BRY 09.30.2012-10Q
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
T
 
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2012
o
 
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from            to          

Commission file number 1-9735
BERRY PETROLEUM COMPANY
(Exact name of registrant as specified in its charter)
DELAWARE
(State of incorporation or organization)
 
77-0079387
(I.R.S. Employer Identification Number)
1999 Broadway, Suite 3700
Denver, Colorado 80202
(Address of principal executive offices, including zip code)
Registrant's telephone number, including area code: (303) 999-4400
Indicate by check mark 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 T    NO £
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES T    NO £
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer T
 
Accelerated filer £
 
Non-accelerated filer £
 (Do not check if a
smaller reporting company)
 
Smaller reporting company £
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). YES £    NO T
As of October 26, 2012 the registrant had 52,386,165 shares of Class A Common Stock ($0.01 par value) outstanding. The registrant also had 1,763,866 shares of Class B Stock ($0.01 par value) outstanding on October 26, 2012, all of which is held by a single holder.


Table of Contents


BERRY PETROLEUM COMPANY
INDEX TO FORM 10-Q
September 30, 2012

 
Page
PART I. FINANCIAL INFORMATION
 
Item 1. Condensed Financial Statements (Unaudited)
 
 

2

Table of Contents

BERRY PETROLEUM COMPANY
Condensed Balance Sheets
(Unaudited)
(In Thousands, Except Share Information)

 
September 30,
2012
 
December 31,
2011
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
104

 
$
298

Restricted short-term investments
125

 
65

Accounts receivable
114,916

 
115,952

Deferred income taxes

 
13,779

Derivative instruments
10,573

 
6,117

Assets held for sale

 
14,622

Prepaid expenses and other
15,503

 
16,801

Total current assets
141,221

 
167,634

Oil and natural gas properties (successful efforts basis), buildings and equipment, net
3,010,126

 
2,531,393

Derivative instruments
11,122

 
7,027

Other assets
30,891

 
28,898

 
$
3,193,360

 
$
2,734,952

LIABILITIES AND SHAREHOLDERS' EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
155,766

 
$
126,489

Revenue and royalties payable
44,405

 
49,253

Accrued liabilities
48,392

 
35,066

Derivative instruments
1,309

 
20,365

Deferred income taxes
3,486

 

Total current liabilities
253,358

 
231,173

Long-term liabilities:
 
 
 
Deferred income taxes
248,018

 
185,450

Senior secured revolving credit facility
510,000

 
531,500

8.25% Senior subordinated notes due 2016

 
200,000

10.25% Senior notes due 2014, net of unamortized discount of $2,715 and $6,564, respectively
202,542

 
348,692

6.75% Senior notes due 2020
300,000

 
300,000

6.375% Senior notes due 2022
600,000

 

Asset retirement obligation
84,257

 
64,019

Derivative instruments
1,358

 
15,505

Other long-term liabilities
17,541

 
17,884

 
1,963,716

 
1,663,050

Shareholders' equity:
 
 
 
Preferred stock, $0.01 par value, 2,000,000 shares authorized; no shares outstanding

 

Capital stock, $0.01 par value:
 
 
 
Class A Common Stock, 100,000,000 shares authorized; 52,385,165 and 52,067,994 shares issued and outstanding, respectively
524

 
521

Class B Stock, 3,000,000 shares authorized; 1,763,866 and 1,797,784 shares issued and outstanding, respectively (liquidation preference of $0.50 per share)
18

 
18

Capital in excess of par value
362,051

 
350,158

Accumulated other comprehensive loss
(1,736
)
 
(5,517
)
Retained earnings
615,429

 
495,549

Total shareholders' equity
976,286

 
840,729

 
$
3,193,360

 
$
2,734,952

The accompanying notes are an integral part of these Condensed Financial Statements.

3

Table of Contents

BERRY PETROLEUM COMPANY
Condensed Statements of Operations
(Unaudited)
(In Thousands, Except Per Share Data)

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
REVENUES
 
 
 
 
 
 
 
Oil and natural gas sales
$
232,916

 
$
225,325

 
$
688,350

 
$
643,474

Electricity sales
9,514

 
9,826

 
21,354

 
24,202

Natural gas marketing
1,939

 
3,612

 
5,378

 
11,282

Gain on sale of assets
170

 

 
1,770

 

Interest and other income, net
286

 
463

 
1,678

 
1,394

 
244,825

 
239,226

 
718,530

 
680,352

EXPENSES
 
 
 
 
 
 
 
Operating costs—oil and natural gas production
70,778

 
61,979

 
187,491

 
177,842

Operating costs—electricity generation
4,727

 
6,965

 
14,000

 
19,969

Production taxes
9,700

 
9,185

 
30,048

 
24,926

Depreciation, depletion & amortization—oil and natural gas production
58,887

 
54,581

 
158,869

 
158,657

Depreciation, depletion & amortization—electricity generation
461

 
487

 
1,382

 
1,479

Natural gas marketing
1,753

 
3,285

 
4,917

 
10,475

General and administrative
17,767

 
14,922

 
53,473

 
47,123

Interest
20,572

 
19,928

 
61,446

 
53,295

Impairment of oil and natural gas properties

 

 
67

 

Dry hole, abandonment, impairment and exploration
2,729

 
196

 
7,283

 
619

Gain on purchase

 

 

 
(1,046
)
Extinguishment of debt

 
14,391

 
41,545

 
14,391

Realized and unrealized loss (gain) on derivatives, net
28,287

 
(162,145
)
 
(56,314
)
 
(126,437
)
 
215,661

 
23,774

 
504,207

 
381,293

Earnings before income taxes
29,164

 
215,452

 
214,323

 
299,059

Income tax provision
11,038

 
81,451

 
81,283

 
112,389

Net earnings
$
18,126

 
$
134,001

 
$
133,040

 
$
186,670

Basic net earnings per share
$
0.33

 
$
2.45

 
$
2.41

 
$
3.42

Diluted net earnings per share
$
0.33

 
$
2.42

 
$
2.39

 
$
3.38

Dividends per share
$
0.08

 
$
0.08

 
$
0.24

 
$
0.23

The accompanying notes are an integral part of these Condensed Financial Statements.

4

Table of Contents


BERRY PETROLEUM COMPANY
Condensed Statements of Comprehensive Earnings
(Unaudited)
(In Thousands)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
Net earnings
$
18,126

 
$
134,001

 
$
133,040

 
$
186,670

Other comprehensive earnings, net of income taxes:
 
 
 
 
 
 
 
Amortization of accumulated other comprehensive loss related to de-designated hedges, net of income tax benefits of $924, $5,886, $2,318 and $17,559, respectively
1,505

 
9,604

 
3,781

 
28,649

Other comprehensive earnings
1,505

 
9,604

 
$
3,781

 
$
28,649

Comprehensive earnings
$
19,631

 
$
143,605

 
$
136,821

 
$
215,319

The accompanying notes are an integral part of these Condensed Financial Statements.


5

Table of Contents

BERRY PETROLEUM COMPANY
Condensed Statements of Cash Flows
(Unaudited)
(In Thousands)
 
Nine Months Ended
 
September 30,
 
2012
 
2011
Cash flows from operating activities:
 
 
 
Net earnings
$
133,040

 
$
186,670

Depreciation, depletion and amortization
160,251

 
160,136

Gain on sale of assets
(1,770
)
 

Gain on purchase

 
(1,046
)
Extinguishment of debt
6,842

 
3,377

Amortization of debt issuance costs and net discount
5,350

 
6,261

Impairment of oil and natural gas properties
67

 

Dry hole and impairment
2,515

 
316

Derivatives
(34,760
)
 
(139,683
)
Stock-based compensation expense
7,589

 
7,451

Deferred income taxes
77,511

 
105,096

Other, net
(1,620
)
 
(275
)
Allowance for bad debt
450

 

Change in book overdraft
7,573

 
5,359

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
504

 
(24,614
)
Inventories, prepaid expenses, and other current assets
(2,634
)
 
(2,263
)
Accounts payable and revenue and royalties payable
15,097

 
48,438

Accrued interest and other accrued liabilities
15,611

 
16,667

Net cash provided by operating activities
391,616


371,890

Cash flows from investing activities:
 
 
 
Exploration and development of oil and natural gas properties
(524,036
)
 
(424,144
)
Property acquisitions
(75,706
)
 
(155,443
)
Capitalized interest
(13,977
)
 
(24,236
)
Proceeds from sale of assets
17,294

 

