UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-Q
 
ý    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2018
 
☐    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: 001-37712
 
ROSEHILL RESOURCES INC.
(Exact Name of Registrant as Specified in its Charter)
 
Delaware
 
47-5500436
(State or Other Jurisdiction of Incorporation or Organization)
 
(IRS Employer Identification No.)
 
16200 Park Row, Suite 300
Houston, Texas 77084
(Address of principal executive offices)
 (281) 675-3400
 
Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 ý   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 ý   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
ý   
Smaller reporting company
 
 
Emerging growth company
ý
 
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. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ý

As of November 2, 2018, 13,731,596 shares of Class A common stock, par value $0.0001 per share, and 29,807,692 shares of Class B common stock, par value $0.0001 per share, were issued and outstanding.




ROSEHILL RESOURCES INC.
FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2018
 
TABLE OF CONTENTS
 

 
 
Page
PART I – FINANCIAL INFORMATION
 
 
 
 
Item 1.
Financial Statements (Unaudited).
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
PART II – OTHER INFORMATION
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 6.
 
 
 


1



PART I - FINANCIAL INFORMATION 
Item 1. Financial Statements.

2



ROSEHILL RESOURCES INC. 
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In thousands, except share and per share amounts)
 
 
September 30, 2018
 
December 31, 2017
ASSETS
 
 
 
 

Current assets:
 
 

 
 

Cash and cash equivalents
 
$
11,001

 
$
20,677

Restricted cash
 

 
4,005

Accounts receivable
 
23,299

 
1,527

Accounts receivable, related parties
 
16,662

 
16,022

Prepaid and other current assets
 
1,488

 
1,312

Total current assets
 
52,450

 
43,543

Property and equipment:
 
 

 
 

Oil and natural gas properties (successful efforts), net
 
630,386

 
431,332

Other property and equipment, net
 
2,472

 
1,283

Total property and equipment, net
 
632,858

 
432,615

Other assets, net
 
4,448

 
824

Total assets
 
$
689,756

 
$
476,982

LIABILITIES, MEZZANINE EQUITY AND STOCKHOLDERS’ EQUITY
 
 
 
 

Current liabilities:
 
 

 
 

Accounts payable
 
$
23,226

 
$
31,868

Accounts payable, related parties
 
12

 
223

Derivative liabilities
 
53,263

 
10,772

Accrued liabilities and other
 
31,753

 
15,492

Accrued capital expenditures
 
43,010

 
45,045

Total current liabilities
 
151,264

 
103,400

Long-term liabilities:
 
 
 
 
Long-term debt, net
 
288,013

 
93,199

Asset retirement obligations, net of current portion
 
13,037

 
8,522

Deferred tax liabilities
 
5,676

 

Derivative liabilities
 
56,825

 
8,008

Other
 
154

 
321

Total long-term liabilities
 
363,705

 
110,050

Total liabilities
 
514,969

 
213,450

Commitments and contingencies (Note 16)
 


 


Mezzanine equity
 
 
 
 
Series B Preferred Stock, $0.0001 par value, 10.0% Redeemable, $1,000 per share liquidation preference; of the 1,000,000 shares of Preferred Stock authorized, 210,000 shares designated, 155,180 and 150,626 shares issued and outstanding as of September 30, 2018 and December 31, 2017, respectively
 
151,535

 
140,868

Stockholders’ equity
 
 

 
 

Series A Preferred Stock, $0.0001 par value, 8.0% Cumulative Perpetual Convertible, $1,000 per share liquidation preference; of the 1,000,000 shares of Preferred Stock authorized, 150,000 shares designated, 100,653 and 97,698 shares issued and outstanding as of September 30, 2018 and December 31, 2017, respectively
 
83,615

 
80,660

Class A Common Stock; $0.0001 par value, 250,000,000 and 95,000,000 shares authorized at September 30, 2018 and December 31, 2017, respectively, and 6,740,852 and 6,222,299 shares issued and outstanding as of September 30, 2018 and December 31, 2017, respectively
 
1

 
1

Class B Common Stock; $0.0001 par value, 30,000,000 shares authorized, 29,807,692 shares issued and outstanding as of September 30, 2018 and December 31, 2017
 
3

 
3

Additional paid-in capital
 
7,264

 
29,946

Retained earnings (deficit)
 
(109
)
 

Total common stockholders’ equity
 
7,159

 
29,950

Noncontrolling interest
 
(67,522
)
 
12,054

Total stockholders' equity
 
23,252

 
122,664

Total liabilities, mezzanine and stockholders’ equity
 
$
689,756

 
$
476,982

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

3



ROSEHILL RESOURCES INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited) 
(In thousands, except per share amounts) 

 
 
Three Months
 
Nine Months
 
 
Ended September 30,
 
Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
Revenues:
 
 

 
 
 
 

 
 

Oil sales
 
$
72,799

 
$
11,435

 
$
197,414

 
$
36,464

Natural gas sales
 
2,633

 
1,881

 
6,686

 
5,592

Natural gas liquids sales
 
7,125

 
1,979

 
14,770

 
5,405

Total revenues
 
82,557

 
15,295

 
218,870

 
47,461

Operating expenses:
 
 

 
 

 
 

 
 

Lease operating expenses
 
9,205

 
2,944

 
29,315

 
6,479

Production taxes
 
4,034

 
707

 
10,515

 
2,174

Gathering and transportation
 
1,327

 
835

 
3,246

 
2,329

Depreciation, depletion, amortization and accretion
 
47,469

 
8,383

 
104,784

 
26,150

Exploration costs
 
1,348

 
434

 
3,659

 
1,208

General and administrative
 
8,342

 
5,069

 
23,369

 
8,738

Transaction costs
 

 
149

 

 
2,618

(Gain) loss on disposition of property and equipment
 
29

 

 
325

 
(11
)
Total operating expenses
 
71,754

 
18,521

 
175,213

 
49,685

Operating income
 
10,803

 
(3,226
)
 
43,657

 
(2,224
)
Other income (expense):
 
 

 
 

 
 

 
 

Interest expense, net
 
(5,363
)
 
(300
)
 
(13,892
)
 
(1,274
)
Gain (loss) on commodity derivative instruments, net
 
(67,314
)
 
(1,451
)
 
(108,553
)
 
1,751

Other income (expense), net
 
(93
)
 
(148
)
 
329

 
(105
)
Total other income (expense), net
 
(72,770
)
 
(1,899
)
 
(122,116
)
 
372

Loss before income taxes
 
(61,967
)
 
(5,125
)
 
(78,459
)
 
(1,852
)
Income tax expense (benefit)
 
22,923

 
(923
)
 
5,523

 
(650
)
Net income (loss)
 
(84,890
)
 
(4,202
)
 
(83,982
)
 
(1,202
)
Net income (loss) attributable to noncontrolling interest
 
(61,450
)
 
(5,680
)
 
(83,873
)
 
(8,009
)
Net income attributable to Rosehill Resources Inc. before preferred stock dividends
 
(23,440
)
 
1,478

 
(109
)
 
6,807

Series A Preferred Stock dividends and deemed dividends
 
2,011

 
1,942

 
5,907

 
10,014

Series B Preferred Stock dividends, deemed dividends, and return
 
5,917

 

 
17,494

 

Net income (loss) attributable to Rosehill Resources Inc. common stockholders
 
$
(31,368
)
 
$
(464
)
 
$
(23,510
)
 
$
(3,207
)
Earnings (loss) per common share:
 
 

 
 

 
 

 
 

Basic
 
$
(4.76
)
 
$
(0.08
)
 
$
(3.66
)
 
$
(0.55
)
Diluted
 
$
(4.76
)
 
$
(0.08
)
 
$
(3.66
)
 
$
(0.55
)
Weighted average common shares outstanding:
 
 

 
 

 
 

 
 

Basic
 
6,592

 
5,857

 
6,416

 
5,857

Diluted
 
6,592

 
5,857

 
6,416

 
5,857








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

4



ROSEHILL RESOURCES INC.
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(Unaudited) 
(In thousands, except share amounts)
 
 
 
Preferred Stock Series A
 
Common Stock
 
 
 
 
 
 
 
 
 
 
 
 
 
Class A
 
Class B
 
 
 
 
 
 
 
 
 
 
 
 
Shares
 
Value
 
Shares
 
Value
 
Shares
 
Value
 
Additional
Paid-in Capital
 
Retained Earnings (Deficit)
 
Total
Common Stockholders’ Equity
 
Non-
controlling
Interest
 
Total Equity
Balance at
December 31, 2017
 
97,698

 
$
80,660

 
6,222,299

 
$
1

 
29,807,692

 
$
3

 
$
29,946

 
$

 
$
29,950

 
$
12,054

 
$
122,664

Net income (loss)
 

 

 

 

 

 

 

 
(109
)
 
(109
)
 
(83,873
)
 
(83,982
)
Restricted stock issued
 

 

 
550,814

 

 

 

 

 

 

 

 

Restricted stock withheld for taxes
 

 

 
(32,261
)
 

 

 

 
(258
)
 

 
(258
)
 

 
(258
)
Stock-based compensation
 

 

 

 

 

 

 
5,274

 

 
5,274

 

 
5,274

Series A Preferred Stock dividends
 
2,955

 
2,955

 

 

 

 

 
(5,907
)
 

 
(5,907
)
 

 
(2,952
)
Series B Preferred Stock dividends, deemed dividends and return
 

 

 

 

 

 

 
(17,494
)
 

 
(17,494
)
 

 
(17,494
)
Impact of transactions affecting noncontrolling interest
 

 

 

 

 

 

 
(4,297
)
 

 
(4,297
)
 
4,297

 

Balance at
September 30, 2018
 
100,653

 
$
83,615

 
6,740,852

 
$
1

 
29,807,692

 
$
3

 
$
7,264

 
$
(109
)
 
$
7,159

 
$
(67,522
)
 
$
23,252





















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

5



ROSEHILL RESOURCES INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited) 
(In thousands) 
 
 
Nine Months Ended September 30,
 
 
2018
 
2017
Cash flows from operating activities:
 
 

 
 

Net income
 
$
(83,982
)
 
$
(1,202
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 

 
 

