10-Q 1 ten-q.txt TEN-Q.TXT SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------- FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended December 31, 2004 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period ended Commission file number: 0-10990 CASTLE ENERGY CORPORATION ------------------------------------------------------ (Exact Name of Registrant as Specified in its Charter) Delaware 76-0035225 ------------------------------- ------------------------------------ (State or Other Jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 357 South Gulph Road, Suite 260, King of Prussia, Pennsylvania 19406 -------------------------------------------------------------- ---------- (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code (610) 992-9900 ---------------------------------------------------- (Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report) Indicate by check [X] whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days Yes [X] No [ ]. Indicate by check [X] whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act) Yes [ ] No [X]. Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date: 6,990,384 shares of Common Stock, $.50 par value, outstanding as of February 7, 2005. CASTLE ENERGY CORPORATION INDEX
PAGE # ------ Part I. Financial Information Item 1. Financial Statements: Consolidated Balance Sheets - December 31, 2004 (Unaudited) and September 30, 2004............................................................... 2 Consolidated Statements of Operations - Three Months Ended December 31, 2004 and 2003 (Unaudited)........................................... 3 Condensed Consolidated Statements of Cash Flows - Three Months Ended December 31, 2004 and 2003 (Unaudited)........................................... 4 Consolidated Statements of Stockholders' Equity and Other Comprehensive Income - Year Ended September 30, 2004 and Three Months Ended December 31, 2004 (Unaudited)................................................... 5 Notes to the Consolidated Financial Statements (Unaudited)...................... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations...................................................................... 17 Item 3. Qualitative and Quantitative Disclosures About Market Risk...................... 21 Item 4. Controls and Procedures......................................................... 21 Part II. Other Information Item 1. Legal Proceedings............................................................... 22 Item 6. Exhibits and Reports on 8-K..................................................... 22 Signature........................................................................................... 23
-1- PART I. FINANCIAL INFORMATION Item 1. Financial Statements CASTLE ENERGY CORPORATION CONSOLIDATED BALANCE SHEETS ("$000'S" OMITTED EXCEPT SHARE AMOUNTS)
DECEMBER 31, SEPTEMBER 30, 2004 2004 ------------- ------------- (UNAUDITED) ASSETS Current assets: Cash and cash equivalents .................................................... $ 33,103 $ 33,742 Restricted cash .............................................................. 120 120 Accounts receivable .......................................................... 727 582 Account receivable - Delta Petroleum Corporation ............................. 339 Marketable securities ........................................................ 19 19 Prepaid expenses and other current assets .................................... 142 203 Note receivable - Networked Energy LLC, net of allowance for doubtful account of $126 .................................................... ------------- ------------- Total current assets ..................................................... 34,111 35,005 Property, plant and equipment, net: Furniture, fixtures, equipment and vehicles .................................. 186 111 Oil and gas properties, net (full cost method): Proved properties .......................................................... 8,902 9,012 Unproved properties not being amortized .................................... Investment in Networked Energy LLC, net of impairment reserve of $354 .......... Investment in Delta Petroleum Corporation ...................................... 41,120 39,698 ------------- ------------- Total assets ............................................................... $ 84,319 $ 83,826 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Dividend payable ............................................................. $ 346 $ 343 Accounts payable ............................................................. 298 749 Accrued expenses ............................................................. 134 906 Contingent note payable to Dominion Oklahoma Texas Exploration and Production, Inc. ............................................................ 807 Accrued taxes on appreciation of marketable securities ....................... 1 1 Asset retirement obligations ................................................. 3 3 ------------- ------------- Total current liabilities .................................................. 1,589 2,002 Net refining liabilities retained .............................................. 2,155 2,404 Asset retirement obligations ................................................... 241 227 Deferred income taxes .......................................................... 5,503 5,170 Other liabilities .............................................................. 37 19 ------------- ------------- Total liabilities .......................................................... 9,525 9,822 ------------- ------------- Commitments and contingencies .................................................. Stockholders' equity: Series B participating preferred stock; par value - $1.00; 10,000,000 shares authorized; no shares issued Common stock; par value - $0.50; 25,000,000 shares authorized; 11,826,404 shares issued at December 31, 2004 and 11,781,404 shares issued at September 30, 2004 .......................................................... 5,914 5,891 Additional paid-in capital ................................................... 86,341 85,691 Accumulated other comprehensive income, net of taxes ......................... 288 170 Retained earnings ............................................................ 48,918 48,919 ------------- ------------- 141,461 140,671 Treasury stock at cost - 4,911,020 shares at December 31, 2004 and September 30, 2004 .......................................................... (66,667) (66,667) ------------- ------------- Total stockholders' equity.................................................. 74,794 74,004 ------------- ------------- Total liabilities and stockholders' equity ................................. $ 84,319 $ 83,826 ============= =============
The accompanying notes are an integral part of these consolidated financial statements -2- CASTLE ENERGY CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS ("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS) (UNAUDITED)
THREE MONTHS ENDED DECEMBER 31, -------------------------- 2004 2003 ----------- ----------- Revenue: Oil and gas sales .................................................... $ 699 ----------- 699 ----------- Expenses: Oil and gas production ............................................... 95 General and administrative ........................................... 943 $ 1,239 Depreciation, depletion and amortization ............................. 129 12 ----------- ----------- 1,167 1,251 ----------- ----------- Operating income (loss) ................................................ (468) (1,251) ----------- ----------- Other income (expense): Interest income ...................................................... 140 36 Other income ......................................................... 9 Equity in income of Delta Petroleum Corporation ...................... 842 260 ----------- ----------- 991 296 ----------- ----------- Income (loss) before provision for (benefit of) income taxes ........... 523 (955) ----------- ----------- Provision for (benefit of) income taxes: State ................................................................ 5 9 Federal .............................................................. 175 284 ----------- ----------- 180 293 ----------- ----------- Net income (loss) ...................................................... $ 343 $ (1,248) =========== =========== Net income (loss) per share: Basic ................................................................ $ .05 $ (.19) =========== =========== Diluted .............................................................. $ .05 $ (.19) =========== =========== Weighted average number of common and potential dilutive common shares outstanding: Basic ................................................................ 6,892,389 6,592,884 =========== =========== Diluted .............................................................. 7,114,870 6,592,884 =========== ===========
The accompanying notes are an integral part of these consolidated financial statements -3- CASTLE ENERGY CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS ("000'S" OMITTED) (UNAUDITED)
