Q3 2012 Form 10-Q
 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 2012
 OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File No. 001-33016
 EAGLE ROCK ENERGY PARTNERS, L.P.
(Exact Name of Registrant as Specified in Its Charter)
Delaware
 
68-0629883
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification Number)
 1415 Louisiana Street, Suite 2700
Houston, Texas 77002
(Address of principal executive offices, including zip code)

(281) 408-1200
(Registrant's telephone number, including area code)

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  x No  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, 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  x    No  o

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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated Filer  x
Accelerated Filer  o
Non-accelerated Filer  o
Smaller reporting company  o
 (Do not check if a smaller reporting company)

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

The issuer had 147,433,375 common units outstanding as of October 31, 2012.





TABLE OF CONTENTS
 
 
 
Page 
PART I. FINANCIAL INFORMATION
Item 1.
Financial Statements
 
Unaudited Condensed Consolidated Balance Sheets as of September 30, 2012 and December 31, 2011
 
Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2012 and 2011
 
Unaudited Condensed Consolidated Statement of Members' Equity for the nine months ended September 30, 2012
 
Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2012 and 2011
 
Notes to Unaudited Condensed Consolidated Financial Statements
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Item 4.
Controls and Procedures
PART II. OTHER INFORMATION
Item 1.
Legal Proceedings
Item 1A.
Risk Factors
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.
Defaults Upon Senior Securities
Item 4.
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
 

 


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PART I. FINANCIAL INFORMATION


Item 1. Financial Statements
EAGLE ROCK ENERGY PARTNERS, L.P.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
($ in thousands)

 
September 30,
2012
 
December 31,
2011
ASSETS
 
 
 
CURRENT ASSETS:
 
 
 
Cash and cash equivalents
$
194

 
$
877

Accounts receivable (a)
96,637

 
97,832

Risk management assets
33,963

 
13,080

Prepayments and other current assets
13,547

 
13,739

Total current assets
144,341

 
125,528

PROPERTY, PLANT AND EQUIPMENT — Net
1,792,414

 
1,763,674

INTANGIBLE ASSETS — Net
85,917

 
109,702

DEFERRED TAX ASSET
1,449

 
1,432

RISK MANAGEMENT ASSETS
14,354

 
24,290

OTHER ASSETS
44,414

 
21,062

TOTAL
$
2,082,889

 
$
2,045,688

 
 

 
 

LIABILITIES AND MEMBERS' EQUITY
 

 
 

CURRENT LIABILITIES:
 

 
 

Accounts payable
$
135,960

 
$
145,985

Accrued liabilities
29,753

 
12,734

Taxes payable
372

 
487

Risk management liabilities
1,396

 
11,649

Total current liabilities
167,481

 
170,855

LONG-TERM DEBT
875,446

 
779,453

ASSET RETIREMENT OBLIGATIONS
35,145

 
33,303

DEFERRED TAX LIABILITY
43,898

 
45,216

RISK MANAGEMENT LIABILITIES
3,012

 
6,893

OTHER LONG TERM LIABILITIES
2,522

 
2,621

COMMITMENTS AND CONTINGENCIES (Note 12)


 


MEMBERS' EQUITY (b)
955,385

 
1,007,347

TOTAL
$
2,082,889

 
$
2,045,688

________________________ 

(a)
Net of allowance for bad debt of $1,011 as of September 30, 2012 and $1,347 as of December 31, 2011.
(b)
143,830,873 and 127,606,229 common units were issued and outstanding as of September 30, 2012 and December 31, 2011, respectively. These amounts do not include unvested restricted common units granted under the Partnership's long-term incentive plan of 3,590,827 and 2,560,110 as of September 30, 2012 and December 31, 2011, respectively.

See accompanying notes to unaudited condensed consolidated financial statements.  


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EAGLE ROCK ENERGY PARTNERS, L.P.


UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
($ in thousands, except per unit amounts)
 
 
 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
 
2012
 
2011
 
2012
 
2011
 REVENUE:
 
 

 
 

 
 

 
 

Natural gas, natural gas liquids, oil, condensate and sulfur sales
 
$
184,494

 
$
264,119

 
$
580,152

 
$
732,491

Gathering, compression, processing and treating fees
 
13,604

 
11,567

 
35,566

 
37,116

Commodity risk management (losses) gains
 
(35,503
)
 
94,313

 
51,854

 
68,206

Other revenue
 
794

 
141

 
3,976

 
1,406

Total revenue
 
163,389

 
370,140

 
671,548

 
839,219

COSTS AND EXPENSES:
 
 

 
 

 
 

 
 

Cost of natural gas, natural gas liquids, and condensate
 
110,430

 
166,293

 
338,798

 
486,286

Operations and maintenance
 
27,074

 
24,897

 
81,685

 
66,323

Taxes other than income
 
4,748

 
4,556

 
14,518

 
13,061

General and administrative
 
16,807

 
16,068

 
52,384

 
43,746

Other operating income
 

 

 

 
(2,893
)
Impairment
 
55,900

 
9,870

 
122,824

 
14,754

Depreciation, depletion and amortization
 
40,395

 
35,040

 
118,043

 
90,314

Total costs and expenses
 
255,354

 
256,724

 
728,252

 
711,591

OPERATING (LOSS) INCOME
 
(91,965
)
 
113,416

 
(56,704
)
 
127,628

OTHER EXPENSE:
 
 

 
 

 
 

 
 

Interest expense, net
 
(14,199
)
 
(10,050
)
 
(35,087
)
 
(19,579
)
Interest rate risk management losses
 
(1,118
)
 
(6,878
)
 
(4,160
)
 
(11,183
)
Other income (expense), net
 
1

 
(3
)
 
(44
)
 
(167
)
Total other expense
 
(15,316
)
 
(16,931
)
 
(39,291
)
 
(30,929
)
(LOSS) INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
 
(107,281
)
 
96,485

 
(95,995
)
 
96,699

INCOME TAX BENEFIT
 
(386
)
 
(1,077
)
 
(556
)
 
(1,810
)
(LOSS) INCOME FROM CONTINUING OPERATIONS
 
(106,895
)
 
97,562

 
(95,439
)
 
98,509

DISCONTINUED OPERATIONS, NET OF TAX
 

 
(197
)
 

 
210

NET (LOSS) INCOME
 
$
(106,895
)
 
$
97,365

 
$
(95,439
)
 
$
98,719

  
NET INCOME PER COMMON UNIT—BASIC AND DILUTED:
 
 
 
 
 
 
 
 
Income from Continuing Operations
 
 
 
 
 
 
 
 
Common units - Basic
 
$
(0.78
)
 
$
0.78

 
$
(0.74
)
 
$
0.92

Common units - Diluted
 
$
(0.78
)
 
$
0.76

 
$
(0.74
)
 
$
0.88

Discontinued Operations
 
 
 
 
 
 
 
 
Common units - Basic
 
$

 
$

 
$

 
$

Common units - Diluted
 
$

 
$

 
$

 
$

Net Income
 
 
 
 
 
 
 
 
Common units - Basic
 
$
(0.78
)
 
$
0.78

 
$
(0.74
)
 
$
0.92

Common units - Diluted
 
$
(0.78
)
 
$
0.76

 
$
(0.74
)
 
$
0.88

Weighted Average Units Outstanding (in thousands)
 
 
 
 
 
 
 
 
Common units - Basic
 
138,059

 
122,575

 
132,710

 
105,042

Common units - Diluted
 
138,059

 
128,077

 
132,710

 
111,657

 See accompanying notes to unaudited condensed consolidated financial statements.

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EAGLE ROCK ENERGY PARTNERS, L.P.



UNAUDITED CONDENSED CONSOLIDATED STATEMENT OF MEMBERS’ EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2012
($ in thousands, except unit amounts)
 
Number of
Common
Units
 
Common
Units
BALANCE — December 31, 2011
127,606,229

 
$
1,007,347

Net loss

 
(95,439
)
Distributions

 
(86,773
)
Vesting of restricted units
145,562

 

Exercised warrants
5,300,588

 
31,804

Repurchase of common units
(32,526
)
 
(292
)
Equity based compensation

 
8,092

Common units issued in equity offering
10,811,020

 
94,838

Unit issuance costs for equity offering

 
(4,192
)
BALANCE — September 30, 2012
143,830,873

 
$
955,385


 See accompanying notes to unaudited condensed consolidated financial statements.  


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EAGLE ROCK ENERGY PARTNERS, L.P.


UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
($ in thousands)
 
Nine Months Ended September 30,
 
2012
 
2011
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net (loss) income
$
(95,439
)
 
$
98,719

Adjustments to reconcile net income to net cash provided by operating activities:

 

Discontinued operations

 
(210
)
Depreciation, depletion and amortization
118,043

 
90,314

Impairment
122,824

 
14,754

Amortization of debt issuance costs
2,425

 
1,688

Reclassing financing derivative settlements
(11,964
)
 
(3,706
)
Equity-based compensation
8,092

 
3,441

Loss on sale of assets
34

 
701

Other operating income

 
(2,893
)
Other
578

 
(1,271
)
Changes in assets and liabilities—net of acquisitions:
 
 
 
Accounts receivable
(1,105
)
 
(1,020
)
Prepayments and other current assets
(871
)
 
(180
)
Risk management activities
(25,081
)
 
(114,403
)
Accounts payable
(23,662
)
 
(11,063
)
Accrued liabilities
17,019

 
10,972

Other assets
1,807

 
(376
)
Other current liabilities
(1,700
)
 
(516
)
Net cash provided by operating activities
111,000

 
84,951

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Additions to property, plant and equipment
(223,333
)
 
(79,811
)
Acquisitions, net of cash acquired

 
(220,326
)
Proceeds from sale of assets
215

 
5,712

Deposit for acquisition
(22,750
)
 

Purchase of intangible assets
(3,836
)
 
(3,122
)
Net cash used in investing activities
(249,704
)
 
(297,547
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from long-term debt
663,550

 
826,379

Repayment of long-term debt
(814,050
)
 
(913,379
)
Proceeds from senior notes
246,253

 
297,837

Payment of debt issuance costs
(5,081
)
 
(16,800
)
Proceeds from derivative contracts
11,964

 
3,706

Common unit issued in equity offerings
94,838

 

Issuance costs for equity offerings
(4,192
)
 

Exercise of warrants
31,804

 
78,239

Repurchase of common units
(292
)
 
(119
)
Distributions to members and affiliates
(86,773
)
 
(49,080
)
Net cash provided by financing activities
138,021

 
226,783

CASH FLOWS FROM DISCONTINUED OPERATIONS:
 
 
 
Operating activities

 
(574
)
Net cash used in discontinued operations

 
(574
)
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS
(683
)
 
13,613

CASH AND CASH EQUIVALENTS—Beginning of period
877

 
4,049

CASH AND CASH EQUIVALENTS—End of period
$
194

 
$
17,662

 
 
 
 
NONCASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
Units issued for acquisitions
$

 
$
336,125

Transaction fees, not paid
$

 
$
706

Investments in property, plant and equipment, not paid
$
14,700

 
$
28,860

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
Interest paid—net of amounts capitalized
$
22,555

 
$
8,700

Cash paid for taxes
$
793

 
$
1,205

See accompanying notes to unaudited condensed consolidated financial statements.  

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EAGLE ROCK ENERGY PARTNERS, L.P.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. ORGANIZATION AND DESCRIPTION OF BUSINESS
 
Description of Business—Eagle Rock Energy Partners, L.P. ("Eagle Rock Energy" or the "Partnership") is a domestically-focused growth-oriented limited partnership engaged in the business of (i) gathering, compressing, treating, processing and transporting natural gas; fractionating and transporting natural gas liquids ("NGLs"); crude oil logistics and marketing; and natural gas marketing and trading (collectively the "Midstream Business"); and (ii) developing and producing interests in oil and natural gas properties (the "Upstream Business"). The Partnership's midstream assets are located in four significant natural gas producing regions: (i) the Texas Panhandle; (ii) East Texas/Louisiana; (iii) South Texas; (iv) and the Gulf of Mexico. These four regions are productive, mature, natural gas producing basins that have historically experienced significant drilling activity. Natural gas transported to the Partnership's gas processing plants, either in the Partnership's pipelines or third party pipelines, is treated to remove contaminants and conditioned or processed into marketable natural gas and NGLs. The Partnership reports its Midstream Business results through three segments: the Texas Panhandle Segment, the East Texas and Other Midstream Segment and the Marketing and Trading Segment.  The Partnership's upstream assets are located in four significant oil and gas producing regions: (i) Southern Alabama (which includes the associated gathering, processing and treating assets); (ii) Mid-Continent (which includes areas in Oklahoma, Arkansas, Texas Panhandle and North Texas); (iii) Permian (which includes areas in West Texas); and (iv) East Texas/South Texas/Mississippi. The Partnership reports its Upstream Business through one segment.

The general partner of Eagle Rock Energy is Eagle Rock Energy GP, L.P., and the general partner of Eagle Rock Energy GP, L.P. is Eagle Rock Energy G&P, LLC, both of which are wholly-owned subsidiaries of the Partnership.

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Presentation and Principles of Consolidation—The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements presented in the Partnership's Annual Report on Form 10-K for the year ended December 31, 2011. That report contains a more comprehensive summary of the Partnership's major accounting policies. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all appropriate adjustments, all of which are normally recurring adjustments unless otherwise noted, considered necessary to present fairly the financial position of the Partnership and its consolidated subsidiaries and the results of operations and cash flows for the respective periods. Operating results for the three and nine months ended September 30, 2012 are not necessarily indicative of the results that may be expected for the full year ending December 31, 2012.

Eagle Rock Energy is the owner of non-operating undivided interests in certain gas processing plants and gas gathering systems. Eagle Rock Energy owns these interests as tenants-in-common with the majority owner-operator of the facilities. Accordingly, Eagle Rock Energy includes its pro-rata share of assets, liabilities, revenues and expenses related to these assets in its financial statements. All intercompany accounts and transactions are eliminated in the unaudited condensed consolidated financial statements.

The Partnership has provided a discussion of significant accounting policies in its Annual Report on Form 10-K for the year ended December 31, 2011. Certain items from that discussion are repeated or updated below as necessary to assist in the understanding of these financial statements.
Use of Estimates—The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Significant estimates are required for proved oil and natural gas reserves, which can affect the carrying value of oil and natural gas properties. The Partnership evaluates its estimates and assumptions on a regular basis. The Partnership bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates and such differences could be material.

Inventory—Inventory is stated at the lower of cost or market, with cost being determined using the average cost method. At September 30, 2012 and December 31, 2011, the Partnership had $3.2 million and $1.4 million, respectively, of crude oil finished goods inventory, which is recorded as part of Other Current Assets within the unaudited condensed

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consolidated balance sheet.

Impairment of Long-Lived Assets—Management evaluates whether the carrying value of non-oil and natural gas long-lived assets has been impaired when circumstances indicate the carrying value of those assets may not be recoverable. This evaluation is based on undiscounted cash flow projections. The carrying amount is not recoverable if it exceeds the undiscounted sum of cash flows expected to result from the use and eventual disposition of the assets. Management considers various factors when determining if these assets should be evaluated for impairment, including, but not limited to:

significant adverse changes in legal factors or in the business climate;
a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast which demonstrates continuing losses associated with the use of a long-lived asset;
an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset;
significant adverse changes in the extent or manner in which an asset is used or in its physical condition;
a significant change in the market value of an asset; or
a current expectation that, more likely than not, an asset will be sold or otherwise disposed of before the end of its estimated useful life.

For its oil and natural gas long-lived assets, accounted for utilizing the successful efforts method, the Partnership reviews its proved properties at the field level when management determines that events or circumstances indicate that the recorded carrying value of the properties may not be recoverable. Such events include a negative revision to the proved reserves estimates, unfavorable projections of future prices, the timing of future production and estimates of future costs to produce the oil and natural gas. Unproved properties (both individually significant and insignificant) are assessed periodically within specific geographic areas and, if necessary, impairments are charged to expense.

If the carrying value is not recoverable on an undiscounted basis, the impairment loss is measured as the excess of the asset's carrying value over its fair value. Management assesses the fair value of long-lived assets using commonly accepted techniques, and may use more than one method, including, but not limited to, recent third party comparable sales, internally developed discounted cash flow analysis and analysis from outside advisors. Significant changes in market conditions resulting from events such as the condition of an asset or a change in management's intent to utilize the asset would generally require management to reassess the cash flows related to the long-lived assets.  

See Notes 4 and 6 for further discussion on impairment charges.
 
Revenue Recognition—Eagle Rock Energy's primary types of sales and service activities reported as operating revenue include:
 
sales of natural gas, NGLs, crude oil, condensate and sulfur; 
natural gas gathering, processing and transportation, from which Eagle Rock Energy generates revenues primarily through the compression, gathering, treating, processing and transportation of natural gas; and 
NGL transportation from which the Partnership generates revenues from transportation fees.
 
Revenues associated with sales of natural gas, NGLs, crude oil, condensate and sulfur are recognized when title passes to the customer, which is when the risk of ownership passes to the customer and physical delivery occurs. Revenues associated with transportation and processing fees are recognized in the period when the services are provided.
 
For gathering and processing services, the Partnership either receives fees or commodities from natural gas producers under various types of contracts including percentage-of-proceeds, fixed recovery and percent-of-index arrangements. The Partnership also recognizes fee-based service revenues for services such as transportation, compression and processing.

The Partnership's Upstream Segment recognizes natural gas revenues based on the amount of natural gas sold to purchasers. The volumes of natural gas sold may differ from the volumes to which the Partnership is entitled based on its interests in the properties. Differences between volumes sold and volumes based on entitlements create natural gas imbalances. Material imbalances are reflected as adjustments to reported natural gas reserves and future cash flows.  For the Upstream Segment, as of September 30, 2012, the Partnership had long-term payables totaling $1.4 million. For the Upstream Segment, as of December 31, 2011, the Partnership had imbalance receivables totaling $0.3 million and long-term payables totaling $1.6 million.
 
Transportation and Exchange Imbalances—In the course of transporting natural gas and NGLs for others, the

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Partnership may receive for redelivery different quantities of natural gas or NGLs than the quantities actually delivered. These transactions result in transportation and exchange imbalance receivables or payables which are recovered or repaid through the receipt or delivery of natural gas or NGLs in future periods, if not subject to cash out provisions. Imbalance receivables are included in accounts receivable and imbalance payables are included in accounts payable on the unaudited condensed consolidated balance sheets and marked-to-market using current market prices in effect for the reporting period of the outstanding imbalances. For the Midstream Business, as of September 30, 2012, the Partnership had imbalance receivables totaling $0.1 million and imbalance payables totaling $2.0 million. For the Midstream Business, as of December 31, 2011, the Partnership had imbalance receivables totaling $0.6 million and imbalance payables totaling $0.5 million. Changes in market value and the settlement of any such imbalance at a price greater than or less than the recorded imbalance results in either an upward or downward adjustment, as appropriate, to the cost of natural gas sold.

 Derivatives—Authoritative guidance establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires an entity to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The guidance provides that normal purchase and sale contracts, when appropriately designated, are not subject to the guidance. Normal purchases and sales are contracts which provide for the purchase or sale of something, other than a financial instrument or derivative instrument that will be delivered in quantities expected to be used or sold by the reporting entity over a reasonable period in the normal course of business. The Partnership's forward natural gas and crude oil purchase and sales contracts are designated as normal purchases and normal sales, with the exception of certain contracts with our natural gas trading and marketing business. The Partnership uses financial instruments such as swaps, collars and other derivatives to mitigate the risks to cash flows resulting from changes in commodity prices and interest rates. The Partnership recognizes these financial instruments on its unaudited condensed consolidated balance sheet at the instrument's fair value with changes in fair value reflected in the unaudited condensed consolidated statement of operations, as the Partnership has not designated any of these derivative instruments as hedges. The cash flows from derivatives are reported as cash flows from operating activities unless the derivative contract is deemed to contain a financing element. Derivatives deemed to contain a financing element are reported as a financing activity in the unaudited condensed consolidated statement of cash flows. See Note 10 for a description of the Partnership's risk management activities.

Other Reclassifications—Certain prior period financial statement balances have been reclassified to conform to the current year presentation. These reclassifications had no effect on the recorded net income.

NOTE 3. NEW ACCOUNTING PRONOUNCEMENTS
 
In May 2011, the Financial Accounting Standards Board ("FASB") issued additional guidance intended to result in convergence between GAAP and International Financial Reporting Standards ("IFRS") requirements for measurement of and disclosures about fair value. The amendments are not expected to have a significant impact on companies applying GAAP. Key provisions of the amendments include: a prohibition on grouping financial instruments for purposes of determining fair value, except when an entity manages market and credit risks on the basis of the entity’s net exposure to the group; an extension of the prohibition against the use of a blockage factor to all fair value measurements (that prohibition currently applies only to financial instruments with quoted prices in active markets); and a requirement that for recurring Level 3 fair value measurements, entities disclose quantitative information about unobservable inputs, a description of the valuation process used and qualitative details about the sensitivity of the measurements. In addition, for items not carried at fair value but for which fair value is disclosed, entities will be required to disclose the level within the fair value hierarchy that applies to the fair value measurement disclosed. This guidance was effective for the Partnership on January 1, 2012 and did not have a significant impact on the Partnership’s fair value measurements, financial condition, results of operations or cash flows.

In December 2011, the FASB issued new guidance related to disclosure requirements about the nature of an entity's rights of set-off and related arrangements associated with its financial instruments and derivative instruments. The new disclosures are designed to make financial statements that are prepared under U.S. GAAP more comparable to those prepared under IFRS. To better facilitate comparison between financial statements prepared under U.S. GAAP and IFRS, the new disclosures will give financial statement users information about both gross and net exposures. The disclosure requirements are effective for annual reporting periods beginning on or after January 1, 2013, and interim periods therein, with retrospective application required. The Partnership is currently evaluating the impact, if any, of the adoption of this guidance on its consolidated financial statements and related disclosures.