Deposits on asset sales
(3,300
)
 

Net cash used in investing activities
(599,725
)

(603,823
)
Cash flows from financing activities:
 
 
 
Proceeds from issuances on line of credit

 
368,100

Repayments of borrowings under line of credit

 
(355,900
)
Proceeds from issuance of 6.375% Senior notes due 2022
600,000

 

Repurchase of 8.25% Senior subordinated notes due 2016
(200,000
)
 

Repurchase of 10.25% Senior notes due 2014
(149,999
)
 
(91,044
)
Long-term borrowings under credit facility
1,215,500

 
529,400

Repayments of long-term borrowings under credit facility
(1,237,000
)
 
(214,400
)
Financing obligation
(309
)
 
(281
)
Debt issuance costs
(11,424
)
 
(1,176
)
Dividends paid
(13,160
)
 
(12,480
)
Stock options and restricted stock issued
3,551

 
7,333

Excess income tax benefit
756

 
2,197

Net cash provided by financing activities
207,915


231,749

Net decrease in cash and cash equivalents
(194
)
 
(184
)
Cash and cash equivalents at beginning of period
298

 
278

Cash and cash equivalents at end of period
$
104

 
$
94

Noncash investing activities:
 
 
 
Accrued capital expenditures
$
61,044

 
$
19,162

Asset retirement obligation
16,854

 
6,477

The accompanying notes are an integral part of these Condensed Financial Statements.

6

Table of Contents

BERRY PETROLEUM COMPANY
Condensed Statements of Shareholders' Equity
(Unaudited)
(In Thousands, Except Per Share Data)

 
Class
A
 
Class
B
 
Capital in
Excess of Par
Value
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Loss
 
Total
Shareholders'
Equity
Balances at December 31, 2011
$
521

 
$
18

 
$
350,158

 
$
495,549

 
$
(5,517
)
 
$
840,729

Stock options and restricted stock issued
3

 

 
3,548

 

 

 
3,551

Stock based compensation expense

 

 
7,589

 

 

 
7,589

Income tax effect of stock option exercises

 

 
756

 

 

 
756

Dividends ($0.24 per share)

 

 

 
(13,160
)
 

 
(13,160
)
Net earnings

 

 

 
133,040

 

 
133,040

Amortization of Accumulated other comprehensive loss related to de-designated hedges, net of income taxes

 

 

 

 
3,781

 
3,781

Balances at September 30, 2012
$
524

 
$
18

 
$
362,051

 
$
615,429

 
$
(1,736
)
 
$
976,286

The accompanying notes are an integral part of these Condensed Financial Statements.

7

Table of Contents

BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements
(Unaudited)

1. Basis of Presentation

These Condensed Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial reporting. Pursuant to the rules and regulations of the Securities and Exchange Commission (SEC), the unaudited Condensed Financial Statements do not include all disclosures required by GAAP. For a more complete understanding of Berry Petroleum Company's (the Company) operations, financial position and accounting policies, the unaudited Condensed Financial Statements and notes thereto should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 2011, previously filed with the SEC.

All adjustments, consisting of normal and recurring accruals, which are, in the opinion of management, necessary to fairly state the Company's Condensed Financial Statements have been included herein. Interim results are not necessarily indicative of expected annual results because of the impact of fluctuations in prices received for oil and natural gas, as well as other factors. In the course of preparing the Condensed Financial Statements, management makes various assumptions, judgments and estimates to determine the reported amounts of assets, liabilities, revenues and expenses, and to prepare disclosures of commitments and contingencies. Changes in these assumptions, judgments and estimates will occur as a result of the passage of time and the occurrence of future events, and, accordingly, actual results could differ from amounts previously established.
 
The Company's cash management process provides for the daily funding of checks as they are presented to the bank. Included in accounts payable at September 30, 2012 and December 31, 2011 were $23.7 million and $16.1 million, respectively, representing outstanding checks in excess of the bank balance (book overdraft).

Recent Accounting Standards

In December 2011, the Financial Accounting Standards Board issued Accounting Standards Update (ASU) No. 2011-11 which requires that an entity disclose both gross and net information about instruments and transactions that are either eligible for offset in the balance sheet or subject to an agreement similar to a master netting agreement, including derivative instruments. ASU 2011-11 was issued in order to facilitate comparison between GAAP and IFRS financial statements by requiring enhanced disclosures, but does not change existing GAAP that permits balance sheet offsetting. This authoritative guidance is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The Company is currently evaluating the provisions of ASU 2011-11 and assessing the impact, if any, it may have on the Company's financial position or results of operations.

2. Acquisitions and Divestitures

2012 Acquisitions

On September 12, 2012, the Company completed the acquisition of approximately 14,000 net acres contiguous to the Company's Brundage Canyon asset in the Uinta for an aggregate purchase price of $39.6 million, including usual and customary post-closing adjustments. Disclosures of purchase price allocation and also of pro forma revenues and net earnings for this acquisition are not material and have not been presented.

On April 13, 2012, the Company completed the acquisition of approximately 2,000 net acres and one well in the Wolfberry trend in the Permian for an aggregate purchase price of $14.9 million including usual and customary post-closing adjustments. Disclosures of purchase price allocation and also of pro forma revenues and net earnings for the acquisition of this acquisition are not material and have not been presented.

2012 Divestiture

On December 21, 2011, the Company entered into an agreement to sell its assets related to proved developed properties in Elko, Eureka and Nye Counties, Nevada, which closed on January 31, 2012, for total cash consideration of $15.6 million. The Company recorded a $1.6 million gain in conjunction with the sale. The gain was recorded in the Condensed Statements of Operations under the caption gain on sale of assets.


8

Table of Contents
BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements (Continued)
(Unaudited)
2. Acquisitions and Divestiture (Continued)

2011 Acquisition

On May 25, 2011, the Company acquired interests in producing properties on approximately 6,000 net acres in the Wolfberry trend in the Permian for an aggregate purchase price of $128.4 million. The acquisition was financed using the Company's credit facility. Disclosures of pro forma revenues and net earnings for this acquisition are not material and have not been presented.

3. Debt

Issuance and Sale of 6.375% Senior Notes Due 2022

On March 9, 2012, the Company issued $600 million aggregate principal amount of its 6.375% Senior notes due 2022 (2022 Notes) for net proceeds of $589.5 million. Interest is payable in arrears semi-annually in March and September of each year, beginning September 2012. The 2022 Notes are senior unsecured obligations of the Company, which rank effectively junior to all of the Company's existing and any future secured debt, to the extent of the value of the collateral securing that debt, equally in right of payment with the Company's 10.25% Senior notes due 2014 (2014 Notes) and 6.75% Senior notes due 2020 (2020 Notes), and senior in right of payment to any of the Company's future subordinated debt.
        
On and after March 15, 2017, the Company may redeem all or, from time to time, a part of the 2022 Notes upon not less than 30 nor more than 60 days’ notice, at the following redemption prices (expressed as a percentage of principal amount of notes to be redeemed), plus accrued and unpaid interest, if any, to the applicable redemption date (subject to the right of holders of record on the relevant record date to receive interest due on the relevant interest payment date), if redeemed during the 12-month period beginning on March 15 of the years indicated below:

2017
103.188
%
2018
102.125
%
2019
101.063
%
2020 and thereafter
100.000
%

In addition, before March 15, 2015, the Company may, at its option, on any one or more occasions redeem up to 35% of the aggregate principal amount of the 2022 Notes with the net cash proceeds of certain equity offerings and if certain conditions are met as described in the indenture governing the 2022 Notes, at a redemption price of 106.375% of the principal amount thereof, plus accrued and unpaid interest, if any, to the redemption date. At any time prior to March 15, 2017, the Company may also redeem all or part of the 2022 Notes at a redemption price equal to 100% of the principal amount of the notes redeemed plus a “make-whole” premium described in the indenture, plus accrued and unpaid interest, if any, to the redemption date.

Tender Offer and Redemption of Notes

On April 3, 2012, pursuant to the terms of the Offer to Purchase dated March 6, 2012, the Company repurchased $150.0 million aggregate principal amount of its 2014 Notes for an aggregate purchase price of $181.5 million, including accrued and unpaid interest. A related loss of $30.9 million was recorded in the second quarter of 2012, consisting of $26.4 million for premiums paid over par and $4.5 million for write-offs of net discounts and debt issuance costs. The 2014 Notes were repurchased using net proceeds from the issuance of the Company's 2022 Notes. Following the closing of the tender offer on April 3, 2012, $205.3 million aggregate principal amount of 2014 Notes was outstanding.

