of the Credit Facility as of June 30, 2022 and expects to be in compliance with the financial covenants for the next 12 months.

A commitment fee of 0.50% is assessed quarterly on the daily average unused borrowing base on the Credit Facility.

Balance at

Balance at

June 30,

December 31,

Current

Interest Rate

2022

2021

Borrowing Base

3 mo.

Revolving line of credit

$

-

$

-

$

14,000,000

LIBOR + 3.25% (1)

(1) At June 30, 2022, the interest rate was 4.876%.

6. Shareholders' Equity

(a)Authorized shares

The Company is authorized to issue an unlimited number of Common Shares with no par value and an unlimited number of Preferred Shares with no par value.

(b)Purchases of Equity Shares

Normal Course Issuer Bid

Commencing on March 8, 2022, the Company conducted a normal course issuer bid ("NCIB") to repurchase our issued and outstanding common shares, when doing so was accretive to management's estimates of intrinsic value per share. The NCIB ends on March 7, 2023. The Company uses discretionary cash to fund these repurchases. During the six months ended June 30, 2022, Epsilon repurchased 697,100 common shares of the authorized 1,183,410 purchase amount and spent $4,554,822 under the NCIB. The repurchased stock had an average price of $6.53 per share. The Company cancelled 423,000 common shares during the three months ended June 30, 2022.

Commencing on January 1, 2021, Epsilon conducted a normal course issuer bid ("NCIB") to repurchase our issued and outstanding common shares, when doing so was accretive to management's estimates of intrinsic value per share. The NCIB ended on December 31, 2021. The Company used discretionary cash to fund these repurchases. During the year ended December 31, 2021, Epsilon repurchased 534,015 common shares of the authorized 1,193,000 purchase

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Notes to the Unaudited Condensed Consolidated Financial Statements

amount and spent $2,423,007 under the NCIB. The repurchased stock had an average price of $4.54 per share and were subsequently cancelled during the three months ended March 31, 2022.

Repurchases may be made at management's discretion from time to time through the facilities of the NASDAQ Global Market. The price paid for the common shares will be, subject to applicable securities laws, the prevailing market price of such common shares on the NASDAQ Global Market at the time of such purchase. The Company intends to fund the purchase out of available cash and does not expect to incur debt to fund the share repurchase program. The shares are accounted for as treasury shares until such a time as they are cancelled.

The following table contains activity relating to our acquisition of equity securities during the six months ended June 30, 2022:

Maximum number

of shares that

may yet be

Total number

Average price

purchased under

of shares

paid per

the plans or

purchased

share

programs

Beginning of normal-course issuer bid, March 8, 2022

1,183,410

March 2022 (1)

-

$

-

April 2022 (1)

23,700

$

6.66

May 2022 (1)

254,500

$

7.01

June 2022 (1)

418,900

$

6.24

Total as of June 30, 2022

697,100

$

6.53

486,310

(1) Epsilon repurchased these shares under its share repurchase program that commenced on March 8, 2022, as described above.

(c)Equity Incentive Plan

Epsilon's board of directors (the "Board") adopted the 2020 Equity Incentive Plan (the "2020 Plan") on July 22, 2020 subject to approval by Epsilon's shareholders at Epsilon's 2020 Annual General and Special Meeting of Shareholders, which occurred on September 1, 2020 (the "Meeting"). Shareholders approved the 2020 Plan at the Meeting. Following Epsilon's listing on the NASDAQ Global Market, the Board determined that it is in the best interest of the shareholders to approve a new incentive plan that is compliant with U.S. public company equity plan rules and practices that would replace Epsilon's Amended and Restated 2017 Stock Option Plan (including its predecessors) and the Share Compensation Plan (collectively referred to as the "Predecessor Plans"). No further awards will be granted under the Predecessor Plans.

The 2020 Plan provides for incentive compensation in the form of stock options, stock appreciation rights, restricted stock and stock units, performance shares and units, other stock-based awards and cash-based awards. Under the 2020 Plan, Epsilon will be authorized to issue up to 2,000,000 Common Shares. As of December 31, 2021, the Company granted, after the Compensation Committee approved the terms, target formulas, and peer group applicable to the performance incentive awards, 20,834 common shares and 48,000 time-based restricted shares to the CEO and the board of directors.

Restricted Stock Awards

For the six months ended June 30, 2022, 89,925 shares of Restricted Stock with a weighted average market price at the grant date of $6.33 were awarded to the Company's board of directors and employees. For the year ended December 31, 2021, 48,000 common shares of Restricted Stock with a weighted average market price at the grant date of $5.04 were awarded to the Company's board of directors. These shares vest over a three-year period, with one-third of the shares

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

being issued per period on the anniversary of the award resolution. The vesting of the shares is contingent on the individuals' continued employment or service. The Company determined the fair value of the granted Restricted Stock-based on the market price of the common shares of the Company on the date of grant.

The following table summarizes Restricted Stock activity for the six months ended June 30, 2022, and the year ended December 31, 2021:

Six months ended

Year ended

June 30, 2022

December 31, 2021

Number of

Weighted

Number of

Weighted

Restricted

Average

Restricted

Average

Shares

Remaining Life

Shares

Remaining Life

Outstanding

(years)

Outstanding

(years)

Balance non-vested Restricted Stock at beginning of period

166,002

1.38

290,070

1.60

Granted

89,925

1.50

48,000

3.00

Vested

-

-

(137,668)

-

Forfeited

-

-

(34,400)

-

Balance non-vested Restricted Stock at end of period

255,927

1.10

166,002

1.38

Stock compensation expense for the granted Restricted Stock is recognized over the vesting period. Stock compensation expense recognized during the three and six months ended June 30, 2022 was $146,860 and $241,972, respectively (for the three and six months ended June 30, 2021, $137,207 and $274,413, respectively).

At June 30, 2022, the Company had unrecognized stock-based compensation related to these shares of $931,239 to be recognized over a weighted average period of 1.19 years (at December 31, 2021: $696,833 over 1.11 years).

Performance Share Unit Awards ("PSU")

For the six months ended June 30, 2022, no PSUs were awarded. For the year ended December 31, 2021, a total of 62,501 common shares vested and were issued, of which 20,834 of the common shares were granted as a result of the Company exceeding its 2020 TSR performance target. The Company grants PSUs, which are paid in stock, to certain key employees. PSUs are based on a three-year performance period with performance being measured each year at December 31. The PSUs will vest on the last day of the performance period. The number of PSUs that will ultimately vest is based on two performance targets as follows:

The targets for the PSUs are based on (i) the relative total stockholder return ("TSR") percentile ranking and (ii) the relative cash flow per debt adjusted share - growth ("CFDAS Growth") percentile ranking of the Company, each as compared to the Company's Performance Peer Group during the applicable one-yearperformance period ending on December 31.
Cash Flow per Debt Adjusted Share ("CFDAS") is defined as EBITDA (earnings before interest, taxes, depreciation and amortization) divided by the sum of the 1) the total debt plus the value of preferred stock minus cash and the amount of dividends paid for the year divided by the share price at the end of the year; and 2) the actual share count at year end.
The vesting of each PSU Award will be based 50%on TSR performance and 50%based on CFDAS Growth performance.
The recipient of the award must be employed with the Company at the time of vesting.

The number of shares ultimately issued under these awards can range from zero to 200% of target award amounts.

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The PSUs are accounted for as equity awards. The fair value of the 50% for performance based on CFDAS Growth was determined as the market price of the common shares of the Company on the date of grant. Weighted average fair value of CFDAS PSUs granted during the year ended December 31, 2021 was $3.41 per unit. The fair value of the 50% for performance based on TSR was determined on the grant date by the application of a Monte Carlo simulation model. For the year ended December 31, 2021, the Compensation Committee did not approve the issuance of any new PSU's.

The Monte Carlo simulation model utilizes multiple input variables that determine the probability of satisfying the market condition stipulated in the performance stock awards, to calculate the fair value of the awards. Expected volatilities in the model were estimated using a historical period consistent with the expected term for each annual performance period of the awards. The risk-free interest rate was based on the United States Treasury rate measured over a term commensurate with the expected term for each annual performance period of the awards. The expected term is based on the time between the valuation date and the end of each annual performance period of the awards. The valuation model assumes dividends are immediately reinvested.