Depreciation, depletion, amortization and accretion
 
104,784

 
26,150

Deferred income taxes
 
5,523

 
(650
)
Stock-based compensation
 
5,364

 
175

(Gain) loss on sale of fixed assets
 
325

 
(11
)
(Gain) loss on derivative instruments
 
108,500

 
(1,382
)
Net cash received (paid) in settlement of derivative instruments
 
(17,193
)
 
19

Amortization of debt issuance costs
 
1,723

 
168

Settlement of asset retirement obligations
 
(551
)
 
(725
)
Changes in operating assets and liabilities:
 
 
 
 
(Increase) decrease in accounts receivable and accounts receivable, related parties
 
(22,412
)
 
122

(Increase) decrease in prepaid and other assets
 
(176
)
 
(462
)
Increase (decrease) in accounts payable and accrued liabilities and other
 
14,828

 
13,531

Increase (decrease) in accounts payable, related parties
 
(211
)
 
(206
)
Net cash provided by operating activities
 
116,522

 
35,527

Cash flows from investing activities:
 
 

 
 

Additions to oil and natural gas properties
 
(292,955
)
 
(93,536
)
Acquisition of White Wolf
 
(4,005
)
 

Acquisition of land and leasehold, royalty, and mineral interest
 
(15,245
)
 
(6,500
)
Additions to other property and equipment
 
(1,834
)
 
(343
)
Proceeds from sale of other property and equipment
 

 
46

Net cash used in investing activities
 
(314,039
)
 
(100,333
)
Cash flows from financing activities:
 
 

 
 

Proceeds from revolving credit facility
 
274,000

 
50,000

Repayment on revolving credit facility
 
(80,000
)
 
(55,000
)
Proceeds from issuance of Series A Preferred Stock and Warrants, net
 

 
95,000

Series A Preferred Stock issuance costs
 

 
(4,220
)
Net proceeds from the Transaction
 

 
18,688

Distribution to noncontrolling interest
 

 
(40,487
)
Distribution to Tema
 

 
(2,267
)
Debt issuance costs
 
(2,497
)
 
(661
)
Dividends paid on preferred stock
 
(7,388
)
 

Restricted stock used for tax withholdings
 
(258
)
 

Payment on capital lease obligation
 
(21
)
 
(25
)
Net cash provided by financing activities
 
183,836

 
61,028

Net increase (decrease) in cash, cash equivalents, and restricted cash
 
(13,681
)
 
(3,778
)
Cash, cash equivalents, and restricted cash, beginning of period
 
24,682

 
8,434

Cash, cash equivalents, and restricted cash, end of period
 
$
11,001

 
$
4,656



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

6



ROSEHILL RESOURCES INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(Unaudited) 
(In thousands)

Supplemental cash flow information and noncash activity:
 
 
Nine Months Ended September 30,
 
 
2018
 
2017
Supplemental disclosures:
 
 
 
 
Cash paid for interest
 
$
10,160

 
$
246

 
 
 
 
 
Supplemental noncash activity:
 
 
 
 
Asset retirement obligations incurred
 
$
4,367

 
$
783

Net settlement of related party receivable and payable
 

 
199

Changes in accrued capital expenditures
 
(2,035
)
 
15,603

Changes in accounts payable for capital expenditures
 
(7,662
)
 

Series A Preferred Stock dividends paid-in-kind
 
2,955

 
3,314

Series A Preferred Stock dividends declared and payable
 
1,005

 

Series A Preferred Stock deemed dividend
 

 
6,700

Series B Preferred Stock dividends paid-in-kind
 
4,554

 

Series B Preferred Stock cash dividends declared and payable
 
2,323

 

Series B Preferred Stock return
 
5,130

 

Series B Preferred Stock deemed dividend
 
984

 


Reconciliation of cash, cash equivalents and restricted cash presented on the Condensed Consolidated Statement of Cash Flows:
 
 
September 30, 2018
 
December 31, 2017
Cash and cash equivalents
 
$
11,001

 
$
20,677

Restricted cash
 

 
4,005

Total cash, cash equivalents and restricted cash
 
$
11,001

 
$
24,682


As of December 31, 2017, restricted cash was attributable to the White Wolf Acquisition purchase price in an escrow account. The full amount of the escrow account was released to the sellers in March 2018.




















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

7



ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Note 1 – Organization and Basis of Presentation
 
Organization

Rosehill Resources Inc. (the “Company” or “Rosehill”) is an independent oil and natural gas company focused on the acquisition, exploration, development and production of unconventional oil and associated liquids-rich natural gas reserves in the Permian Basin. The Company’s assets are concentrated in the Delaware Basin, a sub-basin of the Permian Basin.

The Company was incorporated in Delaware on September 21, 2015 as a special purpose acquisition company under the name of KLR Energy Acquisition Corp. (“KLRE”) for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination involving the Company and one or more businesses. On April 27, 2017, the Company acquired a portion of the equity of Rosehill Operating Company, LLC (“Rosehill Operating”), in a transaction structured as a reverse recapitalization (the “Transaction”), into which Tema Oil & Gas Company (“Tema”), a wholly owned subsidiary of Rosemore, Inc. (“Rosemore”), contributed certain assets and liabilities. At the closing of the Transaction, the Company became the sole managing member of Rosehill Operating. Following the Transaction, the Company changed its name to Rosehill Resources Inc.

As the sole managing member of Rosehill Operating, the Company, through its officers and directors, is responsible for all operational and administrative decision-making and control of all of the day-to-day business affairs of Rosehill Operating without the approval of any other member, unless specified in the Second Amended and Restated Limited Liability Company Agreement of Rosehill Operating (the “LLC Agreement”).

Transaction

On April 27, 2017, upon closing the Transaction, the Company acquired a portion of the common units of Rosehill Operating (the “Rosehill Operating Common Units”) for (i) the contribution to Rosehill Operating by the Company of $35 million in cash (the “Cash Consideration”), excluding the working capital adjustment, and the issuance to Rosehill Operating by the Company of 29,807,692 shares of its Class B Common Stock, (ii) the assumption by Rosehill Operating of $55 million in Tema indebtedness and (iii) the contribution to Rosehill Operating by the Company of the remaining cash proceeds of the Company’s initial public offering net of redemptions of approximately$60.6 million. In connection with the closing of the Transaction, the Company issued to Rosehill Operating 4,000,000 warrants exercisable for shares of the Company’s Class A Common Stock (the “Tema warrants”) in exchange for 4,000,000 warrants exercisable for Rosehill Operating Common Units (the “Rosehill warrants”). The Cash Consideration, estimated working capital adjustment, Tema warrants and shares of Class B Common Stock were immediately distributed to Tema. The working capital adjustment was originally estimated to be $5.6 million and was contributed to Rosehill Operating by the Company upon closing the Transaction. As of December 31, 2017, the final working capital adjustment of $2.4 million due to the Company from Tema was reflected as a reduction to the preliminary purchase price.

In connection with the Transaction, the Company issued and sold 75,000 shares of its 8% Series A Cumulative Perpetual Convertible Preferred Stock (the “Series A Preferred Stock”) and 5,000,000 warrants in a private placement to certain qualified institutional buyers and accredited investors (the “PIPE Investors”) for net proceeds of $70.8 million (the “PIPE Investment”). The Company issued an additional 20,000 shares of Series A Preferred Stock to Rosemore Holdings, Inc. (wholly owned subsidiary of Rosemore) and KLR Energy Sponsor, LLC (the “Sponsor”) in connection with the closing of the Transaction for net proceeds of $20 million. The Company contributed the net proceeds from the PIPE Investment and from the issuance of 20,000 shares of Series A Preferred Stock to Rosemore Holdings, Inc. and the Sponsor to Rosehill Operating in exchange for Rosehill Operating Series A preferred units and additional Rosehill warrants. Of these proceeds, $55 million was used to retire the indebtedness assumed by Rosehill Operating.
 
Net cash provided by the Company upon the closing of the Transaction was $109.5 million, which consisted of $90.8 million of net proceeds from the sale of Series A Preferred Stock and $18.7 million from the sale of common shares prior to the Transaction, net of redemptions and offering and transaction costs.


8

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Basis of Presentation

The condensed consolidated financial results of the Company consist of the financial results of Rosehill and Rosehill Operating, its consolidated subsidiary. Pursuant to the Transaction described above, the Company acquired approximately 16.4% of the Rosehill Operating Common Units, while Tema retained approximately 83.6% of the Rosehill Operating Common Units. As of September 30, 2018, the Company owns approximately 18.4% of the Rosehill Operating Common Units and Tema owns approximately 81.6% of the Rosehill Operating Common Units, excluding the shares of Rosehill Operating Common Units issued in connection with the Class A Common Stock Offering and the exercise of the Underwriters’ option, each as defined in Note 17 - Subsequent Events, that closed subsequent to September 30, 2018.

The Transaction was accounted for as a reverse recapitalization. As a result, the reports filed by the Company subsequent to the Transaction are prepared “as if” Rosehill Operating is the predecessor and legal successor to the Company. The historical operations of Rosehill Operating are deemed to be those of the Company. Thus, the financial statements included in this report reflect (i) the historical operating results of Rosehill Operating prior to the Transaction; (ii) the combined results of the Company and Rosehill Operating following the Transaction; (iii) the assets and liabilities of Rosehill Operating at their historical cost; and (iv) the Company’s equity and earnings per share for all periods presented.

All periods prior to the date of the Transaction shown in the accompanying condensed consolidated financial statements have been prepared on a “carve-out” basis and are derived from the accounting records of Tema. The accompanying condensed consolidated financial statements prior to the Transaction include direct expenses related to Rosehill Operating and expense allocations for certain functions of Tema including, but not limited to, general corporate expenses related to finance, legal, information technology, human resources, communications, insurance, utilities, and compensation. These expenses have been allocated on the basis of direct usage when identifiable, actual volumes and revenues, with the remainder allocated proportionately on a barrel of oil equivalent (“Boe”) basis. Management considers the basis on which the expenses have been allocated to reasonably reflect the utilization of services provided to or the benefit received by Rosehill Operating during the periods presented. The allocations may not, however, reflect the expenses that would have been incurred as an independent company for the periods presented. Actual costs that may have been incurred prior to the Transaction would depend on a number of factors, including the organizational structure, whether functions were outsourced or performed by employees and strategic decisions made in areas such as information technology and infrastructure. The allocations and related estimates and assumptions are described more fully in Note 15 - Transactions with Related Parties.

The unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”) have been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosures made are adequate to make the information not misleading. It is suggested that these condensed financial statements be read in conjunction with the financial statements and the notes thereto included in the Company’s latest Annual Report on Form 10-K. The unaudited condensed consolidated financial statements reflect all normal and recurring adjustments that are, in the opinion of management, necessary for the fair presentation of the results of operations for the interim periods.

Variable Interest Entities

Rosehill Operating is a variable interest entity. The Company determined that it is the primary beneficiary of Rosehill Operating as the Company is the sole managing member and has the power to direct the activities most significant to Rosehill Operating’s economic performance as well as the obligation to absorb losses and receive benefits that are potentially significant. The Company consolidated 100% of Rosehill Operating’s assets and liabilities and results of operations in the Company’s condensed consolidated financial statements. Although Tema had a larger ownership interest in Rosehill Operating, because it has disproportionately fewer voting rights, Tema is shown as a noncontrolling interest holder of Rosehill Operating. For further discussion, see Noncontrolling Interest in Note 13 - Stockholders’ Equity.

Note 2 – Summary of Significant Accounting Policies and Recently Issued Accounting Standards
 
The significant accounting policies followed by the Company are set forth in Note 2 – Summary of Significant Accounting Policies included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.
 

9

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Accounting Standards Adopted in 2018
 
Equity-based Compensation. In May 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2017-09 – Compensation – Stock Compensation (Topic 718); Scope of Modification Accounting. The new guidance clarifies when to account for a change to the terms or conditions of a share-based payment award as a modification. Under the new guidance, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award as equity or liability changes as a result of the change in terms or conditions. The Company adopted ASU 2017-09 in 2018. The adoption of ASU 2017-09 did not have a material impact on the Company’s condensed consolidated financial statements for the nine months ended September 30, 2018.

Recently Issued Accounting Standards Not Yet Adopted

Revenue Recognition. ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASC 606”), supersedes the revenue recognition requirements in Topic 605, Revenue Recognition, and industry-specific guidance in Subtopic 932-605, Extractive Activities-Oil and Gas-Revenue Recognition and requires an entity to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration the entity expects to be entitled to in exchange for those goods or services. Subsequently, in April 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing as further clarification on identifying performance obligations and the licensing implementation guidance. In May 2016, the FASB issued ASU 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients, as clarifying guidance to improve the operability and understandability of the implementation guidance on principal versus agent considerations. In December 2016, the FASB further issued ASU 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers, to increase stakeholders’ awareness of the proposals and to expedite improvements to ASU 2014-09.

The Company is in the process of reviewing its various contracts with customers and evaluating the effects of ASC 606 on its financial statements and disclosures. Based on the Company’s analysis to date, changes are expected in the presentation of revenues and expenses as net versus gross for certain contracts; however, net income and cash flows are not expected to be impacted. The Company’s analysis will be completed in the fourth quarter, and it is not currently able to estimate the quantitative effect of the aforementioned change. The Company continues to evaluate and compile the information required for the new disclosure requirements, which also includes any changes to relevant business practices, accounting policies and control activities as a result of the adoption of ASC 606. The Company plans to adopt ASC 606 using the modified retrospective method on January 1, 2019.

Financial Assets and Financial Liabilities. In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. The pronouncement requires, among other things, public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes and requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset. For the Company, these changes become effective for fiscal years beginning after December 15, 2018. In February 2018, the FASB issued ASU 2018-03, Technical Corrections and Improvements to Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, which clarifies certain aspects of the guidance issued in ASU 2016-01 including: the ability to irrevocably elect to change the measurement approach for equity securities measured using the practical expedient (at cost plus or minus observable transactions less impairment) to a fair value method in accordance with Topic 820, Fair Value Measurement; clarification that if an observable transaction occurs for such securities, the adjustment is as of the observable transaction date; clarification that the prospective transition approach for equity securities without a readily determinable fair value is meant only for instances in which the practical expedient is elected; and various other clarifications. The expected adoption of ASU 2016-01 and ASU 2018-03 are being evaluated by the Company and the adoption is not expected to have a significant impact on the Company’s condensed consolidated financial statements.

Leases. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which requires the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under current U.S. GAAP. In January 2018, the FASB issued ASU 2018-01, Leases (Topic 842): Land Easement Practical Expedient for Transition to Topic 842, which provides clarifying guidance regarding land easements and adds practical expedients. In July 2018, further amendments were issued under ASU 2018-10, Codification Improvements to Topic 842, Leases. In July 2018, the FASB issued ASU 2018-11, Leases (Topic 842): Targeted Improvements, which provides entities with an additional transition method in which an entity initially applies the new leases standard at the adoption date and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. ASU 2016-02 and its related updates are effective for the Company for fiscal years beginning after December 15, 2019. The Company is currently evaluating the method of adoption and the impact of the adoption of this guidance on its condensed consolidated financial statements and disclosures.

10

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
Financial Instruments – Credit Losses. In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments requiring the measurement of all expected credit losses for financial assets, which include trade receivables, held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. The guidance in this ASU is effective for the Company for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021 with early adoption permitted for interim and annual periods beginning after December 15, 2018. The evaluation of this standard and its impact on the Company’s condensed consolidated financial statements and related disclosures is currently being assessed.

Derivatives and Hedging. In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, which expands and refines hedge accounting for both financial and non-financial risk components, aligns the recognition and presentation of the effects of hedging instruments and hedge items in the financial statements, and includes certain targeted improvements to ease the application of current guidance related to the assessment of hedge effectiveness. ASU 2017-12 is effective for the Company for fiscal years beginning after December 15, 2019. Early adoption is permitted. The Company is currently evaluating the impact of the adoption of this guidance on its condensed consolidated financial statements.

Fair Value Measurement Disclosures. In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement, which removes, modifies, and adds disclosure requirements on fair value measurements. ASU 2018-13 is effective for the Company for fiscal years beginning after December 15, 2019 and the Company is permitted to early adopt any removed or modified disclosures upon issuance of this ASU and delay adoption of the additional disclosures until their effective date. The Company is currently evaluating the impact of the adoption of this guidance on its disclosures.

Note 3 – Earnings Per Share
 
The Transaction was structured as a reverse recapitalization by which the Company issued stock for the net assets of Rosehill Operating accompanied by a recapitalization. Earnings per share has been recast for all historical periods to reflect the Company’s capital structure for all comparative periods.  
 
The following table sets forth the calculation of basic and diluted weighted average shares outstanding and earnings per share for the indicated periods:
 
 
 
Three Months
 
Nine Months
 
 
Ended September 30,
 
Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
(In thousands, except per share data)
Net income (loss) (numerator):
 
 

 
 

 
 

 
 

Basic:
 
 

 
 

 
 

 
 

Net income (loss) attributable to common stockholders of Rosehill Resources Inc.
 
$
(31,368
)
 
$
(464
)
 
$
(23,510
)
 
$
(3,207
)
Diluted:
 
 

 
 

 
 

 
 

Net income (loss) attributable to common stockholders of Rosehill Resources Inc. - diluted
 
$
(31,368
)
 
$
(464
)
 
$
(23,510
)
 
$
(3,207
)
 
 
 
 
 
 
 
 
 
Weighted average shares (denominator):
 
 

 
 

 
 

 
 

Weighted average shares – basic
 
6,592

 
5,857

 
6,416

 
5,857

Weighted average shares – diluted
 
6,592

 
5,857

 
6,416

 
5,857

Basic loss per share
 
$
(4.76
)
 
$
(0.08
)
 
$
(3.66
)
 
$
(0.55
)
Diluted loss per share
 
$
(4.76
)
 
$
(0.08
)
 
$
(3.66
)
 
$
(0.55
)
 

11

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

For the three months ended September 30, 2018, the Company excluded 29.8 million shares of Class A Common Stock issuable upon exchange of the Company’s Class B Common Stock, 25.6 million shares of Class A Common Stock issuable upon exercise of the Company’s warrants, 8.7 million shares of Class A Common Stock issuable upon conversion of the Company’s Series A Preferred Stock, and 1.0 million shares of Class A Common Stock issuable upon vesting under the Company’s Long-Term Incentive Plan from the computation of diluted earnings per share because the effect of such events was anti-dilutive. For the nine months ended September 30, 2018, the Company excluded 29.8 million shares of Class A Common Stock issuable upon exchange of the Company’s Class B Common Stock, 25.6 million shares of Class A Common Stock issuable upon exercise of the Company’s warrants, 8.6 million shares of Class A Common Stock issuable upon conversion of the Company’s Series A Preferred Stock, and 1.0 million shares of Class A Common Stock issuable upon vesting under the Company’s Long-Term Incentive Plan from the computation of diluted earnings per share because the effect of such events was anti-dilutive.

For the three months ended September 30, 2017, the Company excluded 29.8 million shares of Class A Common Stock issuable upon exchange of the Company’s Class B Common Stock, 25.6 million shares of Class A Common Stock issuable upon exercise of the Company’s warrants, and 8.4 million shares of Class A Common Stock issuable upon conversion of the Company’s Series A Preferred Stock from the computation of diluted earnings per share because the effect of such events was anti-dilutive. For the nine months ended September 30, 2017, the Company excluded 29.8 million shares of Class A Common Stock issuable upon exchange of the Company’s Class B Common Stock, 25.6 million shares of Class A Common Stock issuable upon exercise of the Company’s warrants, and 8.3 million shares of Class A Common Stock issuable upon conversion of the Company’s Series A Preferred Stock from the computation of diluted earnings per share because the effect of such events was anti-dilutive.