On April 9, 2012, the Company redeemed all $200 million aggregate principal amount of its 8.25% Senior subordinated notes due 2016 (2016 Notes) for an aggregate purchase price of $215.5 million, including accrued and unpaid interest. A related loss of $10.6 million was recorded in the second quarter of 2012 consisting of $8.3 million for premiums paid over par and $2.3 million for write-offs of debt issuance costs. The 2016 Notes were redeemed using net proceeds from the issuance of the Company's 2022 Notes.


9

Table of Contents
BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements (Continued)
(Unaudited)
3. Debt (Continued)

Senior Secured Revolving Credit Facility

On April 13, 2012, as part of the semi-annual borrowing base redetermination process, the Company entered into a fourth amendment to its credit facility. Among other things, the fourth amendment increased the borrowing base to $1.4 billion. Total lender commitments remained unchanged at $1.2 billion.
    
Borrowings under the credit facility bear interest at either (i) LIBOR plus a margin between 1.50% and 2.50% or (ii) the prime rate plus a margin between 0.50% and 1.50%, in each case, based on the amount utilized. The annual commitment fee on the unused portion of the credit facility ranges between 0.35% and 0.50% based on the amount utilized.

As of September 30, 2012, there were $510.0 million in outstanding borrowings under the credit facility and $23.2 million in outstanding letters of credit, leaving $666.8 million in borrowing capacity available under the credit facility. The maximum amount available under the credit facility is subject to semi-annual redeterminations of the borrowing base in April and October of each year, based on the value of the Company's proved oil and natural gas reserves, in accordance with the lenders' customary procedures and practices. The Company and the lenders each have the right to one additional redetermination each year. The semi-annual redetermination in October 2012 did not result in any changes to the borrowing base, lender commitments, or other terms of the credit facility.

4. Income Taxes

The effective income tax rate for the three months ended September 30, 2012 and 2011 was 37.8% and 37.8%, respectively. The effective income tax rate for the nine months ended September 30, 2012 and 2011 was 37.9% and 37.6%, respectively. The Company's provision for income taxes differed from the U.S. statutory rate of 35% primarily due to state income taxes, domestic production activities deduction, percentage depletion, nondeductible employee compensation and other permanent differences.

As of September 30, 2012, the Company had a gross liability for uncertain income tax benefits of $2.8 million, which, if recognized, would impact the effective income tax rate. There have been no significant changes to the calculation of uncertain income tax benefits during 2012. Consistent with the Company's policy, interest and penalties on income taxes have been recorded as a component of the income tax provision. The Company estimates that it is reasonably possible that the balance of unrecognized income tax benefits as of September 30, 2012 could decrease by a maximum of $2.6 million in the next 12 months due to the expiration of statutes of limitation and audit settlements.

5. Earnings Per Share

Basic net earnings per share is calculated by dividing net earnings available to common shareholders by the weighted average shares outstanding-basic during each period. Diluted earnings per share is calculated by dividing earnings available to common shareholders by the weighted average shares outstanding-dilutive, which includes the effect of potentially dilutive securities. Potentially dilutive securities consist of unvested restricted stock awards and outstanding stock options. No potential shares of common stock are included in the computation of any diluted per share amount when a net loss exists.

The two-class method of computing net earnings per share is required for those entities that have participating securities. The two-class method is an earnings allocation formula that determines net earnings per share for participating securities according to dividends declared (or accumulated) and participation rights in undistributed earnings. Unvested restricted shares issued under the Company's equity incentive plans prior to January 1, 2010 have the right to receive non-forfeitable dividends, participating on an equal basis with common shares, and thus are classified as participating securities. Participating securities do not have a contractual obligation to share in the Company's losses. Therefore, in periods of net loss, no portion of the loss is allocated to participating securities. Unvested restricted shares issued subsequent to January 1, 2010 under the Company's equity incentive plans do not participate in dividends. Stock options issued under the Company's equity incentive plans do not participate in dividends.


10

Table of Contents
BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements (Continued)
(Unaudited)
5. Earnings Per Share (Continued)

The following table shows the computation of basic and diluted net earnings per share for the three and nine months ended September 30, 2012 and 2011:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in thousands, except per share data)
2012
 
2011
 
2012
 
2011
Net earnings
$
18,126

 
$
134,001

 
$
133,040

 
$
186,670

Less: net earnings allocable to participating securities
118

 
1,207

 
709

 
1,797

Net earnings available for common shareholders
$
18,008

 
$
132,794

 
$
132,331

 
$
184,873

 
 
 
 
 
 
 
 
Basic net earnings per share
$
0.33

 
$
2.45

 
$
2.41

 
$
3.42

Diluted net earnings per share
$
0.33

 
$
2.42

 
$
2.39

 
$
3.38

Basic weighted average shares outstanding
54,945

 
54,211

 
54,883

 
54,029

Add: Dilutive effects of stock options and RSUs
336

 
654

 
395

 
743

Dilutive weighted average shares outstanding
55,281

 
54,865

 
55,278

 
54,772

 
Not included in the diluted earnings per share calculation were 0.7 million and 0.6 million stock options and RSUs, for the three and nine months ended September 30, 2012, respectively, because their effect would have been anti-dilutive. There were no stock options or RSUs excluded from the diluted earnings per share calculation for the three and nine months ended September 30, 2011

6. Asset Retirement Obligation

The following table summarizes the activity for the Company's asset retirement obligation (ARO) for the nine months ended September 30, 2012 and 2011:

 
Nine Months Ended
 
September 30,
(in thousands)
2012
 
2011
Beginning balance at January 1
$
64,019

 
$
53,443

Liabilities incurred
5,862

 
2,169

Liabilities settled
(2,763
)
 
(1,921
)
Liabilities assumed
2,651

 
119

Disposition of assets
(705
)
 

Accretion expense
4,201

 
3,593

Revisions in estimated cash flows
10,992

 
4,308

Ending balance at September 30
$
84,257

 
$
61,711


ARO reflects the estimated present value of the amount of dismantlement, removal, site reclamation and similar activities associated with the Company's oil and natural gas properties. Inherent in the fair value calculation of ARO are numerous assumptions and judgments including the ultimate settlement amounts, inflation factors, credit adjusted discount rates, timing of settlement and changes in the legal, regulatory, environmental and political environments. To the extent future revisions to these assumptions impact the fair value of the existing ARO liability, a corresponding adjustment is made to the oil and natural gas property balance.


11

Table of Contents
BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements (Continued)
(Unaudited)


7. Equity Incentive Compensation Plans

Stock-based compensation is measured at the grant date based on the fair value of the awards. The fair value is recognized on a straight-line basis over the requisite service period (generally the vesting period).

Total compensation cost recognized in the Condensed Statements of Operations for the grants under the Company's equity incentive compensation plans was $2.0 million and $1.9 million during the three months ended September 30, 2012 and 2011, respectively, and $7.2 million and $7.0 million during the nine months ended September 30, 2012 and 2011, respectively.

Stock Options

The following table summarizes stock option activity for the nine months ended September 30, 2012:

 
Number of
Shares
 
Weighted
Average
Exercise
Price
 
Aggregate
Intrinsic Value
(in thousands)(1)
 
Number of
Shares
Exercisable
Outstanding at January 1, 2012
1,520,689

 
$
30.32

 
$
17,798

 
1,434,020

Granted
82,262

 
53.02

 


 


Exercised
(200,509
)
 
17.71

 
6,859

 


Canceled/expired

 

 


 


Outstanding at September 30, 2012
1,402,442

 
$
33.45

 
$
11,900

 
1,254,583

__________________________________
(1)
The intrinsic value of a stock option is the amount by which the market value of the underlying stock at the end of the related period exceeds the exercise price of the option.
 
In March 2012, 82,262 stock options were granted under the 2010 Equity Incentive Plan to certain executive officers and other officers of the Company with exercise prices equal to the closing market price of the Company's common stock on the grant date. These stock options generally vest ratably over a four-year service period from the grant date and are exercisable immediately upon vesting through the tenth anniversary of the grant date.

The grant date fair value of each option granted was estimated using the Black-Scholes option pricing model. Expected volatility was calculated based on the historical volatility of the Company's common stock, and the risk-free interest rate was based on U.S. Treasury yield curve rates with maturities consistent with the expected life of each option. The key assumptions used in computing the weighted average fair market value of stock options granted were as follows:

 
2012
Expected volatility
50.00
%
Risk-free interest rate
0.95
%
Dividend yield
0.57
%
Expected term (in years)
5.2


As of September 30, 2012, there were $2.7 million of total unrecognized compensation costs related to outstanding stock options. These costs are expected to be recognized over 3.5 years.