The following table summarizes PSUs for the six months ended June 30, 2022 and the year ended December 31, 2021:

Six months ended

Year ended

June 30, 2022

December 31, 2021

Number of

Weighted

Number of

Weighted

Performance

Average

Performance

Average

Shares

Remaining Life

Shares

Remaining Life

Outstanding

(years)

Outstanding

(years)

Balance non-vested PSUs at beginning of period

151,500

0.75

193,167

1.60

Granted

-

-

20,834

-

Vested

-

-

(62,501)

-

Balance non-vested PSUs at end of period

151,500

0.59

151,500

0.75

Stock compensation expense for the granted PSUs is recognized over the vesting period. Stock compensation expense recognized during the three and six months ended June 30, 2022 related to PSUs was $47,190 and $94,380, respectively (for the three and six months ended June 30, 2021, $98,835 and $164,127, respectively.

At June 30, 2022, the Company had unrecognized stock-based compensation related to these shares of $213,035 to be recognized over a weighted average period of 0.83 years (at December 31, 2021: $310,790 over 1.01 years).

Stock Options

As of June 30, 2022, the Company had outstanding stock options covering 97,500 Common Shares at an overall average exercise price of $5.03 per Common Share to directors, officers, and employees of the Company and its subsidiaries. These 97,500 options have a weighted average expected remaining term of approximately 1.56 years.

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

The following table summarizes stock option activity for the six months ended June 30, 2022 and the year ended December 31, 2021:

Six months ended

Year ended

June 30, 2022

December 31, 2021

Weighted

Weighted

Number of

Average

Number of

Average

Options

Exercise

Options

Exercise

Exercise price in US$

Outstanding

Price

Outstanding

Price (1)

Balance at beginning of period

218,750

$

5.28

245,000

$

5.27

Exercised

(111,250)

$

5.47

(16,250)

$

5.25

Expired/Forfeited

(10,000)

$

5.51

(10,000)

$

5.50

Balance at period-end

97,500

$

5.03

218,750

$

5.28

Exercisable at period-end

97,500

$

5.03

218,750

$

5.28

At June 30, 2022, using the Black Scholes model, the Company had unrecognized stock-based compensation, related to these options, of nil (at December 31, 2021: nil). The aggregate intrinsic value at June 30, 2022 was $83,850 (at December 31, 2021: nil).

During the six months ended June 30, 2022 and the year ended December 31, 2021, the Company awarded no stock options.

(d) Dividends

On February 25, 2022 and May 26, 2022, the Board declared quarterly dividends of $0.0625 per common share (annualized $0.25 per common share) totaling in aggregate an amount of approximately $3.0million that has been paid for the six months ended June 30, 2022.

7. Revenue Recognition

Revenues are comprised primarily of sales of natural gas along with the revenue generated from the Company's ownership interest in the Auburn gas gathering system in Northeastern Pennsylvania. Also included are natural gas, crude oil and NGL revenues from Oklahoma.

Overall, product sales revenue generally is recorded in the month when contractual delivery obligations are satisfied, which occurs when control is transferred to the Company's customers at delivery based on contractual terms and conditions. In addition, gathering and compression revenue generally is recorded in the month when contractual service obligations are satisfied, which occurs as control of those services is transferred to the Company's customers.

The following table details revenue for the three and six months ended June 30, 2022 and 2021.

Three months ended June 30,

Six Months Ended June 30,

2022

2021

2022

2021

Operating revenue

Natural gas

$

15,984,348

$

5,106,922

$

26,687,432

$

11,439,021

Natural gas liquids

688,397

52,529

1,002,825

98,150

Oil and condensate

1,243,091

79,303

1,704,904

140,738

Gathering and compression fees

1,987,168

1,851,095

4,107,941

3,853,252

Total operating revenue

$

19,903,004

$

7,089,849

$

33,503,102

$

15,531,161

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Product Sales Revenue

The Company enters into contracts with third party purchasers to sell its natural gas, oil, NGLs and condensate production. Under these product sales arrangements, the sale of each unit of product represents a distinct performance obligation. Product sales revenue is recognized at the point in time that control of the product transfers to the purchaser based on contractual terms which reflect prevailing commodity market prices. To the extent that marketing costs are incurred by the Company prior to the transfer of control of the product, those costs are included in lease operating expenses on the Company's consolidated statements of operations.

Settlement statements for product sales, and the related cash consideration, are received from the purchaser within 30 days. As a result, the Company must estimate the amount of production delivered to the customer and the consideration that will ultimately be received for sale of the natural gas, oil, NGLs, or condensate. Estimated revenue due to the Company is recorded within the receivables line item on the accompanying consolidated balance sheets until payment is received.

Gas Gathering and Compression Revenue

The Company also provides natural gas gathering and compression services through its ownership interest in the Auburn gas gathering system. For the provision of gas gathering and compression services, the Company collects its share of the gathering and compression fees per unit of gas serviced and recognizes gathering revenue over time using an output method based on units of gas gathered.

The settlement statement from the operator of the Auburn Gas Gathering System is received two months after transmission and compression has occurred. As a result, the Company must estimate the amount of production that was transmitted and compressed within the system. Estimated revenue due to the Company is recorded within the receivables line item on the accompanying consolidated balance sheets until payment is received.

Allowance for Doubtful Accounts

The Company records an allowance for doubtful accounts on a case-by-case basis once there is evidence that collection is not probable. For the three and six months ended June 30, 2022, there were no accounts for which collection was not probable.

The following table details accounts receivable as of June 30, 2022 and December 31, 2021.

June 30,

December 31,

2022

2021

Accounts receivable

Natural gas and oil sales

$

8,339,473

$

2,996,344

Joint interest billing

21,381

60,134

Gathering and compression fees

1,435,391

1,539,976

Other

134,646

477

Total accounts receivable

$

9,930,891

$

4,596,931

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

8. Income Taxes

Income tax provisions for the three and six months ended June 30, 2022 and 2021 are as follows:

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

Current:

Federal

$

2,530,805

$

319,557

$

3,997,702

$

474,927

State

1,192,131

89,188

1,884,446

273,032

Total current income tax expense

3,722,936

408,745

5,882,148

747,959

Deferred:

Federal

233,599

(451,044)

255,614

212,159

State

63,041

(123,452)

63,712

18,704

Total deferred tax expense

296,640

(574,496)

319,326

230,863

Income tax expense

$

4,019,576

$

(165,751)

$

6,201,474

$

978,822

The Company files federal income tax returns in the United States and Canada, and various returns in state and local jurisdictions.

The Company believes it has appropriate support for the income tax positions taken and to be taken on our tax returns and that the accruals for tax liabilities are adequate for all open years based on our assessment of various factors including past experience and interpretations of tax law applied to the facts of each matter. The Company's tax returns are open to audit under the statute of limitations for the years ending December 31, 2018 through December 31, 2021. To the extent we utilize net operating losses generated in earlier years, such earlier years may also be subject to audit.

Our effective tax rate will typically differ from the statutory federal rate primarily as a result of state income taxes and the valuation allowance against the Canadian net operating loss. The effective tax rate for the six months ended June 30, 2022 was higher than the statutory federal rate as a result of the state income taxes and the valuation allowance against the Canadian net operating loss.

9. Commitments and Contingencies

The Company's future minimum lease commitments as of June 30, 2022 are summarized in the following table:

Year ended

December 31,

Payments

2022

$

93,666

2023

62,444

$

156,110

The Company enters into commitments for capital expenditures in advance of the expenditures being made. As of June 30, 2022, the Company had commitments of $1.5 million for capital expenditures.