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NOTE 4. PROPERTY PLANT AND EQUIPMENT
 
Fixed assets consisted of the following:
 
September 30,
2012
 
December 31,
2011
 
  ($ in thousands)
Land
$
2,607

 
$
2,607

Plant
332,461

 
290,460

Gathering and pipeline
663,521

 
681,227

Equipment and machinery
37,323

 
31,720

Vehicles and transportation equipment
4,115

 
4,169

Office equipment, furniture, and fixtures
1,186

 
1,318

Computer equipment
10,771

 
9,539

Linefill
4,307

 
4,324

Proved properties
1,178,251

 
1,050,872

Unproved properties
58,537

 
91,363

Construction in progress
66,661

 
56,588

 
2,359,740

 
2,224,187

Less: accumulated depreciation, depletion and amortization
(567,326
)
 
(460,513
)
Net property plant and equipment
$
1,792,414

 
$
1,763,674

    
The following table sets forth the total depreciation, depletion, capitalized interest costs and impairment expense by type of asset within the Partnership's unaudited condensed consolidated statements of operations:

 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
  ($ in thousands)
Depreciation
$
14,428

 
$
13,509

 
$
42,805

 
$
40,612

Depletion
$
23,422

 
$
18,612

 
$
66,775

 
$
40,918

 
 
 
 
 
 
 
 
Capitalized interest costs
$
256

 
$
131

 
$
987

 
$
203

 
 
 
 
 
 
 
 
Impairment expense:
 
 
 
 
 
 
 
Proved properties (a)
$
20,060

 
$
9,705

 
$
20,060

 
$
9,705

Unproved properties (b)
$

 
$
165

 
$
785

 
$
489

Plant assets (c)(d)
$
32,551

 
$

 
$
39,896

 
$
4,560

Pipeline assets (d)
$
1,124

 
$

 
$
42,899

 
$

________________________________
(a)
During the three and nine months ended September 30, 2012, the Partnership incurred impairment charges in its Upstream Business related to its proved properties in the Barnett Shale that experienced reduced revenues resulting from lower natural gas prices and continuing high operating costs associated with gas compression. During the three and nine months ended September 30, 2011, the Partnership incurred impairment charges in its Upstream Business related to certain proved properties in the Jourdanton Field in South Texas, which included plans for five future drilling locations that we have determined not to pursue due to the current natural gas price environment.
(b)
During the nine months ended September 30, 2012, the Partnership incurred impairment charges in its Upstream Business related to certain unproved property leaseholds expected to expire undrilled in 2013. During the three and nine months ended September 30, 2011, the Partnership incurred impairment charges in its Upstream Business related to (i) certain legacy drilling locations in its unproved properties which it no longer intends to develop based on the performance of offsetting wells and (ii) certain drilling locations in its unproved properties which it no longer intends to develop.
(c)
During the nine months ended September 30, 2011, the Partnership recorded an impairment charge in its Texas Panhandle Segment to fully write-down its idle Turkey Creek plant.
(d)
During the three and nine months ended September 30, 2012, the Partnership incurred impairment charges in its Midstream Business related to certain plants and pipelines in its East Texas and Other Midstream Segment due to (i) reduced throughput volumes as its producer customers curtailed their drilling activity in response to the continued depressed natural gas price environment during the first three months of 2012, (ii) the loss of significant gathering contracts on its Panola system during the three and nine months ended September 30, 2012, and (iii) the substantial

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damage incurred at the Yscloskey processing plant as a result of Hurricane Isaac in August 2012. The value of assets for both the Panola system and the Yscloskey plant have been fully written down.


NOTE 5. ASSET RETIREMENT OBLIGATIONS

The Partnership recognizes asset retirement obligations associated with the retirement of tangible long-lived assets that result from the acquisition, construction and development of the assets. The Partnership records the fair value of a liability for an asset retirement obligation in the period in which it is incurred and a corresponding increase in the carrying amount of the related long-lived asset. The Partnership makes estimates of property abandonment costs that, in some cases, will not be incurred until a substantial number of years in the future. Such cost estimates could be subject to significant revisions in subsequent years due to changes in regulatory requirements, technological advances and other factors that may be difficult to predict. Although uncertainty about the timing and/or method of settlement may exist and may be conditional upon a future event, the obligation to perform the asset retirement activity is unconditional. Accordingly, the Partnership is required to recognize a liability for the fair value of a conditional asset retirement obligation upon initial recognition if the fair value of the liability can be reasonably estimated. The fair value of additions to the asset retirement obligations is estimated using valuation techniques that convert future cash flows to a single discounted amount. Significant inputs to the valuation include estimates of (i) remediation costs, (ii) remaining lives, (iii) future inflation factors and (iv) a credit-adjusted risk free interest rate.

A reconciliation of the Partnership's liability for asset retirement obligations is as follows:
 
2012
 
2011
 
 ($ in thousands)
Asset retirement obligations—December 31 
$
33,303

 
$
24,711

Additional liabilities
1,546

 
143

Liabilities settled 
(1,584
)
 
(264
)
Revision to liabilities
173

 

Additional liability related to acquisitions

 
4,439

Accretion expense
1,707

 
1,274

Asset retirement obligations—September 30
$
35,145

 
$
30,303

 

NOTE 6. INTANGIBLE ASSETS
 
Intangible assets consist of rights-of-way and easements and acquired customer contracts, which the Partnership amortizes over the term of the agreement or estimated useful life. The amortization period for the Partnership's rights-of-way and easements is 20 years. The amortization periods for contracts range from 5 to 20 years.  Intangible assets consisted of the following: 
 
September 30,
2012
 
December 31,
2011
 
($ in thousands)
Rights-of-way and easements—at cost
$
99,172

 
$
99,143

Less: accumulated amortization
(29,457
)
 
(25,570
)
Contracts
106,010

 
121,387

Less: accumulated amortization
(89,808
)
 
(85,258
)
Net intangible assets
$
85,917

 
$
109,702

        

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The following table sets forth amortization and impairment expense by type of intangible asset within the Partnership's unaudited condensed consolidated statements of operations:
 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
($ in thousands)
Amortization
$
2,535

 
$
2,919

 
$
8,437

 
$
8,784

 
 
 
 
 
 
 
 
Impairment expense:
 
 
 
 
 
 
 
Rights-of-way (a)
$
93

 
$

 
$
3,808

 
$

Contracts (a)
$
2,072

 
$

 
$
15,376

 
$

_____________________________________
(a)
During the three and nine months ended September 30, 2012, the Partnership incurred impairment charges in its Midstream Business related to certain rights-of-way and contracts in its East Texas and Other Midstream Segment due to (i) reduced throughput volumes as its producer customers curtailed their drilling activities due to the continued decline in natural gas prices during the first three months of 2012 and (ii) the termination of significant gathering contracts on its Panola system during the three and nine months ended September 30, 2012. The value of the contracts and rights-of-way related to the Panola system have been fully written down (see Note 11).

Estimated future amortization expense related to the intangible assets at September 30, 2012, is as follows (in thousands):
Year ending December 31,
 
2012
$
2,476

2013
$
8,825

2014
$
6,099

2015
$
6,099

2016
$
6,084

Thereafter
$
56,334


NOTE 7. LONG-TERM DEBT

Long-term debt consisted of the following:
 
September 30,
2012
 
December 31,
2011
 
($ in thousands)
Revolving credit facility:
$
331,000

 
$
481,500

Senior notes:
 
 
 
8.375% senior notes due 2019
550,000

 
300,000

Unamortized bond discount
(5,554
)
 
(2,047
)
Total senior notes
544,446

 
297,953

Total long-term debt
$
875,446

 
$
779,453

The Partnership currently pays an annual fee of 0.45% on the unused commitment under the revolving credit facility. As of September 30, 2012, the Partnership had approximately $15.6 million of outstanding letters of credit and approximately $328.5 million of availability under its revolving credit facility, based on total commitments and before considering covenant limitations.
As of September 30, 2012, the Partnership was in compliance with the financial covenants under the revolving credit facility.
Senior Notes
On July 13, 2012, the Partnership, along with its subsidiary, Eagle Rock Energy Finance Corp. ("Finance Corp"), as co-issuer and certain subsidiary guarantors, completed the sale of an additional $250.0 million of 8.375% senior unsecured notes due 2019 (the "Senior Notes") through a private placement exempt from the registration requirements of the Securities Act of 1933. After the original issue discount of $3.7 million and excluding related offering expenses, the Partnership received

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net proceeds of approximately $246.3 million, which were used to repay borrowings outstanding under its revolving credit facility. This issuance supplemented the Partnership's prior $300.0 million of Senior Notes issued in May 2011, all of which are treated as a single series.
The Senior Notes will mature on June 1, 2019, and interest is payable on the Senior Notes on each June 1 and December 1, commencing December 1, 2012.

NOTE 8. MEMBERS’ EQUITY

At September 30, 2012 and December 31, 2011, there were 143,830,873 and 127,606,229 unrestricted common units outstanding, respectively. In addition, there were 3,590,827 and 2,560,110 unvested restricted common units outstanding at September 30, 2012 and December 31, 2011, respectively.
    
During the nine months ended September 30, 2012 and 2011, 5,300,588 and 13,039,928 warrants were exercised, respectively, for an equivalent number of newly issued common units. The final exercise date for the warrants was May 15, 2012, and on that date the remaining unexercised warrants expired. As of December 31, 2011, 5,707,705 warrants were outstanding.

On May 31, 2012, the Partnership announced a program through which it may issue common units, from time to time, with an aggregate market value of up to $100 million. The Partnership is under no obligation to issue equity under the program. As of September 30, 2012, 691,020 units had been issued under this program for net proceeds of approximately $6.1 million.

During the three months ended September 30, 2012, the Partnership closed an underwritten public offering of 10,120,000 common units, which included the full exercise of the underwriters' option to purchase additional common units to cover over-allotments, for net proceeds of approximately $84.5 million.

The Partnership has declared a cash distribution for each quarter since its initial public offering. The table below summarizes the distributions paid and declared for the nine months ended September 30, 2012
Quarter Ended
 
Distribution
per Unit
 
Record Date
 
Payment Date
December 31, 2011
 
$
0.2100

 
February 7, 2012
 
February 14, 2012
March 31, 2012+
 
$
0.2200

 
May 8, 2012
 
May 15, 2012
June 30, 2012
 
$
0.2200

 
August 7, 2012
 
August 14, 2012
September 30, 2012
 
$
0.2200

 
November 7, 2012
 
November 14, 2012
_____________________________
+
The distribution excludes certain restricted unit grants.

NOTE 9. RELATED PARTY TRANSACTIONS
   
The following table summarizes transactions between the Partnership and affiliated entities:
 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
Affiliates of NGP:
  ($ in thousands)
Natural gas purchases from affiliates
$
610

 
$
1,646

 
$
2,285

 
$
4,838


 
September 30, 2012
 
December 31, 2011
Affiliates of NGP:
($ in thousands)
Payable (related to natural gas purchases)
$
219

 
$
371


NOTE 10. RISK MANAGEMENT ACTIVITIES
 
Interest Rate Swap Derivative Instruments


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To mitigate its interest rate risk, the Partnership has entered into interest rate swaps. These swaps convert the variable-rate term loan into a fixed-rate obligation. The purpose of entering into these swaps is to eliminate interest rate variability by converting LIBOR-based variable-rate payments to fixed-rate payments. Amounts received or paid under these swaps were recorded as reductions or increases in interest expense.

The following table sets forth certain information regarding the Partnership's interest rate swaps as of September 30, 2012:
    
Effective Date
 
Expiration
Date
 
Notional
Amount
 
Fixed
Rate 
6/22/2011
 
6/22/2015
 
$
250,000,000

 
2.950
%

During July 2012, in conjunction with the Partnership's issuance of $250.0 million of Senior Notes (see Note 7), which increased its fixed interest rate exposure, the Partnership terminated $200.0 million notional amount of existing fixed rate interest rate swaps at a cost of $3.9 million.

The Partnership's interest rate derivative counterparties include Wells Fargo Bank National Association and The Royal Bank of Scotland plc.
 
Commodity Derivative Instruments
 
The prices of crude oil, natural gas and NGLs are subject to fluctuations in response to changes in supply, demand, market uncertainty and a variety of additional factors which are beyond the Partnership's control.  These risks can cause significant changes in the Partnership's cash flows and affect its ability to achieve its distribution objectives and comply with the covenants of its revolving credit facility.  In order to manage the risks associated with changes in the future prices of crude oil, natural gas and NGLs on its forecasted equity production, the Partnership engages in risk management activities that take the form of commodity derivative instruments.  The Partnership has determined that it is necessary to hedge a substantial portion of its expected production in order to meaningfully reduce its future cash flow volatility.  The Partnership generally limits its hedging levels to less than its total expected future production. While hedging at this level of production does not eliminate all of the volatility in the Partnership's cash flows, it allows the Partnership to mitigate the risk of situations where a modest loss of production would not put it in an over-hedged position.  At times, the Partnership's strategy may involve entering into hedges with strike prices above current future prices or resetting existing hedges to higher price levels in order to meet its cash flow objectives or to stay in compliance with the covenants under its revolving credit facility.  In addition, the Partnership may also terminate or unwind hedges or portions of hedges when the expected future volumes do not support the level of hedges.  Expected future production for its Upstream Business is derived from the proved reserves, adjusted for price-dependent expenses and revenue deductions.  For the Midstream Business, expected future production is based on the expected production from wells currently flowing to the Partnership's processing plants, plus additional volumes the Partnership expects to receive from future drilling activity by its producer customer base.  The Partnership's expectations for its Midstream Business volumes associated with future drilling are based on information it receives from its producer customer base and historical observations. The Partnership applies the appropriate contract terms to these projections to determine its expected future equity share of the commodities.
 
The Partnership uses fixed-price swaps, costless collars and put options to achieve its hedging objectives and often hedges its expected future volumes of one commodity with derivatives of the same commodity.  In some cases, however, the Partnership believes it is better to hedge future changes in the price of one commodity with a derivative of another commodity, which it refers to as "proxy" hedging.  The Partnership will often hedge the changes in future NGL prices using crude oil hedges because NGL prices have been highly correlated to crude oil prices and hedging NGLs directly is usually less attractive due to the relative illiquidity in the NGL forward market.  The Partnership may use natural gas hedges to hedge a portion of its expected future ethane production because forward prices for ethane are often heavily discounted from its current prices.  Also, natural gas prices provide support for ethane prices because in many processing plants ethane can be recombined with the residue gas stream and sold as natural gas.  When the Partnership uses "proxy" hedging, it converts the expected volumes of the underlying commodity to equivalent volumes of the hedged commodity.  In the case of NGLs hedged with crude oil derivatives, these conversions are based on the historical relationship of the prices of the two commodities and management's judgment regarding future price relationships of the commodities.  In the case where ethane is hedged with natural gas derivatives, the conversion is based on the thermal content of ethane.

For accounting purposes, the Partnership has not designated any of its commodity derivative instruments as hedges; instead it marks these derivative contracts to fair value (see Note 11).  Changes in fair values of the commodity derivative

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instruments are recorded as an adjustment to the mark-to-market gains (losses) on risk management transactions within revenue.
 
By using derivative instruments to economically hedge exposure to changes in commodity prices, the Partnership exposes itself to counterparty credit risk. Historically, the Partnership's counterparties have all been participants or affiliates of participants within its revolving credit facility, which is secured by substantially all of the assets of the Partnership. Therefore, the Partnership is not currently required to post any collateral, nor does it require collateral from its counterparties.

The Partnership's commodity derivative counterparties as of September 30, 2012, not including counterparties of its marketing and trading business, included BNP Paribas, Wells Fargo Bank, National Association, Comerica Bank, Bank of Nova Scotia, The Royal Bank of Scotland plc, Bank of America N.A., J Aron and Company (an affiliate of Goldman Sachs), ING Capital Markets LLC, BBVA Compass Bank, Royal Bank of Canada, and CITIBANK, N.A.

The following tables set forth certain information regarding the Partnership's commodity derivatives. Within each table, some trades of the same commodities with the same tenors have been aggregated and shown as weighted averages.

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Commodity derivatives, as of September 30, 2012, that will mature during the years ended December 31, 2012, 2013, 2014 and 2015:
Underlying
 
Type
 
Notional
Volumes
(units) (a)
 
Floor
Strike
Price
($/unit)(b)
 
Cap
Strike
Price
($/unit)(b)
Portion of Contracts Maturing in 2012
 
 
 
 
 
 
 
 
Natural Gas
 
Costless Collar
 
690,000

 
$
5.53

 
$
6.72

Natural Gas
 
Swap (Pay Floating/Receive Fixed)
 
3,330,000

 
5.72

 
 
Crude Oil
 
Costless Collar
 
201,894

 
77.13

 
96.92

Crude Oil
 
Swap (Pay Floating/Receive Fixed)
 
228,717

 
89.30

 
 
Propane
 
Swap (Pay Floating/Receive Fixed)
 
7,862,400

 
1.38

 
 
IsoButane
 
Swap (Pay Floating/Receive Fixed)
 
1,990,800

 
1.80

 
 
Normal Butane
 
Swap (Pay Floating/Receive Fixed)
 
3,528,000

 
1.73

 
 
Natural Gasoline
 
Swap (Pay Floating/Receive Fixed)
 
1,285,200

 
2.22

 
 
Portion of Contracts Maturing in 2013
 
 
 
 
 
 
 
 
Natural Gas
 
Costless Collar
 
3,540,000

 
4.84

 
5.47

Natural Gas
 
Swap (Pay Floating/Receive Fixed)
 
12,170,000

 
4.86

 
 
Crude Oil
 
Costless Collar
 
99,000

 
74.85

 
104.57

Crude Oil
 
Swap (Pay Floating/Receive Fixed)
 
2,110,200

 
96.54

 
 
Propane
 
Swap (Pay Floating/Receive Fixed)
 
25,200,000

 
1.23

 
 
IsoButane
 
Swap (Pay Floating/Receive Fixed)
 
3,578,400

 
1.91

 
 
Normal Butane
 
Swap (Pay Floating/Receive Fixed)
 
4,384,800

 
1.82

 
 
Portion of Contracts Maturing in 2014
 
 
 
 
 
 
 
 
Natural Gas
 
Swap (Pay Floating/Receive Fixed)
 
11,400,000

 
4.55

 
 
Crude Oil
 
Costless Collar
 
240,000

 
90.00

 
106.00

Crude Oil
 
Swap (Pay Floating/Receive Fixed)
 
2,040,000

 
96.45

 
 
Portion of Contracts Maturing in 2015
 
 
 
 
 
 
 
 
Natural Gas
 
Swap (Pay Floating/Receive Fixed)
 
4,800,000

 
3.98

 
 
Crude Oil
 
Costless Collar
 
480,000

 
90.00

 
97.55

_______________________
(a)
Volumes of natural gas are measured in MMbtu, volumes of crude oil are measured in barrels, and volumes of natural gas liquids are measured in gallons.
(b)
Amounts represent the weighted average price in $/MMbtu for natural gas, $/barrel for crude oil and $/gallon for natural gas liquids.

During July 2012, the Partnership enhanced its commodity derivative portfolio by paying $2.8 million to adjust the strike price from $68.30 to $92.00 (the forward market price at the date of the transaction) per barrel on an existing WTI crude oil swap of 20,000 barrels per month for the nine months ended December 31, 2012.

Commodity Derivative Instruments - Marketing & Trading

The Partnership conducts natural gas marketing and trading activities. The Partnership engages in activities intended to capitalize on favorable price differentials between various receipt and delivery locations. The Partnership's activities are governed by its risk policy.

As part of its natural gas marketing and trading activities, the Partnership enters into both financial derivatives and physical contracts. These financial derivatives, primarily basis swaps, are transacted: (i) to economically hedge subscribed capacity exposed to market rate fluctuations and (ii) to mitigate the price risk related to other purchase and sales of natural gas. By entering into a basis swap, one pricing index is exchanged for another, effectively locking in the margin between the natural gas purchase and sale by removing index spread risk on the combined physical and financial transaction.
  
A commodity-related derivative contract may be designated as a "normal" purchase or sale if the commodity is to be physically received or delivered for use or sale in the normal course of business. If designated as "normal," the derivative contract is accounted for under the accrual method of accounting (not marked-to-market) with no balance sheet or income

15

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statement recognition of the contract until settlement. Commodity-related contracts that do not qualify for the normal designation are accounted for as derivatives and are marked-to-market each period.

Through the Partnership's natural gas marketing activity, the Partnership will have credit exposure to additional counterparties. The Partnership minimizes the credit risk associated with natural gas marketing by limiting its exposure to any single counterparty and monitoring the creditworthiness of its counterparties on an ongoing basis. In addition, the Partnership's natural gas purchase and sale contracts, for certain counterparties, are subject to counterparty netting agreements governing settlement under such natural gas purchase and sales contracts.

Marketing and Trading commodity derivative instruments, as of September 30, 2012, that will mature during the years ended December 31, 2012 and 2013:

Type
 
Notional Volumes (MMbtu)
Portion of Contracts Maturing in 2012
 
 
Basis Swaps - Purchases
 
4,960,000

Basis Swaps - Sales
 
4,340,000

Index Swap - Purchases
 
1,705,000

Index Swap - Sales
 
1,085,000

Swap (Pay Fixed/Receive Floating) - Purchases
 
1,162,500

Swap (Pay Floating/Received Fixed) - Sales
 
1,085,000

Forward purchase contract - index
 
12,542,888

Forward sales contract - index
 
9,312,866

Forward purchase contract - fixed price
 
2,926,400

Forward sales contract - fixed price
 
3,620,800

Portion of Contracts Maturing in 2013
 
 
Forward purchase contract - index
 
1,800,000

Forward sales contract - index
 
1,800,000


Changes in the fair value of these financial and physical contracts are recorded as adjustments to natural gas sales.

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Fair Value of Interest Rate and Commodity Derivatives
 
Fair values of interest rate and commodity derivative instruments not designated as hedging instruments in the unaudited condensed consolidated balance sheet as of September 30, 2012 and December 31, 2011:
 
As of September 30, 2012
 
Derivative Assets
 
Derivative Liabilities
 
Balance Sheet Classification
 
Fair Value
 
Balance Sheet Classification
 
Fair Value
 
($ in thousands)
Interest rate derivatives - liabilities
Current assets
 
$
(4,632
)
 
Current liabilities
 
$
(1,149
)
Interest rate derivatives - liabilities
Long-term assets
 
(8,090
)
 
Long-term liabilities
 
(1,958
)
Commodity derivatives - assets
Current assets
 
41,160

 
Current liabilities
 
216

Commodity derivatives - assets
Long-term assets
 
25,683

 
Long-term liabilities
 
16

Commodity derivatives - liabilities
Current assets
 
(2,565
)
 
Current liabilities
 
(463
)
Commodity derivatives - liabilities
Long-term assets
 
(3,239
)
 
Long-term liabilities
 
(1,070
)
Total derivatives
 
 
$
48,317

 
 
 
$
(4,408
)
 
 
 
 
 
 
 
 
 
As of
December 31, 2011
 
Derivative Assets
 
Derivative Liabilities
 
Balance Sheet Classification
 
Fair Value
 
Balance Sheet Classification
 
Fair Value
 
($ in thousands)
Interest rate derivatives - liabilities
Current assets
 
$

 
Current liabilities
 
$
(12,678
)
Interest rate derivatives - liabilities
Long-term assets
 

 
Long-term liabilities
 
(11,331
)
Commodity derivatives - assets
Current assets
 
24,240

 
Current liabilities
 
15,357

Commodity derivatives - assets
Long-term assets
 
26,611

 
Long-term liabilities
 
5,217

Commodity derivatives - liabilities
Current assets
 
(11,160
)
 
Current liabilities
 
(14,328
)
Commodity derivatives - liabilities
Long-term assets
 
(2,321
)
 
Long-term liabilities
 
(779
)
Total derivatives
 
 
$
37,370

 
 
 
$
(18,542
)
            
The following table sets forth the location of gains and losses for derivatives not designated as hedging instruments within the Partnership's unaudited condensed consolidated statement of operations:
Amount of Gain (Loss) Recognized in Income on Derivatives
 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
 
 
2012
 
2011
 
2012
 
2011
 
 
 
($ in thousands)
Interest rate derivatives
Interest rate risk management losses
 
$
(1,118
)
 
$
(6,878
)
 
$
(4,160
)
 
$
(11,183
)
Commodity derivatives
Commodity risk management gains (losses)
 
(35,503
)
 
94,313

 
51,854

 
68,206

Commodity derivatives - trading
Natural gas, natural gas liquids, oil, condensate and sulfur sales
 
(315
)
 
538

 
(385
)
 
538

 
Total
 
$
(36,936
)
 
$
87,973

 
$
47,309

 
$
57,561

 

NOTE 11. FAIR VALUE OF FINANCIAL INSTRUMENTS
 
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The Partnership utilizes market data or assumptions that market participants would use in pricing the asset or liability, including assumptions about risk inherent in the inputs to the valuation technique. The authoritative guidance establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).
 

