MANAGING GROWTH
IN THE 21st CENTURY

SWIFT ENERGY COMPANY 1999 ANNUAL REPORT

Notes to Consolidated Financial Statements

 

1. Summary of Significant Accounting Policies

Principles of Consolidation. The accompanying consolidated financial statements include the accounts of Swift Energy Company (Swift) and our wholly owned subsidiaries, which are engaged in the exploration, development, acquisition, and operation of oil and natural gas properties, with particular emphasis on U.S. onshore natural gas reserves. We also have oil and gas activities in New Zealand, and to a lesser extent in Venezuela and Russia. Our investments in associated oil and gas partnerships and joint ventures are accounted for using the proportionate consolidation method, whereby our proportionate share of each entity’s assets, liabilities, revenues, and expenses are included in the appropriate classifications in the consolidated financial statements. Intercompany balances and transactions have been eliminated in preparing the consolidated statements. In the second quarter of 1998, we began netting supervision fees against general and administrative expenses and oil and gas production costs. This reclassification has been made for all periods presented. Certain other reclassifications have been made to prior year amounts to conform to the current year presentation.

Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities, if any, at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from estimates.

Property and Equipment. We follow the "full-cost" method of accounting for oil and gas property and equipment costs. Under this method of accounting, all productive and nonproductive costs incurred in the acquisition, exploration, and development of oil and gas reserves are capitalized. Under the full-cost method of accounting, such costs may be incurred both prior to or after the acquisition of a property and include lease acquisitions, geological and geophysical services, drilling, completion, equipment, and certain general and administrative costs directly associated with acquisition, exploration, and development activities. Interest costs related to unproved properties are also capitalized to unproved oil and gas properties. General and administrative costs related to production and general overhead are expensed as incurred.

No gains or losses are recognized upon the sale or disposition of oil and gas properties, except in transactions involving a significant amount of reserves. The proceeds from the sale of oil and gas properties are generally treated as a reduction of oil and gas property costs. Fees from associated oil and gas exploration and development limited partnerships are credited to oil and gas property costs to the extent they do not represent reimbursement of general and administrative expenses currently charged to expense.

Future development, site restoration, and dismantlement and abandonment costs, net of salvage values, are estimated on a property-by-property basis, based on current economic conditions, and are amortized to expense as our capitalized oil and gas property costs are amortized. Our properties are all onshore, and historically the salvage value of the tangible equipment offsets our site restoration and dismantlement and abandonment costs. We expect that this relationship will continue in the future.

We compute the provision for depreciation, depletion, and amortization of oil and gas properties on the unit-of-production method. Under this method, we compute the provision by multiplying the total unamortized costs of oil and gas properties—including future development, site restoration, and dismantlement and abandonment costs, but excluding costs of unproved properties—by an overall rate determined by dividing the physical units of oil and gas produced during the period by the total estimated units of proved oil and gas reserves. This calculation is done on a country-by-country basis for those countries with oil and gas production. We currently have production in the United States only. All other equipment is depreciated by the straight-line method at rates based on the estimated useful lives of the property. Repairs and maintenance are charged to expense as incurred. Renewals and betterments are capitalized.

The cost of unproved properties not being amortized is assessed quarterly, on a country-by-country basis, to determine whether such properties have been impaired. Domestically, any impairment assessed is added to the cost of proved properties being amortized. In determining whether such costs should be impaired, our management evaluates, among other factors, current oil and gas industry conditions, international economic conditions, capital availability, foreign currency exchange rates, the political stability in the countries in which we have an investment, and available geological and geophysical information. To the extent costs accumulated in our international initiatives are determined by management to be costs that will not result in the addition of proved reserves, any impairment is charged to income.

Domestic Properties. At the end of each quarterly reporting period, the unamortized cost of oil and gas properties, net of related deferred income taxes, is limited to the sum of the estimated future net revenues from proved properties using period-end prices, discounted at 10%, and the lower of cost or fair value of unproved properties, adjusted for related income tax effects ("Ceiling Test"). This calculation is done on a country-by-country basis for those countries with proved reserves. Currently, we have proved reserves in the United States only.

The calculation of the Ceiling Test and provision for depreciation, depletion, and amortization is based on estimates of proved reserves. There are numerous uncertainties inherent in estimating quantities of proved reserves and in projecting the future rates of production, timing, and plan of development. The accuracy of any reserves estimate is a function of the quality of available data and of engineering and geological interpretation and judgment. Results of drilling, testing, and production subsequent to the date of the estimate may justify revision of such estimate. Accordingly, reserves estimates are often different from the quantities of oil and gas that are ultimately recovered.

In 1998, as a result of low oil and gas prices at September 30, 1998, we reported a non-cash write-down on a before-tax basis of $77.2 million ($50.9 million after tax) on our domestic properties.