12

Table of Contents
BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements (Continued)
(Unaudited)
7. Equity Incentive Compensation Plans (Continued)


Restricted Stock Units

The following table summarizes restricted stock unit (RSU) activity for the nine months ended September 30, 2012:

 
RSUs
 
Weighted
Average
Grant Date
Fair Value
 
Vest Date Fair
Value
(in thousands)
Outstanding at January 1, 2012
915,022

 
$
23.88

 
 

Granted
162,612

 
50.71

 
 

Issued
(50,660
)
 
42.94

 
$
2,446

Canceled/expired
(14,956
)
 
40.53

 
 

Outstanding at September 30, 2012(1)(2)
1,012,018

 
$
27.12

 
 

__________________________________
(1)
The balance outstanding includes 43,554 RSUs granted to non-employee directors that are 100% vested at date of grant, but are subject to deferral elections delaying the date on which the corresponding shares are issued.
(2)
The balance outstanding includes 469,165 RSUs granted to executive officers and other officers that have vested in accordance with the RSU agreement, but are subject to deferral elections delaying the date on which the corresponding shares are issued.

As of September 30, 2012, there were $12.8 million of total unrecognized compensation costs related to RSUs granted. These costs are expected to be recognized over 3.5 years.

Performance Share Program

The following table summarizes performance share award activity for the nine months ended September 30, 2012:

 
Performance
Share Awards(1)
 
Weighted
Average
Grant Date
Fair Value
 
Vest Date Fair
Value
(in thousands)
Outstanding at January 1, 2012
162,849

 
$
39.00

 
 

Granted
59,738

 
63.69

 
 

Issued

 

 
$

Canceled/expired

 

 
 

Outstanding at September 30, 2012
222,587

 
$
45.79

 
 

__________________________________
(1)
Reflects the maximum number of performance shares that can be issued.

In March 2012, 59,738 RSUs that are subject to performance metrics and a three-year service condition (performance shares) were granted to executive officers and certain other officers. The vesting of the performance shares is contingent upon satisfying certain performance criteria. No performance shares will vest unless, from January 1, 2012 to December 31, 2014, the Company maintains an interest coverage ratio of at least 2.5 to 1.0, achieves a defined total shareholder return as compared to the Company's defined peer group and achieves a defined level of compounded annual production growth as measured by average annual barrels of oil equivalent per day (excluding acquisitions and divestitures). If such thresholds are met, the number of performance shares that vest is based on the excess total shareholder return and compounded annual production growth over the thresholds.

For the portion of the performance shares subject to a performance-based vesting condition based on the Company's annual production growth, the grant date fair value was determined by reference to the closing price of the Company's common stock on the date of grant. The Company recognizes compensation expense when it becomes probable that these conditions will be achieved. However, any such compensation expense recognized is reversed if vesting does not actually occur.


13

Table of Contents
BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements (Continued)
(Unaudited)
7. Equity Incentive Compensation Plans (Continued)


For the portion of the performance shares subject to a market performance-based vesting condition based on the Company's total shareholder return, the grant date fair value was estimated using a Monte Carlo simulation method. The Monte Carlo model is based on random projections of stock price paths and must be repeated numerous times to achieve a probabilistic assessment. Expected volatility was calculated based on the historical volatility of the Company's common stock, and the risk-free interest rate is based on U.S. Treasury yield curve rates with maturities consistent with the three-year vesting period. The key assumptions used in valuing the market-based restricted shares were as follows:

 
2012
Number of simulations
100,000

Expected volatility
50
%
Risk-free interest rate
0.42
%

All compensation expense related to the market performance-based awards will be recognized if the requisite service period is fulfilled, even if the market condition is not achieved.

As of September 30, 2012, there were $2.5 million of total unrecognized compensation costs related to performance shares granted. These costs are expected to be recognized over 2.3 years.

8. Derivative Instruments

The Company uses financial derivative instruments as part of its price risk management program to achieve a more predictable, economic cash flow from its oil production by reducing its exposure to price fluctuations. The Company has historically entered into financial commodity swap and collar contracts to fix the floor and ceiling prices received for a portion of the Company's oil and natural gas production. During the second quarter of 2012, the Company began entering into derivative contracts to fix the floor and ceiling prices paid for a portion of its natural gas consumption. The terms of the Company's derivative contracts depend on various factors, including management's view of future crude oil and natural gas prices, acquisition economics on purchased assets and future financial commitments. The Company periodically enters into interest rate derivative agreements to protect against changes in interest rates on its floating rate debt. For further discussion related to the fair value of the Company's derivatives, see Note 9 to the Condensed Financial Statements.

As of September 30, 2012, the Company had commodity derivatives associated with the following volumes:

 
2012
 
2013
 
2014
 
2015
Oil sales, Bbl/D:
21,000

 
16,800

 
7,500

 
3,000

Natural gas purchases, MMBtu/D:

 
10,000

 

 


The Company entered into the following derivative instruments during the nine months ended September 30, 2012:

Crude Oil Sales (NYMEX WTI) Three-Way Collars
Term
 
Average Barrels
Per Day
 
Sold Put / Purchased Put / Sold Call
Full year 2013
 
800
 
$75.00 / $95.00 / $101.70
Full year 2013 and 2014
 
1,000
 
$70.00 / $90.00 / $100.00
Full year 2014
 
1,000
 
$70.00 / $90.00 / $120.00
Full year 2014
 
1,000
 
$70.00 / $90.00 / $121.80
Full year 2014
 
1,500
 
$70.00 / $90.00 / $100.00
Full year 2014 and 2015
 
1,000
 
$70.00 / $90.00 / $104.85
Full year 2015
 
2,000
 
$70.00 / $90.00 / $100.00

14

Table of Contents
BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements (Continued)
(Unaudited)
8. Derivative Instruments (Continued)



Natural Gas Purchases (NYMEX SoCal Border) Three-Way Collars
Term
 
Average MMBtus
Per Day
 
Sold Put / Purchased Call / Sold Call
Full year 2013
 
1,000
 
$2.90 / $4.00 / $5.00
Full year 2013
 
1,000
 
$2.96 / $4.25 / $5.25
Full year 2013
 
1,000
 
$2.70 / $4.00 / $5.00
Full year 2013
 
2,000
 
$3.03 / $4.25 / $5.25

Natural Gas Purchases (NYMEX SoCal Border) Purchased Calls
Term
 
Average MMBtus
Per Day
 
Strike Price
Deferred Premium per MMBtu
Full year 2013
 
1,000
 
$3.50
$0.43
Full year 2013
 
1,000
 
$3.50
$0.46
Full year 2013
 
1,000
 
$3.50
$0.4975
Full year 2013
 
2,000
 
$3.50
$0.5325


In March 2012, the Company terminated certain of its natural gas derivative instruments, which were associated with a total of 15,000 MMBtu/D for the remainder of 2012. The termination resulted in a net loss of $1.9 million, including cash settlements and non-cash fair value losses, and was recorded in the Condensed Statements of Operations under the caption realized and unrealized loss (gain) on derivatives, net.

Discontinuance of Cash Flow Hedge Accounting

Effective January 1, 2010, the Company elected to de-designate all of its commodity and interest rate derivative contracts that had been previously designated as cash flow hedges as of December 31, 2009. As a result, subsequent to December 31, 2009, the Company recognizes all gains and losses from changes in commodity derivative fair values immediately in earnings rather than deferring any such amounts in accumulated other comprehensive loss (AOCL). As a result of discontinuing hedge accounting, the changes in fair values of the Company's derivative contracts designated as cash flow hedges as of December 31, 2009 were frozen in AOCL and are reclassified into earnings as the original hedge transactions settle.

At December 31, 2011, AOCL consisted of $8.9 million ($5.5 million, net of income tax) of net unrealized losses on commodity and interest rate contracts that had been previously designated as cash flow hedges. At September 30, 2012, AOCL consisted of $2.8 million ($1.7 million net of income tax) of net unrealized losses on commodity and interest rate contracts that had been previously designated as cash flow hedges. During the three and nine months ended September 30, 2012, $2.4 million ($1.5 million, net of income tax) and $6.1 million ($3.8 million, net of income tax), respectively, of non-cash amortization of AOCL related to de-designated hedges was reclassified from AOCL into earnings. The Company expects to reclassify the remaining after-tax net losses of $1.7 million related to de-designated commodity and interest rate derivative contracts during the remainder of 2012.