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The three levels of the fair value hierarchy are as follows:
 
Level 1 – Quoted prices are available in active markets for identical assets and liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide information on an ongoing basis.
 
Level 2 – Pricing inputs are other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. Level 2 includes those financial instruments that are valued using models or other valuation methodologies. These models are primarily 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. Substantially all of these assumptions are observable in the market place throughout the full term of the instrument, can be derived from observable data or are supported by observable levels at which transactions are executed in the marketplace.
 
Level 3 – Pricing inputs include significant inputs that are generally less observable from objective sources. These inputs may be used with internally developed methodologies that result in management's best estimate of fair value.
 
As of September 30, 2012, the Partnership has recorded its interest rate swaps and commodity derivative instruments (see Note 10), which includes crude oil, natural gas and NGLs, at fair value. The Partnership reviews the classification of the inputs at the end of each period and has classified the inputs to measure the fair value of its interest rate swaps, crude oil derivatives and natural gas derivatives as Level 2.  In periods prior to the three months ended September 30, 2012, the Partnership has classified the inputs to measure its NGL derivatives as Level 3, as the NGL market was considered to be less liquid and thinly traded. As of September 30, 2011, the Partnership concluded that the inputs for its NGL derivatives were considered to be more observable due to the NGL market being more liquid through the term of the Partnership's contracts and has classified these inputs as Level 2.

The following tables disclose the fair value of the Partnership's derivative instruments as of September 30, 2012 and December 31, 2011
 
As of September 30, 2012
 
Level 1
 
Level 2
 
Level 3
 
Netting (a)
 
Total
 
($ in thousands)
Assets:
 
 
 
 
 
 
 
 
 
Crude oil derivatives
$

 
$
19,504

 
$

 
$
(2,721
)
 
$
16,783

Natural gas derivatives

 
31,215

 

 
(3,315
)
 
27,900

NGL derivatives

 
16,356

 

 

 
16,356

Interest rate swaps

 

 

 
(12,722
)
 
(12,722
)
Total 
$

 
$
67,075

 
$

 
$
(18,758
)
 
$
48,317

 
 
 
 
 
 
 
 
 
 
Liabilities:
 

 
 

 
 

 
 

 
 

Crude oil derivatives
$

 
$
(2,735
)
 
$

 
$
2,721

 
$
(14
)
Natural gas derivatives

 
(4,602
)
 

 
3,315

 
(1,287
)
NGL derivatives

 

 

 

 

Interest rate swaps

 
(15,829
)
 

 
12,722

 
(3,107
)
Total 
$

 
$
(23,166
)
 
$

 
$
18,758

 
$
(4,408
)
____________________________
(a)
Represents counterparty netting under the agreement governing such derivative contracts.

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Table of Contents

 
As of
December 31, 2011
 
Level 1
 
Level 2
 
Level 3
 
Netting (a)
 
Total
 
($ in thousands)
Assets:
 
 
 
 
 
 
 
 
 
Crude oil derivatives
$

 
$
11,795

 
$

 
$
(14,150
)
 
$
(2,355
)
Natural gas derivatives

 
58,374

 

 
(17,930
)
 
40,444

NGL derivatives

 
1,256

 

 
(1,975
)
 
(719
)
Total 
$

 
$
71,425

 
$

 
$
(34,055
)
 
$
37,370

 
 
 
 
 
 
 
 
 
 
Liabilities:
 

 
 

 
 

 
 

 
 

Crude oil derivatives
$

 
$
(24,051
)
 
$

 
$
14,150

 
$
(9,901
)
Natural gas derivatives

 
(1,290
)
 

 
17,930

 
16,640

NGL derivatives

 
(3,247
)
 

 
1,975

 
(1,272
)
Interest rate swaps

 
(24,009
)
 

 

 
(24,009
)
Total 
$

 
$
(52,597
)
 
$

 
$
34,055

 
$
(18,542
)
____________________________
(a)
Represents counterparty netting under the agreement governing such derivative contracts.
 
The following table sets forth a reconciliation of changes in the fair value of the Level 3 NGL derivatives during the three and nine months ended September 30, 2012 and 2011:
 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
($ in thousands)
Net liability beginning balance
$

 
$
(9,632
)
 
$

 
$
(5,733
)
Settlements 

 
6,156

 

 
15,562

Total gains or losses (realized and unrealized) 

 
521

 

 
(12,784
)
Transfers out of Level 3

 
2,955

 

 
2,955

Net liability ending balance
$

 
$

 
$

 
$


The Partnership valued its Level 3 NGL derivatives using forward curves, interest rate curves and volatility parameters, when applicable. In addition, the impact of counterparty credit risk is factored into the value of derivative assets, and the Partnership's credit risk is factored into the value of derivative liabilities.
  
Realized and unrealized losses related to the interest rate derivatives are recorded as part of interest rate risk management gains and losses in the unaudited condensed consolidated statements of operations.  Realized and unrealized gains and losses and premium amortization related to the Partnership's commodity derivatives are recorded as a component of revenue in the unaudited condensed consolidated statements of operations. 
 
Fair Value of Assets and Liabilities Measured on a Non-recurring Basis

The following table discloses the fair value of the Partnership's assets measured at fair value on a nonrecurring basis during the nine months ended September 30, 2012:
 
September 30, 2012
 
Level 1
 
Level 2
 
Level 3
 
Total Losses
 
($ in thousands)
Proved properties
$
16,212

 
$

 
$

 
$
16,212

 
$
20,060

Plant assets
$
180

 
$

 
$

 
$
180

 
$
5,033

Pipeline assets
$
1,089

 
$

 
$

 
$
1,089

 
$
37,148

Rights-of-way
$
167

 
$

 
$

 
$
167

 
$
3,154

Contracts
$
49

 
$

 
$

 
$
49

 
$
1,056



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The Partnership calculated the fair value of the impaired assets using a discounted cash flow analysis to determine the excess of the asset's carrying value over its fair value. Significant inputs to the valuation of fair value of the proved properties included estimates of (i) future estimated cash flows, including revenue, expenses and capital expenditures, (ii) estimated timing of cash flows, (iii) estimated forward commodity prices, adjusted for estimate location differentials and (iv) a discount rate reflective of our cost of capital. For other assets impaired by the Partnership during nine months ended September 30, 2012, the assets were fully written down and thus are not included in the table above. See Notes 4 and 6 for a further discussion of the impairment charges.

The carrying amount of cash equivalents is believed to approximate their fair values because of the short maturities of these instruments. The fair value of accounts receivable and accounts payable are not materially different from their carrying amounts because of the short-term nature of these instruments.
 
As of September 30, 2012, the outstanding debt associated with the Partnership's revolving credit facility bore interest at a floating rate; as such, the Partnership believes that the carrying value of this debt approximates its fair value. The Partnership's 8.375% Senior Notes bear interest at a fixed rate; based on the market price of the Senior Notes as of September 30, 2012, the Partnership estimates that the fair value of the Senior Notes was $539.0 million compared to a carrying value of $544.4 million. Fair value of the senior notes was estimated based on prices quoted from third-party financial institutions, which are characteristic of Level 2 fair value measurement inputs.

NOTE 12. COMMITMENTS AND CONTINGENCIES
 
Litigation—The Partnership is subject to lawsuits which arise from time to time in the ordinary course of business, such as the interpretation and application of contractual terms related to the calculation of payment for liquids and natural gas proceeds. The Partnership had no accruals as of September 30, 2012 and December 31, 2011 related to legal matters, and current lawsuits are not expected to have a material adverse effect on our financial position, results of operations or cash flows. The Partnership has been indemnified up to a certain dollar amount for two lawsuits. If there ultimately is a finding against the Partnership in these two indemnified cases, the Partnership would expect to make a claim against the indemnification up to limits of the indemnification.

Insurance—The Partnership covers its operations and assets with insurance which management believes is consistent with that in force for other companies engaged in similar commercial operations with similar type properties.  This insurance includes: (1) commercial general liability insurance covering liabilities to third parties for bodily injury, property damage and pollution arising out of the Partnership's operations; (2) workers’ compensation liability coverage for employees to required statutory limits; (3) automobile liability insurance covering liability to third parties for bodily injury and property damage arising out of the operation of all owned, hired and non-owned vehicles by its employees on company business; (4) property insurance covering the replacement cost of all owned real and personal property, including coverage for losses due to boiler and machinery breakdown, earthquake, flood and consequent business interruption/extra expense; (5) control of well/operator's extra expense insurance for operated and non-operated wells in the Upstream Segment; and (6) corporate liability insurance including coverage for directors and officers and employment practices liabilities.  In addition, the Partnership maintains excess liability insurance providing limits in excess of the established primary limits for commercial general liability and automobile liability insurance.

Environmental—The operation of pipelines, plants and other facilities for gathering, transporting, processing, treating, or storing natural gas, NGLs and other products is subject to stringent and complex laws and regulations pertaining to health, safety and the environment. As an owner or operator of these facilities, the Partnership must comply with United States laws and regulations at the federal, state and local levels that relate to air and water quality, hazardous and solid waste management and disposal and other environmental matters. The cost of planning, designing, constructing and operating pipelines, plants, and other facilities must incorporate compliance with environmental laws and regulations and safety standards. Failure to comply with these laws and regulations may trigger a variety of administrative, civil and potentially criminal enforcement measures, including citizen suits, which can include the assessment of monetary penalties, the imposition of remedial requirements and the issuance of injunctions or restrictions on operation. Management believes that, based on currently known information, compliance with these laws and regulations will not have a material adverse effect on the Partnership's combined results of operations, financial position or cash flows. At September 30, 2012 and December 31, 2011, the Partnership had accrued approximately $2.9 million and $3.2 million, respectively, for environmental matters.

In July 2012, the Alabama Department of Environmental Management (“ADEM”) notified one of the Partnership's subsidiaries that ADEM had made a determination that alleged violations warrant enforcement action and determined that the alleged violations are appropriate for resolution by Consent Order and proposed the terms of a to-be-mutually agreed-upon Consent Order (“Proposed Consent Order”).  Such notification and the Proposed Consent Order are the result of findings made

20

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by ADEM relating to the Partnership's subsidiary's Flomaton/Fanny Church Oil and Gas Production and Treating Facility. The Proposed Consent Order primarily relates to allegations of emissions in excess of those allowed by the production rate.  Prior to receiving the Proposed Consent Order, the Partnership self-reported its emission rates and worked with ADEM to complete a series of quality improvement plans to address the causes of the alleged violations. The Proposed Consent Order includes a $100,000 fine, which may be negotiated to a lesser amount at the discretion of ADEM.

Retained Revenue Interest—Certain assets of the Partnership's Upstream Segment are subject to retained revenue interests.  These interests were established under purchase and sale agreements that were executed by the Partnership's predecessors in title.  The terms of these agreements entitle the owners of the retained revenue interests to a portion of the revenues received from the sale of the hydrocarbons above specified base oil and natural gas prices.  These retained revenue interests do not represent a real property interest in the hydrocarbons.  The Partnership's reported revenues are reduced to account for the retained revenue interests on a monthly basis.
 
The retained revenue interests affect the Partnership's interest at the Big Escambia Creek, Flomaton and Fanny Church fields in Escambia County, Alabama. With respect to the Partnership's Flomaton and Fanny Church fields, these retained revenue interests are in effect for any calendar year in which the Partnership surpasses certain average net production rates. The Partnership did not surpass such rates in 2011 and does not anticipate doing so in 2012. With respect to the Partnership's Big Escambia Creek field, the retained revenue interest commenced in 2010 and continues through the end of 2019.
 
Other Commitments—The Partnership utilizes assets under operating leases for its corporate office, certain rights-of-way and facilities locations, vehicles and in several areas of its operations. Rental expense, including leases with no continuing commitment, amounted to approximately $2.1 million, $6.4 million, $1.8 million and $6.1 million for the three and nine months ended September 30, 2012 and 2011, respectively. Rental expense for leases with escalation clauses is recognized on a straight-line basis over the initial lease term.

NOTE 13. SEGMENTS
     
During the fourth quarter of 2011, the Partnership's chief executive officer (who is its chief operating decision-maker "CODM") decided that due to the relative size of the East Texas/Louisiana, South Texas and Gulf of Mexico segments, these three reporting segments would be collapsed into a single reporting segment and that a new Marketing and Trading reporting segment would be created.  The Partnership's Marketing and Trading results were previously presented within its Texas Panhandle Segment.  The Partnership now conducts, evaluates and reports on its Midstream Business within three distinct segments—the Texas Panhandle Segment, the East Texas and Other Midstream Segment, which consolidates its former East Texas/Louisiana, South Texas and Gulf of Mexico Segments, and the Marketing and Trading Segment. The Partnership's Upstream Segment and functional (Corporate and Other) segment remain unchanged from what had been previously reported.
    
Based on the Partnership’s approach to managing its assets, the Partnership believes its operations consist of three segments in its Midstream Business, one Upstream Segment and one Corporate segment:

(i)    Midstream—Texas Panhandle Segment:
gathering, compressing, treating, processing and transporting natural gas; fractionating, transporting and marketing NGLs;

(ii)    Midstream—East Texas and Other Midstream Segment:
gathering, compressing, processing and treating natural gas and marketing of natural gas, NGLs and condensate in South Texas, East Texas, Louisiana, Gulf of Mexico and inland waters of Texas;

(iii)    Midstream—Marketing and Trading Segment:
crude oil logistics and marketing in the Texas Panhandle and Alabama; and natural gas marketing and trading;

(iv)    Upstream Segment:
crude oil, condensate, natural gas, NGLs and sulfur production from operated and non-operated wells; and
  
(v)    Corporate and Other Segment:
risk management, intersegment eliminations and other corporate activities such as general and administrative expenses.
 
The Partnership's CODM currently reviews its operations using these segments. The CODM evaluates segment performance based on segment operating income or loss from continuing operations. Summarized financial information

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concerning the Partnership's reportable segments is shown in the following tables:

Three Months Ended September 30, 2012
 
Texas
Panhandle
Segment
 
East Texas and Other
Midstream
Segment
 
Marketing
and Trading Segment
 
Total
Midstream
Business
 
Upstream
Segment
 
Corporate
and Other Segment
 
Total
Segments
($ in thousands)
Sales to external customers
 
$
64,921

 
 
$
35,026

 
$
60,756

 
$
160,703

 
$
38,189

 
 
$
(35,503
)
(a)
 
$
163,389

Intersegment sales
 
28,025

 
 
10,020

 
(40,891
)
 
(2,846
)
 
14,277

 
 
(11,431
)
 
 

Cost of natural gas and natural gas liquids
 
67,098

 
 
33,145

 
10,187

 
110,430

 

 
 

 
 
110,430

Intersegment cost of natural gas, oil and condensate
 

 
 

 
8,598

 
8,598

 

 
 
(8,598
)
 
 

Operating costs and other expenses
 
12,705

 
 
4,940

 
2

 
17,647

 
14,175

 
 
16,807

 
 
48,629

Depreciation, depletion and amortization
 
10,164

 
 
6,232

 
92

 
16,488

 
23,484

 
 
423

 
 
40,395

Impairment
 

 
 
35,840

 

 
35,840

 
20,060

 
 

 
 
55,900

Operating income (loss) from continuing operations
 
$
2,979

 
 
$
(35,111
)
 
$
986

 
$
(31,146
)
 
$
(5,253
)
 
 
$
(55,566
)
 
 
$
(91,965
)
Capital Expenditures
 
$
34,200

 
 
$
2,358

 
$
108

 
$
36,666

 
$
43,754

 
 
$
1,134

 
 
$
81,554



Three Months Ended September 30, 2011
 
Texas
Panhandle
Segment
 
East Texas and Other
Midstream
Segment
 
Marketing
and Trading Segment
 
Total
Midstream
Business
 
Upstream
Segment
 
Corporate
and Other Segment
 
Total
Segments
($ in thousands)
Sales to external customers
 
$
95,312

 
 
$
66,265

 
$
63,583

 
$
225,160

 
$
50,667

 
 
$
94,313

(a)
 
$
370,140

Intersegment sales
 
26,247

 
 
4,330

 
(31,980
)
 
(1,403
)
 
8,854

 
 
(7,451
)
 
 

Cost of natural gas and natural gas liquids
 
87,797

 
 
56,536

 
21,960

 
166,293

 

 
 

 
 
166,293

Intersegment cost of natural gas, oil and condensate
 

 
 

 
8,825

 
8,825

 

 
 
(8,825
)
 
 

Operating costs and other expenses
 
10,826

 
 
5,888

 
2

 
16,716

 
12,737

 
 
16,068

 
 
45,521

Depreciation, depletion and amortization
 
9,145

 
 
6,948

 

 
16,093

 
18,636

 
 
311

 
 
35,040

Impairment
 

 
 

 

 

 
9,870

 
 

 
 
9,870

Operating income from continuing operations
 
$
13,791

 
 
$
1,223

 
$
816

 
$
15,830

 
$
18,278

 
 
$
79,308

 
 
$
113,416

Capital Expenditures
 
$
21,443

 
 
$
3,619

 
$
1,151

 
$
26,213

 
$
31,868

 
 
$
623

 
 
$
58,704


Nine Months Ended September 30, 2012
 
Texas
Panhandle
Segment
 
East Texas and Other
Midstream
Segment
 
Marketing
and Trading Segment
 
Total
Midstream
Business
 
Upstream
Segment
 
Corporate
and Other Segment
 
Total
Segments
($ in thousands)
Sales to external customers
 
$
205,604

(c)
 
$
120,454

 
$
180,727

 
$
506,785

 
$
112,909

 
 
$
51,854

(a)
 
$
671,548

Intersegment sales
 
72,514

 
 
26,471

 
(106,794
)
 
(7,809
)
 
42,035

 
 
(34,226
)
 
 

Cost of natural gas and natural gas liquids
 
189,703

 
 
111,203

 
37,892

 
338,798

 

 
 

 
 
338,798

Intersegment cost of natural gas, oil and condensate
 

 
 

 
32,612

 
32,612

 

 
 
(32,612
)
 
 

Operating costs and other expenses
 
37,342

 
 
15,833

 
3

 
53,178

 
43,025

 
 
52,384

 
 
148,587

Depreciation, depletion and amortization
 
29,554

 
 
20,034

 
147

 
49,735

 
67,070

 
 
1,238

 
 
118,043

Impairment
 

 
 
101,979

 

 
101,979

 
20,845

 
 

 
 
122,824

Operating income (loss) from continuing operations
 
$
21,519

 
 
$
(102,124
)
 
$
3,279

 
$
(77,326
)
 
$
24,004

 
 
$
(3,382
)
 
 
$
(56,704
)
Capital Expenditures
 
$
112,487

 
 
$
8,010

 
$
339

 
$
120,836

 
$
116,523

 
 
$
2,463

 
 
$
239,822

Segment Assets
 
$
647,676

 
 
$
285,913

 
$
40,900

 
$
974,489

 
$
1,021,156

 
 
$
87,244

(b)
 
$
2,082,889


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Table of Contents

Nine Months Ended September 30, 2011
 
Texas
Panhandle
Segment
 
East Texas and Other
Midstream
Segment
 
Marketing
and Trading Segment
 
Total
Midstream
Business
 
Upstream
Segment
 
Corporate
and Other Segment
 
Total
Segments
($ in thousands)
Sales to external customers
 
$
317,718

 
 
$
217,996

 
$
126,341

 
$
662,055

 
$
108,958

(d)
 
$
68,206

(a)
 
$
839,219

Intersegment sales
 
26,247

 
 
4,330

 
(31,980
)
 
(1,403
)
 
31,378

 
 
(29,975
)
 
 

Cost of natural gas and natural gas liquids
 
247,512

 
 
176,202

 
62,572

 
486,286

 

 
 

 
 
486,286

Intersegment cost of natural gas, oil and condensate
 

 
 

 
29,817

 
29,817

 

 
 
(29,817
)
 
 

Operating costs and other expenses
 
31,434

 
 
16,645

 
2

 
48,081

 
31,303


 
40,853

 
 
120,237

Intersegment operations and maintenance
 

 
 

 

 

 
66

 
 
(66
)
 
 

Depreciation, depletion and amortization
 
27,382

 
 
20,868

 

 
48,250

 
41,046

 
 
1,018

 
 
90,314

Impairment
 
4,560

 
 

 

 
4,560

 
10,194

 
 

 
 
14,754

Operating income (loss) from continuing operations
 
$
33,077

 
 
$
8,611

 
$
1,970

 
$
43,658

 
$
57,727

 
 
$
26,243

 
 
$
127,628

Capital Expenditures
 
$
36,722

 
 
$
6,116

 
$
1,438

 
$
44,276

 
$
56,688

 
 
$
1,155

 
 
$
102,119

Segment Assets
 
$
566,574

 
 
$
375,023

 
$
35,156

 
$
976,753

 
$
960,963

 
 
$
87,416

(b)
 
$
2,025,132

______________________________
(a)
Represents results of the Partnership's commodity risk management activity.
(b)
Includes elimination of intersegment transactions. 
(c)
Sales to external customers in the Texas Panhandle Segment for the nine months ended September 30, 2012, includes $2.9 million of business interruption insurance recovery related to damage sustained by the Partnership's Cargray processing facility due to severe winter weather in 2011, which is recognized as part of Other Revenue in the unaudited condensed consolidated statements of operations.
(d)
Sales to external customers for the nine months ended September 30, 2011, includes $2.0 million of business interruption insurance recovery related to the shutdown of the Partnership's Eustace plant in 2011 in the Upstream Segment, which is recognized as part of Other Revenue in the unaudited condensed consolidated statement of operations.

NOTE 14. INCOME TAXES
 
Provision for Income Taxes -The Partnership's provision for income taxes relates to (i) state taxes for the Partnership and (ii) federal taxes for Eagle Rock Energy Acquisition Co., Inc. and Eagle Rock Energy Acquisition Co. II, Inc. and their wholly-owned subsidiary corporations, Eagle Rock Upstream Development Company, Inc. and Eagle Rock Upstream Development Company II, Inc., which are subject to federal income taxes.
Effective Rate - The effective rate for the nine months ended September 30, 2012 was 0.6% compared to (1.9)% for the nine months ended September 30, 2011. Due to the fact that the effective rate is a ratio of total tax expense compared to pre-tax book net income, the change is due primarily to book and tax temporary differences for the nine months ended September 30, 2012 as compared to the nine months ended September 30, 2011.

NOTE 15. EQUITY-BASED COMPENSATION
 
Eagle Rock Energy G&P, LLC, the general partner of the general partner of the Partnership, has a long-term incentive plan (as amended, the "LTIP"), for its employees, directors and consultants who provide services to the Partnership and its subsidiaries and affiliates. The LTIP provides for the issuance of an aggregate of up to 7,000,000 common units, to be granted either as options, restricted units or phantom units, of which, as of September 30, 2012, a total of 1,699,988 common units remained available for issuance. Grants of common units under the LTIP are made at the discretion of the board. Distributions declared and paid on outstanding restricted units are paid directly to the holders of the restricted units. No options or phantom units have been issued to date.