THREE MONTHS ENDED DECEMBER 31, -------------------------- 2004 2003 ----------- ----------- Cash flows from (used in) operating activities ......................... $ (575) $ (1,173) ----------- ----------- Cash flows from investing activities: Purchase of furniture, fixture, equipment and vehicles ............... (85) ----------- ----------- Net cash provided by (used in) investing activities ................ (85) ----------- ----------- Cash flows from financing activities: Proceeds from exercise of stock options .............................. 364 Dividends paid to stockholders ....................................... (343) (330) ----------- ----------- Net cash provided by (used in) financing activities ................ 21 (330) ----------- ----------- Net increase (decrease) in cash and cash equivalents ................... (639) (1,503) Cash and cash equivalents - beginning of period ........................ 33,742 10,615 ----------- ----------- Cash and cash equivalents - end of period .............................. $ 33,103 $ 9,112 =========== ===========
The accompanying notes are an integral part of these consolidated financial statements -4- CASTLE ENERGY CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND OTHER COMPREHENSIVE INCOME ("$000'S" OMITTED EXCEPT PER SHARE AMOUNTS)
YEAR ENDED SEPTEMBER 30, 2004 AND THREE MONTHS ENDED DECEMBER 31, 2004 (UNAUDITED) -------------------------------------------------------------------------- ACCUMULATED COMMON STOCK ADDITIONAL OTHER --------------------------- PAID-IN COMPREHENSIVE COMPREHENSIVE SHARES AMOUNT CAPITAL INCOME INCOME(LOSS) ------------ ------------ ------------ ------------- ------------- Balance -October 1, 2003 ......................... 11,503,904 $ 5,752 $ 68,532 $ 1,383 Options exercised ................................ 277,500 139 1,232 Tax benefit of options exercised ................. 468 Issuance of additional stock by Delta Petroleum Corporation, net of $4,595 tax ...................................... 15,459 Dividends declared ($.20 per share) .............. Comprehensive income (loss): Net income (loss) .............................. $ 13,620 Other comprehensive income (loss): Reclassification adjustment, net of $649 tax .................................... (1,153) (1,153) Equity in other comprehensive income (loss) of Delta Petroleum Corporation, net of $32 tax benefit ......... (60) (60) ------------ ------------ ------------ ------------- ------------- $ 12,407 ============= Balance - September 30, 2004 ..................... 11,781,404 5,891 85,691 170 Options exercised ................................ 45,000 23 341 Tax benefit of options exercised ................. 56 Issuance of additional stock by Delta Petroleum Corporation, net of $142 tax .... 253 Dividends declared ($.05 per share) .............. Comprehensive income (loss): Net income (loss) .............................. $ 343 Other comprehensive income (loss): Equity in other comprehensive income (loss) of Delta Petroleum Corporation, net of $67 tax benefit ......... 118 118 ------------ ------------ ------------ ------------- ------------- $ 461 ============= Balance - December 31, 2004 ...................... 11,826,404 $ 5,914 $ 86,341 $ 288 ============ ============ ============ ============= YEAR ENDED SEPTEMBER 30, 2004 AND THREE MONTHS ENDED DECEMBER 31, 2004 (UNAUDITED) ----------------------------------------------------------- TREASURY STOCK RETAINED --------------------------- EARNINGS SHARES AMOUNT TOTAL ------------ ------------ ------------ ------------ Balance -October 1, 2003 ......................... $ 36,643 4,911,020 $ (66,667) $ 45,643 Options exercised ................................ 1,371 Tax benefit of options exercised ................. 468 Issuance of additional stock by Delta Petroleum Corporation, net of $4,595 tax ...................................... 15,459 Dividends declared ($.20 per share) .............. (1,344) (1,344) Comprehensive income (loss): Net income (loss) .............................. 13,620 13,620 Other comprehensive income (loss): Reclassification adjustment, net of $649 tax .................................... (1,153) Equity in other comprehensive income (loss) of Delta Petroleum Corporation, net of $32 tax benefit ......... (60) ------------ ------------ ------------ ------------ Balance - September 30, 2004 ..................... 48,919 4,911,020 (66,667) 74,004 Options exercised ................................ 364 Tax benefit of options exercised ................. 56 Issuance of additional stock by Delta Petroleum Corporation, net of $142 tax .... 253 Dividends declared ($.05 per share) .............. (344) (344) Comprehensive income (loss): Net income (loss) .............................. 343 343 Other comprehensive income (loss): Equity in other comprehensive income (loss) of Delta Petroleum Corporation, net of $67 tax benefit ......... 118 ------------ ------------ ------------ ------------ Balance - December 31, 2004 ...................... $ 48,918 4,911,020 $ (66,667) $ 74,794 ============ ============ ============ ============
The accompanying notes are an integral part of these consolidated financial statements -5- CASTLE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ("$000'S" OMITTED EXCEPT SHARE AMOUNTS) (UNAUDITED) Note 1 - Basis of Preparation The unaudited consolidated financial statements of Castle Energy Corporation (the "Company") included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain reclassifications have been made, where applicable, to make the periods presented comparable. Although certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations, the Company believes that the disclosures included herein are adequate to make the information presented not misleading. Operating results for the three month period ended December 31, 2004 are not necessarily indicative of the results that may be expected for the fiscal year ending September 30, 2005 or for subsequent periods. These unaudited consolidated financial statements should be read in conjunction with the financial statements and the notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2004. In the opinion of the Company, the unaudited consolidated financial statements contain all adjustments necessary for a fair statement of the results of operations for the three month periods ended December 31, 2004 and 2003 and for a fair statement of financial position at December 31, 2004. Note 2 - September 30, 2004 Balance Sheet The amounts presented in the balance sheet as of September 30, 2004 were derived from the Company's audited consolidated financial statements which were included in its Annual Report on Form 10-K for the fiscal year ended September 30, 2004. Note 3 - Discontinued Operations From August 1989 to September 30, 1995, several of the Company's subsidiaries conducted refining operations. By December 12, 1995, the Company's refining subsidiaries had sold all of their refining assets and the purchasers had assumed all related liabilities, including contingent environmental liabilities. The Company's refining subsidiaries own no refining assets, have been inactive for over eight years and are in the process of liquidation. As a result, the Company has accounted for its refining operations as discontinued operations. Such discontinued refining operations have not impacted the Company's operations since September 30, 1995, although they may impact the Company's future operations. Net refining liabilities retained represent the remaining liabilities from discontinued refining operations. Such amounts remain on the consolidated balance sheet pending final resolution. Note 4 - Environmental Liabilities/Litigation ChevronTexaco Litigation On August 13, 2002, three subsidiaries of ChevronTexaco filed Cause No. 02-4162-JPG in the United States District Court for the Southern District of Illinois against the Company, as well as against two inactive subsidiaries of the Company and three unrelated parties. The lawsuit seeks damages and declaratory relief under contractual and statutory claims arising from environmental damage at the now dismantled Indian Refinery. In particular, the lawsuit claims that the Company is contractually obligated to indemnify and defend ChevronTexaco against all liability and costs, including lawsuits, claims and administrative actions initiated by the United States Environmental Protection Agency ("EPA") and others, that ChevronTexaco has incurred or will incur as a result of environmental contamination at and around the Indian Refinery, even if that environmental contamination was caused by Texaco, Inc. and its present and former subsidiaries ("Texaco" - now merged into ChevronTexaco) which previously owned the refinery for over 75 years. The suit -6- CASTLE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ("$000'S" OMITTED EXCEPT SHARE AMOUNTS) (UNAUDITED) also seeks costs, damages and declaratory relief against the Company under the Federal Comprehensive Environmental Response Compensation Liability Act ("CERCLA"), the Oil Pollution Act of 1990 ("OPA") and