Going Concern

The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern, which contemplates continuity of operations, realization of assets and the satisfaction of liabilities in the normal course of business for the twelve month period following the date of these consolidated financial statements. As such, the accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of assets and their carrying amounts, or the amount and classification of liabilities that may result should the Company be unable to continue as a going concern.

The Company's overall liquidity position and cash available for capital expenditures continue to be negatively impacted by continued weak natural gas prices, declining production and increasing cash interest expense on its outstanding indebtedness. Due to the sale of the Company's Gulf of Mexico properties in January 2018 and normal production declines, production has declined by 41% in the third quarter of 2018 when compared to the fourth quarter of 2017 and cash flow from operations for the nine months ended September 30, 2018 was $1.9 million. At September 30, 2018, the Company had approximately $25.5 million of cash and approximately $334.5 million aggregate principal amount of outstanding indebtedness, and had deferred ten dividend payments with respect to the Company's Series B Preferred Stock and accrued a $14.1 million payable related to the ten deferred payments and the quarterly dividend that was payable on October 15, 2018. In addition, beginning with the August 15, 2018 interest payment on the Company's 2021 PIK Notes (as defined below), the Company is required to pay interest on its 2021 PIK Notes at 10% in cash (instead of 1% in cash and 9% in payment in kind). The Company elected not to pay the cash interest payments that were due on August 15, 2018 under the Company's 2021 PIK Notes and 2021 Notes (as defined below) which totaled approximately $14.2 million (see Note 6 for additional information).

As a result of the forgoing, the Company engaged in discussions and negotiations with the lenders under the Multidraw Term Loan, certain holders of the Company’s 2021 Notes and 2021 PIK Notes, and their legal and financial advisors regarding various alternatives with respect to the Company’s capital structure and financial position, including the significant amount of indebtedness, and the August 15, 2018 interest payments overdue on the Company’s 2021 Notes and 2021 PIK Notes.

Voluntary Reorganization under Chapter 11 of the Bankruptcy Code

As a result of the forgoing discussions and negotiations, on November 6, 2018 (the “Petition Date”), the Company, PetroQuest Energy, L.L.C. (“PQE”) and their direct and indirect subsidiaries (collectively, the “Debtors”) filed voluntary petitions (collectively, the “Petition,” and the cases commenced thereby, the “Chapter 11 Cases”) seeking relief under Chapter 11 of Title 11 of the United States Code (the “Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of Texas (the “Bankruptcy Court”). The Chapter 11 Cases are being administered jointly under the caption In re: PetroQuest Energy, Inc., et. al. (Case No. 18-36322).

The Debtors will continue to operate as debtors-in-possession under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code. The Company expects ordinary-course operations to continue substantially uninterrupted during and after the Chapter 11 Cases.

Restructuring Support Agreement

In connection with the Chapter 11 filing, on the Petition Date, the Debtors entered into a restructuring support agreement (the “Restructuring Support Agreement”) with (i) holders (the “2021 Noteholders”) of 81.83% of the Company’s 10% Second Lien Senior Secured Notes due 2021 (the “2021 Notes”) issued under that certain Indenture dated as of February 17, 2016, among the Company, the Subsidiary Guarantors (as defined therein) and Wilmington Trust, National Association, as trustee and collateral trustee thereunder, (ii) holders (the “2021 PIK Noteholders” and, together with the 2021 Noteholders, the “Supporting Noteholders”) of 84.76% of the Company’s 10% Second Lien Senior Secured PIK Notes due 2021 (the “2021 PIK Notes”) issued under that certain Indenture dated as of September 27, 2016, among the Company, the Subsidiary Guarantors (as defined therein) and Wilmington Trust, National Association, as indenture trustee and collateral trustee thereunder, and (iii) each of the lenders, or investment advisors or managers for the account of each of the lenders (collectively, and any successors or permitted assigns that become party thereto, the “Supporting Lenders” and collectively with the Supporting Noteholders, the “Supporting Parties”) under the Company’s multi-draw term loan agreement (the “Multidraw Term Loan Agreement”), by and among PQE, the Company, Wells Fargo Bank, National Association, as administrative agent, and lenders holding Term Loans (as defined therein) party thereto from time to time.

The Restructuring Support Agreement contemplates the restructuring (the “Restructuring”) of the Debtors pursuant to the plan of reorganization attached thereto (the “Plan”), the terms of which have been agreed upon by the Debtors and Supporting Parties.

The Restructuring Support Agreement provides for certain milestones requiring, among other things, that the Debtors commence the solicitation of votes to accept or reject the Plan on or before November 20, 2018, the confirmation order be entered by the Bankruptcy Court on or before December 21, 2018 and the Plan becomes effective on or before December 31, 2018.

The Restructuring Support Agreement contains certain covenants on the part of each of the Debtors and the Supporting Parties, including, subject to the terms of the Restructuring Support Agreement, limitations on the parties’ ability to pursue transactions other than the Restructuring, commitments by the Supporting Parties to vote in favor of the Plan, and commitments of the Debtors and the Supporting Parties to negotiate in good faith to finalize the documents and agreements governing the Restructuring. The Restructuring Support Agreement also provides for certain conditions to the obligations of the parties and for termination upon the occurrence of certain events, including without limitation, the failure to achieve certain milestones and certain breaches by the parties under the Restructuring Support Agreement.