The restricted units granted are valued at the market price as of the date issued. The awards generally vest over three years on the basis of one-third of the award each year. The Partnership recognizes compensation expense on a straight-line basis over the requisite service period for the restricted unit grants. During the restriction period, distributions associated with the granted awards will be distributed to the awardees.
 

23

Table of Contents

A summary of the restricted common units’ activity for the nine months ended September 30, 2012 is provided below:
 
Number of
Restricted
Units
 
Weighted
Average
Fair Value
Outstanding at December 31, 2011
2,560,110

 
$
8.71

Granted
1,343,455

 
$
9.50

Vested
(145,562
)
 
$
8.54

Forfeited
(167,176
)
 
$
9.11

Outstanding at September 30, 2012
3,590,827

 
$
8.99

    
For the three and nine months ended September 30, 2012 and 2011, non-cash compensation expense of approximately $3.1 million, $8.1 million, $1.5 million and $3.4 million, respectively, was recorded related to the granted restricted units as general and administrative expense on the unaudited condensed consolidated statements of operations.
 
As of September 30, 2012, unrecognized compensation costs related to the outstanding restricted units under the LTIP totaled approximately $22.5 million. The remaining expense is to be recognized over a weighted average of 2.18 years.

In connection with the vesting of certain restricted units during the nine months ended September 30, 2012, the Partnership cancelled 32,526 of the newly vested common units in satisfaction of $0.3 million of employee tax liability paid by the Partnership. Pursuant to the terms of the LTIP, these cancelled units are available for future grants under the LTIP.
 
NOTE 16. EARNINGS PER UNIT
 
Basic earnings per unit is computed by dividing the net income (loss) by the weighted average number of units outstanding during a period. To determine net income (loss) allocated to each class of ownership (common and restricted common units), the Partnership first allocates net income (loss) in accordance with the amount of distributions made for the quarter by each class, if any. The remaining net income (loss) is allocated to each class in proportion to the class weighted average number of units outstanding for a period, as compared to the weighted average number of units for all classes for the period.

As of September 30, 2012 and 2011, the Partnership had unvested restricted common units outstanding, which are considered dilutive securities. These units are considered in the diluted weighted average common units outstanding number in periods of net income. In periods of net losses, these units are excluded from the diluted weighted average common units outstanding number.

Any warrants outstanding during the period are considered to be dilutive securities. These outstanding warrants will be considered in the diluted weighted average common units outstanding number in periods of net income, except if the exercise price of the outstanding warrants is greater than the average market price of the common units for such periods. In periods of net losses, the outstanding warrants are excluded from the diluted weighted average common units outstanding.

The following table presents the Partnership's calculation of basic and diluted units outstanding for the periods indicated:
 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
  ($ in thousands)
Weighted average units outstanding during period:
 
 
 
 
 
 
 
Common units - Basic
138,059

 
122,575

 
132,710

 
105,042

Effect of Dilutive Securities:
 
 
 
 
 
 
 
Warrants

 
4,395

 

 
5,635

Restricted Units

 
1,107

 

 
980

Common units - Diluted
138,059

 
128,077

 
132,710

 
111,657

 
The restricted common units granted under the LTIP, as discussed in Note 15, contain non-forfeitable rights to the distributions declared by the Partnership and therefore meet the definition of participating securities. Participating securities

24

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are required to be included in the computation of earnings per unit pursuant to the two-class method. For the three and nine months ended September 30, 2011, the Partnership determined that it is more dilutive to apply the two-class method versus the treasury stock method in calculating dilutive earnings per unit. Thus, the unvested restricted common units are included in the computation of the diluted weighted average common units outstanding calculation, but the denominator in the computation of diluted earnings per unit only includes the basic weighted average common units outstanding and weighted average warrants outstanding.
 
The following table presents the Partnership's basic and diluted loss per unit for the three months ended September 30, 2012:

 
 
Total
 
Common Units
 
Restricted Common Units
 
 
($ in thousands, except for per unit amounts)
Net loss
 
(106,895
)
 

 

Distributions
 
32,433

 
$
31,643

 
$
790

Assumed net loss after distribution to be allocated
 
(139,328
)
 
(139,328
)
 

Assumed net loss to be allocated
 
$
(106,895
)
 
$
(107,685
)
 
$
790

 
 
 
 
 
 
 
Basic and diluted loss per unit
 
 
 
$
(0.78
)
 
 


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The following table presents the Partnership's basic and diluted loss per unit for the nine months ended September 30, 2012:
 
 
Total
 
Common Units
 
Restricted Common Units
 
 
($ in thousands, except for per unit amounts)
Net loss
 
(95,439
)
 
 
 
 
Distributions
 
91,847

 
$
89,675

 
$
2,172

Assumed net loss after distribution to be allocated
 
(187,286
)
 
(187,286
)
 

Assumed net loss to be allocated
 
$
(95,439
)
 
$
(97,611
)
 
$
2,172

 
 
 
 
 
 
 
Basic and diluted loss per unit
 
 
 
$
(0.74
)
 
 

The following table presents the Partnership's basic income per unit for the three months ended September 30, 2011:
 
 
Total
 
Common Units
 
Restricted Common Units
 
 
($ in thousands, except for per unit amounts)
Net income from continuing operations
 
$
97,562

 
 
 
 
Distributions
 
24,863

 
$
24,515

 
$
348

Assumed net income from continuing operations after distribution to be allocated
 
72,699

 
71,574

 
1,125

Assumed allocation of net income from continuing operations
 
97,562

 
96,089

 
1,473

Discontinued operations, net of tax
 
(197
)
 
(197
)
 

Assumed net income to be allocated
 
$
97,365

 
$
95,892

 
$
1,473

 
 
 
 
 
 
 
Basic income from continuing operations per unit
 
 
 
$
0.78

 
 
Basic discontinued operations per unit
 
 
 
$

 
 
Basic income per unit
 
 
 
$
0.78

 
 

The following table presents the Partnership's diluted income per unit for the three months ended September 30, 2011:

 
 
Total
 
Common Units
 
Restricted Common Units
 
 
($ in thousands, except for per unit amounts)
Net income from continuing operations
 
$
97,562

 
 
 
 
Distributions
 
25,742

 
$
25,394

 
$
348

Assumed net income from continuing operations after distribution to be allocated
 
71,820

 
70,733

 
1,087

Assumed allocation of net income from continuing operations
 
97,562

 
96,127

 
1,435

Discontinued operations, net of tax
 
(197
)
 
(197
)
 

Assumed net income to be allocated
 
$
97,365

 
$
95,930

 
$
1,435

 
 
 
 
 
 
 
Diluted income from continuing operations per unit
 
 
 
$
0.76

 
 
Diluted discontinued operations per unit
 
 
 
$

 
 
Diluted income per unit
 
 
 
$
0.76

 
 


26

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The following table presents the Partnership's basic income per unit for the nine months ended September 30, 2011:
 
 
Total
 
Common Units
 
Restricted Common Units
 
 
($ in thousands, except for per unit amounts)
Net income from continuing operations
 
$
98,509

 
 
 
 
Distributions
 
52,489

 
$
51,668

 
$
821

Assumed net loss from continuing operations after distribution to be allocated
 
46,020

 
45,231

 
789

Assumed allocation of net income from continuing operations
 
98,509

 
96,899

 
1,610

Discontinued operations, net of tax
 
210

 
206

 
4

Assumed net income to be allocated
 
$
98,719

 
$
97,105

 
$
1,614

 
 
 
 
 
 
 
Basic income from continuing operations per unit
 
 
 
$
0.92

 
 
Basic discontinued operations per unit
 
 
 
$

 
 
Basic income per unit
 
 
 
$
0.92

 
 
  

The following table presents the Partnership's diluted income per unit for the nine months ended September 30, 2011:
 
 
Total
 
Common Units
 
Restricted Common Units
 
 
($ in thousands, except for per unit amounts)
Net income from continuing operations
 
$
98,509

 
 
 
 
Distributions
 
53,616

 
$
52,795

 
$
821

Assumed net loss from continuing operations after distribution to be allocated
 
44,893

 
44,162

 
731

Assumed allocation of net income from continuing operations
 
98,509

 
96,957

 
1,552

Discontinued operations, net of tax
 
210

 
207

 
3

Assumed net income to be allocated
 
$
98,719

 
$
97,164

 
$
1,555

 
 
 
 
 
 
 
Diluted income from continuing operations per unit
 
 
 
$
0.88

 
 
Diluted discontinued operations per unit
 
 
 
$

 
 
Diluted income per unit
 
 
 
$
0.88

 
 
  

NOTE 17.   DISCONTINUED OPERATIONS

The following table represents activity from discontinued operations for the three and nine months ended September 30, 2011:

 
 
Wildhorse System (a)
 
Minerals Business (b)
($ in thousands)
Three Months Ended September 30, 2011:
 
 
 
 
Revenues
 
$

 
$

Income from Operations
 
$

 
$

Discontinued operations, net of tax
 
$
(197
)
 
$

Nine Months Ended September 30, 2011:
 
 
 
 
Revenues
 
$
6,859

 
$

Income from Operations
 
$
548

 
$

Discontinued operations, net of tax
 
$
(246
)
 
$
456

Proceeds from sale
 
$
5,712

 
$

_____________________________
(a)
On May 20, 2011, the Partnership sold its Wildhorse Gathering System (which was accounted for in its East Texas and Other Midstream Segment).
(b)
On May 24, 2010, the Partnership completed the sale of its Minerals Business. During the nine months ended September 30, 2011, the Partnership

27

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received payments related to pre-effective date operations and recorded this amount as part of discontinued operations for the period.

NOTE 18. OTHER OPERATING INCOME

In July 2008, SemGroup, L.P. and certain of its subsidiaries (“SemGroup”) filed petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code. The Partnership historically sold portions of its condensate production from its Texas Panhandle and East Texas midstream systems to SemGroup. In August 2009, the Partnership sold $3.9 million of its outstanding receivables from SemGroup, which represented its 20-day administrative claims under 503(b)(9) of the United States Bankruptcy Code, for which it received a payment of $3.0 million. Due to certain repurchase obligations under the assignment agreement, the Partnership recorded the payment as a current liability within accounts payable as of December 31, 2010 and maintained the balance as a liability until it was clear that the repurchase obligations could no longer be triggered. Due to the expiration of the repurchase obligations during the year ended December 31, 2011, the Partnership released its reserve for these receivables and recorded other operating income of $2.9 million related to these reserves.

NOTE 19. SUBSIDIARY GUARANTORS
 
As of September 30, 2012, the Partnership had issued registered debt securities guaranteed by its subsidiaries.  As of September 30, 2012, all guarantors are wholly-owned or available to be pledged and such guarantees are joint and several and full and unconditional.  In accordance with Rule 3-10 of SEC Regulation S-X, the Partnership has prepared Unaudited Condensed Consolidating Financial Statements as supplemental information.  The following unaudited condensed consolidating balance sheets at September 30, 2012 and December 31, 2011, unaudited condensed consolidating statements of operations for the three and nine months ended September 30, 2012 and 2011, and unaudited condensed consolidating statements of cash flows for the nine months ended September 30, 2012 and 2011, present financial information for Eagle Rock Energy as the parent on a stand-alone basis (carrying any investments in subsidiaries under the equity method), financial information for the co-issuer and the subsidiary guarantors, which are all 100% owned by the parent, on a stand-alone basis, and the consolidation and elimination entries necessary to arrive at the information for the Partnership on a consolidated basis.  The subsidiary guarantors are not restricted from making distributions to the Partnership.

During the three months ended September 30, 2012, the Partnership created a new subsidiary to purchase certain crude oil pipeline assets. This subsidiary did not become a guarantor under the Partnership's registered debt securities prior to September 30, 2012. As a result, the assets and associated cash flows related to this subsidiary are recorded under the "Non-Guarantor Investment" columns within the Unaudited Condensed Consolidated Balance Sheet as of September 30, 2012 and the Unaudited Condensed Consolidating Statement of Cash Flows for the nine months ended September 30, 2012.

28

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 Unaudited Condensed Consolidating Balance Sheet
September 30, 2012
 
Parent Issuer
 
Co-Issuer
 
Subsidiary Guarantors
 
Non-Guarantor Investments
 
Consolidating
Entries
 
Total
 
($ in thousands)
ASSETS:
 
 
 
 
 
 
 
 
 
 
 
Accounts receivable – related parties
$
626,618

 
$

 
$

 
$

 
$
(626,618
)
 
$

Other current assets
30,447

 
1

 
113,893

 

 

 
144,341

Total property, plant and equipment, net
1,751

 

 
1,786,773

 
3,890

 

 
1,792,414

Investment in subsidiaries
1,153,031

 

 

 
976

 
(1,154,007
)
 

Total other long-term assets
47,716

 

 
98,418

 

 

 
146,134

Total assets
$
1,859,563

 
$
1

 
$
1,999,084

 
$
4,866

 
$
(1,780,625
)
 
$
2,082,889

LIABILITIES AND EQUITY:
 
 
 
 
 
 
 
 
 
 
 
Accounts payable – related parties
$

 
$

 
$
626,478

 
$
140

 
$
(626,618
)
 
$

Other current liabilities
17,631

 

 
149,850

 

 

 
167,481

Other long-term liabilities
11,101

 

 
73,476

 

 

 
84,577

Long-term debt
875,446

 

 

 

 

 
875,446

Equity
955,385

 
1

 
1,149,280

 
4,726

 
(1,154,007
)
 
955,385

Total liabilities and equity
$
1,859,563

 
$
1

 
$
1,999,084

 
$
4,866

 
$
(1,780,625
)
 
$
2,082,889


Unaudited Condensed Consolidating Balance Sheet
December 31, 2011
 
Parent Issuer
 
Co-Issuer
 
Subsidiary
Guarantors
 
Non-Guarantor Investments
 
Consolidating Entries
 
Total
 
($ in thousands)
ASSETS:
 
 
 
 
 
 
 
 
 
 
 
Accounts receivable – related parties
$
541,384

 
$

 
$

 
$

 
$
(541,384
)
 
$

Other current assets
15,749

 
1

 
109,778

 

 

 
125,528

Total property, plant and equipment, net
1,393

 

 
1,762,281

 

 

 
1,763,674

Investment in subsidiaries
1,229,606

 

 

 
1,033

 
(1,230,639
)
 

Total other long-term assets
30,928

 

 
125,558

 

 

 
156,486

Total assets
$
1,819,060

 
$
1

 
$
1,997,617

 
$
1,033

 
$
(1,772,023
)
 
$
2,045,688

LIABILITIES AND EQUITY:
 
 
 
 
 
 
 
 
 
 
 
Accounts payable – related parties
$

 
$

 
$
541,384

 
$

 
$
(541,384
)
 
$

Other current liabilities
18,110

 

 
152,745

 

 

 
170,855

Other long-term liabilities
14,150

 

 
73,883

 

 

 
88,033

Long-term debt
779,453

 

 

 

 

 
779,453

Equity
1,007,347

 
1

 
1,229,605

 
1,033

 
(1,230,639
)
 
1,007,347

Total liabilities and equity
$
1,819,060

 
$
1

 
$
1,997,617

 
$
1,033

 
$
(1,772,023
)
 
$
2,045,688




29

Table of Contents


Unaudited Condensed Consolidating Statement of Operations
For the Three Months Ended September 30, 2012
 
Parent Issuer
 
Co-Issuer
 
Subsidiary Guarantors
 
Non-Guarantor Investments
 
Consolidating
Entries
 
Total
 
($ in thousands)
Total revenues
$
(30,350
)
 
$

 
$
193,739

 
$

 
$

 
$
163,389

Cost of natural gas and natural gas liquids

 

 
110,430

 

 

 
110,430

Operations and maintenance

 

 
27,074

 

 

 
27,074

Taxes other than income

 

 
4,748

 

 

 
4,748

General and administrative
3,324

 

 
13,483

 

 

 
16,807

Depreciation, depletion and amortization
76

 

 
40,319

 

 

 
40,395

Impairment

 

 
55,900

 

 

 
55,900

Income from operations
(33,750
)
 

 
(58,215
)
 

 

 
(91,965
)
Interest expense, net
(14,199
)
 

 

 

 

 
(14,199
)
Other non-operating income
2,251

 

 
2,744

 

 
(4,995
)
 

Other non-operating expense
(2,987
)
 

 
(3,127
)
 
2

 
4,995

 
(1,117
)
Income (loss) before income taxes
(48,685
)
 

 
(58,598
)
 
2

 

 
(107,281
)
Income tax provision (benefit)
103

 

 
(489
)
 

 

 
(386
)
Equity in earnings of subsidiaries
(58,107
)
 

 

 

 
58,107

 

Net income (loss)
$
(106,895
)
 
$

 
$
(58,109
)
 
$
2

 
$
58,107

 
$
(106,895
)

Unaudited Condensed Consolidating Statement of Operations
For the Three Months Ended September 30, 2011
 
Parent Issuer
 
Co-Issuer
 
Subsidiary Guarantors
 
Non-Guarantor Investments
 
Consolidating Entries
 
Total
 
($ in thousands)
Total revenues
$
81,278

 
$

 
$
288,862

 
$

 
$

 
$
370,140

Cost of natural gas and natural gas liquids

 

 
166,293

 

 

 
166,293

Operations and maintenance

 

 
24,897

 

 

 
24,897

Taxes other than income

 

 
4,556

 

 

 
4,556

General and administrative
1,562

 

 
14,506

 

 

 
16,068

Other operating income

 

 

 

 

 

Depreciation, depletion and amortization
42

 

 
34,998

 

 

 
35,040

Impairment

 

 
9,870

 

 

 
9,870

Income from operations
79,674

 

 
33,742

 

 

 
113,416

Interest expense, net
(10,050
)
 

 

 

 

 
(10,050
)
Other non-operating income
2,233

 

 
630

 

 
(2,863
)
 

Other non-operating expense
(21,297
)
 

 
11,554

 
(1
)
 
2,863

 
(6,881
)
Income (loss) before income taxes
50,560

 

 
45,926

 
(1
)
 

 
96,485

Income tax benefit
(58
)
 

 
(1,019
)
 

 

 
(1,077
)
Equity in earnings of subsidiaries
46,747

 

 

 

 
(46,747
)
 

Income (loss) from continuing operations
97,365

 

 
46,945

 
(1
)
 
(46,747
)
 
97,562

Discontinued operations, net of tax

 

 
(197
)
 

 

 
(197
)
Net income (loss)
$
97,365

 
$

 
$
46,748

 
$
(1
)
 
$
(46,747
)
 
$
97,365



30

Table of Contents



Unaudited Condensed Consolidating Statement of Operations
For the Nine Months Ended September 30, 2012
 
Parent Issuer
 
Co-Issuer
 
Subsidiary Guarantors
 
Non-Guarantor Investments
 
Consolidating
Entries
 
Total
 
($ in thousands)
Total revenues
$
35,614

 
$

 
$
635,934

 
$

 
$

 
$
671,548

Cost of natural gas and natural gas liquids

 

 
338,798

 

 

 
338,798

Operations and maintenance

 

 
81,685

 

 

 
81,685

Taxes other than income

 

 
14,518

 

 

 
14,518

General and administrative
8,862

 

 
43,522

 

 

 
52,384

Depreciation, depletion and amortization
227

 

 
117,816

 

 

 
118,043

Impairment

 

 
122,824

 

 

 
122,824

Income (loss) from operations
26,525

 

 
(83,229
)
 

 

 
(56,704
)
Interest expense, net
(35,087
)
 

 

 

 

 
(35,087
)
Other non-operating income
6,750

 

 
8,232

 

 
(14,982
)
 

Other non-operating expense
(9,768
)
 

 
(9,410
)
 
(8
)
 
14,982

 
(4,204
)
Income (loss) before income taxes
(11,580
)
 

 
(84,407
)
 
(8
)
 

 
(95,995
)
Income tax provision (benefit)
963

 

 
(1,519
)
 

 

 
(556
)
Equity in earnings of subsidiaries
(82,896
)
 

 

 

 
82,896

 

Net income (loss)
$
(95,439
)
 
$

 
$
(82,888
)
 
$
(8
)
 
$
82,896

 
$
(95,439
)


31

Table of Contents

Unaudited Condensed Consolidating Statement of Operations
For the Nine Months Ended September 30, 2011
 
Parent Issuer
 
Co-Issuer
 
Subsidiary Guarantors
 
Non-Guarantor Investments
 
Consolidating Entries
 
Total
 
($ in thousands)
Total revenues
$
61,796

 
$

 
$
777,423

 
$

 
$

 
$
839,219

Cost of natural gas and natural gas liquids

 

 
486,286

 

 

 
486,286

Operations and maintenance

 

 
66,323

 

 

 
66,323

Taxes other than income

 

 
13,061

 

 

 
13,061

General and administrative
3,279

 

 
40,467

 

 

 
43,746

Other operating income

 

 
(2,893
)
 

 

 
(2,893
)
Depreciation, depletion and amortization
122

 

 
90,192

 

 

 
90,314

Impairment

 

 
14,754

 

 

 
14,754

(Loss) income from operations
58,395

 

 
69,233

 

 

 
127,628

Interest expense, net
(19,571
)
 

 
(8
)
 

 

 
(19,579
)
Other non-operating income
6,513

 

 
2,848

 

 
(9,361
)
 

Other non-operating expense
(26,497
)
 

 
5,798

 
(12
)
 
9,361

 
(11,350
)
(Loss) income before income taxes
18,840

 

 
77,871

 
(12
)
 

 
96,699

Income tax provision (benefit)
138

 

 
(1,948
)
 

 

 
(1,810
)
Equity in earnings of subsidiaries
80,017

 

 

 

 
(80,017
)
 

Income (loss) from continuing operations
98,719

 

 
79,819

 
(12
)
 
(80,017
)
 
98,509

Discontinued operations, net of tax

 

 
210

 

 

 
210

Net income (loss)
$
98,719

 
$

 
$
80,029

 
$
(12
)
 
$
(80,017
)
 
$
98,719



32

Table of Contents

Unaudited Condensed Consolidating Statement of Cash Flows
For the Nine Months Ended September 30, 2012
 
Parent Issuer
 
Co-Issuer
 
Subsidiary Guarantors
 
Non-Guarantor Investments
 
Consolidating Entries
 
Total
 
($ in thousands)
Net cash flows (used in) provided by operating activities
$
(105,577
)
 
$

 
$
216,531

 
$
46

 
$

 
$
111,000

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
 
 
 
 
 
 
 
 
Acquisitions, net of cash acquired

 

 

 

 

 

Deposit for acquisition
(22,750
)
 

 

 

 

 
(22,750
)
Additions to property, plant and equipment
(586
)
 

 
(218,997
)
 
(3,750
)
 

 
(223,333
)
Purchase of intangible assets

 

 
(3,836
)
 

 

 
(3,836
)
Proceeds from sale of asset

 

 
215

 

 

 
215

Contribution to subsidiaries
(6,331
)
 

 
(3,750
)
 

 
10,081

 

Net cash flows used in investing activities
(29,667
)
 

 
(226,368
)
 
(3,750
)
 
10,081

 
(249,704
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
 
 
 
 
 