the Solid Waste Disposal Act, as amended, ("RCRA"). History In December 1995, Indian Refining Limited Partnership, an inactive refining subsidiary of the Company ("IRLP") sold its refinery, the Indian Refinery, to American Western Refining L.P. ("American Western"), an unaffiliated party. As part of the related purchase and sale agreement, American Western assumed all environmental liabilities and indemnified IRLP with respect thereto. Subsequently, American Western filed for bankruptcy and sold large portions of the Indian Refinery to an outside party pursuant to a bankruptcy proceeding. The outside party has substantially dismantled the Indian Refinery. American Western filed a liquidation plan in 2001. American Western anticipated that the liquidation plan would be confirmed in January 2002 but confirmation was delayed primarily because of legal challenges by Texaco, and subsequently ChevronTexaco. American Western's liquidation plan was confirmed in April 2003. In the plan, IRLP reduced a $5,400 secured claim against American Western to $800. In exchange the EPA and Illinois EPA entered into an Agreement and Covenant Not to Sue with IRLP, which extinguished all CERCLA claims against IRLP. Under the American Western liquidation plan, IRLP received $599 which it distributed to its creditors. During fiscal 1998, the Company was informed that the EPA had investigated offsite acid sludge waste found near the Indian Refinery and had investigated and remediated surface contamination on the Indian Refinery property. Neither the Company nor IRLP was initially named with respect to these two actions. In October 1998, the EPA named the Company and two of its inactive refining subsidiaries as potentially responsible parties for the expected clean-up of an area of approximately 1,000 acres, which the EPA later designated as the Indian Refinery-Texaco Lawrenceville Superfund Site. In addition, eighteen other parties were named including Texaco and a subsidiary of Texaco which had owned the refinery until December of 1988. The Company subsequently responded to the EPA indicating that it was neither the owner nor the operator of the Indian Refinery and thus not responsible for its remediation. In November 1999, the Company received a request for information from the EPA concerning the Company's involvement in the ownership and operation of the Indian Refinery. The Company responded to the EPA information request in January 2000. Claims by Texaco On August 7, 2000, the Company received notice of a claim against it and two of its inactive refining subsidiaries from Texaco. Texaco had made no previous claims against the Company although the Company's subsidiaries had owned the refinery from August 1989 until December 1995. In its claim, Texaco demanded that the Company and its former subsidiaries indemnify Texaco for all liability resulting from environmental contamination at and around the Indian Refinery. In addition, Texaco demanded that the Company assume Texaco's defense in all matters relating to environmental contamination at and around the Indian Refinery, including lawsuits, claims and administrative actions initiated by the EPA, and indemnify Texaco for costs that Texaco had already incurred addressing environmental contamination at the Indian Refinery. Finally, Texaco also claimed that the Company and two of its inactive subsidiaries were liable to Texaco under the CERCLA as owners and operators of the Indian Refinery. The Company responded to Texaco disputing the factual and legal contentions for Texaco's claims against the Company. The Company's management and special counsel subsequently met with representatives of Texaco but the parties disagreed concerning Texaco's claims. In October 2001, Texaco merged with Chevron and the merged company was named ChevronTexaco. In May 2002, the Company received a letter from ChevronTexaco which asserted a new claim against the Company and its subsidiaries pursuant to OPA -7- CASTLE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ("$000'S" OMITTED EXCEPT SHARE AMOUNTS) (UNAUDITED) for costs and damages incurred or to be incurred by ChevronTexaco resulting from actual or threatened discharges of oil to navigable waters at or near the Indian Refinery. ChevronTexaco estimated these costs and damages to be $20,500. The Company subsequently corresponded with ChevronTexaco and voluntarily provided a number of documents requested by ChevronTexaco. In June 2002, ChevronTexaco indicated to the Company that ChevronTexaco did not intend to sue the Company. Subsequently, ChevronTexaco requested additional documents from the Company, which the Company promptly and voluntarily again supplied to ChevronTexaco. In August 2002, the Company's management and special counsel met with legal and management representatives of ChevronTexaco in an effort to resolve outstanding issues. At the meeting a special outside counsel of ChevronTexaco asserted claims against the Company based upon newly expressed legal theories. ChevronTexaco also informed the Company that residential landowners adjacent to the Indian Refinery site had recently filed a toxic torts suit against ChevronTexaco in Illinois state court. The meeting ended in an impasse. Litigation On August 13, 2002, ChevronTexaco filed the above litigation in federal court. By letter dated August 28, 2002, ChevronTexaco tendered the Illinois state court litigation to the Company for indemnification, but the Company promptly responded, denying responsibility. Following the initiation of litigation the Company retained Bryan Cave LLP as trial counsel. On October 25, 2002, the Company filed motions to dismiss as a matter of law the contractual claims in Texaco's complaint, as well as the OPA and RCRA claims. At the same time, the Company filed its answer to ChevronTexaco's lawsuit on the remaining CERCLA claim. A pre-trial scheduling conference was held May 5, 2003 and on May 8, 2003 two unrelated defendants were dismissed from the case with prejudice under a stipulation with ChevronTexaco on undisclosed terms. On June 2, 2003, the Federal District Court denied the Company's motions to dismiss, following which, on July 9, 2003, the Company filed answers to the contractual, OPA and RCRA claims. The parties are currently conducting discovery and depositions. The Company is awaiting a rescheduling of the presumptive trial date for this case from the Federal District Court caused by the court's crowded criminal docket. The Company expects to pursue motions for summary judgment prior to trial. The central argument to both ChevronTexaco's contractual and statutory claims is that the Company should be treated as a "successor" and "alter ego" of certain of its present and former subsidiaries, and thereby should be held directly liable for ChevronTexaco's claims against those entities. ChevronTexaco makes this argument notwithstanding the fact that the Company never directly owned the refinery and never was a party to any of the disputed contracts. ChevronTexaco has also claimed that the Company itself directly operated the refinery. The leading opinion in this area of the law, as issued by the U.S. Supreme Court in June 1998 in the comparable matter of United States v. Bestfoods, 524 U.S. 51, 118 S.Ct. 1876 (1998), supports the Company's positions. Estimated gross undiscounted clean-up costs for this refinery are at least $80,000-$150,000 according to public statements by Texaco to the Company and third parties. In January 2003, the United States and the State of Illinois filed a motion in the American Western bankruptcy case which stated that the estimated total response costs for one portion of the site alone could range from $109,000 to $205,000. ChevronTexaco has asserted in its contractual claim that the Company should indemnify ChevronTexaco for all environmental liabilities related to the Indian Refinery. If ChevronTexaco were to prevail on this theory, the Company could be held liable for the entirety of the estimated -8- CASTLE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ("$000'S" OMITTED EXCEPT SHARE AMOUNTS) (UNAUDITED) clean up costs, a sum far in excess of the Company's financial capability. On the other hand, if the Company were found liable by reason of ChevronTexaco's statutory claims for contribution and reimbursement under CERCLA and/or OPA, the Company could be required to pay a percentage of the clean-up costs based on equitable allocation factors such as comparative time of ownership and operation, toxicity and amount of hazardous materials released, remediation funded to date, as well as other factors. Since the Company's subsidiary only operated the Indian Refinery five years, whereas Texaco operated it over seventy-five years, the Company would expect that its share of remediation liability would at a minimum be reduced to an amount proportional to the years of operation by its subsidiary, although such may not be the case. Additionally, since Texaco and its subsidiaries intentionally disposed of hazardous wastes on site at the Indian Refinery while the Company's subsidiary arranged to remove for offsite destruction and