Note 4 – Accounts Receivable
 
Accounts receivable is comprised of the following:

 
 
September 30, 2018
 
December 31, 2017
 
 
Related Parties
 
Third-Parties
 
Related Parties
 
Third-Parties
 
 
(In thousands)
Revenue receivable
 
$
16,508

 
$
20,125

 
$
13,601

 
$
1,153

Transaction purchase price settlement
 

 

 
2,381

 

Joint interest billings
 
135

 
2,547

 
20

 
83

Other
 
19

 
627

 
20

 
291

Accounts receivable
 
$
16,662

 
$
23,299

 
$
16,022

 
$
1,527

 
Note 5 – Derivative Instruments
 
Commodity derivatives. The Company enters into various derivative instruments primarily to mitigate a portion of the exposure to potentially adverse market changes in oil and natural gas commodity prices and the associated impact on cash flows. All contracts are entered into for other-than-trading purposes. Oil and natural gas commodity derivative instruments are recorded on the condensed consolidated balance sheet at fair value as either an asset or a liability with changes in fair value recognized currently in earnings. While commodity derivative instruments are utilized to manage the price risk attributable to expected oil and natural gas production, the Company’s commodity derivative instruments are not designated as accounting hedges under the accounting guidance. The related cash flow impact of the commodity derivative activities is reflected as cash flows from operating activities unless they are determined to have a significant financing element at inception, in which case they are classified within financing activities.

Series B Preferred Stock bifurcated derivative - In the event of a change of control, the Company shall redeem in cash all of the outstanding shares of Series B Preferred Stock, excluding Series B PIK Shares, each as defined in Note 11 - 10% Series B Redeemable Preferred Stock, for a price per share equal to the Base Return Amount as defined in Note 11 - 10% Series B Redeemable Preferred Stock. The Company assessed the change of control feature and determined that the redemption of the outstanding shares of Series B Preferred Stock, excluding Series B PIK Shares, for a price per share equal to the Base Return Amount was a bifurcated derivative. See Note 11 - 10% Series B Redeemable Preferred Stock for defined terms and more detail.

12

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


The following tables summarize the location and fair value amounts of all the Company’s derivative instruments in the condensed consolidated balance sheets, as well as the gross recognized derivative assets, liabilities and amounts offset in the condensed consolidated balance sheets:

 
 
September 30, 2018
 
 
Gross Fair Value
 
Gross Amounts Offset (1)
 
Net Recognized Fair Value
 
 
(In thousands)
Assets
 
 
 
 
 
 
     Commodity derivatives - current
 
$
14,090

 
$
(14,090
)
 
$

     Commodity derivatives - non-current
 
16,679

 
(16,679
)
 

Total assets
 
$
30,769

 
$
(30,769
)
 
$

 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
     Commodity derivatives - current
 
$
(67,353
)
 
$
14,090

 
$
(53,263
)
     Commodity derivatives - non-current
 
(72,932
)
 
16,679

 
(56,253
)
Series B Preferred Stock bifurcated derivative - non-current
 
(572
)
 

 
(572
)
Total liabilities
 
$
(140,857
)
 
$
30,769

 
$
(110,088
)

(1)
The Company has agreements in place with all of its counterparties that allow for the financial right of offset for derivative assets and liabilities.

 
 
December 31, 2017
 
 
Gross Fair Value
 
Gross Amounts Offset (1)
 
Net Recognized Fair Value
 
 
(In thousands)
Assets
 
 
 
 
 
 
     Commodity derivatives - current
 
$
1,079

 
$
(1,079
)
 
$

     Commodity derivatives - non-current
 
120

 
(120
)
 

Total assets
 
$
1,199

 
$
(1,199
)
 
$

 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
     Commodity derivatives - current
 
$
(11,851
)
 
$
1,079

 
$
(10,772
)
     Commodity derivatives - non-current
 
(7,503
)
 
120

 
(7,383
)
Series B Preferred Stock bifurcated derivative - non-current
 
(625
)
 

 
(625
)
Total liabilities
 
$
(19,979
)
 
$
1,199

 
$
(18,780
)

(1)
The Company has agreements in place with all of its counterparties that allow for the financial right of offset for derivative assets and liabilities.


13

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

As of September 30, 2018, the open commodity derivative positions with respect to future production were as follows:

 
 
2018
 
2019
 
2020
 
2021
 
2022
Commodity derivative swaps
Oil:
 
 
 
 
 
 
 
 
 
 
Notional volume (Bbls)
699,000

 
2,664,000

 
960,000

 
360,000

 
300,000

 
Weighted average fixed price ($/Bbl)
$
55.15

 
$
53.59

 
$
51.16

 
$
50.42

 
$
50.12

Natural gas:
 
 
 
 
 
 
 
 
 
 
Notional volume (MMBtu)
960,000

 
2,220,000

 
1,500,000

 
1,200,000

 
1,200,000

 
Weighted average fixed price ($/MMbtu)
$
3.02

 
$
2.88

 
$
2.84

 
$
2.85

 
$
2.87

Ethane:
 
 
 
 
 
 
 
 
 
 
Notional volume (Gallons)
2,523,528

 
12,444,138

 

 

 

 
Weighted average fixed price ($/Gallons)
$
0.35

 
$
0.28

 
$

 
$

 
$

Propane:
 
 
 
 
 
 
 
 
 
 
Notional volume (Gallons)
1,682,352

 
8,296,218

 

 

 

 
Weighted average fixed price ($/Gallons)
$
0.97

 
$
0.79

 
$

 
$

 
$

Pentanes:
 
 
 
 
 
 
 
 
 
 
Notional volume (Gallons)
560,700

 
2,765,700

 

 

 

 
Weighted average fixed price ($/Gallons)
$
1.53

 
$
1.47

 
$

 
$

 
$

 
 
 
 
 
 
 
 
 
 
 
Commodity derivative two-way collars
Oil:
 
 
 
 
 
 
 
 
 
 
Notional volume (Bbls)
182,000

 
601,000

 

 

 

 
Weighted average ceiling price ($/Bbl)
$
61.28

 
$
61.30

 
$

 
$

 
$

 
Weighted average floor price ($/Bbl)
$
57.53

 
$
55.21

 
$

 
$

 
$

 
 
 
 
 
 
 
 
 
 
 
Commodity derivative three-way collars
Oil:
 
 
 
 
 
 
 
 
 
 
Notional volume (Bbls)

 
1,531,832

 
3,294,000

 

 

 
Weighted average ceiling price ($/Bbl)
$

 
$
68.52

 
$
70.29

 
$

 
$

 
Weighted average floor price ($/Bbl)
$

 
$
57.62

 
$
57.50

 
$

 
$

 
Weighted average sold put option price ($/Bbl)
$

 
$
45.51

 
$
47.50

 
$

 
$

 
 
 
 
 
 
 
 
 
 
 
Crude oil basis swaps
Midland / Cushing:
 
 
 
 
 
 
 
 
 
 
Notional volume (Bbls)
920,000

 
4,800,832

 
3,513,600

 

 

 
Weighted average fixed price ($/Bbl)
$
(4.95
)
 
$
(4.93
)
 
$
(1.43
)
 
$

 
$

 
 
 
 
 
 
 
 
 
 
 
Argus WTI roll:
 
 
 
 
 
 
 
 
 
 
Notional volume (Bbls)
920,000

 

 

 

 

 
Weighted average fixed price ($/Bbl)
$
1.14

 
$

 
$

 
$

 
$

 
 
 
 
 
 
 
 
 
 
 
Natural gas basis swaps
EP Permian
 
 
 
 
 
 
 
 
 
 
Notional volume (MMBtu)

 
1,781,472

 
2,096,160

 

 

 
Weighted average fixed price ($/MMBtu)
$

 
$
(1.03
)
 
$
(1.03
)
 
$

 
$



14

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

For the three and nine months ended September 30, 2018 and 2017, the effect of the derivative activity on the Company’s Condensed Consolidated Statements of Operations was as follows:
 
 
Three Months
 
Nine Months
 
 
Ended September 30,
 
Ended September 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
(In thousands)
Realized gain (loss) on derivatives
 
 

 
 

 
 

 
 

Commodity derivative options
 
$

 
$
18

 
$
19

 
$
172

Commodity derivative swaps
 
(4,999
)
 
454

 
(17,212
)
 
(10
)
Total
 
(4,999
)
 
472

 
(17,193
)
 
162

Interest rate swap
 

 
6

 

 
(143
)
Total realized gain (loss) on derivatives
 
$
(4,999
)
 
$
478

 
$
(17,193
)
 
$
19

 
 
 
 
 
 
 
 
 
Unrealized gain (loss) on derivatives
 
 

 
 

 
 

 
 

Commodity derivative options
 
$
(45,349
)
 
$
55

 
$
(59,514
)
 
$
361

Commodity derivative swaps
 
(16,966
)
 
(1,978
)
 
(31,846
)
 
1,228

Total
 
(62,315
)
 
(1,923
)
 
(91,360
)
 
1,589

Interest rate swap
 

 

 
$

 
$
(226
)
Series B Preferred Stock bifurcated derivative
 
(104
)
 

 
53

 

Total unrealized gain (loss) on derivatives
 
$
(62,419
)
 
$
(1,923
)
 
$
(91,307
)
 
$
1,363

 
The gains and losses resulting from the cash settlement and mark-to-market of the commodity derivatives are included within “Gain (loss) on commodity derivative instruments, net” in the Condensed Consolidated Statements of Operations. The gains and losses resulting from the cash settlement and mark-to-market of the interest rate swap are included in “Interest expense, net” in the Condensed Consolidated Statements of Operations.

Note 6 – Fair Value Measurements
 
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). Fair value measurements are classified and disclosed within the following fair value hierarchy:
 
Level 1 – Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. Active markets are those in which transactions for the assets or liabilities occur with sufficient frequency and volume to provide pricing information on an ongoing basis.
 
Level 2 – Quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability. This category includes those derivative instruments that are valued using observable market data.
 
Level 3 – Measured based on prices or valuation models that require inputs that are both significant to the fair value measurement and less observable from objective sources. Pricing inputs are unobservable for the investment and include situations where there is little, if any, market activity for the investment.
 
Observable data is considered to be market data if it is readily available, regularly distributed or updated, reliable and verifiable, not proprietary, and provided by multiple, independent sources that are actively involved in the relevant market. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an investment’s level with the fair value hierarchy is based on lowest level of input that is significant to the fair value measurement. The assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the investment. However, the determination of what constitutes “observable” requires significant judgment. The categorization of an investment within the hierarchy is based upon the pricing transparency of the investment and does not necessarily correspond to the perceived risk of that investment.