 
 
 
Proceeds from long-term debt
663,550

 

 

 

 

 
663,550

Repayment of long-term debt
(814,050
)
 

 

 

 

 
(814,050
)
Proceed from senior notes
246,253

 

 

 

 

 
246,253

Payment of debt issuance cost
(5,081
)
 

 

 

 

 
(5,081
)
Proceeds from derivative contracts
11,964

 

 

 

 

 
11,964

Common unit issued in equity offerings
94,838

 

 

 

 

 
94,838

Issuance costs for equity offerings
(4,192
)
 

 

 

 

 
(4,192
)
Exercise of warrants
31,804

 

 

 

 

 
31,804

Repurchase of common units
(292
)
 

 

 

 

 
(292
)
Distributions to members and affiliates
(86,773
)
 

 

 

 

 
(86,773
)
Contribution from parent

 

 
6,331

 
3,750

 
(10,081
)
 

Net cash flows provided by financing activities
138,021

 

 
6,331

 
3,750

 
(10,081
)
 
138,021

Net increase (decrease) in cash and cash equivalents
2,777

 

 
(3,506
)
 
46

 

 
(683
)
Cash and cash equivalents at beginning of year
1,319

 
1

 
(572
)
 
129

 

 
877

Cash and cash equivalents at end of year
$
4,096

 
$
1

 
$
(4,078
)
 
$
175

 
$

 
$
194



33

Table of Contents

Unaudited Condensed Consolidating Statement of Cash Flows
For the Nine Months Ended September 30, 2011
 
Parent Issuer
 
Co-Issuer
 
Subsidiary Guarantors
 
Non-Guarantor Investments
 
Consolidating Entries
 
Total
 
($ in thousands)
Net cash flows (used in) provided by operating activities
$
3,263

 
$

 
$
81,633

 
$
55

 
$

 
$
84,951

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
 
 
 
 
 
 
 
 
Acquisitions, net of cash acquired

 

 
(220,326
)
 

 

 
(220,326
)
Additions to property, plant and equipment
(269
)
 

 
(79,542
)
 

 

 
(79,811
)
Purchase of intangible assets

 

 
(3,122
)
 

 

 
(3,122
)
Proceeds from sale of asset

 

 
5,712

 

 

 
5,712

Contributions to subsidiaries
(227,583
)
 

 

 

 
227,583

 

Net cash flows used in investing activities
(227,852
)
 

 
(297,278
)
 

 
227,583

 
(297,547
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
 
 
 
 
 
 
 
 
Proceeds from long-term debt
826,379

 

 

 

 

 
826,379

Repayment of long-term debt
(913,379
)
 

 

 

 

 
(913,379
)
Proceed from senior notes
297,837

 

 

 

 

 
297,837

Payment of debt issuance cost
(16,800
)
 

 

 

 

 
(16,800
)
Repurchase of common units
(119
)
 

 

 

 

 
(119
)
Exercise of warrants
78,239

 

 

 

 

 
78,239

Proceeds from derivative contracts
3,706

 

 

 

 

 
3,706

Contributions from parent

 

 
227,583

 

 
(227,583
)
 

Distributions to members and affiliates
(49,080
)
 

 

 

 

 
(49,080
)
Net cash flows provided by financing activities
226,783

 

 
227,583

 

 
(227,583
)
 
226,783

Net cash flows used in discontinued operations

 

 
(574
)
 

 

 
(574
)
Net (decrease) increase in cash and cash equivalents
2,194

 

 
11,364

 
55

 

 
13,613

Cash and cash equivalents at beginning of year
4,890

 
1

 
(885
)
 
43

 

 
4,049

Cash and cash equivalents at end of year
$
7,084

 
$
1

 
$
10,479

 
$
98

 
$

 
$
17,662


34

Table of Contents


NOTE 20. SUBSEQUENT EVENTS

Acquisition of BP America Production Company's Midstream Assets in the Texas Panhandle
    
On October 1, 2012, the Partnership announced the acquisition of the Sunray and Hemphill processing plants and associated 2,500 mile gathering system serving the liquids-rich Texas Panhandle (the "BP Panhandle System") for $230.6 million, including certain closing adjustments, from BP America Production Company ("BP"). As of September 30, 2012, $22.8 million was held as a deposit for the acquisition. The remaining purchase price was funded on October 1, 2012, through borrowings under the Partnership's revolving credit facility.

In addition, the Partnership and BP entered into a 20-year, fixed-fee Gas Gathering and Processing Agreement under which the Partnership will gather and process BP's natural gas production from wells connected to the BP Panhandle System. Furthermore, BP has committed itself to the Partnership under the same agreement, and committed its farmees to the Partnership under substantially the same terms , with respect to all future natural gas production from new wells drilled within an initial two-year period from closing, subject to mutually-agreed extensions, and within a two-mile radius of any portion of the Partnership's gathering system serving such BP connected wells. 

Amendment to the Partnership's Gas Gathering and Processing Agreement with Anadarko E&P Company LP

On October 3, 2012, the Partnership announced that it entered into an Amendment (the "Amendment") to its existing Gas Gathering and Processing Agreement (the "Agreement") with Anadarko E&P Company LP ("Anadarko") to support Anadarko's drilling program in western Louisiana.

The Amendment, among other things, (i) obligates Anadarko, for a 10-year period, to dedicate wells drilled in an additional area of approximately 800,000 acres in Allen, Beauregard, Evangeline, Rapides and Vernon Parishes, Louisiana, and to deliver to Eagle Rock Energy for gathering and processing the total volume of natural gas produced from such wells, (ii) changes the fee structure for all dedicated wells spud on or after April 1, 2012 by Anadarko on the subject lands (inclusive of both the lands under the Agreement, which covers an area of approximately 1.1 million acres, and the Amendment) to provide for a fixed gathering fee arrangement (rather than a commodity-price sensitive processing fee), and (iii) revises the mechanism that provides for Eagle Rock Energy's recovery of capital expenditures for connecting its pipelines to Anadarko-operated wells spud on or after April 1, 2012. The natural gas from all dedicated wells on the subject acreage is currently gathered and delivered into Eagle Rock Energy's Brookeland gathering system and plant for processing and treating. Wells spud prior to April 1, 2012 remain governed by the legacy fee structure set forth in the Agreement.

Borrowing Base Redetermination

On October 9, 2012, the Partnership announced that the Upstream Segment component of the borrowing base under its revolving credit facility was set at $400 million by its commercial lenders as part of its regularly scheduled semi-annual borrowing base redetermination. This represented an increase of $58 million from the previous level of $342 million. The redetermined borrowing base was effective October 1, 2012, with no additional fees or increase in interest rate spread incurred. The Partnership's total borrowing base, including it Midstream Segment (as last determined at June 30, 2012) and giving effect to the new Upstream Segment, was approximately $780 million. The total borrowing capacity under the revolving credit facility is limited to the lower of the borrowing base and the total lender commitments, which remain unchanged at $675 million.

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

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This report includes “forward-looking statements” as defined by the Securities and Exchange Commission (the "SEC"). All statements, other than statements of historical facts, included in this report that address activities, events or developments that we expect, believe or anticipate will or may occur in the future are forward-looking statements. These statements are based on certain assumptions made by us based on our experience and perception of historical trends, current conditions, expected future developments and other factors we believe are appropriate under the circumstances. Such statements are subject to a number of assumptions, risks and uncertainties, many of which are beyond our control, which may cause our actual results to differ materially from those implied or expressed by the forward-looking statements. We do not assume any obligation to update such forward-looking statements following the date of this report. For a complete description of known material risks, please read our risk factors set forth in our Annual Report on Form 10-K for the year ended December 31, 2011 and in "Part II. Item 1A. Risk Factors." These factors include but are not limited to:
Drilling and geological / exploration risks;
Assumptions regarding oil and natural gas reserve levels and costs to exploit and timing of development;
Volatility or declines (including sustained declines) in commodity prices;
Our significant existing indebtedness;
Hedging activities;
Ability to obtain credit and access capital markets;
Ability to remain in compliance with the covenants set forth in our credit facility;
Conditions in the securities and/or capital markets;
Future processing volumes and throughput;
Loss of significant customers;
Availability and cost of processing and transporting of natural gas liquids ("NGLs");
Competition in the oil and natural gas industry;
Relevant legislative or regulatory changes, including retroactive royalty or production tax regimes, changes in environmental, health and safety regulation, hydraulic fracturing regulation, environmental risks and liability under federal, state and foreign environmental laws and regulations;
Ability to make favorable acquisitions and integrate operations from such acquisitions;
Shortages of personnel and equipment;
Potential losses associated with trading in derivative contracts;
Increases in interest rates;
Creditworthiness of our counterparties;
Weather, including the occurrence of any adverse weather conditions and/or natural disasters affecting our business;
Any other factors that impact or could impact the exploration of oil or natural gas resources, including but not limited to the geology of a resource, the total amount and costs to develop recoverable reserves, legal title, regulatory, natural gas administration, marketing and operations factors relating to the extraction of oil and natural gas; and
Tax risk associated with pass-through investment, including potential reduction in tax shield or creation of phantom income in the event distributions are not enough to support the tax burden.

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OVERVIEW
 
The following discussion and analysis of financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements, and the notes thereto, appearing elsewhere in this report, as well as our Annual Report on Form 10-K for the year ended December 31, 2011 filed with the Securities and Exchange Commission. For a description of oil and natural gas terms, see our Annual Report on Form 10-K for the year ended December 31, 2011.

We are a domestically-focused, growth-oriented, publicly-traded Delaware limited partnership engaged in the following two businesses:
 
Midstream Business—gathering, compressing, treating, processing, transporting, marketing and trading natural gas; fractionating, transporting and marketing NGLs; and crude oil logistics and marketing; and
 
Upstream Business—developing and producing oil and natural gas property interests.
 
During the fourth quarter of 2011, we decided that due to the relative size of the East Texas/Louisiana, South Texas and Gulf of Mexico segments, these three reporting segments would be aggregated into a single reporting segment and that a new Marketing and Trading reporting segment would be created.  Our Marketing and Trading results were previously presented within our Texas Panhandle Segment.
 
We now conduct, evaluate and report on our Midstream Business within three segments—the Texas Panhandle Segment, the East Texas and Other Midstream Segment (which consolidates our former East Texas/Louisiana, South Texas and Gulf of Mexico Segments) and the Marketing and Trading Segment. Our Texas Panhandle Segment consists of gathering and processing assets in the Texas Panhandle. Our East Texas and Other Midstream Segment consists of gathering and processing assets in East Texas/Northern Louisiana, South Texas, Southern Louisiana, the Gulf of Mexico and Galveston Bay. Our Marketing and Trading Segment consists of crude oil logistics and marketing in the Texas Panhandle and Alabama and natural gas marketing and trading.  During the three and nine months ended September 30, 2012, our Midstream Business had an operating loss from continuing operations of $31.1 million and $77.3 million, respectively, compared to operating income from continuing operations of $15.8 million and $43.7 million generated during the three and nine months ended September 30, 2011, respectively.  
 
We conduct, evaluate and report on our Upstream Business as one segment. On May 3, 2011, we completed the acquisition of CC Energy II L.L.C. ("Crow Creek Energy"). Our Upstream Segment includes operated and non-operated wells located in the Mid-Continent (which includes areas in Oklahoma, Arkansas, the Texas Panhandle and North Texas); Permian (which includes areas in West Texas); East Texas / South Texas / Mississippi; and Southern Alabama (which also includes two treating facilities, and one natural gas processing plant and related gathering systems).  During the three and nine months ended September 30, 2012, our Upstream Business generated operating (loss) income of $(5.3) million and $24.0 million, respectively, compared to operating income of $18.3 million and $57.7 million generated during the three and nine months ended September 30, 2011, respectively.  
 
Our final reporting segment is our Corporate and Other Segment, which is where we account for our risk management activity (excluding any risk management activity associated with our natural gas marketing and trading activities which we account for in the Midstream Business), intersegment eliminations and our general and administrative expenses.  During the three and nine months ended September 30, 2012, our Corporate and Other Segment incurred operating loss of $55.6 million and $3.4 million, respectively, compared to operating income of $79.3 million and $26.2 million during the three and nine months ended September 30, 2011, respectively.  Results reflected a net (loss) gain, realized and unrealized, on our commodity derivatives of $(35.5) million and $51.9 million during the three and nine months ended September 30, 2012, respectively, compared to a net gain, realized and unrealized, on our commodity derivatives of $94.3 million and $68.2 million during the three and nine months ended September 30, 2011, respectively.  See "Results of Operations - Corporate and Other Segment" for a further discussion of the impact of our commodity derivatives.

Impairment
 
During the three and nine months ended September 30, 2012, we recorded an impairment charge in our Midstream Business for certain assets within our East Texas and Other Midstream Segment of $35.8 million and $102.0 million, respectively, due to (i) reduced throughput volumes as our producer customers curtailed their drilling activity in response to the continued depressed natural gas price environment, (ii) the loss of significant gathering contracts on our Panola system during the three and nine months ended September 30, 2012, and (iii) the substantial damage incurred at the Yscloskey processing

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plant as a result of Hurricane Isaac in August 2012. During the nine months ended September 30, 2011, we recorded an impairment charge of $4.6 million in our Texas Panhandle Segment to fully write-down our idle Turkey Creek plant. During the three and nine months ended September 30, 2012, we recorded an impairment charge in our Upstream Segment of $20.1 million and $20.8 million, respectively, due to (i) certain leaseholds in our unproved properties that we expect to expire undrilled in 2013 and (ii) our proved properties in the Barnett Shale that are expected to have reduced operating income resulting from natural production declines, lower future natural gas prices and ongoing relatively high operating costs associated with gas compression. During the three and nine months ended September 30, 2011, we incurred impairment charges in our Upstream Segment of $9.9 million and $10.2 million, respectively, due to (i) certain legacy drilling locations in our unproved properties which we no longer intend to develop based on the performance of offsetting wells during the three months ended June 30, 2011, (ii) certain proved properties in the Jourdanton Field in South Texas, which included plans for five future drilling locations that we have determined not to pursue due to the current natural gas price environment and (iii) certain drilling locations in our unproved properties which we no longer intend to develop during the three months ended September 30, 2011.

Pursuant to GAAP, our impairment analysis does not take into account the value of our commodity derivative instruments, which generally increase as the estimates of future prices decline.  Further declines in commodity prices and other factors could result in additional impairment charges and changes to the fair value of our derivative instruments.

Potential Impact of New Environmental Standards
 
We have certain obligations under our air emissions permit to lower the SO2 emissions of our Alabama plant operations.  Additionally, in mid-2010, the Environmental Protection Agency (the "EPA") enacted new National Ambient Air Quality Standards ("2010 NAAQS") which substantially lowered the emissions limits for SO2 and mandated timelines for compliance, subject to State assessments of non-attainment and attainment areas.  In order to fulfill our permit obligations, ensure compliance with the new 2010 NAAQS requirements, as applicable, and replace and upgrade certain assets in our Alabama facilities, we expect to spend approximately $60 million through the end of 2013 at our Alabama facilities, inclusive of the approximately $8.6 million spent to date.  The expected facility upgrades to our Alabama operations should not only increase the marketable sulfur recovered from the inlet gas stream, but also are anticipated to reduce plant fuel consumption, improve the plant's operating reliability, reduce the frequency of plant turnarounds and extend the plant's operating life.  Management does not anticipate, however, that the required spending will generate returns consistent with our internal rate of return thresholds for discretionary capital investment.

Subsequent Events

Acquisition of BP America Production Company's Midstream Assets in the Texas Panhandle

On October 1, 2012, we announced the closing of the acquisition of all of BP America Production Company's ("BP") Midstream assets in the Texas Panhandle, including the Sunray and Hemphill processing plants and associated 2,500 mile gathering system (the "BP Panhandle System") for $230.6 million, which includes certain closing adjustments. As of September 30, 2012, $22.8 million was held as a deposit for the acquisition. The remaining purchase price was funded on October 1, 2012, through borrowings under our revolving credit facility.

In addition, on October 1, 2012, we entered into a 20-year, fixed-fee Gas Gathering and Processing Agreement with BP under which we will gather and process BP's natural gas production from the existing wells connected to the BP Panhandle System. Furthermore, BP has committed itself to us under the same agreement, and committed its farmees to us under substantially the same terms, with respect to all future natural gas production from new wells drilled within an initial two-year period from closing, subject to mutually-agreed extensions, and within a two-mile radius of any portion of our gathering system serving such BP connected wells.

Amendment to Our Gas Gathering and Processing Agreement with Anadarko E&P Company LP

On October 3, 2012, we announced that we entered into an Amendment (the "Amendment") to our existing Gas Gathering and Processing Agreement (the "Agreement") with Anadarko E&P Company LP ("Anadarko") to support Anadarko's drilling program in western Louisiana.

The Amendment, among other things, (i) obligates Anadarko, for a 10-year period, to dedicate wells drilled in an additional area of approximately 800,000 acres in Allen, Beauregard, Evangeline, Rapides and Vernon Parishes, Louisiana, and to deliver to Eagle Rock for gathering and processing the total volume of natural gas produced from such wells, (ii) changes the

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fee structure for all dedicated wells spud on or after April 1, 2012 by Anadarko on the subject lands (inclusive of both the lands under the Base Agreement, which covers an area of approximately 1.1 million acres, and the Amendment) to provide for a fixed gathering fee arrangement (rather than a commodity-price sensitive processing fee), and (iii) revises the mechanism that provides for Eagle Rock's recovery of capital expenditures for connecting its pipelines to Anadarko-operated wells spud on or after April 1, 2012. The natural gas from all dedicated wells on the subject acreage is currently gathered and delivered into Eagle Rock's Brookeland gathering system and plant for processing and treating. Wells spud prior to April 1, 2012 remain governed by the legacy fee structure set forth in the Agreement.

Borrowing Base Redetermination

On October 9, 2012, we announced that the upstream component of the borrowing base under our revolving credit facility was set at $400 million by our commercial lenders as part of its regularly scheduled semi-annual borrowing base redetermination. This represented an increase of $58 million, or 17%, from the previous level of $342 million. The redetermined borrowing base was effective October 1, 2012, with no additional fees or increase in interest rate spread incurred. Our total borrowing base, including our Midstream Segment (as last determined atJune 30, 2012) and giving effect to the new Upstream Segment, was approximately $780 million. The total borrowing capacity under the revolving credit facility is limited to the lower of the borrowing base and the total lender commitment, which remains unchanged at $675 million.

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RESULTS OF OPERATIONS
 
Summary of Consolidated Operating Results
 
Below is a table of a summary of our consolidated operating results for the three and nine months ended September 30, 2012 and 2011.

 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
  ($ in thousands)
Revenues:
 
 
 
 
 
 
 
Natural gas, natural gas liquids, oil, condensate and sulfur sales
$
184,494

 
$
264,119

 
$
580,152

 
$
732,491

Gathering, compression, processing and treating fees
13,604

 
11,567

 
35,566

 
37,116

Realized commodity derivative gains (losses)
15,802

 
(2,698
)
 
38,428

 
(17,958
)
Unrealized commodity derivative (losses) gains
(51,305
)
 
97,011

 
13,426

 
86,164

Other revenue
794

 
141

 
3,976

 
1,406

Total revenue
163,389

 
370,140

 
671,548

 
839,219

Cost of natural gas, natural gas liquids, and condensate
110,430

 
166,293

 
338,798

 
486,286

Costs and expenses:
 
 
 
 
 

 
 

Operations and maintenance
27,074

 
24,897

 
81,685

 
66,323

Taxes other than income
4,748

 
4,556

 
14,518

 
13,061

General and administrative
16,807

 
16,068

 
52,384

 
43,746

Other operating income

 

 

 
(2,893
)
Impairment
55,900

 
9,870

 
122,824

 
14,754

Depreciation, depletion and amortization
40,395

 
35,040

 
118,043

 
90,314

Total costs and expenses
144,924

 
90,431

 
389,454

 
225,305

Operating (loss) income
(91,965
)
 
113,416

 
(56,704
)
 
127,628

Other income (expense):
 

 
 

 
 

 
 

Interest expense, net
(14,199
)
 
(10,050
)
 
(35,087
)
 
(19,579
)
Unrealized interest rate derivatives gains (losses)
615

 
(3,165
)
 
4,418

 
2,191

Realized interest rate derivative losses
(1,733
)
 
(3,713
)
 
(8,578
)
 
(13,374
)
Other income (expense), net
1

 
(3
)
 
(44
)
 
(167
)
Total other expense
(15,316
)
 
(16,931
)
 
(39,291
)
 
(30,929
)
(Loss) income from continuing operations before income taxes
(107,281
)
 
96,485

 
(95,995
)
 
96,699

Income tax benefit
(386
)
 
(1,077
)
 
(556
)
 
(1,810
)
(Loss) income from continuing operations
(106,895
)
 
97,562

 
(95,439
)
 
98,509

Discontinued operations, net of tax

 
(197
)
 

 
210

Net (loss) income
$
(106,895
)
 
$
97,365

 
$
(95,439
)
 
$
98,719

Adjusted EBITDA(a)
$
59,101

 
$
62,177

 
$
179,594

 
$
146,419

________________________
(a)
See "Non-GAAP Financial Measures" for a definition and reconciliation to GAAP.

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Midstream Business (Three Segments)
 
Texas Panhandle Segment

 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(Amounts in thousands, except volumes and realized prices)
Revenues:
 
 
 
 
 
 
 
Natural gas, natural gas liquids and condensate sales
$
60,213

 
$
90,420

 
$
189,230

 
$
304,813

Intersegment sales - natural gas and condensate
28,025

 
26,247

 
72,514

 
26,247

Gathering, compression, processing and treating fees
4,708

 
4,892

 
13,510

 
12,905

Other revenue

 

 
2,864

 

Total revenue
92,946

 
121,559

 
278,118

 
343,965

Cost of natural gas, natural gas liquids, and condensate
67,098

 
87,797

 
189,703

 
247,512

Operating costs and expenses:
 
 
 
 
 
 
 
Operations and maintenance
12,705

 
10,826

 
37,342

 
31,434

Depreciation and amortization
10,164

 
9,145

 
29,554

 
27,382

Impairment

 

 

 
4,560

Total operating costs and expenses
22,869

 
19,971

 
66,896

 
63,376

Operating income
$
2,979

 
$
13,791

 
$
21,519

 
$
33,077

 
 
 
 
 
 
 
 
Capital expenditures
$
34,200

 
$
21,443

 
$
112,487

 
$
36,722

 
 
 
 
 
 
 
 
Realized prices:
 

 
 

 
 

 
 

Condensate (per Bbl)
$
81.08

 
$
79.43

 
$
86.74

 
$
82.31

Natural gas (per MMbtu)
$
2.64

 
$
3.86

 
$
2.37

 
$
3.95

NGLs (per Bbl)
$
36.23

 
$
53.39

 
$
39.55

 
$
55.28

Production volumes:
 

 
 

 
 

 
 

Gathering volumes (Mcf/d)(a)
183,415

 
163,665

 
159,229

 
154,011

NGLs (net equity Bbls)(b)
228,696

 
231,965

 
855,499

 
609,097

Condensate (net equity Bbls)(b)
164,246

 
260,228

 
499,660

 
728,860

Natural gas (MMbtu/d)(a) 
(990
)
 
(7,418
)
 
(4,661
)
 
(5,517
)
_______________________

(a)
Gathering volumes (Mcf/d) and natural gas short positions (MMbtu/d) are calculated by taking the total volume and then dividing by the number of days in the respective period.
(b)
Effective January 2012, reported NGL volumes include those volumes recovered from our equity condensate through stabilization. These NGL volumes were previously reported as condensate. This change results in an increase to reported NGL equity barrels and a corresponding decrease to reported condensate equity barrels.
 