disposal any hazardous wastes it may have generated, any allocation to the Company and/or its subsidiaries might be further reduced. The Company and its special counsel, Reed Smith LLP, do not consider an unfavorable outcome for the Company in ChevronTexaco's lawsuit to be probable and the Company intends to vigorously defend itself against all of ChevronTexaco's claims in the litigation and any lawsuits that may follow. In addition to the numerous defenses that the Company has against ChevronTexaco's contractual claim for indemnity, the Company and its special counsel believe that by the express language of the agreement which ChevronTexaco construes to create an indemnity, ChevronTexaco has irrevocably elected to forego all rights of contractual indemnification it might otherwise have had against the Company. Contingent Environmental Liabilities Although the Company does not believe it is liable for any of its subsidiaries' clean-up costs and intends to vigorously defend itself in such regard, the Company cannot predict the ultimate outcome or timing of these matters due to inherent uncertainties. If funds for environmental clean-up are not provided by former and/or present owners, it is possible that the Company and/or one of its former refining subsidiaries could be held responsible or could be named parties in additional legal actions to recover remediation costs. In recent years, government and other plaintiffs have often sought redress for environmental liabilities from the party most capable of payment without regard to responsibility or fault. Although any environmental liabilities related to the Indian Refinery have been transferred to others, there can be no assurance that the parties assuming such liabilities will be able to pay them. American Western, owner of the Indian Refinery, filed for bankruptcy and is in the process of liquidation. As noted above, the EPA named the Company as a potentially responsible party for remediation of the Indian Refinery and requested and received relevant information from the Company and ChevronTexaco has tendered the defense of a state court toxic torts action to the Company. Whether or not the Company is ultimately held liable in the current litigation or other proceedings, it is probable that the Company will incur substantial legal fees and experience a diversion of corporate resources from other opportunities. OTHER LITIGATION Long Trusts Lawsuit In November 2000, the Company and three of its subsidiaries were defendants in a jury trial in Rusk County, Texas. The plaintiffs in the case, the Long Trusts, are non-operating working interest owners in certain wells previously operated by Castle Texas Production Limited Partnership ("CTPLP"), an inactive exploration and production subsidiary of the Company. The wells were among those sold to Union Pacific Resources Corporation ("UPRC") in May 1997. The Long Trusts claimed that CTPLP did not allow them to sell gas from March 1, 1996 to January 31, 1997 as required by applicable joint operating agreements, -9- CASTLE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ("$000'S" OMITTED EXCEPT SHARE AMOUNTS) (UNAUDITED) and they sued CTPLP and the Company's other subsidiaries, claiming (among other things) breach of contract, breach of fiduciary duty, conversion and conspiracy. The Long Trusts sought actual damages, exemplary damages, prejudgment and post-judgment interest, attorney's fees and court costs. CTPLP counterclaimed for approximately $150 of unpaid joint interest billings plus interest, attorney's fees and court costs. After a three-week trial, the District Court in Rusk County submitted 36 questions to the jury which covered the claims and counterclaim in the lawsuit. Based upon the jury's answers, the District Court entered judgment on some of the Long Trusts' claims against the Company and its subsidiaries, as well as CTPLP's counterclaim against the Long Trusts. The District Court issued an amended judgment on September 5, 2001 which became final December 19, 2001. The net amount awarded to the plaintiffs was approximately $2,700. The Company and its subsidiaries and the Long Trusts subsequently filed notices of appeal, submitted legal briefs in April 2002, reply briefs in June and July 2002, and ultimately argued the case before the 12th Court of Appeals in Tyler, Texas in October 2002. On July 31, 2003, that court reversed and remanded in part the trial court's judgment against the Company and its subsidiaries while affirming the judgment against the Long Trusts which had awarded damages on the counterclaim asserted by CTPLP. In its decision, the appellate court held that the trial court had submitted erroneous theories to the jury, expressly rejecting the Long Trusts' claims for breach of fiduciary duty, conversion, implied covenants and exemplary damages. It also remanded the Long Trusts' claims for breach of contract to the district court for retrial. The appellate court upheld the trial court's award to CTPLP on its counterclaim for approximately $150 of unpaid joint interests billings, $450 in attorneys' fees, plus interest and court costs. Both the Company and its subsidiaries and the Long Trusts thereafter submitted motions for a rehearing on certain rulings to the 12th Court of Appeals. That court denied both motions for a rehearing. The Long Trusts subsequently filed a petition for review with the Supreme Court of Texas. On March 26, 2004, the Texas Supreme Court denied the Long Trusts petition for review and the Long Trusts filed a petition for rehearing with that court two weeks later. That petition was also subsequently denied, whereupon the Court of Appeals issued its mandate on June 9, 2004, completing the appellate process. Certain breach of contract claims by the Long Trusts which were reversed and remanded by the appellate court may be retried by the plaintiffs. Based on the evidence at the initial trial coupled with the guidance to the trial court given in the appellate decision, the Company believes that it will be able to prove that there was no breach of contract and that Long Trusts suffered no damages, and that any such breach of contract claims, even if decided adversely to the Company, will not result in a material loss to the Company. Pursuant to the mandate of the Texas Court of Appeals, the Company has now moved to sever CTPLP's claims against the Long Trusts from any retrial of the Long Trust's contract claims against the Company and to collect on CTPLP's judgment against the Long Trusts which is secured by a letter of credit posted by the Long Trusts with the trial court. The Company estimates the judgment to be in excess of $1,000, including accrued interest, as of December 31, 2004. Subsequent to June 30, 2004, upon issue of the mandate by the Texas Court of Appeals, the Company's $3,886 supersedeas bond was released under Texas law. The Company's $4,110 letter of credit, including accrued interest, securing that bond was also released and those funds are no longer restricted cash. On September 17, 2004, the Long Trusts filed a motion for clarification with the Court of Appeals which in essence sought to reverse that court's severance of CTPLP's claims from the retrial of the Long Trusts' breach of contract claims. The Company has opposed the Long Trusts' motion on a number of grounds and believes that it has no merit. At the request of the Long Trusts, the trial court set a trail date for March 14, 2005 to retry the Long Trusts contract claims, but did not sever the CTPLP's claims as mandated. On December 3, 2004, the Company filed a Petition for Writ of Mandamus with the Court of Appeals requesting that the trial court be stayed from proceeding further, and be ordered to comply with the June mandate of the Court of Appeals. On January 31, 2005, the Court of Appeals stayed the trial court from proceeding pending further orders from the Court of Appeals. -10- CASTLE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ("$000'S" OMITTED EXCEPT SHARE AMOUNTS) (UNAUDITED) The Company has not accrued any recoveries for this litigation as of December 31, 2004, but will record recoveries if and when they are ultimately realized (collected). Pilgreen Litigation As part of the oil and gas properties acquired from AmBrit Energy Corporation ("AmBrit") in June 1999, Castle Exploration Company, Inc., a wholly-owned subsidiary of the Company ("CECI") acquired a 10.65% overriding royalty interest ("ORRI") in the Simpson lease in south Texas, including the Pilgreen #2ST gas well. CECI subsequently transferred that interest to Castle Texas Oil and Gas Limited Partnership ("CTOGLP"), an indirect wholly-owned subsidiary. Because the operator suspended revenue attributable to the ORRI from first production due to title disputes, AmBrit, the previous owner, filed claims against the operator of the Pilgreen well, and CTOGLP acquired rights in that litigation with respect to the period after January 1, 1999. In August 2002, $282 was released to the Company of which $249 was recorded as income by the Company and the remaining $33 paid to Delta Petroleum Corporation ("Delta"). Because of