15

Table of Contents
BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements (Continued)
(Unaudited)
8. Derivative Instruments (Continued)


The following tables detail the fair value of derivatives recorded on the Company's Condensed Balance Sheets, by category:

 
September 30, 2012
 
Derivative Assets
 
Derivative Liabilities
(in millions)
Balance Sheet
Classification
 
Fair Value
 
Balance Sheet
Classification
 
Fair Value
Current:
 
 
 
 
 
 
 
Commodity
Derivative assets
 
$
10.6

 
Derivative liabilities
 
$
1.3

Long term:
 
 
 
 
 
 
 
Commodity
Derivative assets
 
11.1

 
Derivative liabilities
 
1.4

Total derivatives
 
 
$
21.7

 
 
 
$
2.7


 
December 31, 2011
 
Derivative Assets
 
Derivative Liabilities
(in millions)
Balance Sheet
Classification
 
Fair Value
 
Balance Sheet
Classification
 
Fair Value
Current:
 
 
 
 
 
 
 
Commodity
Derivative assets
 
$
6.1

 
Derivative liabilities
 
$
20.4

Long term:
 
 
 
 
 
 
 
Commodity
Derivative assets
 
7.0

 
Derivative liabilities
 
15.5

Total derivatives
 
 
$
13.1

 
 
 
$
35.9


The table below summarizes the location and the amount of derivative instrument losses (gains) before income taxes reported in the Condensed Statements of Operations for the periods indicated:

 
 
 
Three Months Ended
 
Nine Months Ended
(in millions)
Location of Loss (Gain)
Recognized in Earnings
 
September 30,
September 30,
Description of Loss (Gain)
2012
 
2011
 
2012
 
2011
Commodity
 
 
 
 
 
 
 
 
 
Loss reclassified from AOCL into earnings (amortization of frozen amounts)
Oil and natural gas sales
 
$
2.7

 
$
15.5

 
$
7.9

 
$
45.0

Loss (gain) recognized in earnings (cash settlements and mark-to-market movements)
Realized and unrealized loss (gain) on derivatives, net
 
28.3

 
(162.1
)
 
(56.3
)
 
(126.4
)
Interest rate
 
 
 
 
 
 
 
 
 
(Gain) loss reclassified from AOCL into earnings (amortization of frozen amounts)
Interest
 
$
(0.3
)
 
$

 
$
(1.8
)
 
$
1.2



16

Table of Contents
BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements (Continued)
(Unaudited)
8. Derivative Instruments (Continued)


Credit Risk

The Company does not require collateral or other security from counterparties to support derivative instruments. However, the agreements with those counterparties typically contain netting provisions such that if a default occurs, the non-defaulting party can offset the amount payable to the defaulting party under the derivative contract with the amount due from the defaulting party. As a result of the netting provisions, the Company's maximum amount of loss due to credit risk is limited to the net amounts due to and from the counterparties under the derivative contracts. The maximum amount of loss due to credit risk that the Company would have incurred if all counterparties to its derivative contracts failed to perform at September 30, 2012 was $19.8 million.

As of September 30, 2012, the counterparties to the Company's commodity derivative contracts consist of nine financial institutions. The Company's counterparties or their affiliates are also lenders under the Company's credit facility. As a result, the counterparties to the Company's derivative agreements share in the collateral supporting the Company's credit facility. The Company is not generally required to post additional collateral under derivative agreements.

Certain of the Company's derivative agreements contain cross default provisions that require acceleration of amounts due under such agreements if the Company were to default on its obligations under its material debt agreements. In addition, if the Company were to default on certain of its material debt agreements, including its derivative agreements, the Company would be in default under the credit facility. As of September 30, 2012, the Company was in a net liability position with three of the counterparties to the Company's derivative instruments. As of September 30, 2012, the Company's largest two counterparties accounted for 80% of the value of its total net derivative positions.

9. Fair Value Measurements

The authoritative guidance for fair value measurements establishes a three-tier fair value hierarchy, which prioritizes the inputs used to measure fair value. These tiers include: Level 1, defined as unadjusted quoted prices in active markets for identical assets or liabilities; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs for use when little or no market data exists, therefore requiring an entity to develop its own assumptions.

A financial instrument's categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The Company's assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the classification of assets and liabilities within the fair value hierarchy. The Company recognizes transfers between levels at the end of the reporting period for which the transfer has occurred.

The fair value of all derivative instruments is estimated with industry-standard models that consider various assumptions, including quoted forward prices for commodities, time value, volatility factors and current market and contractual prices for the underlying instruments, as well as other relevant economic measures. The fair value of all derivative instruments is estimated using a combined income and market valuation methodology based upon forward commodity price and volatility curves. The curves are obtained from independent pricing services, and the Company has made no adjustments to the obtained prices. The independent pricing services publish observable market information from multiple brokers and exchanges. All valuations were compared against counterparty valuations to verify the reasonableness of prices. The Company also considers counterparty credit risk and its own credit risk in its determination of all estimated fair values. The Company has consistently applied these valuation techniques in all periods presented and believes it has obtained the most accurate information available for the types of derivative contracts it holds.


17

Table of Contents
BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements (Continued)
(Unaudited)
9. Fair Value Measurements (Continued)


Assets (Liabilities) Measured at Fair Value on a Recurring Basis

The following table presents information about the Company's financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2012 and December 31, 2011, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair values:

(in millions)
Total
 
Level 1
 
Level 2
 
Level 3
Commodity derivative asset (liability), net
 
 
 
 
 
 
 
September 30, 2012
$
19.0

 
$

 
$
19.0

 
$

December 31, 2011
$
(22.7
)
 
$

 
$
(22.7
)
 
$


Changes in Level 3 Fair Value Measurements

The table below includes a rollforward of the Condensed Balance Sheet amounts (including the change in fair value) for financial instruments classified by the Company within Level 3 of the fair value hierarchy. When a determination is made to classify a financial instrument within Level 3, the determination is based upon the significance of the unobservable factors to the overall fair value measurement. Level 3 financial instruments typically include, in addition to the unobservable or Level 3 components, observable components (that is, components that are actively quoted and can be validated to external sources).

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(in millions)
2012
 
2011
 
2012
 
2011
Fair value liability, beginning of period
$

 
$

 
$

 
$
(101.8
)
Transfers out of Level 3(1)

 

 

 
101.8

Realized and unrealized (gain) loss included in earnings

 

 

 

Settlements

 

 

 

Fair value liability, end of period
$

 
$

 
$

 
$

Total unrealized (gain) loss included in earnings related to financial assets and liabilities still on the Condensed Balance Sheets at September 30, 2012 and 2011
$

 
$

 
$

 
$

__________________________________
(1)
During the first quarter of 2011, the inputs used to value oil collars, natural gas collars and natural gas basis swaps were directly or indirectly observable, and these instruments were transferred to Level 2.

For further discussion related to the Company's derivatives, see Note 8 to the Condensed Financial Statements.


18

Table of Contents
BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements (Continued)
(Unaudited)
9. Fair Value Measurements (Continued)


Fair Market Value of Financial Instruments

The Company uses various assumptions and methods in estimating the fair values of its financial instruments. The following table presents fair value information about the Company's financial instruments:
September 30, 2012
Carrying
Amount
 
Estimated
Fair Value
(in millions)
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Cash and cash equivalents
$

 
$

 
$

 
$

 
$

Senior secured revolving credit facility(1)
510

 

 
510

 

 
510

10.25% Senior notes due 2014(2)
205

 
229

 

 

 
229

6.75% Senior notes due 2020
300

 
324

 

 

 
324

6.375% Senior notes due 2022
600

 
632

 

 

 
632

 
$
1,615

 
$
1,185

 
$
510

 
$

 
$
1,695

__________________________________
(1)
The Company's credit facility can be repaid at any time without penalty. Interest is generally fixed for 30-day increments at the prime rate or LIBOR plus a stipulated margin for the amount utilized and at a stipulated percentage as a commitment fee for the portion not utilized. The carrying amount of the credit facility approximated fair value due to the short-term maturities of the borrowings and because the borrowings bear interest at variable market rates.
(2)
Carrying amount does not include unamortized discount of $2.7 million.