Revenues and Cost of Natural Gas, NGLs and Condensate. For the three and nine months ended September 30, 2012, revenues minus cost of natural gas, NGLs and condensate for our Texas Panhandle Segment operations totaled $25.8 million and $88.4 million, respectively, compared to $33.8 million and $96.5 million for the three and nine months ended September 30, 2011, respectively. These decreases were primarily driven by the decline in natural gas and NGL prices and lower condensate equity volumes. In addition, on April 30, 2012, we reported an incident and related fire at our Phoenix-Arrington Ranch processing facility which caused the facility to remain shut-in until July 2, 2012. After restarting, the plant experienced efficiency and run time issues as the NGL recovery rates were slow to come back to pre-incident levels. Experiencing lower-than-normal NGL recovery rates, despite good throughput, is particularly problematic for us in the Texas Panhandle Segment because of the significant number of fixed NGL recovery contracts. As such, during times of low NGL recovery, we continue to pay our producer customers at the agreed-upon fixed recovery rates notwithstanding our reduced actual NGL recoveries. We estimate that our results (revenues less cost of natural gas, NGLs and condensate) were negatively impacted due to the downtime by approximately $0.7 million and $2.8 million for the three and nine months ended September 30, 2012, respectively. We have business interruption insurance and expect to pursue reimbursement for the downtime associated with the incident above the associated deductible. As of September 30, 2012, we had not accrued any amounts related to our business interruption insurance. In addition, during the three months ended March 31, 2012, a third-

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party owned fractionation plant, which services all of our Panhandle processing plants, experienced downtime for approximately nine days. During that time, we curtailed NGL production through reduced recoveries at our plants. We estimate that our results for the nine months ended September 30, 2012, were negatively impacted by approximately $1.0 million due to the fractionation plant's downtime.

On June 4, 2012, we announced the successful start-up of a 60 MMcf/d cryogenic processing facility in the Granite Wash play in the Texas Panhandle (the "Woodall Plant"). Due to an incident in early June 2012 on a third-party pipeline that serves as a major residue outlet, our processing volumes in the Texas Panhandle were curtailed, primarily at the Woodall Plant. We initially mitigated this reduced flow by utilizing capacity on another residue outlet. In September 2012, we connected into a third residue outlet, which has fully alleviated the processing restrictions. We estimate that our results were negatively impacted by this incident by approximately $2.5 million and $3.1 million during the three and nine months ended September 30, 2012, respectively.

These decreases were offset by the receipt of insurance proceeds related to business interruptions incurred in 2011. In January and February 2011, severe winter weather caused operating downtime at three facilities and a reduction in existing volumes of natural gas, NGLs and condensate. This severe winter weather also caused damage to our Cargray processing facility, resulting in reduced recoveries of NGLs. The Cargray processing facility was repaired in late June 2011. The operating downtime and the affected recoveries at the Cargray facility impacted revenues minus cost of natural gas by $4.1 million across the Texas Panhandle Segment during the nine months ended September 30, 2011, respectively. During the nine months ended September 30, 2012, we received an insurance payment of $2.9 million, which was recorded as other revenue, for business interruption related to the downtime caused by the severe winter weather in 2011.

Our Texas Panhandle Segment lies within ten counties in Texas and consists of our East Panhandle System and our West Panhandle System. The limited drilling activity in the West Panhandle System is not sufficient to offset the natural declines experienced on this system. The combination of our contract mix and the high NGL content of the natural gas gathered in the West Panhandle System provides us with a high level of equity NGL and condensate production. As such, any declines in gathered volumes from the West Panhandle System must be offset with increases in gathered volumes from other systems on a greater than one-to-one basis in order to maintain our total equity NGL and condensate production. We have seen continued drilling activity in the East Panhandle System by our producer customers and continue to expect drilling activity and the resulting volumes to continue during the remainder of 2012. Accordingly, in early August 2011 and April 2012, we entered into amendments to our Natural Gas Liquids Exchange Agreement with ONEOK to increase the maximum allowable volumes of natural gas liquids that we may deliver from our East Panhandle System to ONEOK for transportation and fractionation services and correspondingly decrease the maximum allowable volumes from our West Panhandle System. The amendments also provided for additional volumes expected after completion of our Woodall and Wheeler Plants in the Granite Wash play, which are discussed below.

Operating Expenses. Operating expenses, including taxes other than income, for the three and nine months ended September 30, 2012, increased $1.9 million and $5.9 million, respectively, as compared to the three and nine months ended September 30, 2011. The increase was primarily driven by increased costs related to the expansion of the Phoenix-Arrington Ranch Plant, which was completed in the fourth quarter of 2011, labor and related expenses associated with the new Woodall Plant and repair costs related to the Phoenix incident. The incident and resulting fire that occurred at our Phoenix-Arrington Ranch Plant in April 2012 is covered under our property insurance, and we expect to be reimbursed for repair costs above our associated deductible. Through September 30, 2012, we incurred repair costs of $2.4 million, of which we have recorded a receivable of $1.9 million as an offset against this amount.
 
Depreciation and Amortization. Depreciation and amortization expenses for the three and nine months ended September 30, 2012 increased $1.0 million and $2.2 million, respectively, from the three and nine months ended September 30, 2011. The increase was due to increased depreciation expense primarily associated with the new Woodall Plant and other capital expenditures placed into service during the period.
 
Impairment. No impairment charges were incurred during the three and nine months ended September 30, 2012. During the nine months ended September 30, 2011, we recorded an impairment charge of $4.6 million in our Texas Panhandle Segment to fully write down our idle Turkey Creek plant. We determined that the components of our Turkey Creek plant could not be used elsewhere within our business, and thus we decided to remove all above-ground equipment and structures.

Capital Expenditures. Capital expenditures for the three and nine months ended September 30, 2012, increased by $12.8 million and $75.8 million, respectively, compared to the three and nine months ended September 30, 2011. The increase was primarily driven by spending related to the construction of our Woodall and Wheeler Plants located in the Texas Panhandle.


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The construction of the Woodall Plant and associated gathering and compression is expected to cost approximately $81.5 million, of which $79.0 million had been spent through September 30, 2012.

On October 31, 2011, we announced our intention to install a high-efficiency cryogenic processing plant in Wheeler County, Texas, in the heart of the Granite Wash play. We expect the installation of the new 60 MMcf/d processing plant (the "Wheeler Plant") and construction of the associated infrastructure to be completed in the second quarter of 2013. The addition of our Woodall and Wheeler Plants to our existing processing infrastructure in the Texas Panhandle Segment is in response to incremental processing needs driven by increased drilling activity by producers in the Granite Wash play. The construction of the Wheeler Plant and associated gathering and compression is expected to cost approximately $63 million, of which $32.4 million had been spent through September 30, 2012.

East Texas and Other Midstream Segment
 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
(Amounts in thousands, except volumes and realized prices)
Revenues:
 
 
 
 
 
 
 
Natural gas, natural gas liquids and condensate sales
$
26,130

 
$
59,590

 
$
98,398

 
$
193,785

Intersegment sales - natural gas
10,020

 
4,330

 
26,471

 
4,330

Gathering, compression, processing and treating fees
8,896

 
6,675

 
22,056

 
24,211

Total revenue
45,046

 
70,595

 
146,925

 
222,326

Cost of natural gas, natural gas liquids, and condensate
33,145

 
56,536

 
111,203

 
176,202

Operating costs and expenses:
 
 
 
 
 

 
 

Operations and maintenance
4,940

 
5,888

 
15,833

 
16,645

Impairment
35,840

 

 
101,979

 

Depreciation and amortization
6,232

 
6,948

 
20,034

 
20,868

Total operating costs and expenses
47,012

 
12,836

 
137,846

 
37,513

Operating (loss) income from continuing operations
(35,111
)
 
1,223

 
(102,124
)
 
8,611

Discontinued operations (a)

 
(197
)
 

 
(194
)
Operating (loss) income
$
(35,111
)
 
$
1,026

 
$
(102,124
)
 
$
8,417

 
 
 
 
 
 
 
 
Capital expenditures
$
2,358

 
$
3,619

 
$
8,010

 
$
6,116

 
 
 
 
 
 
 
 
Realized prices:
 

 
 

 
 

 
 

Condensate (per Bbl)
$
91.57

 
$
93.82

 
$
100.66

 
$
94.28

Natural gas (per MMbtu)
$
2.85

 
$
4.36

 
$
2.67

 
$
4.42

NGLs (per Bbl)
$
32.24

 
$
52.57

 
$
39.45

 
$
51.13

Production volumes:
 
 
 
 
 

 
 

Gathering volumes (Mcf/d)(b)
248,094

 
312,103

 
268,512

 
331,003

NGLs (net equity Bbls)
81,997

 
114,280

 
258,322

 
345,255

Condensate (net equity Bbls)
7,010

 
10,519

 
28,737

 
35,426

Natural gas (MMbtu/d)(b) 
392

 
1,758

 
1,482

 
1,963

_________________________
(a)
Includes sales of natural gas of $66 to the Upstream Segment for the nine months ended September 30, 2011.
(b)
Gathering volumes (Mcf/d) and natural gas long position (MMbtu/d) are calculated by taking the total volume and then dividing by the number of days in the respective period.

 
Revenues and Cost of Natural Gas, NGLs and Condensate. For the three and nine months ended September 30, 2012, revenues minus cost of natural gas and NGLs for our East Texas and Other Midstream Segment totaled $11.9 million and $35.7 million, respectively, compared to $14.1 million and $46.1 million for the three and nine months ended September 30, 2011, respectively. During the three and nine months ended September 30, 2012 and 2011, we recorded revenues associated with deficiency payments of $2.2 million, $2.9 million, $0.1 million and $1.5 million, respectively. We receive deficiency payments under certain of our gathering contracts when delivered volumes fail to meet certain thresholds. These amounts are included within gathering and treating services revenue. Excluding these deficiency payments, revenues minus cost of natural gas,

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NGLs and condensate for the three and nine months ended September 30, 2012 and 2011, would have been $9.7 million, $32.8 million, $14.0 million and $44.6 million, respectively. The decrease, excluding deficiency payments, for the three and nine months ended September 30, 2012 compared to the three and nine months ended September 30, 2011, is primarily due to a decrease in gathering and equity volumes and lower natural gas and NGL prices.
    
In addition, our Yscloskey Plant in Louisiana, in which we have a non-operated ownership interest, suffered significant damage by Hurricane Isaac in August 2012 and has been out of service since that time. We estimate that revenues minus cost of natural gas and NGLs for the third quarter of 2012 was negatively impacted by approximately $0.2 million due to the damage suffered by the plant.

The gathering volumes for the three and nine months ended September 30, 2012, decreased as compared to the three and nine months ended September 30, 2011, due to the impact of Hurricane Issac, as discussed above, natural declines in the production of the existing wells and reduced drilling activity in dry-gas formations related to a decline in natural gas prices.

Operating Expenses. Operating expenses for the three and nine months ended September 30, 2012 decreased $0.9 million and $0.8 million, respectively, compared to the three and nine months ended September 30, 2011 as a result of lower maintenance costs.

Impairment. We recorded impairment expense of $35.8 million and $102.0 million during the three and nine months ended September 30, 2012, respectively, on certain assets due to (i) reduced throughput volumes as our producer customers curtailed their drilling activity in response to the continued depressed natural gas price environment during the first three months of 2012, (ii) the loss of significant gathering contracts on our Panola system during the three and nine months ended September 30, 2012 and (iii) the substantial damage incurred at the Yscloskey Plant as a result of Hurricane Isaac in August 2012. No impairment charges were incurred in the three and nine months ended September 30, 2011.

Depreciation and Amortization. Depreciation and amortization expenses for the three and nine months ended September 30, 2012, decreased $0.7 million and $0.8 million, respectively, compared to the three and nine months ended September 30, 2011. The decrease was due to decreased depreciation expense as a result of the impairment charge recorded during the first six months of 2012.
 
Capital Expenditures. Capital expenditures for the three and nine months ended September 30, 2012, decreased $1.3 million and increased $1.9 million, respectively, compared to the three and nine months ended September 30, 2011. Capital expenditures for the three and nine months ended September 30, 2011, were offset by the sale of $2.3 million of excess pipe inventory related to the East Texas Mainline expansion project which was cancelled in 2010. Excluding this transaction, capital expenditures in the nine months ended September 30, 2012, decreased $0.4 million compared to the same period in 2011, due to fewer new well connects.
 
Discontinued Operations.  No discontinued operations were recorded during the three and nine months ended September 30, 2012. On May 20, 2011, we sold the Wildhorse Gathering System. For the three and nine months ended September 30, 2011, we generated revenues of $6.9 million, and income from operations of $0.5 million.


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Marketing and Trading Segment
 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
  ($ in thousands)
Revenues:
 
 
 
 
 
 
 
Natural gas, oil and condensate sales
$
60,756

 
$
63,583

 
$
180,727

 
$
126,341

Intersegment sales - natural gas and condensate
(40,891
)
 
(31,980
)
 
(106,794
)
 
(31,980
)
Total revenue
19,865

 
31,603

 
73,933

 
94,361

Cost of oil and condensate
10,187

 
21,960

 
37,892

 
62,572

Intersegment cost of oil and condensate
8,598

 
8,825

 
32,612

 
29,817

Operating costs and expenses:


 
 

 
 
 
 
Operations and maintenance
2

 
2

 
3

 
2

Depreciation and amortization
92

 

 
147

 

Total operating costs and expenses
94

 
2

 
150

 
2

Operating income
$
986

 
$
816

 
$
3,279

 
$
1,970

 
 
 
 
 
 
 
 
Capital Expenditures
$
108

 
$
1,151

 
$
339

 
$
1,438


We formed a crude and condensate marketing subsidiary during the fourth quarter of 2010 to develop and implement marketing uplift strategies surrounding crude oil and condensate production in Alabama and in the Texas Panhandle. In Alabama, we purchase product from our Upstream Segment and certain other working interest owners in the Big Escambia Creek, Fanny Church and Flomaton fields, and seek to increase the value of the product through: (i) blending and treating to lower the gravity and reduce the contaminants, respectively, of the purchased condensate; and (ii) transporting the higher quality condensate to premium market locations. In this regard, neither our Upstream Segment nor the other participating working interest owners bear increased risk in the relocating and treating of the condensate.

In the Texas Panhandle area, we are currently evaluating various storage and transportation opportunities to aggregate our product along with other third-party condensate and move it to more attractive markets.

We also conduct natural gas marketing and trading activities, which activities began during the third quarter of 2011. We seek to capitalize on the physical and financial arbitrage opportunities that naturally extend from our upstream and midstream assets. Where in the past, we generally sold to wholesale buyers at the tailgates and wellheads of our assets, now we hold transportation agreements and move our product to many locations and types of buyers. This strategy diversifies our credit and performance risk and allows us to capitalize on daily, monthly and seasonal changes in market conditions.

As part of our natural gas marketing and trading activities, we enter into both financial derivatives and physical contracts. Our financial derivatives, primarily basis swaps, are transacted: (i) to economically hedge subscribed capacity exposed to market rate fluctuations, and (ii) to mitigate the price risk related to other purchase and sales of natural gas. By entering into a basis swap, one pricing index is exchanged for another, effectively locking in the margin between the natural gas purchase and sale by removing index spread risk on the combined physical and financial transaction.

A commodity-related derivative contract may be designated as a "normal" purchase or sale if the commodity is to be physically received or delivered for use or sale in the normal course of business. If designated as "normal," the derivative contract is accounted for under the accrual method of accounting (not marked-to-market) with no balance sheet or income statement recognition of the contract until settlement. Commodity-related contracts that do not qualify for the normal designation are accounted for as derivatives and are marked-to-market each period.

For the three and nine months ended September 30, 2012, revenues minus cost of oil and condensate totaled $1.1 million and $3.4 million, respectively, compared to $0.8 million and $2.0 million for the three and nine months ended September 30, 2011, respectively. Revenues for the three and nine months ended September 30, 2012, include an unrealized mark-to-market loss of $0.2 million and $0.4 million, respectively, and a gain of $0.5 million for the three and nine months ended September 30, 2011, respectively, related to the financial derivatives and physical contracts.

In addition, our condensate marketing operations in Alabama were negatively impacted by Hurricane Isaac, which hit

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the gulf coast of Louisiana and Alabama in August 2012. Due to the storm, all maritime commerce in the region, including barge operations into and out of oil storage and processing facilities such as our leased storage at a third-party terminal in Mobile, Alabama, was halted. The storm and subsequent clean-up and repair operations caused our inventory levels to increase by approximately 50 MBbls, which negatively impacted our operating income for the third quarter of 2012 by an estimated $2.8 million (recorded in the Corporate Segment as an intercompany elimination). Barge operations resumed during the second week of October 2012.

Upstream Segment
 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
2012
 
2011 (a)
 
2012
 
2011 (a)
 
(Amounts in thousands,
except volumes
and realized prices)
Revenues:
 
 
 
 
 
 
 
Oil and condensate
$
14,376

 
$
17,269

 
$
44,088

 
$
33,799

Intersegment sales - condensate
11,431

 
7,451

 
34,226

 
29,975

Natural gas (b)
8,324

 
16,014

 
22,474

 
31,294

Intersegment sales - natural gas
2,846

 
1,403

 
7,809

 
1,403

NGLs (c)
10,979

 
12,186

 
34,060

 
29,678

Sulfur (d)
3,716

 
5,057

 
11,175

 
12,781

Other
794

 
141

 
1,112

 
1,406

Total revenue
52,466

 
59,521

 
154,944

 
140,336

Operating Costs and expenses:
 
 
 
 
 
 
 

Operations and maintenance (e)
14,175

 
12,737

 
43,025

 
31,369

Depletion, depreciation and amortization
23,484

 
18,636

 
67,070

 
41,046

Impairment
20,060

 
9,870

 
20,845

 
10,194

Total operating costs and expenses
57,719

 
41,243

 
130,940

 
82,609

Operating (loss) income
$
(5,253
)
 
$
18,278

 
$
24,004

 
$
57,727

 
 
 
 
 
 
 
 
Capital expenditures
$
43,754

 
$
31,868

 
$
116,523

 
$
56,688

 
 
 
 
 
 
 
 
Realized average prices (f):
 
 
 
 
 
 
 

Oil and condensate (per Bbl)
$
83.16

 
$
81.65

 
$
86.93

 
$
82.57

Natural gas (per Mcf)
$
2.67

 
$
4.08

 
$
2.40

 
$
3.95

NGLs (per Bbl)
$
36.40

 
$
52.35

 
$
40.16

 
$
55.37

Sulfur (per Long ton)
$
130.77

 
$
187.03

 
$
141.27

 
$
179.48

Production volumes:
 
 
 
 
 
 
 

Oil and condensate (Bbl)
310,349

 
302,766

 
900,873

 
772,350

Natural gas (Mcf)
4,177,156

 
4,274,811

 
12,614,258

 
8,272,176

NGLs (Bbl)
301,644

 
227,614

 
848,047

 
533,223

Total (Mcfe)
7,849,113

 
7,457,091

 
23,107,779

 
16,105,615

Sulfur (Long ton)
28,414

 
27,706

 
79,111

 
71,509

________________________
(a)
Includes operations related to the acquisition of Crow Creek Energy starting on May 3, 2011.
(b)
Revenues include a change in the value of product imbalances by $18, $(37), $(38) and $22 for the three and nine months ended September 30, 2012 and 2011, respectively.
(c)
Revenues include a change in the value of product imbalances by $(215), $(301), $270 and $155 for the three and nine months ended September 30, 2012 and 2011, respectively.
(d)
Revenues include a change in the value of product imbalances by $(32), $0, $(125) and $(54) for the three and nine months ended September 30, 2012 and 2011, respectively.
(e)
Includes purchase of natural gas of $66 from the East Texas and Other Midstream Segment for the nine months ended September 30, 2011.
(f)
Calculation does not include impact of product imbalances.
 

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Revenues. For the three and nine months ended September 30, 2012, Upstream Segment revenues decreased by $7.1 million and increased by $14.6 million, respectively, as compared to the three and nine months ended September 30, 2011.  The addition of production volumes from the acquisition of Crow Creek Energy, which closed on May 3, 2011, impacted the Upstream Segment's revenues relative to the corresponding prior year period positively by $26.0 million during the nine months ended September 30, 2012, respectively. Excluding the acquisition, revenues decreased due to lower realized natural gas and NGL prices, partially offset by higher volumes for the three and nine months ended September 30, 2012, compared to the three and nine months ended September 30, 2011.

In August 2010, our East Texas oil and natural gas production was temporarily shut-in due to an unscheduled shut-down of the Eustace processing facility owned and operated by a third-party. The shut-in negatively impacted our net revenues from January 1, 2011 to March 11, 2011, the date the plant was brought back into service, by approximately $3.9 million (excluding recoveries). We recognized $5.0 million related to our business interruption insurance claim in other revenue, of which $2.0 million was recognized in the three months ended March 31, 2011 and $3.0 million was recognized in the fourth quarter of 2010. The maximum recovery under our business interruption insurance policy is $5.0 million per occurrence. During the three months ended September 30, 2012, we received an $0.8 million settlement from the third-party operator related to this incident, which was recorded as other revenue.

In May and June 2012, we completed turnarounds of approximately eight and seven days, respectively, of our Big Escambia Creek facility to make certain equipment repairs and routine inspections of equipment. We estimate the net revenue impact due to the loss of production was approximately $3.8 million and the turnaround expense was approximately $0.5 million. The turnarounds reduced our production in the three months ended June 30, 2012 by approximately 23 MBbls of oil, 88 MMcf of residue gas, 18 MBbls of NGLs and 3,400 long ton of sulfur.

Operating Expenses. Operating expenses, including severance and ad valorem taxes, increased by $1.4 million and$11.7 million for the three and nine months ended September 30, 2012, respectively, as compared to the three and nine months ended September 30, 2011.  The increase was due to higher production expenses and severance taxes related to the increase in production, of which $0.2 million and $9.5 million was directly related to the operation of the properties acquired in the acquisition of Crow Creek Energy during the three and nine months ended September 30, 2012, respectively, compared to the same period in 2011.

On July 19, 2012, one of our operated wells in Wayne County, Mississippi experienced an uncontrolled flow event during a well workover operation. The incident required the mobilization of our emergency response personnel to control the well's flow and secure the area in coordination with local, county and state emergency management agencies. Various contractors, including well control contractors, were mobilized to assist our response team. The flow from the well was fully controlled and secured on July 24, 2012. We have Control of Well insurance and are currently pursuing reimbursement for this incident. We estimate the cost of the incident to be between $9 - $11 million and have offset amounts paid above our deductible of $150,000 by recording a receivable for reimbursement under our insurance policy. As of September 30, 2012, we have a receivable of $6.6 million related to the expected reimbursement.