a claim by Dominion Oklahoma Texas Exploration and Production, Inc. ("Dominion") (see below), a working interest owner in the same well, that CTOGLP's ORRI in the Simpson lease should be deemed burdened by 3.55% overriding royalty interest, there is still a title dispute as to approximately $120 of suspended CTOGLP Pilgreen #2ST production proceeds for the Company's account. (The Company sold all of its oil and gas assets, including the Pilgreen #2ST well, to Delta on May 31, 2002 but effective as of October 1, 2001.) The Company has named Dominion as a defendant in a legal action seeking a declaratory judgment that the Company is entitled to its full 10.65% overriding royalty interest in the Pilgreen well. The Company believes that Dominion's title exception to CTOGLP's overriding royalty interest is erroneous and notes that several previous title opinions have confirmed the validity of CTOGLP's interest. The litigation is related to the Dominion litigation (see below). Accordingly, the Company believes that CTOGLP will prevail in this litigation if CTOGLP prevails in the Dominion Litigation or that CTOGLP will fail in this litigation if it fails in the Dominion Litigation. Since the Company has not recorded any revenue related to the $120 of suspended revenue, it expects to record $120 of revenue if it prevails, but no expense if it fails in this litigation. CTOGLP, along with several unrealized parties, has also filed suit to collect production proceeds from an additional well on the Simpson lease in which CTOLGP had a 5.325% overriding royalty interest suspended by the operator because of title disputes. The Company intends to contest this matter vigorously. At the present time, the amount held in escrow applicable to the additional well attributable to the Company's interest is approximately $66 although approximately $22 of that amount would be subject to Dominion's claims in the Pilgren Litigation. The Company has not recorded any of the $66 of suspended revenue as income but will record it as income when and if it is realized (collected). Dominion Litigation On March 18, 2002, Dominion, operator of the Mitchell and Migl-Mitchell wells in the Southwest Speaks field in south Texas and a working interest owner in the Pilgreen #2ST well, filed suit in Texas against CTOGLP seeking declaratory judgment in a title action that the overriding royalty interest held by CTOGLP in these wells should be deemed to be burdened by certain other overriding royalty interests aggregating 3.55% and should therefore be reduced from 10.65% to 7.10%. Dominion is also seeking an accounting and refund of payments for overriding royalty to CTOGLP in excess of the 7.10% since April 2000. The Company currently estimates the amount in controversy to be approximately $783. Dominion threatened to suspend all revenue payable to the Company from the Mitchell and Migl-Mitchell to offset its claim. The Company and Dominion subsequently examined the land and lease documents concerning the overriding royalty interests. The Company believes that Dominion's title -11- CASTLE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ("$000'S" OMITTED EXCEPT SHARE AMOUNTS) (UNAUDITED) exception to CTOGLP's overriding royalty interest is erroneous and notes that several previous title opinions have confirmed the validity of CTOGLP's interest. In July 2003, Dominion filed a motion for partial summary judgment concerning the Company's claim that it had assumed the liabilities of its predecessor in interest and CTOGLP filed its response to Dominion's motion as well as its own cross motion for partial summary judgment. In September 2003, the District Court of Lavaca County granted Dominion's partial motion for partial summary judgment. In January 2004, Dominion filed a motion for final summary judgment on this matter to which CTOGLP and the other defendants filed a response. In May 2004, the District Court of Lavaca County granted Dominion's motion for final summary judgment. The Company has filed an appeal of both the District Court's summary judgments with the Court of Appeals in Corpus Christi. At June 30, 2004, the Company had an accrued provision of $825 related to this litigation, including $44 in estimated interest and plaintiff's legal costs. By agreement between Dominion and the Company during the quarter ended December 31, 2004, CTOGLP executed a promissory note for $783 plus accrued interest, guaranteed by the Company, to avoid the cost of a supersedeas bond; such note to be payable only if the Company fails in its appeal. At December 31, 2004, $807 of the amount previously accrued is represented by a contingent note payable to Dominion and the remaining $18 is included in accrued expenses. Note 5 - New Accounting Pronouncements On September 28, 2004, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 106 ("SAB No. 106"). SAB No. 106 applies to companies using the full cost method of accounting for oil and gas properties and equipment costs, such as the Company. SAB No. 106 affects the way in which the Company calculates its full cost ceiling limitation (the Company now excludes the future cash outflows associated with settling asset retirement obligations related to proved developed properties in the calculation of the ceiling) and the way the Company calculates depletion on its gas properties (only asset retirement costs for new recompletions and new wells are now included in calculating depletion expense). The Company adopted SAB No. 106 on October 1, 2004. The Company expects the adoption of SAB No. 106 on future operating costs, operating income (loss) and net income (loss) to be immaterial. In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment" ("SFAS No. 123(R)"). SFAS No. 123(R) requires an entity to recognize the grant-date fair value of stock options and other equity-based compensation issued to employees in the income statement. SFAS No. 123(R)will be effective for the Company beginning July 1, 2005. The Company does not expect SFAS No. 123(R)to have a material impact on its results of operations since all outstanding options are vested. The Company has not issued any stock options since January 2002. In December 2004, the FASB issued FASB Staff Position FAS 109-1, "Application of FASB Statement No. 109, Accounting for Income Taxes, for the Tax Deduction Provided to U.S. Based Manufacturers by the American Jobs Creation Act of 2004" ("FSP 109"). FSP 109 clarifies how to apply Statement No. 109 to the new tax deduction for income attributable to "domestic production activities." The Company expects that the new tax deduction will first be effective for the Company's fiscal year ended September 30, 2006 and that the affect on future income tax expense, deferred income taxes and income taxes payable will be immaterial. -12- CASTLE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ("$000'S" OMITTED EXCEPT SHARE AMOUNTS) (UNAUDITED) Note 6 - Income Taxes The Company's deferred taxes are comprised of the following: DECEMBER 31, SEPTEMBER 30, 2004 2004 ------------ ------------- (UNAUDITED) Deferred tax liabilities - gross......... $ 5,503 $ 5,170 Valuation allowance...................... ------------ ------------- Deferred tax liabilities - net........... $ 5,503 $ 5,170 ============ ============= The net deferred tax liabilities at December 31, 2004 and September 30, 2004 relate primarily to a difference between the book value and tax basis of the Company's investment in Delta. Note 7 - Restricted Cash Restricted cash at both December 31, 2004 and September 30, 2004, consists of certificates of deposit supporting letters of credit for operating or drilling bonds provided to state or county regulatory agencies. Note 8 - Acquisition of Oil and Gas Properties On March 31, 2004, the Company acquired interests in 138 western Pennsylvania gas wells from Delta Petroleum Corporation ("Delta"). The Company previously owned most of these properties through May 31, 2002 when it sold all of its United States oil and gas properties to Delta. The purchase price paid by the Company was effective January 1, 2004 and was reduced by purchase price adjustments to the closing date of March 31, 2004. For accounting purposes the Company allocated $43 of the purchase price to trucks and the remainder to oil and gas properties. The Company owned approximately 25% of Delta (see Note 9) at the time of purchase and three of the Company's directors were and still are also directors of Delta. Prior to approving the purchase, the Company appointed a committee of independent directors to evaluate and make a recommendation to the Board of Directors with respect to the proposed transaction. The Committee engaged an outside consultant to evaluate the fairness of the proposed purchase. Based upon that consultant's recommendation that the purchase price was reasonable and fair and the favorable recommendation of the committee, the full Board of Directors of the Company unanimously approved the transaction. At the same time the Company also purchased another owner's interests in the same gas properties for $334 subject to similar final closing adjustments. The other owner's interests in the properties were approximately four percent of Delta's interests in the same properties. On March 30, 2004, the Company acquired interests in 28 western Pennsylvania gas wells for $1,100 from five limited partnerships effective January 1, 2004. That transaction closed March 30, 2004. The President of the general partner of the five selling limited partnerships was and still is an officer and director of the Company. As a result, the Company appointed a committee of independent directors to evaluate and make recommendations to the Board with respect to the proposed transaction. The committee engaged an outside consultant to evaluate the fairness of the proposed purchase. Based upon that consultant's opinion that the proposed purchase price was reasonable and fair and the favorable recommendation of the committee, the full Board of Directors of the Company unanimously approved the transaction. -13- CASTLE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ("$000'S" OMITTED EXCEPT SHARE AMOUNTS) (UNAUDITED) The final adjusted purchase price for the oil and gas properties acquired in March 2004 was $8,985. Changes in asset retirement obligations associated with the purchase are as follows: Balance-October 1, 2004 .................... $ 230 Adjustment ................................. 