Litigation

On March 10, 2021, Epsilon filed a complaint against Chesapeake Appalachia, LLC ("Chesapeake") in the United States District Court for the Middle District of Pennsylvania, Scranton, Pennsylvania ("Middle District"). Epsilon claims that Chesapeake has breached a settlement agreement and several operating agreements ("JOAs") to which Epsilon and Chesapeake are parties. Epsilon asserts that Chesapeake has failed to cooperate with Epsilon's efforts to develop resources in the Auburn Development, located in North-Central Pennsylvania, as required under both the settlement agreement and JOAs.

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Notes to the Unaudited Condensed Consolidated Financial Statements

Epsilon requested a preliminary injunction but was unsuccessful in obtaining that injunction. Epsilon filed a motion to amend its original Complaint. Chesapeake opposed. The Court ruled in Epsilon's favor and allowed Epsilon's amendment. Chesapeake moved to dismiss the amended Complaint. The Court granted the motion to dismiss on a narrow issue without prejudice to Epsilon's right to file a new lawsuit based on new proposals made after the Court's decision. Epsilon filed a motion for reconsideration of that decision, but the court denied the motion for reconsideration on January 18, 2022.

Epsilon filed a notice of appeal on February 15, 2022 challenging both the motion to dismiss and motion for reconsideration decisions. Chesapeake filed a cross-appeal on March 1, 2022. A briefing schedule was set with briefing to close in October 2022. A decision on the appeal is not expected until early to mid-2023.

Epsilon re-filed a complaint against Chesapeake in the Middle District on May 9, 2022. Epsilon generally asserts similar claims as in the previous suit, pursuing declaratory judgment claims regarding Chesapeake's obligation to Epsilon to cooperate with Epsilon's efforts in the Auburn Development and regarding Chesapeake's obstruction of Epsilon's efforts with the Pennsylvania Department of Environmental Protection permitting process but not based on specific well proposals. Chesapeake filed a motion to stay pending a decision on the Third Circuit appeal. The motion to stay has been fully briefed. Epsilon expects a decision on the motion to stay in fall 2022.

10. Net Income Per Share

Basic net income per share is computed on the basis of the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed based upon the weighted-average number of common shares outstanding during the period plus the assumed issuance of common shares for all potentially dilutive securities.

The net income used in the calculation of basic and diluted net income per share is as follows:

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

Net income (loss) available to shareholders

$

10,582,988

$

(485,025)

$

16,388,876

$

2,250,542

In calculating the net income per share, basic and diluted, the following weighted-average shares were used:

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

Basic weighted-average number of shares outstanding

23,576,746

23,779,205

23,627,015

23,862,749

Dilutive stock options

25,405

-

19,630

-

Unvested time-based restricted shares

103,258

-

39,340

53,815

Unvested performance-based restricted shares

116,714

-

110,181

24,776

Diluted weighted average shares outstanding

23,822,123

23,779,205

23,796,166

23,941,340

The company excluded the following shares from the diluted EPS because their inclusion would have been anti-dilutive.

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

Anti-dilutive options

72,095

-

77,870

-

Anti-dilutive unvested time-based restricted shares

146,740

77,023

169,127

-

Anti-dilutive unvested performance-based restricted shares

34,786

36,567

41,319

-

Total Anti-dilutive shares

253,621

113,590

288,316

-

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

11. Operating Segments

Operating segments are reported in a manner consistent with the internal reporting provided to the chief operating decision-maker. The chief operating decision-maker, who is responsible for allocating resources and assessing performance of the operating segments, has been identified as executive management. Segment performance is evaluated based on operating profit or loss as shown in the table below. Interest income and expense, and income taxes are managed separately on a group basis.

The Company's reportable segments are as follows:

a. The Upstream segment activities include acquisition, development and production of oil, natural gas, and other liquid reserves on properties within the United States;
b. The Gas Gathering segment partners with twoother companies to operate a natural gas gathering system; and
c. The Corporate segment activities include corporate listing and governance functions of the Company.

Segment activity as of, and for the six months ended June 30, 2022 and 2021 is as follows:

Upstream

Gas Gathering

Corporate

Elimination

Consolidated

As of and for the six months ended June 30, 2022

Operating revenue

Natural gas

$

26,687,432

$

-

$

-

$

-

$

26,687,432

Natural gas liquids

1,002,825

-

-

-

1,002,825

Oil and condensate

1,704,904

-

-

-

1,704,904

Gathering and compression fees

-

4,842,838

-

(734,897)

4,107,941

Total operating revenue (1)

$

29,395,161

$

4,842,838

$

-

$

(734,897)

$

33,503,102

Net earnings (loss) for the period

$

22,359,572

$

3,222,690

$

(9,193,386)

(3)

$

-

$

16,388,876

Operating costs

4,392,404

1,065,603

-

(734,897)

4,723,110

Development geological and geophysical expenses

4,772

-

-

-

4,772

Depletion, depreciation, amortization and accretion

2,638,413

554,545

-

-

3,192,958

Segment assets

$

99,313,811

$

10,732,117

$

754,360

$

-

$

110,800,287

Capital expenditures (2)

4,001,802

91,409

-

-

4,093,211

Proved properties (net)

40,649,783

-

-

-

40,649,783

Unproved properties (net)

18,021,391

-

-

-

18,021,391

Gathering system (net)

-

8,571,168

-

-

8,571,168

Lease right-of-use-asset

-

-

-

-

-

Other property and equipment (net)

930,491

-

-

-

930,491

As of and for the six months ended June 30, 2021

Operating revenue

Natural gas

$

11,439,021

$

-

$

-

$

-

$

11,439,021

Natural gas liquids

98,150

-

-

-

98,150

Oil and condensate

140,738

-

-

-

140,738

Gathering and compression fees

-

4,623,548

-

(770,296)

3,853,252

Total operating revenue (1)

$

11,677,909

$

4,623,548

$

-

$

(770,296)

$

15,531,161

Net earnings (loss) for the period

$

5,684,536

$

2,751,860

$

(6,185,854)

(3)

$

-

$

2,250,542

Operating costs

3,378,327

1,134,790

-

(770,296)

3,742,821

Development geological and geophysical expenses

22,990

-

-

-

22,990

Depletion, depreciation, amortization and accretion

2,592,056

736,898

-

-

3,328,954

Segment assets

$

78,621,390

$

11,941,329

$

133,220

$

-

$

90,695,939

Capital expenditures (2)

2,374,115

70,504

-

-

2,444,619

Proved properties (net)

34,531,736

-

-

-

34,531,736

Unproved properties (net)

21,557,121

-

-

-

21,557,121

Gathering system (net)

-

9,437,587

-

-

9,437,587

Other property and equipment (net)

964,435

-

-

-

964,435

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

(1) Segment operating revenue represents revenues generated from the operations of the segment. Inter-segment sales during the six months ended June 30, 2022 and 2021 have been eliminated upon consolidation. For the six months ended June 30, 2022, Epsilon sold natural gas to 21unique customers. The twocustomers over 10%comprised 23%and 19%of total revenue. For the six months ended June 30, 2021, Epsilon sold natural gas to 25unique customers. The twocustomers over 10%comprised 35%and 10%of total revenue.
(2) Capital expenditures for the Upstream segment consist primarily of the acquisition of properties, and the drilling and completing of wells while Gas Gathering consists of expenditures relating to the expansion and completion of the gathering and compression facility.
(3) Segment reporting for net earnings for the period does not include non-monetary compensation, general and administrative expense, interest income, interest expense, both gains and (losses) on derivative contracts, or income tax amounts as they are managed on a group basis and are instead included in the corporate column for reconciliation purposes.