15

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Fair Value of Financial Instruments
 
The financial instruments measured at fair value on a recurring basis consist of the following:
 
 
 
September 30,
 
December 31,
 
 
2018
 
2017

 
(In thousands)
Derivative assets (liabilities)
 
 

 
 

Derivative liabilities - current
 
$
(53,263
)
 
$
(10,772
)
Derivative liabilities - non-current
 
(56,825
)
 
(8,008
)
Total derivative liabilities
 
$
(110,088
)
 
$
(18,780
)
 
Derivative assets and liabilities primarily represent unsettled amounts related to commodity derivative positions, including swaps and options. Derivative liabilities also include the Series B Preferred Stock bifurcated derivative for the various redemption amounts that the Company could incur if a change of control event occurs. The Company utilizes Level 3 assumptions to estimate the probability of a change of control occurring and when that would occur as the timing impacts the Base Return Amount as defined in Note 11 - 10% Series B Redeemable Preferred Stock. The change in fair value to the Series B Preferred Stock bifurcated derivative for the period is recorded in “Other income (expense), net” in the Condensed Consolidated Statements of Operations.

The tables below set forth by level within the fair value hierarchy represent the net components of the assets and liabilities that were measured at fair value on a recurring basis as of September 30, 2018 and December 31, 2017. These net balances are intended solely to provide information on sources of inputs to fair value and proportions of fair value involving objective versus subjective valuations and do not represent either the actual credit exposure or net economic exposure.
 
 
 
September 30, 2018
 
 
Level 1
 
Level 2
 
Level 3
 
Total
 
 
(In thousands)
Derivative liabilities
 
 
 
 
 
 
 
 
Commodity derivative liabilities - current
 
$

 
$
(53,263
)
 
$

 
$
(53,263
)
Commodity derivative liabilities - non-current
 

 
(56,253
)
 

 
(56,253
)
Series B Preferred Stock bifurcated derivative - non-current
 

 

 
(572
)
 
(572
)
Total derivative liabilities
 
$

 
$
(109,516
)
 
$
(572
)
 
$
(110,088
)

 
 
December 31, 2017
 
 
Level 1
 
Level 2
 
Level 3
 
Total
 
 
(In thousands)
Derivative liabilities
 
 
 
 
 
 
 
 
Commodity derivative liabilities - current
 
$

 
$
(10,772
)
 
$

 
$
(10,772
)
Commodity derivative liabilities - non-current
 

 
(7,383
)
 

 
(7,383
)
Series B Preferred Stock bifurcated derivative - non-current
 

 

 
(625
)
 
(625
)
Total derivative liabilities
 
$

 
$
(18,155
)
 
$
(625
)
 
$
(18,780
)

16

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
The table below sets forth a summary of changes in the fair value of the Company’s level 3 liabilities for the nine months ended September 30, 2018.

Beginning Balance
 
$
625

(Gains) losses reported in earnings
 
(53
)
Ending Balance
 
$
572


Financing Arrangements
 
The carrying amounts of the Company’s cash, cash equivalents, accounts receivable, accounts payable, and accrued liabilities approximate their fair values because of the short-term maturities and/or liquid nature of these assets and liabilities. The Company’s revolving credit facility carrying value is representative of its fair value because the interest rate changes monthly based on the current market of the stated rates in the agreement. Since issuance of the 10% Senior Secured Second Lien Notes (the “Second Lien Notes”) in December 2017, the Company’s credit rating has not changed, bond yields for its credit rating have not changed significantly, and commodity prices, which impact the fair value of its producing assets, have not changed significantly. Based on those factors, the Company believes the carrying value of the Second Lien Notes is representative of their fair values as of September 30, 2018.
 
Non-Financial Assets and Liabilities
 
Non-financial assets and liabilities that are initially measured at fair value are comprised of asset retirement obligations and the corresponding increase to the related long-lived asset and are not remeasured at fair value in subsequent periods. Such initial measurements are classified as Level 3 because certain significant unobservable inputs are utilized in their determination. The fair value of additions to asset retirement obligation liability and certain changes in the estimated fair value of the liability are measured using valuation techniques consistent with the income approach, converting future cash flows to a single discounted amount. Significant inputs to the valuation include (i) estimated plug and abandonment cost per well based on historical experience and information from third-parties; (ii) estimated remaining life per well; (iii) future inflation factors; and (iv) average credit-adjusted risk-free rate. These inputs require significant judgments and estimates by management at the time of the valuation and are the most sensitive and subject to change.
 
If the carrying amount of oil and natural gas properties exceeds the estimated undiscounted future cash flows, the carrying amount of the oil and natural gas properties will be adjusted to the fair value. The fair value of oil and natural gas properties is determined using valuation techniques consistent with the income and market approach. The factors used to determine fair value are subject to management’s judgment and expertise and include, but are not limited to, (i) recent sales prices of comparable properties; (ii) the present value of future cash flows, net of estimated operating and development costs using estimates of proved oil and natural gas reserves; (iii) future commodity prices; (iv) future production estimates; (v) anticipated capital expenditures; and (vi) various discount rates commensurate with the risk and current market conditions associated with the projected cash flows. These assumptions represent “Level 3” inputs.


17

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 7 – Property and equipment
 
Property and equipment is comprised of the following:
 
 
 
September 30,
 
December 31,
 
 
2018
 
2017
 
 
(In thousands)
Proved oil and natural gas properties
 
$
722,284

 
$
423,611

Unproved oil and natural gas properties
 
124,742

 
121,690

Land
 
1,558

 
406

Less: accumulated DD&A
 
(218,198
)
 
(114,375
)
    Total oil and natural gas properties (successful efforts), net
 
630,386

 
431,332

Other property and equipment
 
5,759

 
4,345

Less: accumulated DD&A
 
(3,287
)
 
(3,062
)
    Total other property and equipment
 
2,472

 
1,283

Total property and equipment, net
 
$
632,858

 
$
432,615


Depreciation, depletion, amortization, and accretion expense (“DD&A”) related to oil and natural gas properties was $47.1 million and $8.2 million for the three months ended September 30, 2018 and 2017, respectively, and $103.8 million and $25.7 million for the nine months ended September 30, 2018 and 2017, respectively. Depreciation and amortization expense related to other property and equipment was $0.2 million and $0.1 million for the three months ended September 30, 2018 and 2017, respectively, and $0.5 million and $0.3 million for the nine months ended September 30, 2018 and 2017, respectively. No impairment charges related to proved or unproved oil and natural gas properties were recorded for the three or nine months ended September 30, 2018 and 2017. Capitalized costs included in proved oil and natural gas properties not subject to DD&A totaled $46.2 million at September 30, 2018 and $57.2 million at December 31, 2017.

Note 8 – Asset Retirement Obligations
 
The change in asset retirement obligations for the nine months ended September 30, 2018 is set forth below (in thousands):
Asset retirement obligations, beginning of period
$
8,630

Additional liabilities incurred
4,367

Dispositions

Accretion expense
442

Liabilities settled upon plugging and abandoning wells
(551
)
Revision of estimates
207

Asset retirement obligations, end of period
13,095

Less: current portion of asset retirement obligations
(58
)
Long-term asset retirement obligations
$
13,037

 

18

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 9 – Accrued Liabilities and Other
 
Accrued liabilities and other is comprised of the following as of the respective dates:

 
 
September 30,
 
December 31,
 
 
2018
 
2017
 
 
(In thousands)
Accrued payroll
 
$
3,314

 
$
2,352

Royalties payable
 
11,834

 
3,903

Accrued lease operating expense
 
5,232

 
2,230

Contingent liability - White Wolf Acquisition
 

 
4,005

Preferred Stock dividends payable
 
3,328

 
937

Accrued interest expense
 
2,648

 
639

Other
 
5,397

 
1,426

Total accrued liabilities and other
 
$
31,753

 
$
15,492


Note 10 – Long-term debt, net
 
The Company’s long-term debt is comprised of the following:

 
 
September 30,
 
December 31,
 
 
2018
 
2017
 
 
(In thousands)
Second Lien Notes
 
$
100,000

 
$
100,000

Revolving credit facility
 
194,000

 

          Total debt
 
294,000

 
100,000

Debt issuance cost on Second Lien Notes, net
 
3,372

 
3,830

Discount on Second Lien Notes, net
 
2,615

 
2,971

          Total debt issuance cost and discounts
 
5,987

 
6,801

Total long-term debt, net
 
$
288,013

 
$
93,199


Revolving Credit Facility

On March 28, 2018, the Company entered into an Amended and Restated Credit Agreement (the “Amended and Restated Credit Agreement”) by and among the Company, as borrower, JPMorgan Chase Bank, N.A., as administrative agent, and certain other financial institutions party thereto, as lenders. The borrowings under the Amended and Restated Credit Agreement bear interest at an adjusted base rate plus an applicable margin ranging from 1% to 2% or at an adjusted LIBO Rate plus an applicable margin ranging from 2% to 3%. As of September 30, 2018, the weighted average interest rate of outstanding borrowings under the Amended and Restated Credit Agreement was 5.13%. The Amended and Restated Credit Agreement amends and restates in its entirety the original credit agreement entered into on April 27, 2017 and amended on December 8, 2017. Pursuant to the Amended and Restated Credit Agreement, the lenders party thereto have agreed to provide the Company with a $500 million secured reserve-based revolving credit facility with an initial borrowing base of $150 million. The maturity date of the Amended and Restated Credit Agreement is August 31, 2022 and automatically extends to March 2023 upon the payment in full of the Second Lien Notes. The borrowing base is re-determined semi-annually, with the lenders and the Company each having the right to one interim unscheduled redetermination between any two consecutive semi-annual redeterminations. The first redetermination date occurred on June 29, 2018, increasing the borrowing base from $150 million to $210 million. Beginning in 2019, redeterminations will occur on April 1 and October 1.