10 Acretion ................................... 4 ----- Balance - December 31, 2004 ................ $ 244 ===== The Company's petroleum reservoir engineer estimated the proved reserves applicable to the three Pennsylvania purchases to be approximately eight billion cubic feet of natural gas, of which approximately 87% represents proved producing reserves, while the remaining 13% represents behind pipe and undeveloped reserves. Approximately 130 of 166 wells in which the Company acquired interests are operated by the Company. The Company also entered into an operations management agreement with Delta whereby Delta performed certain well operations functions for the Company on a transitional basis from April 1, 2004 to September 30, 2004. That agreement terminated September 30, 2004 and the Company is now performing the well operations functions previously performed by Delta. -14- CASTLE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ("$000'S" OMITTED EXCEPT SHARE AMOUNTS) (UNAUDITED) Note 9 - Investment in Delta Condensed financial information concerning Delta Petroleum Corporation ("Delta") is as follows: CONDENSED BALANCE SHEETS
DECEMBER 31, SEPTEMBER 30, 2004 2004 ----------- ------------ (Unaudited) (Unaudited) Assets Current assets ......................................................... $ 21,133 $ 15,896 Oil and gas properties, net ............................................ 303,362 261,907 Other assets ........................................................... 1,605 1,330 ----------- ------------ $ 326,100 $ 279,133 =========== ============ Liabilities and Stockholders' Equity Current liabilities, including current portion of long-term debt ....... $ 23,618 $ 15,177 Long-term liabilities and minority interests ........................... 86,198 63,445 Stockholders' equity ................................................... 216,284 200,511 ----------- ------------ $ 326,100 $ 279,133 =========== ============
CONDENSED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED DECEMBER 31, -------------------------- 2004 2003 ----------- ----------- (Unaudited) (Unaudited) Revenue: Oil and gas sales .................................................... $ 20,441 $ 7,714 Other ................................................................ 88 (68) ----------- ----------- 20,529 7,646 ----------- ----------- Expense: Lease operating expenses ............................................. 4,920 2,242 General and administrative ........................................... 4,014 1,863 Depreciation, depletion and amortization ............................. 3,678 2,240 Other ................................................................ 1,806 315 ----------- ----------- 14,418 6,660 ----------- ----------- Other income (expense) ................................................. (1,302) (561) ----------- ----------- Discontinued operations - income (loss) ................................ 227 ----------- ----------- Income (loss) before income taxes ...................................... 4,809 652 Income taxes ........................................................... ----------- ----------- Net income (loss) ...................................................... $ 4,809 $ 652 =========== ===========
The Company currently owns 7,000,000 shares of Delta, or approximately 17%. The Company currently accounts for its investment in Delta on the equity method as three of the Company's directors are directors of Delta. -15- CASTLE ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ("$000'S" OMITTED EXCEPT SHARE AND PER SHARE AMOUNTS) (UNAUDITED) The above condensed financial information has been compiled using Delta's unaudited quarterly financial statements for the quarters ended December 31, 2004 and 2003 and September 30, 2004. Delta's stock is traded on the Nasdaq stock market under the symbol "DPTR." At December 31, 2004, the closing price of Delta's common stock was $15.68 per share. At December 31, 2004, there were approximately 4,000,000 options and warrants to acquire Delta's stock outstanding, including options and warrants that were out of the money. The Company holds none of these options and warrants. If all such options and warrants had been exercised at December 31, 2004, the Company's percentage ownership of Delta would have decreased from approximately 17.2% to approximately 15.7%. Note 10 - Compensation Expense SFAS 123 allows an entity to continue to measure compensation costs in accordance with Accounting Principle Board Opinion No. 25 ("APB 25"). The Company has elected to continue to measure compensation cost in accordance with APB 25 and to comply with the required disclosure-only provisions of SFAS 123. Proforma net income and earnings per share had the Company accounted for its options under the fair value method of SFAS 123 is as follows:
THREE MONTHS ENDED DECEMBER 31, -------------------------- 2004 2003 ----------- ----------- Net income (loss) as reported .................. $ 343 $ (1,248) Adjustment required by SFAS 123 ................ ----------- ----------- Pro-forma net income (loss) .................... $ 343 $ (1,248) =========== =========== Pro-forma net income (loss) per share: Basic ........................................ $ .05 $ (.19) =========== =========== Diluted ...................................... $ .05 $ (.19) =========== =========== Net income (loss) per share as reported: Basic ........................................ $ .05 $ (.19) =========== =========== Diluted ...................................... $ .05 $ (.19) =========== ===========
Note 11 - Subsequent Events Subsequent to December 31, 2004, a director of the Company exercised options for 75,000 shares of the Company's common stock, increasing the number of outstanding shares to 6,990,384. Proceeds from such option exercise were $323. -16- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. ("$000'S" OMITTED EXCEPT SHARE AMOUNTS) RESULTS OF OPERATIONS All statements other than statements of historical fact contained in this report are forward-looking statements. Forward-looking statements in this report generally are accompanied by words such as "anticipate," "believe," "estimate," or "expect" or similar statements. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, no assurance can be given that such expectations will prove correct. Factors that could cause the Company's results to differ materially from the results discussed in such forward-looking statements are discussed below. All forward-looking statements in this Form 10-Q are expressly qualified in their entirety by the cautionary statements in this paragraph. During the period from August 1989 to September 30, 1995, two of the Company's subsidiaries conducted refining operations. By December 12, 1995, the Company's refining subsidiaries had sold all of their refining assets. In addition, Powerine merged into a subsidiary of EMC and was no longer a subsidiary of the Company. The Company's other refining subsidiaries own no refining assets and are in the process of liquidation. As a result, the Company accounted for its refining operations as discontinued operations in the Company's consolidated financial statements as of September 30, 1995 and retroactively. Accordingly, discussion of results of refining operations has been confined to the anticipated impact, if any, of liquidation of the Company's remaining inactive refining subsidiaries and contingent environmental liabilities of the Company and its refining subsidiaries. Since November 1996, the Company has reacquired 4,911,020 shares or 69% of its then outstanding common stock (after taking into account a three-for-one stock split in January 2000). As a result of these share acquisitions, earnings and losses per outstanding share have been higher than would have been the case if