EP Empire Petroleum Corporation

Note 1 - Organization and Basis of Presentation

Empire Petroleum Corporation (the “Company”, collectively with its subsidiaries) is an independent energy company operator engaged in optimizing developed production by employing field management methods to maximize reserve recovery while minimizing costs. Empire operates the following wholly-owned subsidiaries in its areas of operations:

Empire was incorporated in the State of Delaware in 1985. The consolidated financial statements of Empire Petroleum Corporation and subsidiaries include the accounts of the Company and its wholly-owned subsidiaries.

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with United States generally accepted accounting principles (“GAAP”) for interim financial information and the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation of the Company's financial position, the results of operations, and the cash flows for the interim period are included. All adjustments are of a normal, recurring nature. Certain amounts in prior periods have been reclassified to conform to current presentation. Operating results for the interim period are not necessarily indicative of the results that may be expected for the year ending December 31, 2024.

The information contained in this Form 10-Q should be read in conjunction with the audited financial statements and related notes for the year ended December 31, 2023 which are contained in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission (the “SEC”) on March 28, 2024.

Note 2 – Summary of Significant Accounting Policies

Note 3 – Property

The Company follows the successful efforts method of accounting for its oil and natural gas activities. Under this method, costs to acquire oil and natural gas properties and costs incurred to drill and equip development and exploratory wells are deferred until exploration and completion results are evaluated. Exploration drilling costs are expensed if recoverable reserves are not found. Upon sale or retirement of oil and natural gas properties, the costs and related accumulated depreciation, depletion and amortization are eliminated from the accounts and the resulting gain or loss is recognized.

Costs incurred to maintain wells and related equipment and lease and well operating costs are charged to expense as incurred.

Depletion is calculated on a units-of-production basis at the field level based on total proved developed reserves.

Proved oil and natural gas properties are reviewed for impairment at least annually, or as indicators of impairment arise. There have been no indicators of impairment during the three months ended March 31, 2024.

Depletion and amortization expense related to oil and gas properties for the three months ended March 31, 2024 and 2023 was approximately $1,431,000 and $563,000, respectively.

The Company completed four wells in North Dakota related to our Starbuck Drilling program during the first quarter of 2024.

Other property and equipment consists of operating lease assets, vehicles, office furniture, and equipment with lives ranging from three to five years.

Depreciation expense related to other property and equipment for the three months ended March 31, 2024 and 2023 was approximately $59,000.

Note 4 - Asset Retirement Obligations

The Company’s asset retirement obligations represent the estimated present value of the estimated cash flows the Company will incur to plug, abandon, and remediate its producing properties at the end of their productive lives, in accordance with applicable state laws. Market risk premiums associated with asset retirement obligations are estimated to represent a component of the Company’s credit-adjusted risk-free rate that is utilized in the calculations of asset retirement obligations.

The additions in 2024 primarily relate to the completion of four wells in our North Dakota Starbuck Drilling Program during the quarter.

Note 5 – Commodity Derivative Financial Instruments

The Company uses derivative financial instruments to manage its exposure to commodity price fluctuations. Commodity derivative instruments are used to reduce the effect of volatility of price changes on the oil and natural gas the Company produces and sells. The Company does not enter into derivative financial instruments for speculative or trading purposes. The Company’s derivative financial instruments consist of swaps and put options.

The Company does not designate its derivative instruments in such a way that would qualify for hedge accounting. Accordingly, the Company reflects changes in the fair value of its derivative instruments in its consolidated statements of operations as they occur. Unrealized gains and losses related to the contracts are recognized and recorded as changes to the derivative asset or liability on the Company’s consolidated balance sheets.

Note 6 – Accounts Receivable

Note 7 – Accrued Expenses

Note 8 – Debt Including Debt with Related Parties

On December 29, 2023, Empire North Dakota and Empire NDA ("Borrowers”), entered into a Revolver Loan Agreement with Equity Bank (the "Credit Facility”). Pursuant to the Credit Facility (a) the initial revolver commitment amount is $10,000,000; (b) the maximum revolver commitment amount is $15,000,000; (c) commencing on January 31, 2024, and occurring on the last day of each calendar month thereafter, the revolver commitment amount is reduced by $150,000; (d) commencing on March 31, 2024, there are scheduled semiannual collateral borrowing base redeterminations each year on March 31 and September 30; (e) the final maturity date is December 29, 2026; (f) outstanding borrowings bear interest at a rate equal to the prime rate of interest plus 1.50%, and in no event lower than 8.50%; (g) a quarterly commitment fee is based on the unused portion of the commitments; and (h) Borrowers have the right to prepay loans under the Credit Facility at any time without a prepayment penalty.