The Debtors have also filed a motion, and the Bankruptcy Court has entered an interim order, placing restrictions on the trading of the Company’s equity securities for the purpose of preserving certain tax attributes.

Proposed Chapter 11 Restructuring

The Plan provides, among other things, that:


•	Existing common stock and preferred stock of the Company would be extinguished, and existing equity holders would not receive or retain any distribution, property or other value on account of or consideration in respect of their equity interests.

•

Holders of claims (the “First Lien Claims”) arising on account of the Multidraw Term Loan Agreement will be allowed in the aggregate amount of $50,000,000, plus any accrued and unpaid interest and expenses. Each holder of First Lien Claims will receive cash equal to the amount of its claim from funds available pursuant to the Exit Facility in an aggregate amount of $50 million on the terms and conditions described in the Restructuring Support Agreement (the “Exit Facility”).

•

Holders of claims relating to the 2021 Notes (the “Second Lien Notes Claims”) will be allowed in the aggregate amount of $9,427,000, plus any accrued and unpaid interest thereon payable through the Petition Date. Each holder of Second Lien Notes will receive (i) its pro rata share of 100% of the common stock in the reorganized Company (the “New Equity”) on account of such Second Lien Notes Claims, subject to (x) dilution from the issuance of New Equity in connection with the long-term management incentive plan for the reorganized Debtors (the “Management Incentive Plan”) and (y) the New Equity payable to the parties backstopping the Exit Facility (the “Put Option Premium”), and (ii) its pro rata share of $80 million in 10% Secured PIK Notes due 2023 (the “New 2023 PIK Notes”) issued by the reorganized Company pursuant to the indenture dated as of the date the Plan is declared effective (the “Effective Date”); such pro rata share of the New Equity and the New 2023 PIK Notes calculated by including the $275,045,768 (plus any accrued and unpaid interest) of Second Lien PIK Notes Claims as claims that will share pro rata in 100% of the New Equity, subject to (x) dilution from the issuance of New Equity in connection with the Management Incentive Plan and (y) the Put Option Premium.

•

Holders of claims relating to the 2021 PIK Notes (the “Second Lien PIK Notes Claims”) will be allowed in the aggregate amount of $275,045,768, plus any accrued and unpaid interest thereon payable through the Petition Date. Each holder of Second Lien PIK Notes will receive (i) its pro rata share of 100% of the New Equity on account of such Second Lien PIK Notes Claims, subject to (x) dilution from the issuance of New Equity in connection with the Management Incentive Plan and (y) the Put Option Premium, and (ii) its pro rata share of 80 million in New 2023 PIK Notes; such pro rata share of the New Equity and the New 2023 PIK Notes calculated by including the $9,427,000 (plus any accrued and unpaid interest) of Second Lien Notes Claims as claims that will share pro rata in 100% of the New Equity, subject to (x) dilution from the issuance of New Equity in connection with the Management Incentive Plan and (y) the Put Option Premium.


•	Holders of allowed priority claims (other than a priority tax claim or administrative claim) will receive either: (i) payment in full, in cash, equal to the full allowed amount of such claim or (ii) such other treatment as may otherwise be agreed to by such holder, the Debtors, and the Requisite Creditors (as defined the Restructuring Support Agreement).

•

Holders of secured claims (other than a secured tax claim, First Lien Claim, or Second Lien Notes Claim) will receive, at the Debtors’ election, either: (i) cash equal to the full allowed amount of such claim, (ii) reinstatement of such holder’s claim, (iii) the return or abandonment of the collateral securing such claim to such holder, or (iv) such other treatment as may otherwise be agreed to by such holder, the Debtors and the Requisite Creditors.


•	Holders of secured tax claims will receive, at the Debtor’s election, either (i) cash equal to the full amount of its claim, (ii) reinstatement of such holder’s priority tax claim, (iii) the return or abandonment of the collateral securing such claim to such holder, or (iv) such other treatment as may otherwise be agreed to by such Holder, the Debtors and the Requisite Creditors.


•	Holders of general unsecured claims will receive their pro rata share of $400,000 (less the reasonable out of pocket expenses of the claims administrator), except to the extent that the holder of an allowed general unsecured claim agrees to a less favorable treatment, in full and final satisfaction, compromise, settlement, release or discharge of each allowed general unsecured claim.


•	Any claim against a Debtor subject to mandatory subordination pursuant to section 510(b) of the Bankruptcy Code (“Section 510(b) Claim”), if any, shall be discharged, canceled, released, and extinguished and shall be of no further force or effect, and holders of Section 510(b) Claims shall not receive any distribution on account of such Section 510(b) Claims.


•	Intercompany claims shall be reinstated or, at the Debtors’ option, cancelled. No distribution shall be made on account of any intercompany claims other than in the ordinary course of business of the Debtors, as applicable.