Foreign Properties. During the third quarter of 1998, as we do every reporting period, we evaluated all of our foreign unevaluated properties (a detailed description of which is included in Note 8 to the Consolidated Financial Statements), especially in light of the then increased volatility in the oil and gas markets, international uncertainty, and turmoil in the world capital markets.

The increased volatility in the oil and gas markets affected our cash flows available for further exploration and forced us to scale back our capital expenditures budget. All of this was further accentuated in Venezuela by the economic crisis there, the results of which were to diminish the availability of financing in international markets for Venezuelan projects and to worsen Venezuelan currency problems. Petroleos de Venezuela, S.A., layoffs, threatened oil worker strikes, reduced OPEC production allocations, and other third-quarter 1998 events highlighted the problems that the oil and gas industry was encountering in Venezuela. As a result of these and other factors, in the third quarter of 1998 we decided to impair all $2.8 million of costs related to our Venezuelan oil and gas exploration activities.

In addition, in the third quarter of 1998, we impaired all $10.8 million of costs relating to our Russian activities. This impairment was attributed not only to the volatility in the oil and gas markets and the severe tightening of international credit markets discussed above, but also to the increased political instability in Russia and the August 1998 collapse of the Russian currency. We believed that the economic and political situation would result in the lack of capital to develop the reserves underlying our net profits interest in the near term. Although we continue to believe that our net profits interest is legally enforceable under international law, for all these reasons we did not believe that realistically we would be able to recover our investment in Russia in the foreseeable future. Because of this, we determined that we no longer had a reasonable basis to continue capitalization of the costs in our Russia cost center.

The combination of the third-quarter domestic full-cost ceiling write-down and foreign activities impairment charges reduced before-tax earnings by $90.8 million ($59.9 million after tax).

During the fourth quarter of 1998 and the second quarter of 1999, we charged to income as additional depreciation, depletion, and amortization costs our portion of drilling costs associated with an unsuccessful exploratory well in each quarter drilled by other operators in New Zealand. These costs were $400,000 in 1998 and $300,000 in 1999.

Oil and Gas Revenues. Gas revenues are reported using the entitlement method in which we recognize our ownership interest in natural gas production as revenue. If our sales exceed our ownership share of production, the differences are reported as deferred revenue. Natural gas balancing receivables are reported when our ownership share of production exceeds sales. As of December 31, 1999, we did not have any material natural gas imbalances.

Deferred Charges. Legal and accounting fees, underwriting fees, printing costs, and other direct expenses associated with the public offering in November 1996 of our 6.25% Convertible Subordinated Notes (the "Convertible Notes") and with the public offering in August 1999 of our 10.25% Senior Subordinated Notes (the "Senior Notes") have been capitalized and are being amortized over the life of each of the respective note offerings. The Convertible Notes mature on November 15, 2006, and the balance of their issuance costs at December 31, 1999, was $3,445,003, net of accumulated amortization of $1,104,997. The Senior Notes mature on August 1, 2009 and the balance of their issuance costs at December 31, 1999, was $3,417,779, net of accumulated amortization of $83,662. The issuance costs associated with our revolving credit facility, which closed in August 1998, have been capitalized and are being amortized over the life of the facility, which will extend until August 2002. The balance of these issuance costs at December 31, 1999, was $367,426, net of accumulated amortization of $191,268.

Limited Partnerships and Joint Ventures. Between 1984 and 1995, we formed 88 limited partnerships for the purpose of acquiring interests in producing oil and gas properties and, since 1993, 13 partnerships engaged in drilling for oil and gas reserves. We serve as managing general partner of these entities. We acquired producing oil and gas properties for the production purchase partnerships and transferred those properties to the partnership entities that invested in producing oil and gas properties. Producing property partnerships have been in existence for periods ranging from four to thirteen years. Most of these partnerships have produced a majority of their reserves and, having been in existence for long periods of time, have entered the stage where consideration of liquidation proposals is appropriate.

During 1997 and 1998, 21 of these partnerships were liquidated following a vote of the limited partners in each of those partnerships to do so. Ten of these 21 partnerships were the earliest public income partnerships formed by Swift. As of early March 2000, an additional 10 partnerships voted to sell substantially all of their assets and liquidate, and the efforts to sell their assets have just commenced. Also in February and early March 2000, proxy statements were sent to the investors in 55 of the 57 remaining production purchase partnerships soliciting their votes upon proposals to sell their assets and liquidate. The proxy statements for the remaining two partnerships will be mailed shortly. If these proposals are approved, it is anticipated that these liquidations will be substantially completed during 2000 and, if necessary, 2001.

Commencing in September 1993 on a private placement basis, we began offering general and limited partnership interests in limited partnerships to be formed to drill for oil and gas. As managing general partner, we paid for all front-end costs incurred in connection with these offerings, for which we received an interest in the partnerships. Through December 31, 1999, approximately $66.1 million had been raised in thirteen partnerships, one each formed in 1993 and 1994; three each in 1995, 1996, and 1997; and two in 1998. During 1997, eight private drilling partnerships formed between 1979 and 1985 were liquidated following limited partner votes to do so.