no shares had been repurchased. Gas sales increased $699 as a result of the Company's acquisition of 166 Appalachian gas properties on March 30 and 31, 2004 (see Note 8 to the consolidated financial statements included in this Form 10-Q). The Company owned no oil and gas properties from September 2002 to March 30, 2004. Production expenses increased $95 as a result of the Company's acquisition of 166 Appalachian gas properties on March 30, and 31, 2004 (see Note 8 to the consolidated financial statements included in this Form 10-Q). The Company owned no oil and gas properties from September 2002 to March 30, 2004. Depreciation, depletion and amortization increased $117 from the first quarter of fiscal 2004 to the first quarter of fiscal 2005. The increase was entirely attributable to depletion of the gas properties acquired by the Company in March 2004. The Company owned no oil and gas properties from September 2002 to March 30, 2004. General and administrative costs decreased $296 or 23.9% from the quarter ended December 31, 2003 to the quarter ended December 31, 2004. The decrease was caused primarily by decreased legal expenses. In addition, during the quarter ended December 31, 2003, the Company recorded an $86 bad debt provision related to accounts receivable that were then over eighteen months old. No bad debt provision was recorded for the quarter ended December 31, 2004. Interest income increased $104 from the quarter ended December 31, 2003 to the quarter ended December 31, 2004. The increase parallels the increase in the Company's cash and cash equivalents. At December 31, 2003, cash and cash equivalents aggregated $9,112 versus $33,103 at December 31, 2004. -17- The Company's equity in Delta's net income increased $582 or 223% from the quarter ended December 31, 2003 to the quarter ended December 31, 2004. The increase was caused by Delta's increased net income, notwithstanding that the Company's percentage ownership of Delta decreased from approximately 39% at December 31, 2003 to 17.5% at December 31, 2004. The $180 tax provision for the quarter ended December 31, 2004 represented 34% of pre-tax income and approximated the Company's blended (Federal and state combined) tax rate of 36% The entire tax provision for the three months ended December 31, 2004 represents deferred income taxes - not income taxes currently payable. The $293 tax provision for the quarter ended December 31, 2003 resulted primarily because of changes in the Company's expectations concerning future taxable income. LIQUIDITY AND CAPITAL RESOURCES During the three months ended December 31, 2004, the Company used $575 in operating activities. During the same period the Company paid $343 for dividends to stockholders. During the same period the Company received $364 in proceeds from the exercise of stock options. At December 31, 2004, the Company had $33,103 of unrestricted cash, $32,522 of working capital and no long-term debt. At the present time, the Company's anticipated future cash expenditures are primarily recurring general and administrative costs, including substantial legal costs related to the ChevronTexaco litigation (see Item 4 to this Form 10-Q), recurring dividends and lease operating costs related to the Appalachian gas properties acquired by the Company. In addition, the Company continues to review possible future acquisitions of oil and gas properties and, if the Company is successful in such pursuits, additional expenditures would be required. To the extent that such anticipated expenditures cannot be funded from cash flow from the Company's oil and gas operations, the Company can fund such expenditures using its available cash. If the Company were to make another substantial acquisition in excess of its current cash and other liquid working capital, the Company believes it could fund such acquisitions by selling additional shares of Delta or by renewing its previous oil and gas borrowing arrangements with an energy bank and using the related loan proceeds for the acquisition. The Company's future operations are subject to the following risks: a. Litigation - As noted above, the Company is a defendant in three significant unsettled lawsuits. Although the Company does not believe it has any material unrecorded liabilities with respect to any of these lawsuits, the Company could incur significant liabilities if it ultimately is judged to be liable in these lawsuits. This litigation has caused and could continue to cause the Company to incur significant legal costs. If ChevronTexaco were to prevail on its indemnity claim in its lawsuit (see Item 4 to this Form 10-Q), the Company could be held liable for the entirety of the estimated cleanup costs, a sum far in excess of the Company's financial capability. b. Exploration and Production Price Risk - The Company has not hedged any of its anticipated future gas production because the cost to do so appears excessive when compared to the risk involved. As a result, the Company remains exposed to future gas price changes with respect to all of its anticipated future gas production. Such exposure could be significant given the volatility of gas prices. For example, natural gas prices have increased over 50% from 2002 to 2004 and could either increase or decrease a similar percentage in the future. When the Company acquired its gas properties in March 2004, the prices being received for natural gas were $5.00 to $6.00 per mcf sold. The Company paid for its gas reserve acquisitions using such pricing. If natural gas prices decrease in the future, the decrease will directly impact the Company's gas sales, operating income and net income. In addition, if gas prices are low at the end of the Company's quarterly and annual reporting periods, the value of the Company's gas reserves may decrease such that the Company would be forced to record an impairment provision - see "Critical Accounting Policies" below. c. Exploration and Production Operating Risk - All of the Company's current gas properties are onshore properties with relatively low operating risk. Nevertheless, the Company faces the risks -18- encountered from operating approximately 130 gas wells - including the risk of gas leaks, resulting environmental damage, third party liability claims related to operations, including claims by landowners where the operated wells are located, as well as general operating risks. d. Public Market for the Company's Stock - Although there presently exists a market for the Company's stock, such market is volatile and the Company's stock is thinly traded. This volatility may adversely affect the market price and liquidity of the Company's common stock. e. Other Risks - In addition to the specific risks noted above, the Company is subject to general business risks, including insurance claims in excess of insurance coverage, tax liabilities resulting from tax audits and the risks associated with increased litigation generally. f. Market Value of Delta Stock - The Company currently owns 7,000,000 shares of Delta. At December 31, 2004, the market value of such shares was approximately $110,000 and constituted the largest asset of the Company. In the past year Delta's stock price has increased significantly and fluctuated significantly over short periods of time. If Delta's stock price decreases significantly - especially at a time when the Company expects to liquidate some or all of its Delta stock - the Company would be adversely affected. g. Future of the Company - Although the Company has recently acquired interests in 166 gas wells in Pennsylvania (see Note 9), the Company is smaller than most of its competitors which benefit from better fixed cost efficiencies than the Company given their larger sizes and revenues. The Company's fixed costs (computer system, technical skills, field offices, public company compliance costs, etc.) have consumed and are expected to continue to consume a greater percentage of the Company's oil and gas revenues than do those of most of its larger competitors unless the Company is able to make additional future acquisitions at favorable prices. Upon resolution of the Company's outstanding litigation - whether by settlement or judgment - the Company's directors may consider options to liquidate the Company or merge the Company into another company to maximize stockholder value. If such were the case, the Company would face risks concerning the value of the Delta shares it owns, tax risks and risks in the liquidation of its assets. CRITICAL ACCOUNTING POLICIES: The accounting policies critical to the Company are as follows: EQUITY METHOD OF ACCOUNTING At December 31, 2004, the Company owned 17.2% of Delta and accounted for its investment in Delta using the equity method of accounting. Under this method, the Company is required to increase its investment in Delta by its share of Delta's income and decrease such investment by its share of Delta's losses and any distributions from Delta. If Delta incurs future losses, the Company would thus include its share of such losses in its consolidated statement of operations. In addition, the Company estimates that its