•	Intercompany interests shall be reinstated or, at the Debtors’ option, cancelled. No distribution shall be made on account of any Intercompany Interests.

Reorganization Items, Net

The Company has incurred and is expected to continue to incur significant costs associated with the reorganization. These costs, which are expensed as incurred, are expected to significantly affect the Company’s results of operations. Reorganization items represent costs and income directly associated with the Chapter 11 Cases, and will also include adjustments to reflect the carrying value of certain liabilities subject to compromise at their estimated allowed claim amounts, as such adjustments are determined.

Effect of Filing on Creditors

Subject to certain exceptions, under the Bankruptcy Code, the filing of the Petition automatically enjoined, or stayed, the continuation of most judicial or administrative proceedings or filing of other actions against the Debtors or their property to recover, collect or secure a claim arising prior to the Petition Date. Absent an order of the Bankruptcy Court, substantially all of the Debtors’ prepetition liabilities are subject to settlement under the Bankruptcy Code. Although the filing of the Petition triggered defaults on the Debtors’ debt obligations, creditors are stayed from taking any actions against the Debtors as a result of such defaults, subject to certain limited exceptions permitted by the Bankruptcy Code.

Rejection of Executory Contracts

Subject to certain exceptions, under the Bankruptcy Code, the Debtors may assume, assign or reject certain executory contracts and unexpired leases subject to the approval of the Bankruptcy Court and satisfaction of certain other conditions. Generally, the rejection of an executory contract or unexpired lease is treated as a prepetition breach of such executory contract or unexpired lease and, subject to certain exceptions, relieves the Debtors of performing their future obligations under such executory contract or unexpired lease but entitles the contract counterparty or lessor to a prepetition general unsecured claim for damages caused by such deemed breach. Counterparties to such rejected contracts or leases may assert unsecured claims in the Bankruptcy Court against the applicable Debtors’ estate for damages. Generally, the assumption of an executory contract or unexpired lease requires the Debtors to cure existing monetary defaults under such executory contract or unexpired lease and provide adequate assurance of future performance. Accordingly, any description of an executory contract or unexpired lease with any of the Debtors in this Quarterly Report on Form 10-Q, including where applicable a quantification of the Company’s obligations under any such executory contract or unexpired lease with the applicable Debtor, is qualified by any overriding rejection rights the Company has under the Bankruptcy Code. Further, nothing herein is or shall be deemed an admission with respect to any claim amounts or calculations arising from the rejection of any executory contract or unexpired lease and the Debtors expressly preserve all of their rights with respect thereto.

Process for Plan of Reorganization

On the Petition Date, the Debtors filed the Plan, which if confirmed by the Bankruptcy Court, would, among other things, resolve the Debtors’ prepetition obligations, issue new debt and equity for the reorganized Company and establish the reorganized Company’s corporate governance subsequent to exit from bankruptcy.

In addition to being voted on by holders of impaired claims and equity interests, the Plan must satisfy certain requirements of the Bankruptcy Code and must be approved, or confirmed, by the Bankruptcy Court in order to become effective. The Plan will be accepted by a class of holders of claims against the Debtors if at least one-half in number and two-thirds in dollar amount of claims actually voting in each class of claims impaired by the Plan have voted to accept the Plan. A class of claims or equity interests that does not receive or retain any property under the Plan on account of such claims or interests is deemed to have voted to reject the Plan.

Under certain circumstances set forth in Section 1129(b) of the Bankruptcy Code, the Bankruptcy Court may confirm the Plan even if the Plan has not been accepted by all impaired classes of claims and equity interests. The precise requirements and evidentiary showing for confirming the Plan notwithstanding its rejection by one or more impaired classes of claims or equity interests depends upon a number of factors, including the status and seniority of the claims or equity interests in the rejecting class (i.e., unsecured or secured claims, subordinated or senior claims).

Although the Plan provides that the Debtors will emerge from bankruptcy as a going concern, there can be no assurance at this time that the Debtors will be able to successfully confirm and consummate the Plan or any other alternative restructuring transaction, including a sale of all or substantially all of the Debtors’ assets, that satisfies the conditions of the Bankruptcy Code and is confirmed by the Bankruptcy Court, or that the Plan will be implemented successfully. These conditions raise substantial doubt about the Company's ability to continue as a going concern.

Bankruptcy Accounting and Financial Reporting

For the three and nine months ended September 30, 2018 and 2017, the consolidated financial statements have not been modified to reflect the bankruptcy filing. For periods subsequent to filing the Petition, the Company will apply ASC 852, Reorganizations, in preparing the consolidated financial statements. ASC 852 requires that the financial statements distinguish transactions and events that are directly associated with the reorganization from the ongoing operations of the business. Accordingly, certain expenses, gains and losses that are realized or incurred in the Chapter 11 Cases will be recorded in a reorganization line item on the consolidated statements of operations. In addition, the pre-petition obligations that may be impacted by the bankruptcy reorganization process will be classified on the balance sheet in liabilities subject to compromise. These liabilities will be reported at the amounts expected to be allowed by the Bankruptcy Court, even if they may be settled for lesser amounts.