December 31, 2011
 
 
 
(in millions)
Carrying
Amount
 
Estimated
Fair Value
Senior secured revolving credit facility(1)
$
532

 
$
532

8.25% Senior subordinated notes due 2016
200

 
209

10.25% Senior notes due 2014(2)
355

 
402

6.75% Senior notes due 2020
300

 
302

 
$
1,387

 
$
1,445

__________________________________
(1)
The Company's credit facility can be repaid at any time without penalty. Interest is generally fixed for 30-day increments at the prime rate or LIBOR plus a stipulated margin for the amount utilized and at a stipulated percentage as a commitment fee for the portion not utilized. The carrying amount of the credit facility approximated fair value due to the short-term maturities of the borrowings and because the borrowings bear interest at variable market rates.
(2)
Carrying amount does not include unamortized discount of $6.6 million.

10. Commitments and Contingencies

Uinta Crude Oil Sales Contract

The Company is a party to a crude oil sales contract through June 30, 2013 with a refiner for the purchase of a minimum of 5,000 Bbl/D of its Uinta crude oil. Pricing under the contract, which includes transportation and gravity adjustments, is at a fixed percentage of WTI. Gross operated oil production from the Company's Uinta properties subject to the terms of this contract averaged approximately 4,035 Bbl/D in the first nine months of 2012. The Company anticipates the crude oil sales customer will be conducting maintenance on its refinery during the fourth quarter of 2012, resulting on a reduction of the volumes of the Company's Uinta crude oil purchased by such customer during periods of maintenance. Such volumes will either have to be stored or sold into alternative markets to be identified. Due to the possibility of refinery constraints in the Utah region, it is possible that the loss of the Company's crude oil sales customer in Utah could impact the marketability of a portion of the Company's Uinta crude oil volumes. See Item 1A. Risk Factors of the Company's Annual Report on Form 10-K for the year ended 2011 filed with the SEC on February 28, 2012.


19

Table of Contents
BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements (Continued)
(Unaudited)
10. Commitments and Contingencies (Continued)

E. Texas Gathering System

In July 2009, the Company closed on the financing of its E. Texas natural gas gathering system for $18.4 million in cash. The Company entered into concurrent long-term natural gas gathering agreements for the E. Texas production which contained an embedded lease. Accordingly, the $16.7 million net book value of the property is being depreciated over the remaining useful life of the asset and the cash received of $18.4 million was recorded as a financing obligation. A portion of the payments under the agreements is recorded as gathering expense and a portion as interest expense, with the balance being recorded as a reduction to the financing obligation. There are no minimum payments required under these agreements. For the three months ended September 30, 2012 and 2011, the Company incurred costs of $0.8 million and $1.2 million, respectively, under the agreements. For the nine months ended September 30, 2012 and 2011, the Company incurred costs of $2.5 million and $4.3 million, respectively, under the agreements. These amounts are recorded in the Condensed Financial Statements under the caption operating costs—oil and natural gas production.

Carry and Earning Agreement

On January 14, 2011, the Company entered into an amendment relating to certain contractual obligations to a third party co-owner of certain Piceance assets in Colorado. The amendment waives the $0.2 million penalty for each well not spud by February 2011 and requires the Company to reassign to such co-owner, by January 31, 2020, all of the interest acquired by the Company from the co-owner in each 160-acre tract in which the Company has not drilled and completed a well that is producing or capable of producing from a designated formation, or deeper formation, on January 1, 2020. The amendment also requires the Company to pay the first $9.0 million of costs incurred in connection with the construction of either an extension of the existing access road or a new access road, including the third party's 50% share. If by June 30, 2013 (which date may be extended in certain circumstances), the Company has not expended $9.0 million ($4.5 million of which would otherwise be such third party's responsibility) in road construction costs, then it will be obligated to pay the third party 50% of the difference between $12.0 million and the actual amount expended on road construction as of such date. Due to the need to obtain regulatory approvals, the Company has not yet commenced construction of either an extension of the existing access road or a new access road and may be unable to do so by June 30, 2013, thus triggering the payment obligation to the third party.

Legal Matters

Department of the Interior Notice of Proposed Debarment. On June 14, 2012, the Company received a Notice of Proposed Debarment issued by the United States Department of the Interior (DOI). Pursuant to the notice, the DOI's Office of the Inspector General is proposing to debar the Company from participation in certain federal contracts and assistance activities, including oil and natural gas leases, for a period of three years. The basis for the proposed debarment relates to the Company's purported noncompliance with Bureau of Land Management (BLM) regulations relating to the operation of certain equipment, and the submission of related site facility diagrams, in its Uinta operations. In 2011, the Company entered into a settlement agreement with the BLM and paid a $2.1 million civil penalty relating to the matter. The Company intends to contest the proposed debarment and believes the matter is without merit; nevertheless, the Company is currently engaged in discussions with the DOI to resolve the matter administratively.

COGCC Order. On April 21, 2011, the Company received a proposed Order Finding Violation from the Colorado Oil and Gas Conservation Commission (COGCC) alleging that certain releases in late 2007 from a lined reserve pit located on a well pad in western Colorado violated COGCC regulations. Shortly thereafter, the Company entered into negotiations with the COGCC. While the Company denies that it violated any COGCC regulations in connection with the releases, on June 27, 2011, the COGCC approved and the Company later signed an Administrative Order on Consent under which the Company would pay $100,000, and fund a mutually acceptable public project in the amount of $73,000, in full satisfaction of the matter. The Company recorded these amounts in the second quarter of 2011, paid the $100,000 in July 2011 and paid the $73,000 to fund the public project in the third quarter of 2012, settling its obligation under the COGCC order.


20

Table of Contents
BERRY PETROLEUM COMPANY
Notes to Condensed Financial Statements (Continued)
(Unaudited)
10. Commitments and Contingencies (Continued)

Royalty Payments. Certain of the Company's royalty payment calculations are being disputed. On August 1, 2012, a federal court entered a judgment against the Company that the Company had inappropriately taken certain post-wellhead deductions against royalty payments. The Company is in the process of negotiating a settlement of the judgment under which the Company's liability to the royalty owner will be approximately $3.9 million, inclusive of statutory interest, of which approximately $1.3 million had been previously recorded under the caption operating costs—oil and natural gas production. The Company recorded $1.9 million in operating costs—oil and natural gas production and $0.7 million in interest expense in the nine months ended September 30, 2012 in conjunction with the verdict. As of September 30, 2012, the Company may be required to pay amounts of up to approximately $3.9 million with respect to other royalty disputes.

Other. The Company is involved in various other lawsuits, claims and inquiries, most of which are routine to the nature of its business. In the opinion of management, the resolution of these matters will not have a material effect on its financial position, results of operations or operating cash flows.

Environmental Matters

The Company has no material accrued environmental liabilities for its sites, including sites in which governmental agencies have designated the Company as a potentially responsible party, because it is not probable that a loss will be incurred and the minimum cost and/or amount of loss cannot be reasonably estimated. However, due to some of the uncertainties associated with environmental assessment and remediation activities, future expense to remediate the currently identified sites, and sites identified in the future, if any, could be incurred. Management believes, based upon current site assessments, that the ultimate resolution of any matters will not result in material costs incurred.

21

Table of Contents

Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations

The following is management's discussion and analysis of certain significant factors that have affected aspects of our financial position and the results of operations during the periods included in the accompanying Condensed Financial Statements. The following discussion and analysis should be read in conjunction with the discussion under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the audited Financial Statements for the year ended December 31, 2011, included in our Annual Report on Form 10-K and the Condensed Financial Statements included elsewhere herein.

The profitability of our operations in any particular accounting period is directly related to the realized prices of oil, natural gas and electricity sold, the type and volume of oil and natural gas produced and the volume of electricity generated and the results of development, exploitation, acquisition, exploration and derivative activities. The realized prices for natural gas and electricity fluctuate from one period to another due to regional market conditions and other factors, while oil prices are predominantly influenced by global supply and demand. The aggregate amount of oil and natural gas produced may fluctuate based on the success of development and exploitation of oil and natural gas reserves pursuant to current reservoir management. Steam costs are the primary variable component of our operating costs and fluctuate based on the amount of steam we inject and the price of fuel gas used to generate steam. We benefit from lower natural gas prices as a consumer of natural gas in our California operations. In the Permian, Uinta, E. Texas, and Piceance, we benefit from higher natural gas pricing as a producer of natural gas. The cost of natural gas used in our steaming operations and electrical generation, production rates, labor, equipment costs, maintenance expenses and production taxes are expected to be the principal influences on operating costs. Accordingly, our results of operations may fluctuate from period to period based on the foregoing principal factors, among others.