19

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The amounts outstanding under the Amended and Restated Credit Agreement are secured by first priority liens on substantially all of Rosehill Operating’s oil and natural gas properties and associated assets and all of the stock of Rosehill Operating’s material operating subsidiaries that are guarantors of the Amended and Restated Credit Agreement. If an event of default occurs under the Amended and Restated Credit Agreement, JPMorgan Chase Bank, N.A. will have the right to proceed against the pledged capital stock and take control of substantially all of Rosehill Operating and Rosehill Operating’s material operating subsidiaries that are guarantors’ assets. There are currently no guarantors under the Amended and Restated Credit Agreement.

The Amended and Restated Credit Agreement contains various affirmative and negative covenants. These covenants may limit Rosehill Operating’s ability to, among other things: incur additional indebtedness; make loans to others; make investments; enter into mergers; make or declare dividends or distributions; enter into commodity hedges exceeding a specified percentage of Rosehill Operating’s expected production; enter into interest rate hedges exceeding a specified percentage of Rosehill Operating’s outstanding indebtedness; incur liens; sell assets; and engage in certain other transactions without the prior consent of JPMorgan Chase Bank, N.A. and/or the lenders.
 
The Amended and Restated Credit Agreement also requires Rosehill Operating to maintain the following financial ratios: (1) commencing on March 31, 2018, a current ratio, which is the ratio of consolidated current assets (including unused commitments under the Amended and Restated Credit Agreement, but excluding non-cash assets) to consolidated current liabilities (excluding non-cash obligations, current maturities under the Amended and Restated Credit Agreement and the Note Purchase Agreement (as defined below)), of not less than 1.0 to 1.0; (2) (x) commencing on March 31, 2018, a leverage ratio, which is the ratio of the sum of all of Rosehill Operating’s Total Debt to Annualized EBITDAX (as such terms are defined in the Amended and Restated Credit Agreement) for the four fiscal quarters then ended, of not greater than 4.0 to 1.0 and (y) commencing on and after repayment in full of the Second Lien Notes (other than surviving contingent indemnification obligations) and the repayment or redemption in full of the Series B Preferred Stock, a leverage ratio, which is the ratio of the sum of all of Rosehill Operating’s Net Debt to Annualized EBITDAX (as such terms are defined in the Amended and Restated Credit Agreement), of not greater than 4.0 to 1.0 and (3) commencing on March 31, 2018 for so long as the Series B Preferred Stock remains outstanding, a coverage ratio, which is the ratio of (i) EBITDAX (as defined in the Amended and Restated Credit Agreement) to (ii) the sum of (x) Interest Expense (as defined in the Amended and Restated Credit Agreement) plus (y) the aggregate amount of Restricted Payments (as defined in the Amended and Restated Credit Agreement) made in cash pursuant to Sections 9.04(a)(iv) and (v) of the Amended and Restated Credit Agreement during the preceding four fiscal quarters, of not less than 2.5 to 1.0. The Company was in compliance with the leverage ratio and coverage ratio in the Amended and Restated Credit Agreement for the measurement period ended September 30, 2018. As of September 30, 2018, the Company was not in compliance with the current ratio covenant. The Company received a waiver of compliance from its lenders to waive this violation for the quarter ended September 30, 2018.
 
Second Lien Notes

On December 8, 2017, Rosehill Operating issued and sold $100,000,000 in aggregate principal amount of 10.00% Senior Secured Second Lien Notes due January 31, 2023 to EIG Global Energy Partners, LLC (“EIG”) under and pursuant to the terms of that certain Note Purchase Agreement, dated as of December 8, 2017 (as amended by the Limited Consent and First Amendment to Note Purchase Agreement, dated as of March 28, 2018, the “Note Purchase Agreement”), among Rosehill Operating, the Company, the holders of the Second Lien Notes party thereto (the “Holders”) and U.S. Bank National Association, as agent and collateral agent on behalf of the Holders. The Second Lien Notes were issued and sold to the Holders in a private placement exempt from the registration requirements under the Securities Act of 1933, as amended (such issuance and sale, the “Notes Purchase”).

Under the Note Purchase Agreement, Rosehill Operating may, at its option, redeem the Second Lien Notes in whole or in part, together with accrued and unpaid interest thereon, (i) at any time after December 8, 2019 but on or prior to December 8, 2020, at a redemption price equal to 103% of the principal amount of the Second Lien Notes being redeemed, (ii) at any time after December 8, 2020 but on or prior to December 8, 2021, at a redemption price equal to 101.5% of the principal amount of the Second Lien Notes being redeemed and (iii) at any time after December 8, 2021, at a redemption price equal to the principal amount of the Second Lien Notes being redeemed. On or prior to December 8, 2019, Rosehill Operating may, at its option, redeem the Second Lien Notes in whole or in part, together with accrued and unpaid interest thereon, at a redemption price equal to 103% of the principal amount of the Second Lien Notes being redeemed plus an additional make-whole premium set forth in the Note Purchase Agreement.


20

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The Second Lien Notes may become subject to redemption under certain other circumstances, including upon the incurrence of non-permitted debt or, subject to various exceptions, reinvestments rights and prepayment or redemption rights with respect to other debt or equity of Rosehill Operating, upon an asset sale, hedge termination or casualty event. Rosehill Operating will be further required to make an offer to redeem the Second Lien Notes upon a Change in Control (as defined in the Note Purchase Agreement) at a redemption price equal to 101% of the principal amount being redeemed. Other than in connection with a change in control or casualty event, the redemption prices and make-whole premium described in the foregoing paragraph shall also apply, at such times and to the extent set forth therein, to any mandatory redemption of the Second Lien Notes or any acceleration of the Second Lien Notes prior to the stated maturity thereof upon the occurrence of an event of default.

The Note Purchase Agreement requires Rosehill Operating to maintain a leverage ratio, which is the ratio of the sum of all of Rosehill Operating’s Total Debt to Annualized EBITDAX (as such terms are defined in the Note Purchase Agreement) for the four fiscal quarters then ended, of not greater than 4.00 to 1.00.

The Note Purchase Agreement contains various affirmative and negative covenants, events of default and other terms and provisions that are based largely on the Amended and Restated Credit Agreement, with a number of important modifications reflecting the second lien nature of the Second Lien Notes and certain other terms that were agreed to with the Holders. The negative covenants may limit Rosehill Operating’s ability to, among other things, incur additional indebtedness (including under senior unsecured notes), make investments, make or declare dividends or distributions, redeem its preferred equity, acquire or dispose of oil and gas properties and other assets or engage in certain other transactions without the prior consent of the Holders, subject to various exceptions, qualifications and value thresholds. Rosehill Operating is also required to meet minimum commodity hedging levels based on its expected production on an ongoing basis.

The Company is subject to certain limited restrictions under the Note Purchase Agreement, including (without limitation) a negative pledge with respect to its equity interests in Rosehill Operating and a contingent obligation to guarantee the Second Lien Notes upon request by the Holders in the event that the Company incurs debt obligations. The obligations of Rosehill Operating under the Note Purchase Agreement are secured on a second-lien basis by the same collateral that secures its first-lien obligations. In connection with the Notes Purchase, Rosehill Operating has granted first-lien and second-lien security interests over additional collateral to meet the minimum mortgage requirements under the Note Purchase Agreement.

The Company was in compliance with the financial covenants in the Note Purchase Agreement for the measurement period ended September 30, 2018.

Deferred Financing Costs and Debt Discount

The Company capitalizes discounts and certain direct costs associated with the issuance of debt and amortizes such costs over the lives of the respective debt instruments. The Company amortized debt issuance costs and discounts of $0.4 million and less than $0.1 million for the three months ended September 30, 2018 and 2017, respectively, and $1.7 million and $0.2 million for the nine months ended September 30, 2018 and 2017, respectively. The deferred financing costs related to the Amended and Restated Credit Agreement are classified in prepaid assets and the deferred financing costs and discounts related to the Second Lien Notes are netted against the long-term debt. The following table summarizes the Company’s deferred financing costs and debt discounts:
 

21

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
 
September 30,
 
December 31,
 
 
2018
 
2017
 
 
(In thousands)
Revolving credit facility
 
 
 
 
Debt issuance costs
 
$
2,297

 
$
1,219

Accumulated amortization of debt issuance costs
 
(231
)
 
(541
)
Net deferred costs - Revolving credit facility
 
$
2,066

 
$
678

 
 
 
 
 
Second Lien Notes
 
 
 
 
Debt discount
 
$
3,000

 
$
3,000

Accumulated amortization of debt discount
 
(385
)
 
(29
)
Debt issuance costs
 
3,868

 
3,868

Accumulated amortization of debt issuance costs
 
(496
)
 
(38
)
Net deferred costs - Second Lien Notes
 
$
5,987

 
$
6,801

Total deferred financing costs and debt discount, net
 
$
8,053

 
$
7,479

 
Note 11 – 10% Series B Redeemable Preferred Stock

On December 8, 2017, in connection with the acquisition of mineral rights, royalty interest and other associated assets in the Southern Delaware Basin (the “White Wolf Acquisition”), the Company entered into a Series B Redeemable Preferred Stock Purchase Agreement (the “Series B Preferred Stock Agreement”) to issue 150,000 shares of the Company’s 10.00% Series B Redeemable Preferred Stock, par value of $0.0001 per share (the “Series B Preferred Stock”), for an aggregate purchase price of $150.0 million, less transaction costs, advisory and up-front fees of approximately $10.0 million to certain private funds and accounts managed by EIG (collectively, the “Series B Preferred Stock Purchasers”). The Company has the option, subject to certain conditions, to sell from time to time up to an additional 50,000 shares of Series B Preferred Stock, in aggregate, to the Series B Preferred Stock Purchasers and their transferees for a purchase price of $1,000 per share of Series B Preferred Stock. Such option terminates on December 8, 2018.

Holders of the Series B Preferred Stock are entitled to receive, when, as and if declared by the Board of Directors of the Company (the “Board”), cumulative dividends in cash, at a rate of 10.00% per annum on the $1,000 liquidation preference per share of Series B Preferred Stock, payable quarterly in arrears on January 15, April 15, July 15 and October 15 of each year, commencing on January 15, 2018. With respect to dividends declared for any quarter ending on or prior to January 15, 2019, the Company may elect to pay as dividends additional shares of Series B Preferred Stock in kind (the “Series B PIK Shares”) in an amount up to 40% of that which would have been payable had the dividends been fully paid in cash.