Segment activity for the three months ended June 30, 2022 and 2021 is as follows:

Upstream

Gas Gathering

Corporate

Elimination

Consolidated

For the three months ended June 30, 2022

Operating revenue

Natural gas

$

15,984,348

$

-

$

-

$

-

$

15,984,348

Natural gas liquids

688,397

-

-

-

688,397

Oil and condensate

1,243,091

-

-

-

1,243,091

Gathering and compression fees

-

2,356,901

-

(369,733)

1,987,168

Total operating revenue

$

17,915,836

(1)

$

2,356,901

$

-

$

(369,733)

19,903,004

Net earnings (loss) for the period

$

13,757,784

$

1,545,850

$

(4,720,646)

(3)

-

$

10,582,988

Operating costs

2,621,750

541,228

-

(369,733)

2,793,245

Development geological and geophysical expenses

2,386

-

-

-

2,386

Depletion, depreciation, amortization and accretion

1,533,916

269,823

-

-

1,803,739

Bad debt expense

-

-

-

-

-

Capital expenditures(2)

1,390,908

76,016

-

-

1,466,924

For the three months ended June 30, 2021

Operating revenue

Natural gas

$

5,106,922

$

-

$

-

$

-

$

5,106,922

Natural gas liquids

52,529

-

-

-

52,529

Oil and condensate

79,303

-

-

-

79,303

Gathering and compression fees

-

2,236,960

-

(385,865)

1,851,095

Total operating revenue

$

5,238,754

(1)

$

2,236,960

$

-

$

(385,865)

7,089,849

Net earnings (loss) for the period

$

2,153,394

$

1,321,225

$

(3,959,644)

(3)

$

-

$

(485,025)

Operating costs

1,784,138

559,412

-

(385,865)

1,957,685

Development geological and geophysical expenses

11,451

-

-

-

11,451

Depletion, depreciation, amortization and accretion

1,289,771

356,323

-

-

1,646,094

Bad Debt Expense

-

-

-

-

-

Capital expenditures(2)

1,459,675

57,220

-

-

1,516,895

(1) Segment operating revenue represents revenues generated from the operations of the segment. Inter-segment sales during the three months ended June 30, 2022 and 2021 have been eliminated upon consolidation. For the three months ended June 30, 2022, Epsilon sold natural gas to 19unique customers. The fourcustomers over 10%comprised 33%, 17%, 12%and 10%of total revenue. For the three months ended June 30, 2021, Epsilon sold natural gas to 21unique customers. The twocustomers over 10%comprised 23%and 19%of total revenue.

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

(2) Capital expenditures for the Upstream segment consist primarily of the acquisition of properties, and the drilling and completing of wells while Gas Gathering consists of expenditures relating to the expansion and completion of the gathering and compression facility.
(3) Segment reporting for net earnings for the period does not include non-monetary compensation, general and administrative expense, interest income, interest expense, both gains and (losses) on derivative contracts, or income tax amounts as they are managed on a group basis and are instead included in the corporate column for reconciliation purposes.

12. Commodity Risk Management Activities

Commodity Price Risks

Epsilon engages in price risk management activities from time to time. These activities are intended to manage Epsilon's exposure to fluctuations in commodity prices for natural gas by securing derivative contracts for a portion of expected sales volumes.

Inherent in the Company's hedging program, are certain business risks, including market risk and credit risk. Market risk is the risk that the price of natural gas and oil will change, either favorably or unfavorably, in response to changing market conditions. Credit risk is the risk of loss from nonperformance by the Company's counterparty to a contract. Additionally, there is a risk that gas prices could fall to a level low enough to affect the volumes flowing through the gathering system.

The Company enters into certain commodity derivative instruments to mitigate commodity price risk associated with a portion of its future natural gas production and related cash flows. The natural gas revenues and cash flows are affected by changes in commodity product prices, which are volatile and cannot be accurately predicted. The objective for holding these commodity derivatives is to protect the operating revenues and cash flows related to a portion of the future natural gas sales from the risk of significant declines in commodity prices, which helps ensure the Company's ability to fund the capital budget.

Epsilon has historically elected not to designate any of its financial commodity derivative contracts as accounting hedges and, accordingly, accounts for these financial commodity derivative contracts using the mark-to-market accounting method. Under this accounting method, changes in the fair value of outstanding financial instruments are recognized as gains or losses in the period of change and are recorded as loss (gain) on derivative contracts on the condensed consolidated statements of operations and comprehensive income (loss). The related cash flow impact is reflected in cash flows from operating activities. During the three and six months ended June 30, 2022, Epsilon recognized gains (losses) on commodity derivative contracts of $776,994 and ($194,910), respectively. This amount included cash paid on settlements on these contracts of $163,559 and $1,375,287, respectively. For the three and six months ended June 30, 2021, Epsilon recognized losses on commodity derivative contracts of $1,827,334 and $1,361,993, respectively. This amount included cash paid on settlements on these contracts of $91,660 and $27,460, respectively.

Commodity Derivative Contracts

Presented below is a summary of Epsilon's natural gas commodity basis swap and two-way costless collar contracts as of June 30, 2022.

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

Fair Value

Volume

Ceiling

Floor

Basis

June 30,

Derivative Type

(MMbtu)

Price

Price

Differential

2022

2022

Basis swap

765,000

$

(1.15)

7,788

Two-way costless collar

765,000

$

8.20

$

6.50

932,765

$

940,553

As of June 30, 2022, all of the Company's economic derivative hedge positions were with large financial institutions, which are not known to the Company to be in default on their derivative positions. The Company is exposed to credit risk to the extent of non-performance by the counterparties in the derivative contracts discussed above; however, the Company does not anticipate non-performance by such counterparties. None of the Company's derivative instruments contains credit-risk related contingent features. Derivatives are net on the balance sheet as they are subject to the right to offset the liabilities with the assets.

The following tables summarize the gross fair values of our derivative instruments, presenting the impact of offsetting the derivative assets and liabilities on our condensed consolidated balance sheets as of the dates indicated below:

Fair Value of Derivative
Assets

June 30,

December 31,

2022

2021

Current

Basis swap

$

90,782

$

-

Two-way costless collar

$

1,063,754

$

13,312

$

1,154,537

$

13,312

Fair Value of Derivative
Liabilities

June 30,

December 31,

2022

2021

Current

Basis swap

$

(82,994)

$

-

Two-way costless collar

$

(130,989)

$

(253,136)

$

(213,984)

$

(253,136)

Net Fair Value of Derivatives

$

940,553

$

(239,824)

The following table presents the changes in the fair value of Epsilon's commodity derivatives for the periods indicated:

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

Fair value of asset (liability), beginning of the period

$

-

$

401,141

$

(239,824)

$

-

Gains (losses) on derivative contracts included in earnings

776,994

(1,827,334)

(194,910)

(1,361,992)

Settlement of commodity derivative contracts

163,559

91,660

1,375,287

27,459

Fair value of asset (liability), end of the period

$

940,553

$

(1,334,533)

$

940,553

$

(1,334,533)

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Epsilon Energy Ltd.

Notes to the Unaudited Condensed Consolidated Financial Statements

13. Asset Retirement Obligations

Asset retirement obligations were estimated by management based on Epsilon's net ownership interest in all wells and the gathering system, estimated costs to reclaim and abandon such assets and the estimated timing of the costs to be incurred in future periods.

The following tables summarize the changes in asset retirement obligations for the periods indicated:

Six Months Ended

Year ended

June 30,

December 31,

2022

2021

Balance beginning of period

$

2,833,656

$

3,150,243

Liabilities acquired

6,684

7,009

Liabilities disposed of

(24,854)

(381,346)

Wells plugged and abandoned

(118,259)

(31,945)

Change in estimates

-

(8,299)

Accretion

38,738

97,994

Balance end of period

$

2,735,965

$

2,833,656

14. Fair Value Measurements

The methodologies used to determine the fair value of our financial assets and liabilities at June 30, 2022 were the same as those used at December 31, 2021.

Cash and cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities are carried at cost, which approximates their fair value because of the short-term maturity of these instruments. The Company's revolving line of credit has a recorded value that approximates its fair value since its variable interest rate is tied to current market rates and the applicable margins represent market rates.

Commodity derivative instruments consist of two-way costless collar and basis swap contracts for natural gas. The Company's derivative contracts are valued based on a marked to market approach. These assumptions are observable in the marketplace throughout the full term of the contract, can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace, and are therefore designated as Level 2 within the valuation hierarchy. The Company utilizes its counterparties' valuations to assess the reasonableness of its own valuations.