 Depletion, Depreciation and Amortization. Depletion, depreciation and amortization expense increased by $4.8 million and $26.0 million for the three and nine months ended September 30, 2012, respectively, as compared to the same period in the prior year.  The increase was primarily due to $5.6 million and $25.7 million of depletion and amortization expense incurred during the three and nine months ended September 30, 2012, respectively, for the properties acquired in the acquisition of Crow Creek Energy.
 
Impairment.  During the three and nine months ended September 30, 2012, we incurred impairment charges of $20.1 million and $20.8 million, respectively, due to (i) certain unproved property leaseholds that we expect to expire undrilled in 2013 and (ii) our proved properties in the Barnett Shale that experienced reduced revenues resulting from lower natural gas prices and continuing relatively high operating costs associated with gas compression. During the three and nine months ended September 30, 2011, we incurred impairment charges of $9.9 million and $10.2 million, respectively, due to (i) certain legacy drilling locations in our unproved properties which we no longer intend to develop based on the performance of offsetting wells during the three months ended June 30, 2011, (ii) certain proved properties of the Jourdanton Field in South Texas due to lower natural gas prices and relatively high operating costs, and (iii) certain drilling locations in our unproved properties which we no longer intend to develop during the three months ended September 30, 2011.

Capital Expenditures.  Capital expenditures increased by $11.9 million and $59.8 million for the three and nine months ended September 30, 2012, respectively, as compared to the three and nine months ended September 30, 2011.   During the three months ended September 30, 2012, we drilled and completed three gross operated wells and participated in three gross non-operated wells on leases in the Mid-Continent region. Additionally, during the three months ended September 30, 2012,

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we conducted ten workovers and four recompletions across our operations.

Corporate and Other Segment
 
Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
  ($ in thousands)
Revenues:
 
 
 
 
 
 
 
Realized commodity derivative gains (losses)
$
15,802

 
$
(2,698
)
 
$
38,428

 
$
(17,958
)
Unrealized commodity derivative (losses) gains
(51,305
)
 
97,011

 
13,426

 
86,164

Intersegment elimination - Sales of natural gas and condensate
(11,431
)
 
(7,451
)
 
(34,226
)
 
(29,975
)
    Total revenue
(46,934
)
 
86,862

 
17,628

 
38,231

Intersegment elimination - Cost of natural gas and condensate
(8,598
)
 
(8,825
)
 
(32,612
)
 
(29,817
)
General and administrative
16,807

 
16,068

 
52,384

 
43,746

Intersegment elimination - Operations and maintenance

 

 

 
(66
)
Other operating income

 

 

 
(2,893
)
Depreciation and amortization
423

 
311

 
1,238

 
1,018

Operating income (loss)
(55,566
)
 
79,308

 
(3,382
)
 
26,243

Other income (expense):
 

 
 

 
 

 
 

Interest expense, net
(14,199
)
 
(10,050
)
 
(35,087
)
 
(19,579
)
Unrealized interest rate derivatives gains (losses)
615

 
(3,165
)
 
4,418

 
2,191

Realized interest rate derivative losses
(1,733
)
 
(3,713
)
 
(8,578
)
 
(13,374
)
Other income (expense), net
1

 
(3
)
 
(44
)
 
(167
)
Total other expense
(15,316
)
 
(16,931
)
 
(39,291
)
 
(30,929
)
Income (loss) from continuing operations before taxes
(70,882
)
 
62,377

 
(42,673
)
 
(4,686
)
Income tax benefit
(386
)
 
(1,077
)
 
(556
)
 
(1,810
)
Income (loss) from continuing operations
(70,496
)
 
63,454

 
(42,117
)
 
(2,876
)
Discontinued operations, net of tax

 

 

 
404

Segment income (loss)
$
(70,496
)
 
$
63,454

 
$
(42,117
)
 
$
(2,472
)
 
Revenues. Our Corporate and Other Segment's revenues consist of our intersegment eliminations and our commodity derivative activities. Our commodity derivative activities impact our Corporate and Other Segment revenues through (i) the unrealized, non-cash, mark-to-market of our commodity derivatives scheduled to settle in future periods; and (ii) the realized gains or losses on our commodity derivatives settled in the indicated period. Our unrealized commodity gains and losses reflect the change in the mark-to-market value of our derivative position from the beginning of a period to the end.  In general, the change in the mark-to-market value of our derivative position may be due to several factors including the settlement of derivative instruments during the period, the addition of new derivative positions during the period, changes in the forward curves of the underlying commodities from the beginning to the end of the period, changes in interest rates used in the mark-to-market calculations from the beginning to the end of the period and the passage of time during the period.  

During the three and nine months ended September 30, 2012, unrealized gains in our commodity derivative portfolio decreased, as compared to the three and nine months ended September 30, 2011, due to increases in the natural gas, NGL and crude oil forward curves. 

We recognized realized commodity derivative gains during the three and nine months ended September 30, 2012, compared to realized commodity derivative losses during the three and nine months ended September 30, 2011. The increase in the realized gains for the three and nine months ended September 30, 2012, as compared to the same period in the prior year, was due to the settlement of contracts assumed in the acquisition of Crow Creek Energy and lower natural gas and NGL market prices, in relation to the strike prices of our settled contracts, as compared to the same period in the prior year.
 
Given the uncertainty surrounding future commodity prices, and the general inability to predict future commodity prices as they relate to the strike prices at which we have hedged our exposure, it is difficult to predict the magnitude and impact that marking our hedges to market will have on our income from operations in future periods.

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Intersegment Eliminations. During the three and nine months ended September 30, 2012 and 2011, our Upstream Segment sold condensate to the Marketing and Trading Segment within our Midstream Business for resale. In addition, during the three and nine months ended September 30, 2011, our East Texas and Other Midstream Segment sold natural gas to our Upstream Segment to be used as fuel. Due to the increase of condensate inventory as a result of Hurricane Isaac, as discussed within the Marketing and Trading Segment section, our intersegment eliminations negatively impacted our results by $2.8 million for the three and nine months ended September 30, 2012. We expect our condensate inventory levels to return to normal during the fourth quarter of 2012.
 
General and Administrative Expenses. General and administrative expenses increased by $0.7 million and $8.6 million for the three and nine months ended September 30, 2012, respectively, as compared to the same periods in 2011. This increase was primarily due to higher salaries and benefits, which was due to (i) an increase in our headcount due to the acquisition of Crow Creek Energy and (ii) increased equity compensation expense due to additional grants. In addition, we also incurred higher insurance expense related to the increase in our insurable property and to higher insurance rates during the three and nine months ended September 30, 2012. We expect our insurance expense to continue to increase in 2013 due to the increase in our insurable property as a result of our acquisition of the BP Panhandle System, and due to our claims history. The increases for the three and nine months ended September 30, 2012, were partially offset by higher professional fees incurred during the same period in 2011, primarily associated with the acquisition of Crow Creek Energy in May 2011.
 
At the present time, we do not allocate our general and administrative expenses to our operational segments.
 
Total Other Expense.  Total other expense primarily consists of both realized and unrealized gains and losses from our interest rate swaps and interest expense related to our senior secured credit facility and our senior unsecured notes. On June 22, 2011, we terminated a $150 million notional amount 2.56% fixed rate interest rate swap at a total cost of $5.0 million, and extended the maturity of $250 million notional amount of our 4.095% fixed rate interest rate swaps from December 31, 2012 to June 22, 2015, with a fixed rate of 2.95%. During July 2012, in conjunction with our issuance of $250.0 million of senior unsecured notes, which increased our fixed interest rate exposure, we terminated the full $200.0 million notional amount of our existing 4.295% and 4.095% fixed rate interest rate swaps. During the three and nine months ended September 30, 2012, our realized settlement losses decreased by $2.0 million and $4.8 million, respectively, as compared to the three and nine months ended September 30, 2011, due to the transactions described above. For the three and nine months ended September 30, 2012, we recognized unrealized gains of $0.6 million and $4.4 million, respectively, as compared to unrealized losses of $3.2 million and unrealized gains of $2.2 million during the same period in 2011, as a result of a decrease in the forward interest rate curves. These unrealized mark-to-market losses did not have any impact on cash activities for the period, and are excluded by definition from our calculation of Adjusted EBITDA.
 
Interest expense increased by $4.1 million and $15.5 million during the three and nine months ended September 30, 2012, respectively, as compared to the three and nine months ended September 30, 2011.  Interest expense is shown before the impact of our interest rate derivatives, which convert a portion of our outstanding debt from variable-rate interest obligations to fixed-rate interest obligations.  On May 27, 2011, we issued $300 million of senior unsecured notes (which were exchanged for registered notes on February 15, 2012) with a coupon of 8 3/8%; on June 22, 2011, we entered into an Amended and Restated Credit Agreement, which bears interest currently at LIBOR plus 2.50%; and on July 13, 2012, we issued an additional $250 million of senior unsecured notes.  The increases in interest expense were due to the transactions discussed above.
 
Income Tax (Benefit) Provision. Income tax provision for 2012 and 2011 relates to (i) state taxes due by us and (ii) federal taxes due by Eagle Rock Energy Acquisition Co., Inc. and Eagle Rock Energy Acquisition Co. II, Inc. and their wholly-owned subsidiary corporations, Eagle Rock Upstream Development Company, Inc. and Eagle Rock Upstream Development Company II, Inc., which are subject to federal income taxes.

Discontinued Operations. On May 24, 2010, we completed the sale of our fee mineral and royalty interests as well as our equity investment in Ivory Working Interests, L.P. During the nine months ended September 30, 2011, we received payments of $0.5 million related to pre-effective date operations and recorded this amount as part of discontinued operations.

Adjusted EBITDA
 
Adjusted EBITDA, as defined under "Non-GAAP Financial Measures," decreased by $3.1 million and increased by $33.2 million from $62.2 million and $146.4 million for the three and nine months ended September 30, 2011, respectively, to $59.1 million and $179.6 million for the three and nine months ended September 30, 2012, respectively.
 
As described above, revenues minus cost of natural gas and NGLs for the Midstream Business (excluding unrealized

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gains from the Marketing and Trading Segment) decreased by $9.1 million and $16.0 million during the three and nine months ended September 30, 2012, respectively, as compared to the comparable period in 2011. The Upstream Segment revenues (excluding imbalances) decreased $6.7 million and increased $15.1 million during the three and nine months ended September 30, 2012, respectively, as compared to the comparable period in 2011. Intercompany eliminations of revenues minus cost of natural gas and condensate resulted in a $4.2 million and $1.5 million decrease during the three and nine months ended September 30, 2012, respectively, as compared to the comparable period in 2011. Our Corporate and Other Segment's realized commodity derivatives gains increased by $18.5 million and $56.4 million during the three and nine months ended September 30, 2012, as compared to the comparable period in 2011. This resulted in total incremental revenues minus cost of natural gas and NGLs decreasing by $1.5 million and increasing by $54.0 million during the three and nine months ended September 30, 2012, respectively, as compared to the comparable period in 2011.  The incremental revenue amounts are adjusted to exclude the impact of unrealized commodity derivatives, which includes the amortization of put premiums and other derivative costs, and the non-cash mark-to-market Upstream Segment imbalances, none of which are included in the calculation of Adjusted EBITDA.
 
Operating expenses (including taxes other than income) for our Midstream Business increased by $0.9 million and $5.1 million for the three and nine months ended September 30, 2012, respectively, as compared to the same period in 2011, and operating expenses (including taxes other than income) for the Upstream Segment increased $1.4 million and $11.7 million for the three and nine months ended September 30, 2012, respectively, as compared to the comparable period in 2011.
 
General and administrative expenses, excluding the impact of non-cash compensation charges related to our long-term incentive program and other non-recurring items and captured within our Corporate and Other Segment, decreased by $0.8 million and increased by $4.1 million during the three and nine months ended September 30, 2012, respectively, as compared to the respective period in 2011.
 
As a result, revenues (excluding the impact of unrealized commodity derivative activity) minus cost of natural gas, NGLs and condensate for the three and nine months ended September 30, 2012, as compared to the same period in 2011, decreased by $1.5 million and increased by $54.0 million, respectively, operating expenses increased by $2.4 million and $16.8 million, respectively, and general and administrative expenses decreased by $0.8 million and increased by $4.1 million, respectively.  The increases in revenues minus the cost of natural gas, NGLs and condensate, while partially offset by the increases in operating costs and general and administrative expenses, resulted in an increase to Adjusted EBITDA for the nine months ended September 30, 2012, as compared to the nine months ended September 30, 2011.

LIQUIDITY AND CAPITAL RESOURCES
 
Historically, our sources of liquidity have included cash generated from operations, issuances of equity and debt securities and borrowings under our revolving credit facility. Our primary cash requirements have included general and administrative expenses, operating expenses, maintenance and growth capital expenditures, short-term working capital needs, interest payments on our outstanding debt, distributions to our unitholders and acquisitions of new assets or businesses.  In 2010, we issued approximately 21.6 million warrants, each entitling holders to purchase a common unit of Eagle Rock for a price of $6.00 on certain designated exercise dates through May 2012. During the nine months ended September 30, 2012, 5,300,588 warrants were exercised for which we received proceeds of $31.8 million. The final exercise date for the warrants was May 15, 2012, and on that date the remaining unexercised warrants expired.

We believe that our historical sources of liquidity will be sufficient to satisfy our short-term liquidity needs and to fund our committed capital expenditures for at least the next twelve months. Our growth strategy entails substantial expenditures on organic projects in our Midstream Business and new drilling activity in our Upstream Business. We also intend to continue to pursue attractive development and acquisition opportunities in the midstream and upstream sectors. Accordingly, we may utilize various available financing sources, including the issuance of equity or debt securities, to fund all or a portion of our organic growth expenditures and potential acquisitions. Our ability to complete future offerings of equity or debt securities and the timing of these offerings will depend upon various factors including prevailing market conditions and our financial condition.

Equity Offerings

On May 31, 2012, we announced a program through which we may issue common units, from time to time, with an aggregate market value of up to $100 million. We are under no obligation to issue equity under the program. We intend to use the net proceeds from any sales under the program for general partnership purposes, which may include, among other things, repayment of indebtedness, acquisitions, capital expenditures and additions to working capital. As of September 30, 2012, 691,020 units had been issued under this program for net proceeds of approximately $6.1 million.

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During the third quarter of 2012, we closed an underwritten public offering of 10,120,000 common units, which included the full exercise of the underwriters' option to purchase additional common units to cover over-allotments, for net proceeds of approximately $84.5 million, The net proceeds were used to repay a portion of the outstanding borrowings under our revolving credit facility in advance of funding the acquisition of the BP Panhandle System, which closed on October 1, 2012.

Capital Expenditures

The energy business can be capital intensive, requiring significant investment for the acquisition or development of new facilities. We categorize our capital expenditures as (and, as necessary, allocate the attributable portion of our capital expenditures between) either:
 
growth capital expenditures, which are made to (i) acquire, construct, expand or upgrade our gathering, processing and treating assets or (ii) grow our natural gas, NGL, crude or sulfur production; or
 
maintenance capital expenditures, which are made to (i) replace partially or fully depreciated assets, meet regulatory requirements, or maintain the existing operating capacity of our gathering, processing and treating assets or (ii) maintain our natural gas, NGL, crude or sulfur production.
 
The primary impact of this categorization is that we reduce the amount of cash we consider available for distribution by the amount of our maintenance capital expenditures.

Our current 2012 capital budget anticipates that we will spend approximately $300 million in total in 2012. Our capital expenditures were approximately $81.6 million and $239.8 million for the three and nine months ended September 30, 2012, respectively, of which $16.0 million and $35.8 million were related to maintenance capital expenditures and $65.6 million and $204.0 million were related to growth capital expenditures.

We have certain obligations under our air emissions permit to lower the SO2 emissions of our Alabama plant operations.  Additionally, in mid-2010, the Environmental Protection Agency (the "EPA") enacted new National Ambient Air Quality Standards ("2010 NAAQS") which substantially lowered the emissions limits for SO2 and mandated timelines for compliance, subject to State assessments of non-attainment and attainment areas.  In order to fulfill our permit obligations, ensure compliance with the new 2010 NAAQS requirements, as applicable, and replace and upgrade certain assets in our Alabama facilities, we expect to spend approximately $60 million through the end of 2013 at our Alabama facilities, inclusive of the approximately $8.6 million spent to date.  The expected facility upgrades to our Alabama operations should not only increase the marketable sulfur recovered from the inlet gas stream, but also are anticipated to reduce plant fuel consumption, improve the plant's operating reliability, reduce the frequency of plant turnarounds and extend the plant's operating life. Management does not anticipate, however, that the required spending will generate returns consistent with our internal rate of return thresholds for discretionary capital investment.     

Distribution Policy
 
Our distribution policy is to distribute to our unitholders, on a quarterly basis, all of our available cash in the manner described below and as further described in our partnership agreement. Available cash generally means, for any quarter ending prior to liquidation, all cash on hand at the end of that quarter less the amount of cash reserves that the general partner determines to:
 
provide for the proper conduct of our business, including for future capital expenditures and credit and other needs;

comply with applicable law or any partnership debt instrument or other agreement; or

provide funds for distributions to unitholders in respect of any one or more of the next four quarters.
 
The actual distributions we will declare will be subject to our operating performance, prevailing market conditions (including forward oil, natural gas and sulfur prices), the impact of unforeseen events and the approval of our Board of Directors and will be done pursuant to our distribution policy.
 

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Revolving Credit Facility
 
On June 22, 2011, we entered into an Amended and Restated Credit Agreement (the "Credit Agreement") with Wells Fargo Bank, National Association, as administrative agent and swingline lender, Bank of America, N.A. and The Royal Bank of Scotland plc, as co-syndication agents, BNP Paribas, as documentation agent, and the other lenders who are parties to the Credit Agreement.
The revolving credit facility under the Credit Agreement consists of aggregate commitments of $675 million that may, at our request and subject to the terms and conditions of the Credit Agreement, be increased up to a total aggregate amount of $1.2 billion. Availability under the revolving credit facility is subject to a borrowing base comprised of two components: the upstream component and the midstream component. As of September 30, 2012, our borrowing base exceeded our total commitments of $675 million, and we had approximately $328.5 million of availability under the revolving credit facility, based on total commitments and before considering covenant considerations. The Credit Agreement matures on June 22, 2016.
On October 1, 2012, we borrowed approximately $207.9 million under the revolving credit facility in connection with closing the acquisition of BP America Production Company's Texas Panhandle midstream assets.
Senior Unsecured Notes
On May 27, 2011, we completed the sale of $300 million of our 8.375% senior unsecured notes due 2019 (the "Senior Notes") through a private placement, which were exchanged for registered notes on February 15, 2012. The Senior Notes will mature on June 1, 2019, and interest is payable on June 1 and December 1 each year. We used the net proceeds of approximately $290.3 million to repay borrowings outstanding under our revolving credit facility.
On July 13, 2012, we completed the sale of an additional $250.0 million of senior notes through a private placement. After the original discount of $3.7 million and excluding related offering expenses, we received net proceeds of approximately $246.3 million, which were used to repay borrowings outstanding under our revolving credit facility. This issuance supplemented our prior $300.0 million of Senior Notes issued in May 2011, all of which are treated as a single series.

Debt Covenants
 
Our revolving credit facility requires us to maintain certain leverage, current and interest coverage ratios. As of September 30, 2012, we were in compliance with all of our debt covenants, and we believe that we will remain in compliance with our financial covenants through 2012. Our financial covenant requirements and actual ratios as of September 30, 2012, are as follows:
 
 
Per Credit Agreement
Actual
Interest coverage ratio
2.5 (Min)
4.3
Leverage ratio
4.5 (Max)
3.5
Current ratio
1.0 (Min)
2.7

Our goal is to maintain our ratio of outstanding debt to Adjusted EBITDA, or "leverage ratio," at or below 3.5 on a long-term basis, while acknowledging that at times this ratio may exceed our targeted levels, particularly following acquisitions or major development projects. We expect our efforts to maintain or reduce our leverage ratio during 2012 will be primarily through investing in attractive growth opportunities that will increase our Adjusted EBITDA.

Our senior unsecured notes are issued under an indenture that contains certain covenants limiting our ability to, among others, pay distributions, repurchase our equity securities, make certain investments, incur additional indebtedness, and sell assets. At September 30, 2012, we were in compliance with our covenants under the senior unsecured notes indenture.

For a further discussion of our revolving credit facility and senior unsecured notes, see Note 8 to our consolidated financial statements included in Part II, Item 8. Financial Statements and Supplementary Data included in our Annual Report on Form 10-K for the year ended December 31, 2011.


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Cash Flows

Cash Distributions

On January 26, 2012, we declared our fourth quarter 2011 cash distribution of $0.21 per unit to our common unitholders of record as of the close of business on February 7, 2012. The distribution was paid on February 14, 2012.

On April 24, 2012, we declared our first quarter 2012 cash distribution of $0.22 per unit to our common unitholders of record as of the close of business on May 8, 2012 (excluding certain restricted unit grants). The distribution was be paid on May 15, 2012.

On July 24, 2012, we declared our second quarter 2012 cash distribution of $0.22 per unit to our common unitholders of record as of the close of business on August 7, 2012. The distribution was paid on August 14, 2012.

On October 24, 2012, we declared our third quarter 2012 cash distribution of $0.22 per unit to our common unitholders of record as of the close of business on November 7, 2012. The distribution will be paid on November 14, 2012.

Working Capital

Working capital is the amount by which current assets exceed current liabilities. As of September 30, 2012, working capital was a negative $23.1 million as compared to a negative $45.3 million as of December 31, 2011.
 
The net increase in working capital of $22.2 million from December 31, 2011 to September 30, 2012 resulted primarily from the following factors:
 
risk management net working capital balance increased by a net $31.1 million as a result of changes in current portion of mark-to-market unrealized positions as a result of decreases to the forward natural gas, oil and NGL price curves;
 
accounts payable decreased by $10.0 million primarily as a result of lower volumes and timing of payments;

trade accounts receivable increased by $1.2 million primarily from the impact of insurance receivables related to property damages and timing of receipts, partially offset by the following factors:
 
accrued liabilities increased by $17.0 million primarily reflecting accrued interest and the timing of payment of unbilled expenditures related primarily to capital expenditures; and

cash balances and marketable securities decreased overall by $0.7 million.
 
Cash Flows for the Nine Months Ended September 30, 2012 Compared to the Nine Months Ended September 30, 2011

Cash Flow from Operating Activities. Cash flows from operating activities increased $26.0 million during the nine months ended September 30, 2012, as compared to the nine months ended September 30, 2011. This increase was primarily due to an increase in our results of operations, excluding unrealized gains on derivatives, from our acquisition of Crow Creek Energy and a decrease in payments made to terminate or reset certain derivative contracts. During the nine months ended September 30, 2012, we made payments of $3.9 million to terminate the full $200.0 million notional amount of our existing 4.295% and 4.095% fixed rate interest rate swaps and $2.8 million to adjust the strike price on an existing WTI crude oil swap. During the nine months ended September 30, 2011, we made payments of $5.0 million and $4.8 million to unwind interest rate derivative contracts and certain commodity derivative contracts, respectively, and a $14.6 million payment to adjust the strike price on certain existing commodity derivative contracts, as compared to our payment of $1.1 million to partially unwind certain commodity derivative contracts during the nine months ended September 30, 2012. Declines in natural gas prices during the nine months ended September 30, 2012, resulted in us realizing net settlement gains on our commodity derivatives, of which $12.0 million was reclassed to cash flows from financing activities.