Notable Third Quarter 2012 Items

Increased oil production by 5% from the second quarter of 2012
Generated discretionary cash flow of $125.3 million from production of 36,286 BOE/D, of which 76% was oil(1) 
Generated operating margin of $47.34 per BOE, supported by sales of our California heavy oil at a $8.50 average premium to WTI during the quarter(1) 
Average daily production from our Diatomite properties increased 18% from the second quarter of 2012
Production from our North Midway-SunsetNew Steam Floods (NMWSSNSF) properties, which include McKittrick, averaged 1,925 BOE/D, a 10% increase from the second quarter of 2012
Production from our Permian properties averaged 6,860 BOE/D, a 6% increase from the second quarter of 2012
Production from our Uinta properties averaged 5,940 BOE/D, a 5% increase from the second quarter of 2012
Drilled 38 Uinta wells, 23 Permian wells, 17 Diatomite wells and 15 NMWSSNSF wells
Acquired approximately18,000 net acres in our core operating areas in the Uinta, 14,000 of which are contiguous to Brundage Canyon

Notable Items and Expectations for the Fourth Quarter and Full Year 2012

Expect to drill approximately 33 Diatomite wells, 25 additional Uinta wells, 17 additional McKittrick wells and 16 Permian wells during the fourth quarter of 2012
Expect full-year 2012 development capital of approximately $675 million and production of approximately 36,200 BOE/D

Expectations for 2013

Expect full-year 2013 development capital to be between $500 million and $600 million
Expect full-year 2013 total production growth of between 5% and 10% over 2012
Expect full-year 2013 oil production growth of between 10% and 15% over 2012
_____________________
(1)
Discretionary cash flow and operating margin are considered non-GAAP performance measures and reference should be made to "Reconciliation of Non-GAAP Measures" for further explanation as well as reconciliations to the most directly comparable GAAP measures.

Results of Operations.

In the third quarter of 2012, we reported net earnings of $18.1 million, or $0.33 per diluted share, and net cash flows from operations of $143.5 million. Net earnings in the third quarter of 2012 included a loss on derivatives of $20.0 million resulting from non-cash changes in fair values and amortization of accumulated other comprehensive loss (AOCL) related to de-designated hedges as well as dry hole expense of $1.4 million, in each case net of income taxes.

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For the first nine months of 2012, we reported net earnings of $133.0 million, or $2.39 per diluted share, and net cash flows from operations of $391.6 million. Net earnings for the first nine months of 2012 included a $25.8 million loss on extinguishment of debt associated with repurchasing all $200 million aggregate principal amount of our 8.25% Senior subordinated notes due 2016 (2016 Notes) and $150 million aggregate principal amount of our 10.25% Senior notes due 2014 (2014 Notes), a gain on derivatives of $21.6 million resulting from non-cash changes in fair values and amortization of AOCL related to de-designated hedges, $1.7 million of principal and interest related to a settlement of disputed royalty payments, dry hole expense of $1.4 million, a $9.1 million cash settlement related to the early termination of our natural gas derivatives and a $1.0 million gain associated with the sale of assets related to proved developed properties in Elko, Eureka and Nye Counties, Nevada (Nevada Assets), in each case net of income taxes.

Operating Data.

The following table sets forth selected operating data for the three months ended:

 
September 30, 2012
 
%
 
September 30, 2011
 
%
 
June 30, 2012
 
%
Heavy oil production (BOE/D)
18,149

 
50
 
18,173

 
49
 
17,395

 
49
Light oil production (BOE/D)
9,344

 
26
 
7,918

 
22
 
8,901

 
25
Total oil production (BOE/D)
27,493

 
76
 
26,091

 
71
 
26,296

 
74
Natural gas production (Mcf/D)
52,758

 
24
 
64,950

 
29
 
54,271

 
26
Total (BOE/D)(1)
36,286

 
100
 
36,916

 
100
 
35,341

 
100
Oil and natural gas, per BOE:
 
 
 
 
 
 
 
 
 
 
 
Average realized sales price
$
70.22

 
 
 
$
66.74

 
 
 
$
69.07

 
 
Average sales price including cash derivative settlements
$
71.45

 
 
 
$
67.62

 
 
 
$
70.40

 
 
Oil, per BOE:
 
 
 
 
 
 
 
 
 
 
 
Average WTI price
$
92.20

 
 
 
$
89.48

 
 
 
$
93.35

 
 
Price sensitive royalties(2)
(3.12
)
 
 
 
(3.37
)
 
 
 
(3.55
)
 
 
Location differential and other(3)
(0.68
)
 
 
 
4.45

 
 
 
(0.51
)
 
 
Oil derivatives non-cash amortization(4)
(1.10
)
 
 
 
(6.56
)
 
 
 
(1.12
)
 
 
Oil revenue
$
87.30

 
 
 
$
84.00

 
 
 
$
88.17

 
 
Add: Oil derivatives non-cash amortization(4)
1.10

 
 
 
6.56

 
 
 
1.12

 
 
Oil derivative cash settlements(5)
0.64

 
 
 
(6.32
)
 
 
 
0.79

 
 
Average realized oil price
$
89.04

 
 
 
$
84.24

 
 
 
$
90.08

 
 
Natural gas price:
 
 
 
 
 
 
 
 
 
 
 
Average Henry Hub price per MMBtu
$
2.80

 
 
 
$
4.20

 
 
 
$
2.21

 
 
Conversion to Mcf
0.19

 
 
 
0.21

 
 
 
0.15

 
 
Natural gas derivatives non-cash amortization(4)
0.02

 
 
 
0.02

 
 
 
0.03

 
 
Location differential and other
(0.13
)
 
 
 
(0.18
)
 
 
 
(0.11
)
 
 
Natural gas revenue per Mcf
$
2.88

 
 
 
$
4.25

 
 
 
$
2.28

 
 
Add: Natural gas derivatives non-cash amortization(4)
(0.02
)
 
 
 
(0.02
)
 
 
 
(0.03
)
 
 
Natural gas derivative cash settlements(5)
(0.04
)
 
 
 
0.42

 
 
 
(0.03
)
 
 
Average realized natural gas price per Mcf
$
2.82

 
 
 
$
4.65

 
 
 
$
2.22

 
 
__________________________________
(1)
Oil equivalents are determined using the ratio of six Mcf of natural gas to one barrel of oil.
(2)
Our Formax property in SMWSS—Steam Floods is subject to a price-sensitive royalty burden. The royalty is 53% of the amount of the heavy oil posted price above the 2012 base price of $17.43 per barrel as long as we maintain a minimum steam injection level. We met the steam injection level in the third quarter of 2012 and expect to meet the requirement going forward. The base price escalates at 2% annually and will be $17.78 in 2013.
(3)
In California, the per barrel oil posting differential at September 30, 2012 was $9.88, ranged from $7.76 to $9.93 during the third quarter of 2012 and averaged $8.50 during the third quarter of 2012. In Utah, the per barrel oil posting differential at September 30, 2012 was ($15.00), ranged from ($15.00) to ($16.52) during the third quarter of 2012 and averaged ($15.91) during the third quarter of 2012.
(4)
Non-cash amortization of AOCL resulting from discontinuing hedge accounting effective January 1, 2010. Recorded in the Condensed Statements of Operations under the caption oil and natural gas sales.
(5)
Cash settlements on derivatives are recorded in the Condensed Statements of Operations under the caption realized and unrealized loss (gain) on derivatives, net.