15. Subsequent Events

Effective July 1, 2022, Epsilon announced that Jason Stabell and Andrew Williamson had joined the Company as Chief Executive Officer and Chief Financial Officer, respectively. Jason had also joined the Board of Directors. Mike Raleigh, the former CEO of the Company, resigned from the Company and the Board of Directors effective June 30, 2022. Lane Bond, the Company's former Chief Financial Officer, also informed the Board of his desire to retire and entered into a transitional consulting role with the Company beginning July 1, 2022.

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in the understanding of trends and significant changes in or results of operations and the financial condition of Epsilon Energy Ltd. and its subsidiaries for the periods presented. The following discussion and analysis should be read in conjunction with our unaudited consolidated financial statements and notes thereto presented in this report, including the unaudited condensed consolidated financial statements as of June 30, 2022 and 2021 and for the six months then ended together with accompanying notes, as well as our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2021. The following discussion contains "forward-looking statements" that reflect our future plans, estimates, beliefs, and expected performance. Actual results and the timing of events may differ materially from those contained in these forward- looking statements due to a number of factors. See "Part II. Item 1A. Risk Factors" and "Forward-Looking Statements."

Overview

Epsilon Energy Ltd. (the "Company") is a North American onshore focused independent natural gas and oil company engaged in the acquisition, development, gathering and production of natural gas and oil reserves. Our areas of operations are the Marcellus shale section of the Appalachian basin in Pennsylvania and the NW Anadarko basin in Oklahoma. Our assets are in areas with established hydrocarbon resources with significant existing production. In Pennsylvania, we hold 4,597 net acres producing 28 MMcf/d (1H 2022). In Oklahoma, we hold 8,579 net acres producing 3.3 MMcfe/d (1H 2022).

In Pennsylvania, the Company owns a 35% interest in the 52 mile Auburn Gas Gathering System ("Auburn GGS") which is operated by a subsidiary of Williams Partners, LP.

Our common shares trade on the NASDAQ Global Market under the ticker symbol "EPSN."

Business Strategy

The Company is focused on high rate of return capital investments in onshore North American natural gas and oil basins. We are committed to disciplined capital allocation which should include shareholder returns in the form of dividends and share buybacks. We expect that our strong balance sheet and large liquidity position will allow us to opportunistically invest in both our existing project areas and potential new projects.

To date, our investments have been focused in our position in the prolific Marcellus unconventional reservoir in Pennsylvania ("PA"). Our PA assets are supported by our 35% ownership in the Auburn GGS. More recently, we have been active in our position in the NW Stack area of Oklahoma. We have substantial remaining drillable location inventory within our existing leaseholds.

The Company also seeks to identify new opportunities in onshore North American natural gas and oil basins.

Three and six months ended June 30, 2022 Highlights

Operational Highlights

Marcellus Shale - Pennsylvania

During the three months ended June 30, 2022, Epsilon's realized natural gas price was $6.94 per Mcf, a 256% increase over the three months ended June 30, 2021. During the six months ended June 30, 2022, Epsilon's realized natural gas price was $5.68 per Mcf, a 152% increase over the six months ended June 30, 2021.

During the three months ended June 30, 2022, Epsilon's natural gas production was 2.2 Bcf, as compared to 2.5 Bcf during the same period in 2021. During the six months ended June 30, 2022, Epsilon's natural gas production was 4.4 Bcf as compared to 4.9 Bcf during the same period in 2021.

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Gathered and delivered 16.7 Bcf gross (5.8 Bcf net to Epsilon's interest) during the three months ended June 30, 2022, or 183 MMcf/d through the Auburn Gas Gathering System. Gathered and delivered 35.0 Bcf gross (12.2 Bcf net to Epsilon's interest) during the six months ended June 30, 2022, or 193 MMcf/d through the Auburn Gas Gathering System.
At June 30, 2022, the Company had 1 gross (0.18 net) well waiting on completion.

Anadarko, NW Stack Trend - Oklahoma

During the three months ended June 30, 2022, Epsilon's realized price for all Oklahoma production was $8.96 per Mcfe, a 71% increase over the three months ended June 30, 2021. During the six months ended June 30, 2022, Epsilon's realized price for all Oklahoma production was $8.51 per Mcfe, an 87% increase over the six months ended June 30, 2021.

Total production for the three months ended June 30, 2022 included natural gas, oil, and other liquids and was 0.32 Bcfe, a 431% increase over the same period in 2021. Total production for the six months ended June 30, 2022 included natural gas, oil, and other liquids and was 0.49 Bcfe, a 272% increase over the same period in 2021.

In the second quarter of 2022, the Company completed 1 gross (.11 net) well. At June 30, 2022, the Company had 1 gross (.11 net) well waiting on completion.

Non-GAAP Financial Measures-Adjusted EBITDA

Epsilon defines Adjusted EBITDA as earnings before (1) net interest expense, (2) taxes, (3) depreciation, depletion, amortization and accretion expense, (4) impairments of natural gas and oil properties, (5) non-cash stock compensation expense, (6) gain or loss on derivative contracts net of cash received or paid on settlement, and (7) other income. Adjusted EBITDA is not a measure of financial performance as determined under U.S. GAAP and should not be considered in isolation from or as a substitute for net income or cash flow measures prepared in accordance with U.S. GAAP or as a measure of profitability or liquidity.

Additionally, Adjusted EBITDA may not be comparable to other similarly titled measures of other companies. Epsilon has included Adjusted EBITDA as a supplemental disclosure because its management believes that EBITDA provides useful information regarding its ability to service debt and to fund capital expenditures. It further provides investors a helpful measure for comparing operating performance on a normalized or recurring basis with the performance of other companies, without giving effect to certain non-cash expenses and other items. This provides management, investors and analysts with comparative information for evaluating the Company in relation to other natural gas and oil companies providing corresponding non-U.S. GAAP financial measures or that have different financing and capital structures or tax rates. These non-U.S. GAAP financial measures should be considered in addition to, but not as a substitute for, measures for financial performance prepared in accordance with U.S. GAAP.

The table below sets forth a reconciliation of net income to Adjusted EBITDA for the three and six months ended June 30, 2022 and 2021, which is the most directly comparable measure of financial performance calculated under U.S. GAAP and should be reviewed carefully.

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Table of Contents

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

Net income

$

10,582,988

$

(485,025)

$

16,388,876

$

2,250,541

Add Back:

Net interest expense

(21,200)

13,441

(21,102)

32,701

Income tax expense

4,019,576

(165,751)

6,201,474

978,822

Depreciation, depletion, amortization, and accretion

1,803,739

1,646,094

3,192,958

3,328,954

Stock based compensation expense

194,050

236,041

336,352

438,540

Loss on derivative contracts net of cash received or paid on settlement

(940,553)

1,735,674

(1,180,377)

1,334,533

Foreign currency translation loss

(1,071)

279

4,331

611

Adjusted EBITDA

$

15,637,529

$

2,980,753

$

24,922,512

$

8,364,702

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Table of Contents

Results of Operations

Net Operating Revenues

For the six months ended June 30, 2022 revenues increased $18.0 million, or 116%, to $33.5 million from $15.5 million during the same period of 2021.