The Credit Facility is guaranteed by the Company. Borrowers entered into a security agreement, pursuant to which the obligations under the Credit Facility are secured by liens on substantially all of the assets of Borrowers. Furthermore, the obligations under the Credit Facility are secured by a continuing, first priority mortgage lien, pledge of and security interest in not less than 80% of Borrowers’ producing oil, gas and other leasehold and mineral interests, including without limitation, those situated in the States of North Dakota and Montana.

The Credit Facility requires Borrowers to, commencing as of the fiscal quarter ended December 31, 2023, maintain (a) a current ratio of 1.0 to 1.0 or more and (b) a ratio of funded debt to EBITDAX, calculated quarterly and annually based on a trailing twelve-month basis, of no more than 3.50 to 1.00. At March 31, 2024, the Borrowers were technically not in compliance with the current ratio covenant, however, the noncompliance was resolved within the applicable cure period in accordance with the Credit Facility agreement following the completion of a subscription rights offering on April 10, 2024 in which the Company received approximately $20.66 million in cash (see Note 10). The Company is in compliance with the other covenants as of March 31, 2024.

Promissory Note – Related Party

On February 16, 2024, the Company issued a Promissory Note in the aggregate principal amount of $5,000,000 (the "Note”) to Energy Evolution Master Fund, Ltd. (“Energy Evolution”). Energy Evolution has advanced the Company $5,000,000 under the Note. The proceeds of the Note will be used by the Company to fund, in part, its ongoing oil and gas drilling program and for working capital purposes.

The Note matures on February 15, 2026 (the "Maturity Date”) and accrues interest at the rate of 7% per annum. After the Maturity Date, any principal balance of the Note remaining unpaid accrues interest at the rate of 9% per annum. At the option of Energy Evolution, interest payments will be paid either in cash or in shares of common stock of the Company on each of the following dates (or if any such

date is not a business day, the next following business day) (each an "Interest Payment Date”), except upon the occurrence of an Event of Default, in which case interest will accrue and be paid in cash on demand: (i) March 31, 2024; (ii) June 30, 2024; (iii) September 30, 2024; (iv) December 31, 2024; (v) March 31, 2025; (vi) June 30, 2025; (vii) September 30, 2025; (viii) December 31, 2025; and (ix) the Maturity Date. All or any portion of the outstanding principal amount of the Note may be converted into shares of common stock of the Company at a conversion price of $6.25 per share (the "Conversion Price”), at the option of Energy Evolution, at any time and from time to time. If the full principal amount of the Note is drawn and converted into shares of common stock of the Company, 800,000 shares would be issued (without giving effect to any interest that may be converted). Accrued interest on the principal amount converted will be due on the applicable date of conversion in cash or, at the option of Energy Evolution, by issuance of shares of common stock of the Company in the manner set forth in the Note (where the date of conversion is the relevant Interest Payment Date”). The Conversion Price is subject to customary adjustments. The Note may be prepaid at any time or from time to time without the consent of Energy Evolution and without penalty or premium, provided that the Company provides Energy Evolution with at least five business days prior written notice, each principal payment is made in cash and all accrued interest is paid in cash, or at the option of Energy Evolution, the accrued interest may be paid by issuance of shares of common stock of the Company in the manner set forth in the Note (where the Interest Payment Date is the date of prepayment).

The Company determined that an embedded conversion feature included in the Promissory Note required bifurcation from the host contract that is recognized as a separate derivative liability carried at fair value. The estimated fair value of the derivative liability, which represents a Level 3 valuation, was $1,292,000 as of March 31, 2024 and was determined using a binomial lattice model using certain assumptions and inputs discussed in Note 2. Accordingly, the Company has recognized a gain on the fair value adjustment of the derivative liability in the amount of approximately $738,000 in Other Income (Expense) in the Condensed Consolidated Statements of Operations for the quarter ended March 31, 2024. All of the other embedded features of the Note were clearly and closely related to the debt host and did not require bifurcation as a derivative liability.