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The following table sets forth selected operating data for the nine months ended:

 
September 30, 2012
 
%
 
September 30, 2011
 
%
Heavy oil production (BOE/D)
17,519

 
50
 
17,363

 
49
Light oil production (BOE/D)
8,781

 
24
 
7,106

 
20
Total oil production (BOE/D)
26,300

 
74
 
24,469

 
69
Natural gas production (Mcf/D)
54,372

 
26
 
67,097

 
31
Total (BOE/D)(1)
35,362

 
100
 
35,652

 
100
Oil and natural gas, per BOE:
 
 
 
 
 
 
 
Average realized sales price
$
71.18

 
 
 
$
66.11

 
 
Average sales price including cash derivative settlements
$
72.08

 
 
 
$
64.63

 
 
Oil, per BOE:
 
 
 
 
 
 
 
Average WTI price
$
96.16

 
 
 
$
95.42

 
 
Price sensitive royalties(2)
(3.62
)
 
 
 
(3.59
)
 
 
Location differential and other(3)
(1.00
)
 
 
 
(0.48
)
 
 
Oil derivatives non-cash amortization(4)
(1.12
)
 
 
 
(6.77
)
 
 
Oil revenue
$
90.42

 
 
 
$
84.58

 
 
Add: Oil derivatives non-cash amortization(4)
1.12

 
 
 
6.77

 
 
Oil derivative cash settlements(5)
(0.50
)
 
 
 
(10.01
)
 
 
Average realized oil price
$
91.04

 
 
 
$
81.34

 
 
Natural gas price:
 
 
 
 
 
 
 
Average Henry Hub price per MMBtu
$
2.58

 
 
 
$
4.21

 
 
Conversion to Mcf
0.17

 
 
 
0.21

 
 
Natural gas derivatives non-cash amortization(4)
0.01

 
 
 
0.01

 
 
Location differential and other
(0.18
)
 
 
 
(0.15
)
 
 
Natural gas revenue per Mcf
$
2.58

 
 
 
$
4.28

 
 
Add: Natural gas derivatives non-cash amortization(4)
(0.01
)
 
 
 
(0.01
)
 
 
Natural gas derivative cash settlements(5)
0.29

 
 
 
0.41

 
 
Average realized natural gas price per Mcf
$
2.86

 
 
 
$
4.68

 
 
__________________________________
(1)
Oil equivalents are determined using the ratio of six Mcf of natural gas to one barrel of oil.
(2)
Our Formax property in SMWSS—Steam Floods is subject to a price-sensitive royalty burden. The royalty is 53% of the amount of the heavy oil posted price above the 2012 base price of $17.43 per barrel as long as we maintain a minimum steam injection level. We met the steam injection level in the first nine months of 2012 and expect to meet the requirement going forward. The base price escalates at 2% annually and will be $17.78 in 2013.
(3)
In California, the per barrel oil posting differential at September 30, 2012 was $9.88, ranged from $2.18 to $11.52 during the first nine months of 2012 and averaged $8.44 during the first nine months of 2012. In Utah, the per barrel oil posting differential at September 30, 2012 was ($15.00), ranged from ($12.49) to ($16.52) during the first nine months of 2012 and averaged ($15.76) during the first nine months of 2012.
(4)
Non-cash amortization of AOCL resulting from discontinuing hedge accounting effective January 1, 2010. Recorded in the Condensed Statements of Operations under the caption oil and natural gas sales.
(5)
Cash settlements on derivatives are recorded in the Condensed Statements of Operations under the caption realized and unrealized loss (gain) on derivatives, net.



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Table of Contents

The following table sets forth results of operations (in thousands except per share data) for the three month periods ended:


September 30,
2012

September 30,
2011

3Q11 to 3Q12
Change

June 30,
2012

2Q12 to 3Q12
Change
Oil sales
$
218,952


$
199,930


10
 %

$
210,517


4
 %
Natural gas sales
13,964


25,395


(45
)%

11,264


24
 %
Total oil and natural gas sales
$
232,916


$
225,325


3
 %

$
221,781


5
 %
Electricity sales
9,514


9,826


(3
)%

5,860


62
 %
Natural gas marketing
1,939


3,612


(46
)%

1,580


23
 %
Gain (loss) on sale of assets
170




100
 %

(163
)

204
 %
Interest and other income, net
286


463


(38
)%

645


(56
)%
Total revenues and other income
$
244,825


$
239,226


2
 %

$
229,703


7
 %
Net earnings
$
18,126


$
134,001




$
81,016



Diluted earnings per share
$
0.33


$
2.42




$
1.46




The following table sets forth results of operations (in thousands except per share data) for the nine month periods ended:


September 30,
2012

September 30,
2011
 
%
Change
Oil sales
$
649,922


$
564,996

 
15
 %
Natural gas sales
38,428


78,478

 
(51
)%
Total oil and natural gas sales
$
688,350


$
643,474

 
7
 %
Electricity Sales
21,354

 
24,202

 
(12
)%
Natural gas marketing
5,378

 
11,282

 
(52
)%
Gain on sale of assets
1,770

 

 
100
 %
Interest and other income, net
1,678

 
1,394

 
20
 %
Total revenues and other income
$
718,530

 
$
680,352

 
6
 %
Net earnings
$
133,040

 
$
186,670

 

Diluted earnings per share
$
2.39

 
$
3.38

 


Oil and Natural Gas Sales.

Oil and natural gas sales increased $7.6 million, or 3%, to $232.9 million in the third quarter of 2012 compared to the same period in 2011. The increase was primarily due to a 5% increase in the average realized sales price in the third quarter of 2012 compared to the same period in 2011, largely as a result of an increase in oil sales volumes as a percentage of total sales volumes. Our oil sales volume increased 5% in the third quarter of 2012 compared to the third quarter of 2011, while our natural gas sales volumes decreased 19%. The oil sales volume increase was primarily due to increased oil production from all of our oil properties except our legacy South Midway-Sunset—Steam Floods (SMWSS—Steam Floods) properties. Permian oil production in the third quarter of 2012 increased 1,250 BOE/D, or 29%, from the same period in 2011, Uinta oil production increased 320 BOE/D, or 10%, between periods, Diatomite oil production in the third quarter of 2012 increased 315 BOE/D, or 10%, from the same period in 2011 and oil production for NMWSS—NSF increased 170 BOE/D, or 10%, between periods. These increases in oil production were partially offset by a decrease in production from our SMWSS—Steam Floods properties due to expected production declines. The decrease in natural gas sales volumes was primarily due to expected production declines from our E. Texas and Piceance properties, partially offset by increased natural gas production from our Permian and Uinta properties.

    

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Table of Contents

Oil and natural gas sales increased $11.1 million, or 5%, to $232.9 million in the third quarter of 2012 compared to the second quarter of 2012. The increase was primarily due to a 3% increase in the overall sales volumes in the third quarter of 2012 compared to the second quarter of 2012. Additionally, there was a 2% increase in the average realized sales price between periods, primarily due to an increase in oil sales volumes as a percentage of total sales volumes. Oil sales volumes increased 5% in the third quarter of 2012 compared to the second quarter of 2012, while natural gas sales volumes decreased 2% between periods. The oil sales volume increase was primarily due to increased oil production from all of our oil properties, most notably in the Diatomite, which increased 530 BOE/D, or 18%, between periods. Additionally, NMWSS—NSF oil production in the third quarter of 2012 increased 180 BOE/D, or 10%, from the second quarter of 2012. The decrease in natural gas sales volumes was primarily due to expected field decline in E. Texas and the Piceance, partially offset by increased natural gas production in the Uinta and the Permian.

Oil and natural gas sales increased $44.9 million, or 7%, to $688.4 million in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011. The increase was primarily due to an 8% increase in the realized sales price over the same period, largely due to an increase in oil sales volumes as a percentage of total sales volumes. Oil sales volumes in the nine months ended September 30, 2012 increased 8% from the same period in 2011, while our natural gas sales volume decreased 19% between periods. The oil sales volume increase was primarily due to increased oil production from all of our oil properties except our legacy SMWSS—Steam Floods properties, most notably in the Permian, which increased 1,760 BOE/D, or 51%, between periods. Additionally, Diatomite oil production in the nine months ended September 30, 2012 increased 375 BOE/D, or 14%, from the nine months ended September 30, 2011 and NMWSS—NSF increased 210 BOE/D or 14% between periods. The increases in oil production were partially offset by a decrease in production from our SMWSS—Steam Floods properties due to expected production declines. The decrease in natural gas volumes was primarily due to expected production declines from our E. Texas and Piceance properties, partially offset by increased natural gas production from our Uinta and Permian properties.

Electricity Sales.

The following table sets forth selected results of operations for the periods ended:

 
Three Months Ended
 
Nine Months Ended
 
September 30,
2012

September 30,
2011

June 30,
2012
 
September 30,
2012

September 30,
2011
Electricity
 

 

 
 
 
 
 
Electricity sales (in thousands)
$
9,514


$
9,826


$
5,860

 
$
21,354


$
24,202

Operating costs (in thousands)
$
4,727


$
6,965


$
4,256

 
$
14,000


$
19,969

Electric power produced—MWh/D
2,146


2,114


2,061

 
2,099


1,980

Electric power sold—MWh/D
1,939


1,949


1,882

 
1,919


1,817

Average sales price/MWh
$
53.34


$
55.47


$
34.22

 
$
40.62


$
49.07

Fuel gas cost/MMBtu (including transportation)
$
2.97


$
4.38