Revenue and volume statistics for the three and six months ended June 30, 2022 and 2021 were as follows:

Three months ended

Six months ended

June 30,

June 30,

2022

2021

2022

2021

Revenues

Natural gas revenue

$

15,984,348

$

5,106,922

$

26,687,432

$

11,439,021

Volume (MMcf)

2,324

2,548

4,675

5,014

Avg. Price ($/Mcf)

$

6.88

$

2.00

$

5.71

$

2.28

Oil and other liquids revenue

$

1,931,488

$

131,832

$

2,707,729

$

238,888

Volume (MBO)

27.6

3.2

42.5

6.9

Avg. Price ($/Bbl)

$

69.92

$

41.68

$

63.73

$

34.58

Gathering system revenue

$

1,987,168

$

1,851,095

$

4,107,941

$

3,853,252

Total Revenues

$

19,903,004

$

7,089,849

$

33,503,102

$

15,531,161

We earn gathering system revenue as a 35% owner of the Auburn Gas Gathering system. This revenue consists of fees paid by Anchor Shippers (parties listed in Anchor Shipper Gas Gathering Agreement for Northern Pennsylvania, including Epsilon Midstream, LLC) of the system to transport gas from the wellhead to the compression facility, and then to the delivery meter at the Tennessee Gas Pipeline. For the six months ended June 30, 2022, approximately 77% of the Auburn GGS revenues earned were gathering fees, while 23% were compression fees. For the three months ended June 30, 2022 approximately 77% of the Auburn GGS revenues earned were gathering fees, while 23% were compression fees. For the six months ended June 30, 2021, approximately 81% of the Auburn GGS revenues earned were gathering fees, while 19% were compression fees. Gathering revenues from third-party customers represented approximately 6% of total gathering revenues and third-party compression revenues represented 3% of total compression revenues. For the three months ended June 30, 2021 approximately 81% of the Auburn GGS revenues earned were gathering fees, while 19% were compression fees. Gathering revenues from third-party customers represented approximately 5% of revenues and third-party compression revenues represented 2% of revenues. Revenues derived from Epsilon's production which have been eliminated from gathering system revenues amounted to $0.37 million and $0.73 million for the three and six months ended June 30, 2022, respectively, and $0.39 million and $0.77 million for the three and six month ended March 31, 2021, respectively.

Upstream natural gas revenue for the six months ended June 30, 2022 increased by $15.2 million, or 133%, over the same period in 2021. This was primarily a result of higher natural gas prices; however, this was partially offset by lower volumes being produced due to natural decline of the wells. Upstream natural gas revenue for the three months ended June 30, 2022 increased by $10.9 million, or 213%, over the same period in 2021. This was also primarily a result of higher natural gas prices partially offset by lower volumes being produced due to natural decline of the wells.

Upstream oil and other liquids revenue for the six months ended June 30, 2022 increased by $2.5 million, or 1,033%, over the same period in 2021. This was a result of increased production from new wells in Oklahoma in addition to higher prices. Upstream oil and other liquids revenue for the three months ended June 30, 2022 increased by $1.8 million, or 1,365%, over the same period in 2021. This was a result of increased production from new wells in Oklahoma in addition to higher prices.

The Company's share of gathering system revenue increased by $0.1 million and $0.3 million during the three and six months ended June 30, 2022, increasing by 7% and 7%, respectively over the same period in 2021. The Auburn GGS is subject to a cost of service model, whereby the Anchor Shippers dedicate acreage and reserves to the Auburn GGS. In exchange for this dedication, the owners of the Auburn system agree to a fixed rate of return on capital invested which cannot be exceeded. Therefore, rather than being subject to a fixed gathering rate, the Shippers are subject to a fluctuating gathering rate which is redetermined annually in order to produce the contractual return on capital to the Auburn GGS

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owners. The term of the model is fixed from 2012 to 2026. Each year, actual throughput, revenue, operating expenses and capital are captured in the model, and the remaining years are forecasted. The model then resolves a gathering rate that yields the contractual rate of return. All else being equal, to the extent that throughput is higher or capital is lower than the preceding year's forecast, the gathering rate will decline.

Operating Costs

The following table presents total cost and cost per unit of production (Mcfe), including ad valorem, severance, and production taxes for the three and six months ended June 30, 2022 and 2021:

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

Lease operating costs

$

2,621,750

$

1,784,138

$

4,392,404

$

3,378,327

Gathering system operating costs

171,495

173,547

330,706

364,494

$

2,793,245

$

1,957,685

$

4,723,110

$

3,742,821

Upstream operating costs-Total $/Mcfe

1.05

0.68

0.89

0.67

Gathering system operating costs $/Mcf

0.09

0.10

0.09

0.10

Upstream operating costs consist of lease operating expenses necessary to extract natural gas and oil, including gathering and treating the natural gas and oil to ready it for sale.

Upstream operating costs for the six months ended June 30, 2022 increased $1.0 million, or 30%, over the same period in 2021. Upstream operating costs for the three months ended June 30, 2022 increased $0.8 million, or 47%, over the same period in 2021. The increase in total cost was primarily due to rising prices for services leading to a $1.05/Mcfe and $0.89/Mcfe for the three and six months ended June 30, 2022, or 33% and 54%, increase, respectively in the cost associated with operating the wells.

Gathering system operating costs consist primarily of rental payments for the natural gas fueled compression units. Other significant gathering system operating costs include chemicals (to prevent corrosion and to reduce water vapor in the gas stream), saltwater disposal, measurement equipment / calibration and general project management.

The gathering system total per unit operating costs reported include the effects of elimination entries to remove the gas gathering fees billed by the gas gathering system operator to Epsilon's upstream operations, and the volume associated with those fees. The elimination entries amounted to $0.73 million and $0.77 million for the six months ended June 30, 2022 and 2021, respectively and $0.37 million and $0.39 million for the three months ended June 30, 2022 and 2021, respectively (see Note 11, ''Operating Segments,'' of the Notes to Unaudited Condensed Consolidated Financial Statements).

Gathering system costs (net of intercompany elimination) for the six months ended June 30, 2022 decreased $0.03 million, or 9%, over the same period in 2021. Gathering system costs (net of intercompany elimination) for the three months ended March 31, 2022 stayed constant over the same period in 2021.

The Company's share of total gathering system costs decreased $0.04 million, or 5%, for the six months ended June 30, 2022 over 2021. The Company's share of total gathering system costs decreased $0.02 million, or 4%, for the three months ended June 30, 2022 over 2021. This decrease is primarily due to a decrease in throughput volumes into the gathering system.

Depletion, Depreciation, Amortization and Accretion ("DD&A")

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

Depletion, depreciation, amortization and accretion

$

1,803,739

$

1,646,094

$

3,192,958

$

3,328,954

Natural gas and oil and gathering system assets are depleted and depreciated using the units of production method aggregating properties on a field basis. For leasehold acquisition costs and the cost to acquire proved and unproved

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properties, the reserve base used to calculate depreciation and depletion is total proved reserves. At this time, the Company has only minimal leasehold acquisition costs. For natural gas and oil development and gathering system costs, the reserve base used to calculate depletion and depreciation is proved developed reserves. A reserve report is prepared as of December 31, each year.

Depreciation expense includes primarily amounts pertaining to our office furniture and fixtures, leasehold improvements, and computer hardware. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, ranging from 3 to 7 years. Also included in depreciation expense is an amount pertaining to buildings owned by the Company. Depreciation for the buildings is calculated using the straight-line method over an estimated useful life of 30 years.

Accretion expense is related to the asset retirement obligations.

DD&A expense for the six months ended June 30, 2022 was constant compared to the same period in 2021. DD&A expense increased $0.16 million, or 10% for the three months ended June 30, 2022 compared to the same period in 2021. This was primarily due to the increase in depletable costs as a result of transferring unproved leasehold costs to proved for depletion purposes as new wells are put into production.

Impairment

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

Impairment

$

-

$

-

$

-

$

-

Epsilon performs a quantitative impairment test quarterly or whenever events or changes in circumstances indicate that an asset group's carrying amount may not be recoverable, over proved properties using the published NYMEX and basis differential forward prices, timing, methods and other assumptions consistent with historical periods. When indicators of impairment are present, GAAP requires that the Company first compares expected future undiscounted cash flows by asset group to their respective carrying values. If the carrying amount exceeds the estimated undiscounted future cash flows, a reduction of the carrying amount of the natural gas properties to their estimated fair values is required, which is determined based on discounted cash flow techniques using significant assumptions including projected revenues, future commodity prices, and a market-specific weighted average cost of capital which are affected by expectations about future market and economic conditions.

During the three and six months ended June 30, 2022 and 2021, no impairment was required.

General and Administrative

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

General and administrative

$

1,659,193

$

2,284,341

$

2,972,627

$

3,814,001

G&A expenses consist of general corporate expenses such as compensation, legal, accounting and professional fees, consulting services, travel and other related corporate costs such as stock options and restricted stock granted and the related non-cash compensation.