investment in Delta exceeded the Company's proportional share of Delta's equity by approximately $4,000 at December 31, 2004. The Company has allocated such excess to Delta's ownership interests in offshore California leases due to the potential recovery from a lawsuit Delta and other owners of offshore California leases have instituted against the United States for breach of contract. The Company is required to evaluate the recoverability of the leases periodically and write off the excess costs or reduce them to the extent they are not deemed recoverable. In addition, if Delta incurs recurring losses in the future and/or the market value of its stock declines significantly, the Company's investment in the future in Delta could become impaired and the Company would then be required to recognize the impairment. In addition, since the Company only owns 17.2% of Delta currently, it is possible that the Company may commence accounting for its investment in Delta as a marketable security if management considers the Company's influence on Delta to be less than significant. Although the Company's interest in Delta has decreased below 20%, the Company has continued to account for its investment in Delta using the equity method because three of the Company's directors currently comprise one-third of Delta's directors and thus the Company can be deemed to still exercise significant influence on Delta. If the Company's influence in Delta continues to decrease to a level at which it no longer is considered to have a significant influence, the Company would record its investment as a marketable security using the provisions of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." -19- DISCONTINUED REFINING OPERATIONS At December 31, 2004, the Company had recorded net refining liabilities retained of $2,155. As noted in Item 4 to this Form 10-Q, ChevronTexaco has sued the Company for environmental remediation costs that have been estimated at $80,000-$150,000. In January 2003, the United States and the State of Illinois filed a motion which estimated the total costs for just one portion of the Indian Refinery-Texaco-Lawrenceville Superfund Site to be $109,000 to $205,000. The Company's accounting policy with respect to contingent environmental liabilities is to record environmental liabilities when and if environmental assessment and/or remediation costs are probable and can be reasonably estimated. Although the Company and its special counsel do not consider an unfavorable and final outcome for the Company in ChevronTexaco's lawsuit to be probable, the Company would be required to record additional environmental liabilities if it becomes probable that the Company will incur liabilities related to ChevronTexaco's claims and/or other environmental liabilities and such liabilities exceed $2,155. As noted above, if such liabilities exceed the value of the Company's assets, the Company would not have the financial capability to pay such liabilities. The amounts and classification of the estimated values of discontinued net refining assets and net refining liabilities retained could change significantly in the future as a result of litigation or other factors. INVESTMENT IN NETWORK At March 31, 2003, the Company recorded a $480 impairment provision related to its investment in Network. This provision consisted of $354 provision related to the Company's 45% equity investment in Network and a $126 provision related to the Company's $126 note receivable from Network. As a result of these impairment provisions, the Company's investment in Network was reduced to zero. The impairment provisions were recorded because Network had not entered into any revenue generating contracts by that date. Subsequently, Network entered into its first revenue producing contract and recorded net income of $34 for the quarter ended December 31, 2004. If Network is able to enter into additional revenue-generating contracts and generate future net income, the Company may commence recording its share of Network's future net income under the equity method of accounting once the Company's share of such income has exceeded the Company's share of unrecorded Network losses since March 31, 2003, the date that the Company ceased recognizing its share of Network's losses. FULL COST METHOD OF ACCOUNTING FOR OIL AND GAS PROPERTIES The Company follows the full-cost method of accounting for oil and gas properties and equipment costs. Under this method of accounting, net capitalized costs, less related deferred income taxes, in excess of the present value of net future cash inflows (oil and gas sales less production expenses) from proved reserves, tax effected and discounted at 10%, and the cost of properties not being amortized, if any, are charged to expense (full cost ceiling test). If at a future reporting date oil and gas prices decline, it is possible that the Company's book value will exceed the allowable full cost ceiling and the Company would have to write down its oil and gas properties. Even if oil and gas prices subsequently increase, the write down would not be restored under the full cost method of accounting. Although the Company recorded no full cost ceiling provision through December 31, 2004, it could be required to record such a provision in the future - especially if there were a significant decrease in gas prices by the end of a quarterly or annual financial reporting period. See "New Accounting Pronouncements." -20- ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK On March 30 and 31, 2004, the Company acquired interests in Pennsylvania gas wells (see Note 8). The Company has not hedged its share of the expected natural gas production from these wells. As a result, the Company remains at risk with respect to such unhedged expected production. If market prices increase, gas sales applicable to the unhedged production will increase. If market prices decrease, gas sales and the gross margin related to such unhedged production will decrease. At December 31, 2004, the Company owned 7,000,000 shares of Delta. The stock price of Delta has fluctuated significantly in the last three years and thus the market value of the Company's investment in Delta remains subject to significant changes in the market price of Delta stock. ITEM 4. CONTROLS AND PROCEDURES The conclusions of the Company's Chief Executive Officer and Chief Financial Officer concerning the effectiveness of the Company's disclosure controls and procedures and changes in internal controls as of December 31, 2004 are as follows: a) They have concluded that the Company's disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in the reports it files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC. b) There were no significant changes in the Company's internal controls during the quarter ended December 31, 2004 that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. See Exhibits 31.1 and 31.2 to this Form 10-Q. Effective September 30, 2005, the Company expects that it will be subject to certain attestation requirements concerning the effectiveness of its internal controls pursuant to the Section 404 of the Sarbanes Oxley Act. These requirements include management's documenting and testing the Company's internal controls and attesting as to their effectiveness and a reporting by the Company's independent accountants concerning management's attestation. Although the Company is working diligently to comply with these requirements, the Company has only eleven employees and these employees work at four widely scattered locations. The Company's small number of employees and their geographical separation is expected to make compliance with Section 404 - especially with segregation of duty control requirements - very difficult and cost ineffective, if not impossible. While the SEC had indicated it may issue supplementary regulations easing the burden of Section 404 requirements for small entities like the Company, such regulations have not yet been issued. -21- PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS For additional information regarding lawsuits, reference is made to Item 3 of the Company's Form 10-K (Annual Report) for the fiscal year ended September 30, 2004. Also see Note 4 to the December 31, 2004 consolidated financial statements included in Part I. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (A) Exhibits: Exhibit 11.1 - Statement re: Computation of Earnings Per Share Exhibit 31.1 Certificate of Chief Executive Officer (Section 302 of Sarbanes Oxley Act) Exhibit 31.2 Certificate of Chief Financial Officer (Section 302 of Sarbanes Oxley Act) Exhibit 32.1 Certificate of Chief Executive Officer (Section 906 of Sarbanes Oxley Act) Exhibit 32.2 Certificate of Chief Financial Officer (Section 906 of Sarbanes Oxley Act) (B) Reports on Form 8-K Report dated January 21, 2005 concerning Discussion and Appointment of Independent Accountants -22- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: February 11, 2005 CASTLE ENERGY CORPORATION /s/Richard E. Staedtler ------------------------------ Richard E. Staedtler Chief Financial Officer Chief Accounting Officer -23-