Holders of the Series B Preferred Stock have no voting rights and have limited consent rights with respect to the taking of certain corporate actions by the Company. Upon the Company’s voluntary or involuntary liquidation, winding-up or dissolution, each holder of Series B Preferred Stock will be entitled to receive the Base Return Amount (as defined in the Series B Preferred Stock Agreement) plus accrued and unpaid dividends.

The shares of Series B Preferred Stock are redeemable by the Company at the election of the holders on or after December 8, 2023, and upon certain conditions, and at any time at the Company’s option. As the holders of Series B Preferred Stock have an option to redeem the Series B Preferred Stock at a future date, the proceeds from the Series B Preferred Stock have been included in temporary, or “mezzanine” equity, between total liabilities and stockholders’ equity on the Condensed Consolidated Balance Sheets.  The Series B Preferred Stock, while not currently redeemable at the option of the holders, are considered probable of becoming redeemable and therefore will be subsequently remeasured each reporting period by accreting the initial value to the estimated redemption date of December 8, 2023 when the Series B Preferred Stock is redeemable in whole or in part at the election of the holders of Series B Preferred Stock. The accretion is presented as a deemed dividend and recorded in mezzanine equity on the Condensed Consolidated Balance Sheets and within preferred dividends on the Condensed Consolidated Statements of Operations.


22

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

In addition to the 10.00% per annum cumulative dividend holders of the Series B Preferred Stock are entitled to receive, upon redemption of the Series B Preferred Stock, such holders are guaranteed a base return on the initial 150,000 shares purchased in an amount equal to (1) $1,250 per share of Series B Preferred Stock times the number of outstanding shares of Series B Preferred Stock if the Company redeems the shares prior to the first anniversary of the date of issuance of such share of Series B Preferred Stock; (2) $1,350 per share of Series B Preferred Stock times the number of outstanding shares of Series B Preferred Stock if the Company redeems the shares on or after the first anniversary and prior to the second anniversary of the date of issuance of such share of Series B Preferred Stock; and (3) on or after the second anniversary of the date of issuance of such share of Series B Preferred Stock, the greater of (x) $1,500 per share of Series B Preferred Stock and (y) an amount necessary to achieve a 16% internal rate of return (“IRR”) (the “Base Return Amount”) with respect to such shares of Series B Preferred Stock. Since the Series B Preferred Stock can be redeemed by the holders on or after December 23, 2023 and management has no plans to redeem before that date, the Company has accrued a guaranteed return amount in order to achieve the 16% IRR.

In the event of a change of control, the Company shall redeem in cash all of the outstanding shares of Series B Preferred Stock, excluding Series B PIK Shares, for a price per share equal to the Base Return Amount and all Series B PIK Shares at the purchase price of $1,000 per share. The Company assessed the change of control feature and determined that the redemption of the outstanding shares of Series B Preferred Stock, excluding Series B PIK Shares, for a price per share equal to the Base Return Amount was an embedded derivative that requires bifurcation and shall be accounted for at fair value. The Company measured the derivative liability and recorded a discount of $0.6 million upon initial measurement.

The Company reflected the following in mezzanine equity for the Series B Preferred Stock as of September 30, 2018:

 
Series B Preferred Shares
 
 Series B Preferred Stock
 
Guaranteed Return
 
Total
 
(In thousands, except share data)
December 31, 2017
150,626

 
$
140,158

 
$
710

 
$
140,868

Return (16% IRR)

 

 
16,510

 
16,510

Dividends declared and paid or payable in cash

 

 
(6,827
)
 
(6,827
)
Dividends declared and paid-in-kind
4,554

 
4,554

 
(4,554
)
 

Accretion of discount - deemed dividend

 
984

 

 
984

September 30, 2018
155,180

 
$
145,696

 
$
5,839

 
$
151,535


Note 12 – Income Taxes
 
In 2017, the Company became the sole managing member of Rosehill Operating, the Company’s accounting predecessor. Rosehill Operating is a limited liability company that is treated as a partnership for U.S. federal income tax purposes and is not subject to U.S. federal income tax. Any taxable income or loss generated by Rosehill Operating is passed through to and included in the taxable income or loss of its members, including the Company. The Company is a C corporation and is subject to U.S. federal income tax and state and local income taxes.

On December 22, 2017, the U.S. government enacted comprehensive tax legislation through Public Law No. 115-97, commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The provisions of the Tax Act that impact the Company include, but are not limited to, (1) reducing the U.S. federal corporate income tax rate from 35% to 21%; (2) eliminating the corporate alternative minimum tax (“AMT”); (3) allowing businesses to immediately expense the cost of new investments in certain qualified depreciable assets acquired after September 27, 2017 (with a phase-down of such expensing starting in 2023), (4) reducing the maximum deduction for net operating loss (“NOL”) carryforwards generated in tax years beginning after December 31, 2017, to 80% of a taxpayer’s taxable income and (5) imposing additional limits on future deductibility of interest expense and certain executive compensation.

The Company remeasured its deferred tax assets and liabilities at December 31, 2017 using the lower 21% rate, resulting in a decrease in net deferred tax assets and its valuation allowance. Aside from the reduction to the U.S. federal corporate income tax rate, the Tax Act is not expected to have a significant current impact to the Company. The ultimate impact of the Tax Act may differ from the Company’s estimates due to changes in interpretations or assumptions, as well as additional regulatory guidance that may be issued. The Company has not made any further adjustments to its deferred tax assets and liabilities since recording the effects of the tax rate change during the year ended December 31, 2017.

23

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


The Company’s income tax provision was an expense of $22.9 million and a benefit of $0.9 million for the three months ended September 30, 2018 and 2017, respectively, and an expense of $5.5 million and a benefit of $0.7 million for the nine months ended September 30, 2018 and 2017, respectively. The Company’s effective tax rate was 37% and 7% for the three and nine months ended September 30, 2018, respectively. The effective tax rate differs from the enacted statutory rate of 21% for the three and nine months ended September 30, 2018 primarily due to the allocation of profits and losses to Rosehill and the noncontrolling interest holder in accordance with the LLC Agreement, and the impact of state income taxes.

As of September 30, 2018, the Company had approximately $33.4 million of U.S. federal net operating loss carryovers, which will begin to expire in 2035. The Company periodically assesses whether it is more likely than not that it will generate sufficient taxable income to realize its deferred tax assets, including NOL carry forwards. A valuation allowance for deferred tax assets is recognized when it is more likely than not that some or all of the benefit from the deferred tax asset will not be realized. As of September 30, 2018, we have a valuation allowance of $2.9 million. In making this determination, the Company considers all available positive and negative evidence and makes certain assumptions. The Company considers, among other things, its deferred tax liabilities, the overall business environment, its historical earnings and losses, current industry trends, and its outlook for future years.

Upon closing the Transaction, the Company acquired a portion of the Rosehill Operating Common Units, and a deferred tax asset was recorded relating to the outside basis difference of its investment in Rosehill Operating for $5.7 million with an offsetting effect recorded in additional paid in capital. Due to uncertainties relating to the realization of the deferred tax asset, the Company recorded a full valuation allowance with an offsetting effect recorded in additional paid in capital. During the year ended December 31, 2017, the subsequent recognition of tax benefits resulted in a partial reduction of the valuation allowance of $1.5 million, with an offsetting effect recorded in additional paid in capital. Section 382 of the Internal Revenue Code of 1986, as amended (“IRC”), addresses company ownership changes and specifically limits the utilization of tax benefits generated prior to the Transaction following an ownership change. Upon closing of the Transaction, the Company believes it experienced an ownership change within the meaning of IRC Section 382 and recorded a valuation allowance of $0.2 million and an offsetting effect in additional paid in capital to fully offset these tax benefits.

The Company is subject to the following material taxing jurisdictions: the United States, Texas and New Mexico. As of September 30, 2018, the Company has no current tax years under audit. The Company remains subject to examination for federal income taxes and state income taxes for tax years 2015 through 2017.

The Company has evaluated all tax positions for which the statute of limitations remains open and believes that the material positions taken would more likely than not be sustained upon examination. Therefore, as of September 30, 2018, the Company had not established any reserves for, nor recorded any unrecognized benefits related to, uncertain tax positions. The Company’s policy is to recognize interest and penalties related to uncertain tax positions in income tax expense.

Tax Receivable Agreement

In connection with the Transaction, the Company entered into a tax receivable agreement (“Tax Receivable Agreement”) with the noncontrolling interest holder, Tema. The Tax Receivable Agreement provides that the Company will pay to Tema 90% of the net cash savings, if any, in U.S. federal, state and local income tax that the Company realizes (or is deemed to realize in certain circumstances) in periods beginning with and after the closing of the Transaction as a result of the following: (i) any tax basis increases in the assets of Rosehill Operating resulting from the distribution to Tema of the Cash Consideration, the shares of Class B Common Stock and the Tema warrants, all in connection with the Transaction, and resulting from the assumption of Tema liabilities in connection with the Transaction, (ii) the tax basis increases in the assets of Rosehill Operating resulting from a redemption by Rosehill Operating with respect to Tema and (iii) imputed interest deemed to be paid by the Company as a result of, and additional tax basis arising from, payments it makes under the Tax Receivable Agreement.


24

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The estimation of liability under the Tax Receivable Agreement is by its nature imprecise and subject to significant assumptions regarding the amount and timing of future taxable income. As of September 30, 2018, the Company’s preliminary estimate of the Tax Receivable Agreement liability resulting from the distribution of the Cash Consideration to Tema in connection with the Transaction was approximately $50.4 million. However, the Company has not been able to determine that future payments under the Tax Receivable Agreement are likely to occur and therefore has concluded that no recognizable Tax Receivable Agreement liability has been incurred. To the extent the Company realizes tax benefits in future years, or in the event of a change in future tax rates, this liability may change. The Company does not anticipate it will realize cash savings on its 2018 tax return as a result of tax attributes arising from the Transaction, however, it may record a liability in future periods if a payment under the Tax Receivable Agreement is anticipated for the 2018 tax year.