G&A expenses for the six months ended June 30, 2022 and 2021 decreased $0.8 million or 22%. G&A expenses for the three months ended June 30, 2022 and 2021 decreased $0.6 million or 27%. This was mainly due to the decreased legal fees related to the complaint filed against Chesapeake.

Interest Expense

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

Interest expense

$

745

$

22,345

$

16,064

$

49,418

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Interest expense relates to the commitment fees paid on the revolving line of credit.

Interest expense for the three and six months ended June 30, 2022 and 2021 decreased due to the reduction in the borrowing base on our line of credit during this time.

(Loss) Gain on Derivative Contracts

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

Gain (loss) on derivative contracts

$

776,994

$

(1,827,334)

$

(194,910)

$

(1,361,993)

For the three and six months ended June 30, 2022 and 2021, Epsilon entered into NYMEX Henry Hub two-way costless collar and Tennessee basis swap derivative contracts for the purpose of hedging its physical natural gas sales revenue. During the three and six months ended June 30, 2022, we paid net cash settlements of $163,559 and $1,375,287, respectively. During the three and six months ended June 30, 2021, we paid net cash settlements of $91,660 and $27,460, respectively.

For the three and six months ended June 30, 2022, realized losses on derivative contracts increased primarily due to the rally in NYMEX Henry Hub Natural Gas Futures resulting in an increased liability for the short call portion of the two-way costless collar position. As of June 30, 2022, the Company had no derivative contracts beyond December 31, 2022.

Other (Expense) Income

Three months ended June 30,

Six months ended June 30,

2022

2021

2022

2021

Interest income and other income

$

(39,768)

$

8,625

$

(29,953)

$

18,380

For the three and six months ended June 30, 2022 and 2021, other income decreased as a result of derecognizing and asset retirement obligation after the P&A of an asset. This was offset by an increase in interest received as a result of increasing interest rates.

Capital Resources and Liquidity

Cash Flow

The primary source of cash for Epsilon during the three and six months ended June 30, 2022 and 2021 was funds generated from operations. The primary uses of cash for the three and six months ended June 30, 2022 were development of natural gas properties, the repurchase of shares of common stock, and the distribution of dividends. The primary uses of cash for the three and six months ended June 30, 2021 were development of natural gas properties and the repurchase of shares of common stock.

At June 30, 2022, we had a working capital surplus of $33.3 million, an increase of $9.2 million over the $24.1 million surplus at December 31, 2021. The Company anticipates its current cash balance, cash flows from operations, and available sources of liquidity to be sufficient to meet its cash requirements for at least the next twelve months.

Three and six months ended June 30, 2022 compared to 2021

During the six months ended June 30, 2022, $15.8 million was provided by the Company's operating activities, compared to $8.0 million provided during the same period in 2021, a $7.7 million, and 96% increase. The increase was mainly due to increased cash from operations as a result of increased commodity prices, partially offset by the losses created on the hedges as they matured. During the three months ended June 30, 2022, $8.1 million was provided by the Company's operating activities, compared to $2.4 million provided during the same period in 2021, a $5.7 million, and 235% increase. The increase was mainly due to increased cash from operations as a result of increased commodity prices.

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The Company used $2.1 million and $5.0 million of cash for investing activities during the three and six months ended June 30, 2022, respectively. This was spent primarily on leasehold and development costs targeting increasing production in Pennsylvania and Oklahoma. The Company used $1.2 million and $1.7 million of cash for investing activities during the three and six months ended June 30, 2021, respectively. This was spent primarily on leasehold and development costs targeting increasing production in Pennsylvania.

The Company used $5.0 million and $6.3 million of cash for financing activities during the three and six months ended June 30, 2022, respectively. This was spent primarily on dividend payments and the repurchase of shares of common stock. The Company used $0.6 million and $1.1 million of cash for financing activities during the three and six months ended June 30, 2021. This cash was spent on the repurchase of common shares of the Company.

Credit Agreement

In addition, the Company has a senior secured credit facility which includes a total commitment of up to $100 million. The current effective borrowing base is $14 million, which is subject to semi-annual redetermination. There are currently no borrowings under the facility. If Epsilon decides to access the facility, depending on the level of borrowing, the Company will need to increase its hedging activity. Borrowings from the Facility may be used for the acquisition and development of oil and gas properties, investments in cash flow generating assets complimentary to the production of oil and gas, and for letters of credit and other general corporate purposes. Upon each advance, interest is charged at the highest of a) rate of LIBOR plus an applicable margin (3.25%-4.25% based on the percent of the line of credit utilized) with the minimum being 0.25%, b) the Prime Rate, or c) the sum of the Federal Funds Rate plus 0.5%.

Effective April 6, 2021 the agreement was amended to extend the maturity date to March 1, 2024. In addition, the agreement was amended to include a Benchmark Replacement definition and transition plan to be used at such time when the LIBOR rate is discontinued.

On August 2, 2022, the borrowing base of $14 million was reaffirmed until the next periodic redetermination of the borrowing base.

The bank has a first priority security interest in the tangible and intangible assets of Epsilon Energy USA, Inc. to secure any outstanding amounts under the agreement. Under the terms of the agreement, the Company must maintain the following covenants:

Interest coverage ratio greater than 3 based on income adjusted for interest, taxes and non-cash amounts.

Current ratio, adjusted for line of credit amounts used and available and non-cash amounts, greater than 1.

Leverage ratio less than 3.0 based on income adjusted for interest, taxes and non-cash amounts.

Epsilon was in compliance with the financial covenants of the agreement as of June 30, 2022 and expect to be in compliance for the next 12 months. We expect to remain in compliance as we currently have no borrowings under the facility and funded all operations for 2021 and all operations through June 30, 2022 out of operating cash flow and cash on hand, and expect to continue to do so through 2022.

Balance at

Balance at

June 30,

December 31,

Borrowing Base

Interest

2022

2021

June 30, 2022

Rate

Revolving line of credit

$

-

$

-

$

14,000,000

3 mo. LIBOR + 3.25%

Repurchase Transactions

Commencing on March 8, 2022, Epsilon conducted a normal course issuer bid ("NCIB") to repurchase our issued and outstanding common shares, when doing so was accretive to management's estimates of intrinsic value per share. The NCIB ends on March 7, 2023. The Company used discretionary cash to fund these repurchases. During the six months ended June 30, 2022, Epsilon repurchased 697,100 common shares of the authorized 1,183,410 purchase amount and spent

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$4,554,823 under the NCIB. The repurchased stock had an average price of $6.53 per share. The Company cancelled 423,000 common shares during the three months ended June 30, 2022.

Commencing on January 1, 2021, Epsilon conducted a normal course issuer bid ("NCIB") to repurchase our issued and outstanding common shares, when doing so was accretive to management's estimates of intrinsic value per share. The NCIB ended on December 31, 2021. The Company used discretionary cash to fund these repurchases. During the six months ended June 30, 2021, Epsilon repurchased 264,215 common shares of the authorized 1,193,000 purchase amount and spent $1,061,468 under the NCIB. The repurchased stock had an average price of $4.01 per share.

Derivative Transactions

The Company has entered into hedging arrangements to reduce the impact of natural gas price volatility on operations. By reducing the price volatility from a significant portion of natural gas production, the potential effects of changing prices on operating cash flows have been mitigated, but not eliminated. While mitigating the negative effects of falling commodity prices, these derivative contracts also limit the benefits we might otherwise receive from increases in commodity prices.

At June 30, 2022, Epsilon's outstanding natural gas commodity contracts consisted of the following:

Volume

Ceiling

Floor

Basis

Fair Value of Asset

Derivative Type

(MMbtu)

Price

Price

Differential

June 30, 2022

2022

Basis swap

765,000

$

-

$

-

$

(1.15)

7,788

Two-way costless collar

765,000

$

8.20

$

6.50

$

-

932,765

1,530,000

$

940,553

Contractual Obligations

The following table summarizes Epsilon's contractual obligations at June 30, 2022:

Payments Due by Period

Less than

1 - 3

Greater than

Total

1 Year

Years

3 Years

Derivative liabilities(1)

$

213,984

$

213,984

$

-

$

-

Asset retirement obligations, undiscounted

7,357,345

-

-

7,357,345

Capital expenditure commitments

1,487,599

1,487,599

-

-

Operating leases

156,110

93,666

62,444

-

Total future commitments

$

9,215,037

$

1,795,248

$

62,444

$

7,357,345

(1) The liability balance shown represents the gross mark-to-market liability balance of derivative contracts before being offset by contracts in an asset position.