Hedging Activities. Our revenues are primarily the result of sales of our oil and natural gas production. Market prices of oil and natural gas may fluctuate and adversely affect operating results. To mitigate some of this risk, we engage periodically in certain hedging activities, which includes buying protection price floors and entering into participation collars for portions of our and the managed limited partnerships’ oil and natural gas production. These derivative financial instruments are placed with major financial institutions that we believe present minimum credit risk. Costs and any benefits derived from the price floors are recorded as a reduction or an increase, as applicable, in oil and gas sales revenue. The costs to purchase put options are amortized over the option period. The participating collars are designated as hedges and realized gains or losses are recognized in oil and gas revenues when the associated production occurs. The costs related to 1999 hedging activities, consisting only of price floors, totaled approximately $909,000, with benefits of approximately $348,000 being received, resulting in a net cash outlay of approximately $561,000, or $0.013 per Mcfe. Regarding the price floors, the costs related to the open contracts as of December 31, 1999, totaled approximately $98,000 and had a fair market value of $112,500. At December 31, 1999, the participating collars had an approximate value, as quoted by the dealers, of $95,000. The January 2000 collar has expired at a loss of $62,550. The gains or losses of the remaining months are determined from an average of the closing price of the contracts.

Income Taxes. We account for income taxes using the liability method. Deferred taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities, given the provisions of the enacted tax laws.

Deferred Revenues. In May 1992, we purchased interests in certain wells using funds provided by our sale of a volumetric production payment in these properties to Enron. Under the production payment agreement, we are required to deliver to Enron approximately 9.5 Bcf over an eight-year period, or for such longer period as is necessary to deliver a specified heating equivalent quantity at an average price of $1.115 per MMBtu. We receive all proceeds from sale of excess gas at current market prices plus the proceeds from sale of oil or condensate. Volumes remaining to be delivered through October 2000 under the volumetric production payment were approximately 0.4 Bcf at December 31, 1999, and were not included in our proved reserves. Net proceeds from the sale of the production payment were recorded as deferred revenues. Deliveries under the production payment agreement are recorded as oil and gas sales revenues and a corresponding reduction of deferred revenues.

Cash and Cash Equivalents. We consider all highly liquid debt instruments with an initial maturity of three months or less to be cash equivalents.

Credit Risk Due to Certain Concentrations. We extend credit, primarily in the form of monthly oil and gas sales and joint interest owners receivables, to various companies in the oil and gas industry, which results in a concentration of credit risk. The concentration of credit risk may be affected by changes in economic or other conditions and may accordingly impact our overall credit risk. However, we believe that the risk of these unsecured receivables are mitigated by the size, reputation, and nature of the companies to which we extend credit. During 1999, oil and gas sales to subsidiaries of Eastex Crude Company were $21.7 million, or 19.4% of our oil and gas sales. During 1998, oil and gas sales to subsidiaries of PG&E Energy Trading Corporation were $13.0 million, or 16.2% of oil and gas sales, and to Aquila Southwest Pipeline Corporation were $8.0 million, or 10.0% of sales. In 1997, oil and gas sales to PG&E Energy Trading Corporation were $13.5 million, or 19.5% of oil and gas sales; to Aquila Southwest Pipeline Corporation were $8.1 million, or 11.7% of sales, and to Koch Oil Company were $7.1 million, or 10.3% of sales.

Fair Value of Financial Instruments. Our financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, bank borrowings, and convertible notes. The carrying amounts of cash and cash equivalents, accounts receivable, and accounts payable approximate fair value due to the highly liquid nature of these short-term instruments. The fair values of the bank borrowings approximate the carrying amounts as of December 31, 1999 and 1998, and were determined based upon interest rates currently available to us for borrowings with similar terms. Based on quoted market prices as of the respective dates, the fair values of our Convertible Notes were $89.7 million and $81.4 million at December 31, 1999 and 1998, respectively, and the fair value of our Senior Notes was $117.9 million at December 31, 1999. The carrying value of our Convertible Notes was $115.0 million at December 31, 1999 and 1998, and the carrying value of our Senior Notes was $124.1 million at December 31, 1999.

New Accounting Pronouncements. In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." The statement establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. SFAS No. 133 requires that changes in the derivative’s fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows the gains and losses on derivatives to offset related results on the hedged item in the income statements and requires that a company must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. SFAS No. 133, as amended by SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities – Deferral of the Effective Date of FASB Statement No. 133," is effective for fiscal years beginning after June 15, 2000. We are currently evaluating the new standard, but have not yet determined the impact it will have on our financial position and results of operations.

 

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