Note Payable – Related Party

In August 2020, the Company, through its wholly owned subsidiary, Empire Texas, entered into a joint development agreement (the "JDA”) with Petroleum & Independent Exploration, LLC and related entities ("PIE”), a related party (see Note 14), dated August 1, 2020. Under the terms of the JDA, PIE will perform recompletion or workover on specified mutually agreed upon wells ("Workover Wells”) owned by Empire Texas. Concurrent with the JDA with PIE, the Company entered into a term loan agreement dated August 1, 2020, whereby PIE will loan up to $2,000,000, at an interest rate of 6% per annum, maturing August 7, 2024 unless terminated earlier by PIE. The loan proceeds were used for recompletion or workover of certain designated wells. In addition, the Company assigned 85% working and revenue interest to PIE in the designated wells which will be applied to repayment of the loan. As of March 31, 2024, $1,060,004 has been advanced from the PIE loan.

Note 9 - Leases

As a lessee, the Company leases its corporate office headquarters in Tulsa, Oklahoma and one field office. The leases expire between 2024 and 2028. The corporate office has an option to renew for an additional five-year term. The option to renew the lease is generally not considered reasonably certain to be exercised. Therefore, the period covered by such optional period is not included in the determination of the term of the lease and the lease payments during these periods are similarly excluded from the calculation of right-of-use lease asset and lease liability balances.

The Company also leases vehicles primarily used in our field operations. These vehicle leases typically have a three-year life.

The Company recognizes right-of use lease expense on a straight-line basis, except for certain variable expenses that are recognized when the variability is resolved, typically during the period in which they are paid. Variable right-of-use lease payments typically include charges for property taxes, insurance, and variable payments related to non-lease components, including common area maintenance.

Right-of-use lease expense was approximately $136,000 and $77,600 for the three months ended March 31, 2024 and 2023, respectively. Cash paid for right-of-use leases was approximately $125,000 and $78,400 for the same periods.

Supplemental balance sheet information related to the right-of-use leases is as follows:

The weighted-average remaining term for the Company’s right-of-use leases is 2.1 years. The weighted-average discount rate was 8.51% for the first quarter of 2024.

Note 10 – Equity

Pursuant to the Company’s Amended and Restated Certificate of Incorporation (“Charter”), effective as of March 4, 2022, the total number of shares of all classes of stock that the Company has the authority to issue is 200,000,000, consisting of 190,000,000 shares of common stock, par value $0.001 per share, and 10,000,000 shares of preferred stock, par value $0.001 per share.

Preferred Stock

Preferred stock may be issued from time to time in one or more series at the direction of the Board of Directors and the directors also have the ability to fix dividend rates and rights, liquidation preferences, voting rights, conversion rights, rights and terms of redemption and other rights, preferences, privileges and restrictions as determined by the Board of Directors, subject to certain limitations set forth in the Charter.

Series A Voting Preferred Stock

On March 8, 2022, the Company formalized the issuance of preferred stock as was required under the terms of the Company's May 2021 financing agreements with Energy Evolution and issued six shares of Series A Voting Preferred Stock. The Series A Voting Preferred Stock was issued in connection with the strategic investment in the Company by Energy Evolution. For so long as the Series A Voting Preferred Stock is outstanding, the Company’s Board of Directors will consist of six directors. Three of the directors are designated as the Series A Directors and the three other directors (each, a “common director”) are elected by the holders of common stock and/or any preferred stock (other than the Series A Voting Preferred Stock) granted the right to vote on the common directors. Any Series A Director may be removed with or without cause but only by the affirmative vote of the holders of a majority of the Series A Voting Preferred Stock voting separately and as a single class. The holders of the Series A Voting Preferred Stock have the exclusive right, voting separately and as a single class, to vote on the election, removal and/or replacement of the Series A Directors. Holders of common stock or other preferred stock do not have the right to vote on the Series A Directors. The approval of the holders of the Series A Voting Preferred Stock, voting separately and as a single class, is required to authorize any resolution or other action to issue or modify the number, voting rights or any other rights, privileges, benefits, or characteristics of the Series A Voting Preferred Stock, including without limitation, any action to modify the number, structure and/or composition of the Company’s current Board of Directors.