We enter into commitments for capital expenditures in advance of the expenditures being made. Current commitments have been included in the contractual obligations table above.

Based on current natural gas prices and anticipated levels of production, we believe that the estimated net cash generated from operations, together with cash on hand and amounts available under our credit agreement, will be adequate to meet liquidity needs for the next 12 months and beyond, including satisfying our financial obligations and funding our operating and development activities. To that end, the Company has hedged approximately 15% of its anticipated remaining 2022 production through NYMEX costless collars.

Off-Balance Sheet Arrangements

As of June 30, 2022, the Company had no off-balance sheet arrangements.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our earnings and cash flow are significantly affected by changes in the market price of commodities. The prices of natural gas and oil can fluctuate widely and are influenced by numerous factors such as demand, production levels, world political and economic events, and the strength of the US dollar relative to other currencies. Should the price of natural gas and oil decline substantially, the value of our assets could fall dramatically, impacting our future operations and exploration and development activities, along with our gas gathering system revenues. In addition, our operations are exposed to market risks in the ordinary course of our business, including interest rate and certain exposure as well as risks relating to changes in the general economic conditions in the United States.

Gathering System Revenue Risk

The Auburn Gas Gathering System lies within the Marcellus Basin with historically high levels of recoverable reserves and low cost of production. We believe that a short-term low commodity price environment will not significantly impact the reserves produced and thus the revenue of our gas gathering system.

Interest Rate Risk

Market risk is estimated as the change in fair value resulting from a hypothetical 100 basis point change in the interest rate on the outstanding balance under our credit agreement. The credit agreement allows us to fix the interest rate for all or a portion of the principal balance for a period up to three months. To the extent that the interest rate is fixed, interest rate changes affect the instrument's fair market value but do not affect results of operations or cash flows. Conversely, for the portion of the credit agreement that has a floating interest rate, interest rate changes will not affect the fair market value but will affect future results of operations and cash flows.

At June 30, 2022 and 2021, the outstanding principal balance under the credit agreement was nil.

Derivative Contracts

The Company's financial results and condition depend on the prices received for natural gas production. Natural gas prices have fluctuated widely and are determined by economic and political factors. Supply and demand factors, including weather, general economic conditions, the ability to transport the gas to other regions, as well as conditions in other natural gas regions, impact prices. Epsilon has established a hedging strategy and may manage the risk associated with changes in commodity prices by entering into various derivative financial instrument agreements and physical contracts. Although these commodity price risk management activities could expose Epsilon to losses or gains, entering into these contracts helps to stabilize cash flows and support the Company's capital spending program.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

As required by Rule 13a-15(b) under the Exchange Act, we have evaluated, under the supervision and with the participation of our management, including our principal executive officer and our principal financial officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this 10-Q. Our disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed by us in reports that we file under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure and is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. Our principal executive officer and principal financial officer have concluded that our current disclosure controls and procedures were effective as of June 30, 2022 at the reasonable assurance level.

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Changes in Internal Control over Financial Reporting

No changes in our internal control over financial reporting occurred during the quarter ended June 30, 2022 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Inherent Limitations on Effectiveness of Controls

Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting can also be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that of limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, the risk.

PART II OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On March 10, 2021, Epsilon filed a complaint against Chesapeake Appalachia, LLC ("Chesapeake") in the United States District Court for the Middle District of Pennsylvania, Scranton, Pennsylvania ("Middle District"). Epsilon claims that Chesapeake has breached a settlement agreement and several operating agreements ("JOAs") to which Epsilon and Chesapeake are parties. Epsilon asserts that Chesapeake has failed to cooperate with Epsilon's efforts to develop resources in the Auburn Development, located in North-Central Pennsylvania, as required under both the settlement agreement and JOAs.

Epsilon requested a preliminary injunction but was unsuccessful in obtaining that injunction. Epsilon filed a motion to amend its original Complaint. Chesapeake opposed. The Court ruled in Epsilon's favor and allowed Epsilon's amendment. Chesapeake moved to dismiss the amended Complaint. The Court granted the motion to dismiss on a narrow issue without prejudice to Epsilon's right to file a new lawsuit based on new proposals made after the Court's decision. Epsilon filed a motion for reconsideration of that decision, but the court denied the motion for reconsideration on January 18, 2022.

Epsilon filed a notice of appeal on February 15, 2022 challenging both the motion to dismiss and motion for reconsideration decisions. Chesapeake filed a cross-appeal on March 1, 2022. A briefing schedule was set with briefing to close in October 2022. A decision on the appeal is not expected until early to mid-2023.

Epsilon re-filed a complaint against Chesapeake in the Middle District on May 9, 2022. Epsilon generally asserts similar claims as in the previous suit, pursuing declaratory judgment claims regarding Chesapeake's obligation to Epsilon to cooperate with Epsilon's efforts in the Auburn Development and regarding Chesapeake's obstruction of Epsilon's efforts with the Pennsylvania Department of Environmental Protection permitting process but not based on specific well proposals. Chesapeake filed a motion to stay pending a decision on the Third Circuit appeal. The motion to stay has been fully briefed. Epsilon expects a decision on the motion to stay in fall 2022.

ITEM 1A. RISK FACTORS

There have been no material changes from the risk factors disclosed in Item 1A. Risk Factors of our Annual Report on Form 10-K for the year ended December 31, 2021.

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ITEM 2. UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS

(c) Purchases of Equity Securities by Epsilon Energy Ltd.

The following table contains information about our acquisition of equity securities during the six months ended June 30, 2022.

Maximum number

of shares that

may yet be

Total number

Average price

purchased under

of shares

paid per

the plans or

purchased

share

programs

Beginning of normal-course issuer bid, March 8, 2022

1,183,410

March 2022 (1)

-

$

-

April 2022 (1)

23,700

$

6.66

May 2022 (1)

254,500

$

7.01

June 2022 (1)

418,900

$

6.24

Total as of June 30, 2022

697,100

$

6.53

486,310

(1) Commencing on March 8, 2022, the Company entered into a share repurchase program on the NASDAQ conducted in accordance with Rule 10b-18 promulgated under the Securities Exchange Act of 1934. The Company is authorized to repurchase up to 1,183,410 of its outstanding common shares up to an aggregate purchase price limit of $8 million, representing 5% of the outstanding common shares. The program will end on March 7, 2023 unless the common shares or purchase price limits are reached before then or Epsilon provides earlier notice of termination.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

Not applicable.

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ITEM 6. -EXHIBITS

Exhibit

No.

Description of Exhibit

31.1

Sarbanes-Oxley Section 302 certification of Principal Executive Officer.

31.2

Sarbanes-Oxley Section 302 certification of Principal Financial Officer.

32.1

Sarbanes-Oxley Section 906 certification of Principal Executive Officer.

32.2

Sarbanes-Oxley Section 906 certification of Principal Financial Officer.

101.INS

Inline XBRL Instance Document.

101.SCH

Inline XBRL Schema Document.

101.CAL

Inline XBRL Calculation Linkbase Document.

101.DEF

Inline XBRL Definition Linkbase Document.

101.LAB

Inline XBRL Labels Linkbase Document.

101.PRE

Inline XBRL Presentation Linkbase Document.

104

Cover Page Interactive Data File (embedded within the Inline XBRL document)

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Epsilon Energy Ltd.

(Registrant)

Date: August 11, 2022

By:

/s/ J. Andrew Williamson

J. Andrew Williamson

Chief Financial Officer (Principal Financial Officer and Duly Authorized Officer)

38