The Tax Receivable Agreement liability is recorded based upon projected tax savings, and the actual amount and timing of payments will depend upon a number of factors, including the amount and timing of taxable income generated in the future, changes in future tax rates, the use of loss carryovers, and the portion of the Company’s payments constituting imputed interest. If and when Tema exercises its right to cause the Company to redeem all or a portion of its Rosehill Operating Common Units, a liability under the Tax Receivable Agreement relating to such redemption will be recorded. The amount of liability will be based on 90% of the estimated future cash tax savings that the Company will realize as a result of increases in the basis of Rosehill Operating’s assets attributed to the Company resulting from such redemption. The amount of the increase in asset basis, the related estimated cash tax savings and the attendant Tax Receivable Agreement liability will depend, in part, on the price of the Class A Common Stock at the time of the relevant redemption. Due to the uncertainty surrounding the amount and timing of future redemptions of Rosehill Operating Common Units by Tema, the Company does not believe it is appropriate to record additional Tax Receivable Agreement liability until such time that Rosehill Operating Common Units are redeemed for shares of Class A Common Stock or cash.  

Note 13 – Stockholders’ Equity
 
Class A Common Stock. Holders of the Company’s Class A Common Stock are entitled to one vote for each share held on all matters to be voted on by the stockholders. Holders of the Class A Common Stock and holders of the Class B Common Stock voting together as a single class have the exclusive right to vote for the election of directors and on all other matters properly submitted to a vote of the stockholders. Additionally, the Sponsor and Tema agreed to restrictions on certain transfers of the Company’s securities, which include, subject to certain exceptions, restrictions on the transfer of (i) 33% of their common stock through the first anniversary of the closing date of the Transaction, which restrictions lapsed on April 27, 2018, and (ii) 67% of their common stock through the second anniversary of the closing date, provided that sales of common stock above $18.00 per share will be permitted between the first and second anniversaries of the closing date of the Transaction. Further, in connection with underwritten offerings by the Sponsor and Tema, and subject to certain conditions, sales of common stock at a price reasonably expected to equal or exceed $18.00 per share and in any case equal to or in excess of $16.00 per share will be permitted.

Class B Common Stock. Shares of Class B Common Stock may be issued only to Tema, their respective successors and assignees, as well as any permitted transferees of Tema. A holder of Class B Common Stock may transfer shares of Class B Common Stock to any transferee (other than the Company) only if such holder also simultaneously transfers an equal number of such holder’s Rosehill Operating Common Units to such transferee in compliance with the LLC Agreement. Holders of the Company’s Class B Common Stock will vote together as a single class with holders of the Company’s Class A Common Stock on all matters properly submitted to a vote of the stockholders.

 Holders of Class B Common Stock generally have the right to cause the Company to redeem all or a portion of their Rosehill Operating Common Units in exchange for shares of the Company’s Class A Common Stock on a one-to-one basis or, at the Company’s option, an equivalent amount of cash. The Company may, however, at its option, affect a direct exchange of cash or Class A Common Stock for such Rosehill Operating Common Units in lieu of such a redemption. Upon the future redemption or exchange of Rosehill Operating Common Units, a corresponding number of shares of Class B Common Stock will be canceled.
 
In the Transaction, the Company issued to Rosehill Operating 29,807,692 shares of its Class B Common Stock and 4,000,000 warrants exercisable for shares of its Class A Common Stock in exchange for 4,000,000 warrants exercisable for Rosehill Operating Common Units. Rosehill Operating immediately distributed the warrants and shares of Class B Common Stock to Tema.
 

25

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Class F Common Stock. Upon the completion of the Transaction in April 2017, all of the outstanding Class F Common Stock (the “Founder Shares”) were automatically converted into 3,475,665 shares of Class A Common Stock in connection with the Transaction. As used herein, unless the context otherwise requires, the Founder Shares are deemed to include the shares of Class A Common Stock issued upon conversion of the Founder Shares and such converted shares continue to be subject to certain transfer restrictions. 
 
8% Series A Cumulative Perpetual Convertible Preferred Stock. Each share of Series A Preferred Stock has a liquidation preference of $1,000 per share and is convertible, at the holder’s option at any time, initially into 86.9565 shares of the Company’s Class A Common Stock (which is equivalent to an initial conversion price of approximately $11.50 per share of Class A Common Stock), subject to specified adjustments and limitations as set forth in the Certificate of Designations of Series A Preferred Stock (the “Certificate of Designations”). Under certain circumstances, the Company will increase the conversion rate upon a “fundamental change” as described in the Certificate of Designations.
 
The Company contributed the net proceeds of $70.8 million from its issuance of 75,000 shares of Series A Preferred Stock and 5,000,000 warrants exercisable for shares of Class A Common Stock to Rosehill Operating. In connection with the issuance of the Series A Preferred Stock, the Sponsor transferred 476,540 shares of its Class A Common Stock to the PIPE Investors to consummate the Transaction. The net proceeds from the issuance of these shares of Series A Preferred Stock and warrants was attributed to the Series A Preferred Stock, warrants and Class A Common Stock contributed by the Sponsor to the PIPE Investors based on the relative fair value of those securities using, among other factors, the closing price of the Class A Common Stock and the closing price of the warrants on April 27, 2017.

Rosemore and the Sponsor backstopped redemptions by the public stockholders of the Company once 30% of the outstanding shares of Class A Common Stock were redeemed by purchasing 20,000 shares of Series A Preferred Stock for net proceeds of $20 million pursuant to a side letter entered into between Rosemore, the Sponsor and the Company. The Company contributed to Rosehill Operating the net proceeds from the issuance of 20,000 shares of Series A Preferred Stock to Rosemore Holdings, Inc. and the Sponsor.

Upon issuance of the Series A Preferred Stock in April 2017, the nondetachable conversion option embedded in the Series A Preferred Stock was evaluated pursuant to ASC 470-20 and the Company determined that a beneficial conversion feature existed as of the closing date of the Transaction. The beneficial conversion feature was recognized separately from the Series A Preferred Stock in the Company’s condensed consolidated financial statements. The Company recognized in additional paid-in-capital, with an offsetting reduction in the carrying amount of the Series A Preferred Stock, the value of the beneficial conversion feature at the commitment date of $6.7 million. Since the Company’s Series A Preferred Stock is perpetual and has no stated maturity date and no restrictions on conversion, the value attributable to the nondetachable conversion option was recognized immediately as a non-cash deemed dividend on the date that the Series A Preferred Stock was issued. Future issuances of Series A Preferred Stock resulting from dividends paid-in-kind may, depending on the trading price per share of the Company’s Class A Common Stock on the dividend date, contain a beneficial conversion option determined on the same basis as described above and, thus, result in additional non-cash deemed dividends which will reduce net income attributable to Rosehill Resources, Inc. common stockholders when such paid-in-kind shares of Series A Preferred Stock are granted.

The Company also ratably recognizes additional non-cash deemed dividends attributable to the Series A Preferred Stock discount which was created by the issuance of the warrants exercisable for shares of Class A Common Stock and the contribution of the Class A Common Stock, as the Series A Preferred Stock which was sold to the PIPE Investors is converted. Also, upon Series A Preferred Stock conversions, non-cash deemed dividends will be recognized and will reduce net income attributable to Rosehill Resources Inc, common stockholders.

The table below summarizes the Series A Preferred Stock dividends reflected in the Company’s Condensed Consolidated Statements of Operations for the nine months ended September 30, 2018 (in thousands):

Series A Preferred Stock paid-in-kind
$
2,955

Series A Preferred Stock paid or payable in cash
2,952

Series A Preferred Stock dividends
$
5,907



26

ROSEHILL RESOURCES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Warrants. Each of the Company’s warrants entitles the registered holder to purchase one share of the Company’s Class A Common Stock at a price of $11.50 per share, subject to adjustment pursuant to the terms of the warrant agreement. The warrants have a five-year term which commenced on April 27, 2017, upon the completion of the Transaction, and will expire on April 27, 2022. The Company may call the warrants for redemption if the reported last sale price of the Class A Common Stock equals or exceeds $21.00 per share for any 20 trading days within a 30-trading day period ending on the third trading day prior to the date the Company sends the notice of redemption to the warrant holders.
 
There were 588,276 warrants issued in connection with the formation of the Company and 7,597,044 public warrants (the “Public Warrants”) issued in connection with KLRE’s initial public offering. Additionally, there were 8,408,838 warrants issued to the Sponsor and EarlyBirdCapital Inc. pursuant to a private placement (the “Private Placement Warrants”) in connection with the Company’s initial public offering. The Private Placement Warrants are not redeemable by the Company and are exercisable on a cashless basis so long as they are held by the initial holders or their permitted transferees. Otherwise, the Private Placement Warrants have terms and provisions that are identical to those of the warrants described above. If the Private Placement Warrants are held by holders other than the initial holders or their permitted transferees, the Private Placement Warrants will be redeemable by the Company and exercisable by the holders on the same basis as the warrants described above.
 
In connection with the closing of the Transaction, the Company issued 5,000,000 warrants to the PIPE Investors and 4,000,000 warrants to Tema. These warrants were issued on the same terms, and are subject to the same rights and obligations, as described above.
 
As of September 30, 2018, there were 25,594,158 warrants exercisable for shares of Class A Common Stock outstanding at a price of $11.50. All warrants expire on April 27, 2022.
 
Noncontrolling Interest. Noncontrolling interest represents the membership interest held by holders other than the Company. On April 27, 2017, upon the closing of the Transaction, the noncontrolling interest in Rosehill Operating, held by Tema, was approximately 83.6%. The Company has consolidated the financial position and results of operations of Rosehill Operating and reflected the proportionate interest held by Tema as a noncontrolling interest. The noncontrolling interest will change when shares of Series A Preferred Stock are converted into shares of Class A Common Stock, when shares of Class A Common Stock are issued in connection with the Company’s Long-Term Incentive Compensation plan and when Tema elects to exchange the Class B Common Stock received in connection with the transaction for shares of Class A Common Stock. At September 30, 2018, Tema held an approximate 81.6% noncontrolling interest in Rosehill Operating.