The Series A Voting Preferred Stock is held by Phil Mulacek, chairman of the Board of Directors and one of the principals of Energy Evolution, as Energy Evolution’s designee (the “Initial Holder”). The Series A Voting Preferred Stock may be transferred only to certain controlled affiliates of the Initial Holder (“Permitted Transferees”), and the voting rights of the Series A Voting Preferred Stock are contingent upon the Initial Holder and Permitted Transferees (collectively, the “Series A Holders”) holding together at least 3,000,000 shares of the Company’s outstanding common stock.

The Series A Voting Preferred Stock is not entitled to receive any dividends or distributions of cash or other property except in the event of any liquidation, dissolution or winding up of the Company’s affairs. In such event, before any amount is paid to the holders of the Company’s common stock but after any amount is paid to the holders of the Company’s senior securities, the holders of the Series A Voting Preferred Stock will be entitled to receive an amount per share equal to $1.00.

Except as discussed above or as otherwise set forth in the certificate of designation of the Series A Voting Preferred Stock, the holders of the Series A Voting Preferred Stock have no voting rights.

The Series A Voting Preferred Stock is not redeemable at the Company’s election or the election of any holder, except the Company may elect to redeem the Series A Voting Preferred Stock for $1.00 per share following satisfaction of its notice and cure requirements in the event that:

The Series A Voting Preferred Stock is not convertible into common stock or any other security.

Common Stock

On August 27, 2021, the Company’s Board of Directors approved a one-for-four reverse stock split such that every holder of the Company’s common stock would receive one share of common stock for every four shares owned. The reverse stock split was effective as of 6:00 p.m. Eastern Time on March 7, 2022, immediately prior to the Company’s listing of its common stock on the NYSE American.

The holders of shares of common stock are entitled to one vote per share for all matters on which common stockholders are authorized to vote on. Examples of matters that common stockholders are entitled to vote on include, but are not limited to, election of three of the six directors and other common voting situations afforded to common stockholders.

In April 2024, the Company completed a subscription rights offering (“Rights Offering”) which raised gross proceeds of $20.66 million. The Company distributed at no charge to holders of its common stock, as of the close of business on March 7, 2024 (the record date for the Rights Offering), one subscription right for each share of Common Stock held. Each subscription right entitled the holder to purchase 0.161 shares of Common Stock at a subscription price of $5.00 per share per one whole share of Common Stock. The subscription rights were non-transferable and not listed for trading on any stock exchange or market. 

Earnings Per Share

The computation of diluted shares outstanding for the three months ended March 31, 2024 excluded 1,460,589 shares related to stock options, warrants, outstanding RSUs, and convertible debt as their effect would have been anti-dilutive. The computation of diluted shares outstanding for the three months ended March 31, 2023 excluded 2,348,009 shares related to stock options, warrants, and outstanding RSUs, as their effect would have been anti-dilutive.

Note 11 – Stock-Based Compensation

The Company recognizes stock-based compensation expense associated with granted stock options and restricted stock units (RSUs). The Company accounts for forfeitures of equity-based incentive awards as they occur. Stock-based compensation expense related to time-based restricted stock units is based on the price of the common stock on the grant date and recognized as vesting occurs. For options, the fair value is determined using the Black-Scholes option valuation assumptions on dividend yield, expected annual volatility, risk-free interest rate and an expected useful life. Stock-based compensation is recorded with a corresponding increase in Additional Paid-in Capital within the Condensed Consolidated Balance Sheets.

The following summary reflects nonvested restricted stock unit activity and related information for the three months ended March 31, 2024.

The following table summarizes information about stock options outstanding as of March 31, 2024. 

Note 12 – Executive Separations

On March 16, 2023, Thomas W. Pritchard resigned as Chief Executive Officer and a director of the Company to pursue other opportunities. Although not required under Mr. Pritchard’s Employment Agreement with the Company, in recognition of Mr. Pritchard’s past service to the Company, the Company will pay Mr. Pritchard severance benefits in the amount of approximately $360,000, as set forth in Section 4.2 of his Employment Agreement, in one lump sum payment within 30 days after March 23, 2023, rather than in monthly installments. This was accrued as of March 31, 2023, and payment was made in April 2023. The Company also extended the period under which Mr. Pritchard has the right to exercise his outstanding vested non-qualified stock options from three months after the date of his termination of employment to September 16, 2024.  In addition, Mr. Pritchard has surrendered to the Company 340,234 RSUs and options as satisfaction for the $2.1 million receivable that primarily resulted from incorrect withholdings associated with an April 2022 option exercise by Mr. Pritchard. The Company also had a $2.1 million liability recorded at December 31, 2022, related to withholding payables that were remitted in 2023. 

On March 17, 2023, the Board of Directors appointed Michael R. Morrisett to the position of Chief Executive Officer. Mr. Morrisett did not receive any additional compensation for assuming the role of Chief Executive Officer.

Note 13 – Income Taxes

For all periods presented, the Company’s effective tax rate is 0%. Other than the full year of 2022, the Company has generated net operating losses since inception, which would normally reflect a tax benefit in the Condensed Consolidated Statement of Operations and a deferred asset on the Condensed Consolidated Balance Sheet. However, because of the current uncertainty as to the Company’s ability to achieve sustained profitability, a valuation reserve has been established that offsets the amount of any tax benefit available for each period presented in the Condensed Consolidated Statements of Operations. The following table presents a reconciliation of its effective income tax rate to the U.S. statutory income tax rate for the three months ended March 31, 2024 and 2023.

Note 14 – Related Party Transactions

Energy Evolution is a related party of the Company as it beneficially owns approximately 26.6% of the Company’s outstanding shares of common stock as of March 31, 2024. Subsequent to the Rights Offering (see Note 10) Energy Evolution beneficially owns

approximately 30.1% of the Company’s outstanding shares. Additionally, a board member of Energy Evolution was appointed to the Company’s board in October 2021. This board member separately beneficially owns approximately 19.3% of the Company’s outstanding shares of common stock as of March 31, 2024. Subsequent to the Rights Offering this board member beneficially owns approximately 20.6% of the Company’s outstanding shares. The board member also is a majority owner of PIE. In October 2021 another Energy Evolution member was appointed to the Company’s board of directors.

The Company has a JDA with PIE to perform completions or workovers on specified mutually agreed upon wells (see Note 8). As of March 31, 2024, the Company has incurred obligations of approximately $1.1 million as a part of the JDA.

On February 16, 2024, the Company issued a Promissory Note in the aggregate principal amount of $5,000,000 (the "Note”) to Energy Evolution (see Note 8). As of March 31, 2024, Energy Evolution has advanced the Company $5,000,000 under the Note.

Accounts receivable on the Condensed Consolidated Balance Sheet includes approximately $1,030,000 receivable from Energy Evolution. Accrued Expenses includes approximately $213,000 of revenue payable to Energy Evolution.

Note 15 – Commitments and Contingencies

From time to time, the Company is subject to various legal proceedings arising in the ordinary course of business, including proceedings for which the Company may not have insurance coverage. While many of these matters involve inherent uncertainty, as of the date hereof, the Company does not currently believe that any such legal proceedings will have a material adverse effect on the Company’s business, financial position, results of operations or liquidity.

The Company is subject to extensive federal, state, and local environmental laws and regulations. These laws, among other things, regulate the discharge of materials into the environment and may require the Company to remove or mitigate the environmental effects of the disposal or release of petroleum or chemical substances at various sites. Management believes no materially significant liabilities of this nature existed as of the balance sheet date.

Agreed Compliance Order

In January 2024, the Company deposited $1 million into an escrow account in accordance with an Agreed Compliance Order (“ACO”) with the New Mexico Oil Conservation Division (“OCD”) for compliance work on certain inactive wells in New Mexico. Under the terms of the ACO, the escrow funds will be returned to the Company at a rate of $10,000 for each well as the compliance work is completed. In February 2024, $550,000 of the escrow funds were returned to the Company following the completion of work on 55 wells. As of March 31, 2024, the remaining escrow balance of $450,000 is included in other noncurrent assets in the Condensed Consolidated Balance Sheet. In April 2024, we completed work on an additional 25 wells and expect to receive $250,000 from the escrow account in the second quarter of 2024.