Cash Flows from Investing Activities. Cash flows used in investing activities for the nine months ended September 30, 2012 were $249.7 million as compared to cash flows used in investing activities of $297.5 million for the nine months ended September 30, 2011. The key difference between periods was the decrease in our net cash outlay of $220.3 million for acquisitions during the nine months ended September 30, 2011, partially offset by an increase of $143.5 million for capital expenditures, in particular spending related to our Woodall and Wheeler Plants, as well as increased drilling in our Upstream

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Segment.  
    
Cash Flows from Financing Activities. Cash flows provided by financing activities during the nine months ended September 30, 2012 were $138.0 million as compared to cash flows provided by financing activities of $226.8 million for the nine months ended September 30, 2011. Key differences between periods included net repayments of our revolving credit facility of $150.5 million during the nine months ended September 30, 2012, as compared to net repayments of $87.0 million on our revolving credit facility during the nine months ended September 30, 2011.  During the nine months ended September 30, 2012, we received $246.3 million from the sale of our Senior Notes as compared to $297.8 million during the nine months ended September 30, 2011. Cash outflows related to our distributions increased to $86.8 million during the nine months ended September 30, 2012, as compared to $49.1 million during the nine months ended September 30, 2011, as a result of increasing our quarterly distribution from $0.15 for the payments made in the first two quarters of 2011 (for the fourth quarter of 2010 and the first quarter of 2011) and $0.1875 paid in the third quarter of 2011 (for the second quarter of 2011) to $0.21 paid in the first quarter of 2012 (for the fourth quarter of 2011) and $0.22 paid in the second and third quarter of 2012 (for the first and second quarter of 2012). We also received $31.8 million due to the exercise of warrants during the nine months ended September 30, 2012, as compared to $78.2 million from the exercise of warrants during the same period in 2011. During the nine months ended September 30, 2012, we received $90.6 million of net proceeds on our equity offerings.

Hedging Strategy
 
We use a variety of hedging instruments such as fixed-price swaps, costless collars and put options to manage our risks related to our commodity price and interest rate exposure. At times our hedging strategy may involve adjusting strike prices of existing hedges to better reflect current market conditions or to meet other corporate objectives.  In addition, we may also terminate or unwind hedges or portions of hedges when the expected future volumes do not support the level of hedges.  Hedge transactions such as these impact our liquidity in that we are required to pay the present value of the difference between the hedged price and the current futures price.  These transactions also increase our exposure to the counterparties through which we execute the hedges. Under this strategy, during the nine months ended September 30, 2012, we partially unwound two 2013 calendar year WTI crude oil swaps, totaling 28,400 barrels per month, at a cost of $1.1 million. We were using these WTI crude oil swaps to hedge against changes in NGL prices. To continue hedging these NGL volumes, we entered into two calendar year 2013 propane swaps, totaling 2,100,000 gallons per month.

During July 2012, we enhanced our commodity derivative portfolio by paying $2.8 million to adjust the strike price from $68.30 to $92.00 (the forward market price at the date of the transaction) per barrel on an existing WTI crude oil swap of 20,000 barrels per month for the six months ended December 31, 2012.

During July 2012, we also adjusted our interest rate hedge portfolio to re-balance our mix of floating and fixed interest rate exposure following our issuance of $250 million of Senior Notes. To accomplish this, we terminated $200 million notional amount of our existing fixed rate interest rate swaps with original maturities of December 31, 2012 for a total cost of $3.9 million.

For further description of our hedging activity, see Note 10 to our unaudited condensed consolidated financial statements included in Part I, Item 1. Financial Statements and Supplementary Data of this Form 10-Q.
  
Off-Balance Sheet Obligations.
 
We had no off-balance sheet transactions or obligations at September 30, 2012

Recent Accounting Pronouncements
 
For recent accounting pronouncements, please see Note 3 of our unaudited condensed consolidated financial statements included in Part I, Item 1. Financial Statements and Supplementary Data of this Form 10-Q.

Non-GAAP Financial Measures
 
We include in this report Adjusted EBITDA, a non-GAAP financial measure. We provide reconciliations of this non-GAAP financial measure to its most directly comparable financial measures as calculated and presented in accordance with U.S. GAAP.
 
We define Adjusted EBITDA as net income (loss) plus or (minus) income tax provision (benefit); interest-net, including realized interest rate risk management instruments and other expense; depreciation, depletion and amortization

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expense; impairment expense; other operating expense, non-recurring; other non-cash operating and general and administrative expenses, including non-cash compensation related to our equity-based compensation program; unrealized (gains) losses on commodity and interest rate risk management related instruments; gains (losses) on discontinued operations and other (income) expense.  We use Adjusted EBITDA as a measure of our core profitability to assess the financial performance of our assets. Adjusted EBITDA is also used as a supplemental financial measure by external users of our financial statements such as investors, commercial banks and research analysts.  For example, the compliance covenant used by our lenders under our revolving credit facility which is designed to measure the viability of us and our ability to perform under the terms of our revolving credit facility uses our Adjusted EBITDA.  We believe that investors benefit from having access to the same financial measures that our management team uses in evaluating performance.  Adjusted EBITDA is useful in determining our ability to sustain or increase distributions. By excluding unrealized derivative gains (losses), a non-cash, mark-to-market benefit (charge) which represents the change in fair market value of our executed derivative instruments and is independent of our assets’ performance or cash flow generating ability, we believe Adjusted EBITDA reflects more accurately our ability to generate cash sufficient to pay interest costs, support our level of indebtedness, make cash distributions to our unitholders and general partner and finance our maintenance capital expenditures. We further believe that Adjusted EBITDA also describes more accurately the underlying performance of our operating assets by isolating the performance of our operating assets from the impact of an unrealized, non-cash measure designed to describe the fluctuating inherent value of a financial asset. Similarly, by excluding the impact of non-recurring discontinued operations, Adjusted EBITDA provides users of our financial statements a more accurate picture of our current assets’ cash generation ability, independently from that of assets which are no longer a part of our operations. Our Adjusted EBITDA definition may not be comparable to Adjusted EBITDA or similarly titled measures of other entities, as other entities may not calculate Adjusted EBITDA in the same manner as us. For example, we include in Adjusted EBITDA the actual settlement revenue created from our commodity hedges by virtue of transactions undertaken by us to reset commodity hedges to higher prices or purchase puts or other similar floors despite the fact that we exclude from Adjusted EBITDA any charge for amortization of the cost of such commodity hedge reset transactions or puts. 

Adjusted EBITDA should not be considered an alternative to net income, operating income, cash flows from operating activities or any other measure of financial performance presented in accordance with U.S. GAAP.
 
Adjusted EBITDA does not include interest expense, income taxes or depreciation and amortization expense. Because we have borrowed money to finance our operations, interest expense is a necessary element of our costs and our ability to generate net income. Because we use capital assets, depreciation and amortization are also necessary elements of our costs. Therefore, any measures that exclude these elements have material limitations. To compensate for these limitations, we believe that it is important to consider both net income determined under U.S. GAAP, as well as Adjusted EBITDA, to evaluate our performance and liquidity.

The following table sets forth a reconciliation of Adjusted EBITDA to its most directly comparable financial measures calculated and presented in accordance with U.S. GAAP:

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Three Months Ended
September 30,
 
Nine Months Ended September 30,
 
2012
 
2011
 
2012
 
2011
 
($ in thousands)
Reconciliation of Adjusted EBITDA to net cash flows provided by (used in) operating activities and net income:
 
 
 
 
 
 
 
Net cash flows provided by operating activities
$
49,229

 
$
59,258

 
$
111,000

 
$
84,951

Add (deduct):
 
 
 
 
 
 
 
Discontinued operations

 
(197
)
 

 
210

Depreciation, depletion, amortization and impairment
(96,295
)
 
(44,910
)
 
(240,867
)
 
(105,068
)
Amortization of debt issuance costs
(1,019
)
 
(642
)
 
(2,425
)
 
(1,688
)
Risk management portfolio value changes
(44,241
)
 
94,634

 
25,081

 
114,403

Reclassing financing derivative settlements
3,544

 
1,263

 
11,964

 
3,706

Other
(3,401
)
 
(1,106
)
 
(8,704
)
 
22

Accounts receivable and other current assets
16,953

 
(4,283
)
 
1,976

 
1,200

Accounts payable and accrued liabilities
(32,224
)
 
(6,929
)
 
6,643

 
91

Other assets and liabilities
559

 
277

 
(107
)
 
892

Net income
(106,895
)
 
97,365

 
(95,439
)
 
98,719

Add (deduct):
 
 
 
 
 
 
 
Interest expense, net
15,931

 
13,766

 
43,709

 
33,120

Depreciation, depletion, amortization and impairment
96,295

 
44,910

 
240,867

 
105,068

Income tax expense (benefit)
(386
)
 
(1,077
)
 
(556
)
 
(1,810
)
EBITDA
4,945

 
154,964

 
188,581

 
235,097

Add:
 
 
 
 
 
 
 
Unrealized (gains) losses from derivative activity
50,847

 
(94,384
)
 
(17,417
)
 
(88,893
)
Restricted unit compensation expense
3,080

 
1,507

 
8,092

 
3,441

Non-cash mark-to-market Upstream imbalances
229

 
(107
)
 
338

 
(123
)
Discontinued operations

 
197

 

 
(210
)
Other operating income

 

 

 
(2,893
)
ADJUSTED EBITDA
$
59,101

 
$
62,177

 
$
179,594

 
$
146,419


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Item 3. Quantitative and Qualitative Disclosures About Market Risk

Risk and Accounting Policies
 
We are exposed to market risks associated with adverse changes in commodity prices, interest rates and counterparty credit. We may use financial instruments such as put and call options, swaps and other derivatives to mitigate the effects of the identified risks. Adverse effects on our cash flow from changes in crude oil, natural gas, NGL product prices or interest rates could adversely impact our ability to make distributions to our unitholders, meet debt service obligations, fund required capital expenditures, and other similar requirements. Our management has established a comprehensive review of our market risks and has developed risk management policies and procedures to monitor and manage these market risks. Our general partner is responsible for the overall approval of market risk management policies, delegation of transaction authority levels, and for the establishment of a Risk Management Committee ("RMC"). The RMC is composed of officers (including, on an ex officio basis, our chief executive officer) who receive regular briefings on positions and exposures, credit exposures and overall risk management in the context of market activities. The RMC is responsible for the overall management of commodity price risk, interest rate risk and credit risk, including monitoring exposure limits.

Commodity Price Risk
 
We are exposed to the impact of market fluctuations in the prices of crude oil, natural gas, NGLs and other commodities as a result of our gathering, processing, producing and marketing activities, which produce a naturally long position in these commodities. Our profitability and cash flow are affected by changes in prices of these commodities. These prices are impacted by changes in the supply and demand for these commodities, as well as market uncertainty and other factors beyond our control. Historically, changes in the prices of NGLs have generally correlated with changes in the price of crude oil.
 
We manage this commodity price exposure through an integrated strategy that includes management of our contract portfolio, matching sales prices of commodities with purchases, optimization of our portfolio by monitoring basis and other price differentials in our areas of operations, and the use of derivative contracts. Crude oil, natural gas and NGL prices can also indirectly affect our profitability by influencing the level of drilling activity and related opportunities for our service.
 
We frequently use financial derivatives ("hedges") to reduce our exposure to commodity price risk. We have implemented a Risk Management Policy which allows management to execute crude oil, natural gas liquids and natural gas hedging instruments, which may include swaps, collars, options and other derivatives, in order to reduce exposure to substantial adverse changes in the prices of these commodities. These hedges are only intended to mitigate the risk associated with our natural physical position. We monitor and ensure compliance with this Risk Management Policy through senior level executives in our operations, finance and legal departments.

We have not designated our contracts as accounting hedges based on authoritative guidance. As a result, we mark our derivatives to market with the resulting change in fair value being included in our statement of operations. As of September 30, 2012, our commodity hedge portfolio totaled a net asset position of $59.7 million, consisting of assets aggregating $67.1 million and liabilities aggregating $7.3 million. For additional information about our hedging activities and related fair values, see Part I, Item 1. Financial Statement Notes 10 and 11.
 
We continually monitor our hedging and contract portfolio and expect to continue to adjust our hedge position as conditions warrant.

In addition, we have recently begun operations through our natural gas marketing subsidiary. Though we intend for these activities to complement our existing operations, they may expose us to additional and different risks, as our activities are expected to be more comprehensive than our commodities derivative activities described above. To minimize our exposure to trading losses, we have established procedures to monitor and limit risk, including the use of value-at-risk metrics. 
Interest Rate Risk
 
We are exposed to variable interest rate risk as a result of borrowings under our revolving credit facility. To mitigate its interest rate risk, we have entered into various interest rate swaps. These swaps convert the variable-rate term loan into a fixed-rate obligation. The purpose of entering into these swaps is to eliminate interest rate variability by converting LIBOR-based variable-rate payments to fixed-rate payments. Amounts received or paid under these swaps were recorded as reductions or increases in interest expense.


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We have not designated our contracts as accounting hedges. As a result, we mark our derivatives to market with the resulting change in fair value included in our statement of operations. As of September 30, 2012, the fair value liability of these interest rate contracts totaled approximately $15.8 million. For additional information about our interest rate swaps and related fair values, see Part I, Item 1. Financial Statement Notes 10 and 11.

Credit Risk
 
Our principal natural gas sales customers are large gas marketing companies that, in turn, typically sell to large end users such as local distribution companies and electrical utilities. With respect to the sale of our NGLs and condensates, our principal customers are large natural gas liquids purchasers, fractionators and marketers, and large condensate aggregators that then typically sell to large multi-national petrochemical and refining companies. We also sell a small amount of propane to medium sized, local distributors.
 
This concentration of credit risk may affect our overall credit risk in that these customers may be similarly affected by changes in the natural gas, natural gas liquids, petrochemical and other segments of the energy industry, the economy in general, the regulatory environment and other factors.
 
Our derivative counterparties at September 30, 2012, not including counterparties of its marketing and trading business, included BNP Paribas, Wells Fargo Bank, National Association, Comerica Bank, Bank of Nova Scotia, The Royal Bank of Scotland plc, Bank of America N.A., J Aron & Company (an affiliate of Goldman Sachs), ING Capital Markets LLC, BBVA Compass Bank, Royal Bank of Canada and CITIBANK, N.A.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Based on the evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) required by Exchange Act Rules 13a-15(b) or 15d-15(b), our principal executive officer and principal financial officer have concluded that as of the end of the period covered by this report, our disclosure controls and procedures were effective at the reasonable assurance level to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and include controls and procedures designed to ensure that information required to be disclosed by us in such reports is accumulated and communicated to our management, including the principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting
    
There were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d - 15(f) under the Exchange Act) that occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Our operations are subject to a variety of risks and disputes normally incident to our business. As a result, we are and may, at any given time, be a defendant in various legal proceedings and litigation arising in the ordinary course of business. However, we are not currently a party to any material litigation. We maintain insurance policies with insurers in amounts and with coverage and deductibles that we, with the advice of our insurance advisors and brokers, believe are reasonable and prudent. We cannot, however, assure that this insurance will be adequate to protect us from all material expenses related to potential future claims for personal and property damage or that these levels of insurance will be available in the future at economical prices.

In July 2012, the Alabama Department of Environmental Management (“ADEM”) notified one of our subsidiaries that ADEM had made a determination that alleged violations warrant enforcement action and determined that the alleged violations are appropriate for resolution by Consent Order and proposed the terms of a to-be-mutually agreed-upon Consent Order (“Proposed Consent Order”).  Such notification and the Proposed Consent Order are the result of findings made by ADEM relating to our subsidiary's Flomaton/Fanny Church Oil and Gas Production and Treating Facility. The Proposed Consent Order primarily relates to allegations of emissions in excess of those allowed by the production rate.  Prior to receiving the Proposed Consent Order, we self-reported our emission rates and worked with ADEM to complete a series of quality improvement plans to address the causes of the alleged violations. The Proposed Consent Order includes a $100,000 fine, which may be negotiated to a lesser amount at the discretion of ADEM.

Item 1A.
Risk Factors.

In addition to the other information set forth in this quarterly report on Form 10-Q, you should carefully consider the risks discussed in our annual report on Form 10-K for the year ended December 31, 2011, under the headings “Item 1. Business,” “Item 1A. Risk Factors,” “Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations” and “Item 7A. Quantitative and Qualitative Disclosures About Market Risk,” which risks could materially affect our business, financial condition or future results. There have been no material changes in our risk factors from those described in our Annual Report on Form 10-K for the year ended December 31, 2011.
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Mine Safety Disclosures

None

Item 5. Other Information

None


59

Table of Contents

Item 6.
Exhibits
 
Exhibit
Number 
Description 
 
 
2.1
Purchase and Sale Agreement by and between BP America Production Company and Eagle Rock Energy Partners, L.P. (incorporated by reference to Exhibit 1.1 of the registrant's Current Report on Form 8-K filed on August 10, 2012)
 
 
3.1
Certificate of Limited Partnership of Eagle Rock Energy Partners, L.P. (incorporated by reference to Exhibit 3.1 of the registrant's registration statement on Form S-1 (File No. 333-134750))

 
 
3.2
Second Amended and Restated Agreement of Limited Partnership of Eagle Rock Energy Partners, L.P. (incorporated by reference to Exhibit 3.1 of the registrant's current report on Form 8-K filed with the Commission on May 25, 2010)

 
 
3.3
Certificate of Limited Partnership of Eagle Rock Energy GP, L.P. (incorporated by reference to Exhibit 3.3 of the registrant's registration statement on Form S-1 (File No. 333-134750))



3.4
Limited Partnership Agreement of Eagle Rock Energy GP, L.P. (incorporated by reference to Exhibit 3.4 of the registrant’s registration statement on Form S-1 (File No. 333-134750))
 
 
3.5
Certificate of Formation of Eagle Rock Energy G&P, LLC (incorporated by reference to Exhibit 3.5 of the registrant's registration statement on Form S-1 (File No. 333-134750))

 
 
3.6
Third Amended and Restated Limited Liability Company Agreement of Eagle Rock Energy G&P, LLC (incorporated by reference to Exhibit 42 of the registrant's current report on Form 8-K filed with the Commission on July 30, 2010)



3.7
Amendment No. 1 to the Second Amended and Restated Agreement of Limited Partnership of Eagle Rock Energy Partners, L.P. (incorporated by reference to Exhibit 4.1 of the registrant's current report on Form 8-K filed with the Commission on July 30, 2010)
 
 
10.1
Amendment to Brookeland Gas Facilities Gas Gathering and Processing Agreement by and between Anadarko E&P Company LP and Eagle Rock Operating, L.P. (incorporated by reference to Exhibit 10.1 of the registrant's Current Report on Form 8-K filed on October 3, 2012)
 
 
10.2
Gas Gathering and Processing Agreement by and between BP America Production Company and Eagle Rock Field Services, L.P., dated as of October 1, 2012 (incorporated by reference to Exhibit 10.1 of the registrant's Current Report on Form 8-K filed on October 1, 2012)
 
 
10.3
Confidentiality and Noncompete Agreement by and between Eagle Rock Energy G&P, LLC and Joseph A. Mills dated August 3, 2012 (incorporated by reference to Exhibit 10.2 of the registrant's Current Report on Form 10-Q filed on August 3, 2012)


10.4
Confidentiality and Noncompete agreement by and between Eagle Rock Energy G&P, LLC and Jeffrey P. Wood dated August 3, 2012 (incorporated by reference to Exhibit 10.3 of the registrant's Current Report on Form 10-Q filed on August 3, 2012)


10.5
Confidentiality and Non-Solicitation Agreement by and between Eagle Rock Energy G&P, LLC. and Charles C. Boettcher
 dated August 3, 2012 (incorporated by reference to Exhibit 10.4 of the registrant's Current Report on Form 10-Q filed on August 3, 2012)


10.6
Confidentiality and non-solicitation agreement by and between Eagle Rock Energy Partners, L.P. and Joseph Schimelpfening
 dated August 3, 2012 (incorporated by reference to Exhibit 10.5 of the registrant's Current Report on Form 10-Q filed on August 3, 2012)


10.7
Confidentiality and Non-Solicitation Agreement by and between Eagle Rock Energy G&P, LLC and Steven Hendrickson
 dated August 3, 2012 (incorporated by reference to Exhibit 10.6 of the registrant's Current Report on Form 10-Q filed on August 3, 2012)
 
 
10.8
Registration Rights Agreement dated as of July 13, 2012 among Eagle Rock Energy Partners, L.P., Eagle Rock Energy Finance Corp., the Guarantors named therein and the Initial Purchasers named therein (incorporated by reference to Exhibit 4.3 of the registrant's Current Report on Form 8-K filed on July 13, 2012)
 
 
10.9
Purchase Agreement dated as of July 10, 2012 among Eagle Rock Energy Partners, L.P., Eagle Rock Energy Finance Corp., the Guarantors named therein and the Initial Purchasers named therein (incorporated by reference to Exhibit 10.1 of the registrant's Current Report on Form 8-K filed on July 13, 2012)
 
 
31.1*
Certification of Periodic Financial Reports by Joseph A. Mills in satisfaction of Section 302 of the Sarbanes-Oxley Act of 2002
 
 
31.2*
Certification of Periodic Financial Reports by Jeffrey P. Wood in satisfaction of Section 302 of the Sarbanes-Oxley Act of 2002
 
 
32.1**
Certification of Periodic Financial Reports by Joseph A. Mills in satisfaction of Section 906 of the Sarbanes-Oxley Act of 2002
 
 
32.2**
Certification of Periodic Financial Reports by Jeffrey P. Wood in satisfaction of Section 906 of the Sarbanes-Oxley Act of 2002
 
 
101.INS*
XBRL Instance Document
 
 
101.SCH*
XBRL Taxonomy Extension Schema Document
 
 
101.CAL*
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
101.DEF*
XBRL Taxonomy Extension Definition Linkbase Document
 
 
101.LAB*
XBRL Taxonomy Extension Label Linkbase Document
 
 
101.PRE*
XBRL Taxonomy Extension Presentation Linkbase Document

*
Filed herewith
**
Furnished herewith

60

Table of Contents

SIGNATURES
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on November 2, 2012.
 
 
EAGLE ROCK ENERGY PARTNERS, L.P.
 
 
 
 
By:
Eagle Rock Energy GP, L.P., its general partner
 
 
 
 
By:
Eagle Rock Energy G&P, LLC, its general partner
 
 
 
 
By:
/s/ JEFFREY P. WOOD
 
Name:
Jeffrey P. Wood
 
Title:
Senior Vice President, Chief Financial Officer and Treasurer

61

Table of Contents

Index to Exhibits
Exhibit
Number 
Description 
 
 
2.1
Purchase and Sale Agreement by and between BP America Production Company and Eagle Rock Energy Partners, L.P. (incorporated by reference to Exhibit 1.1 of the registrant's Current Report on Form 8-K filed on August 10, 2012)
 
 
3.1
Certificate of Limited Partnership of Eagle Rock Energy Partners, L.P. (incorporated by reference to Exhibit 3.1 of the registrant's registration statement on Form S-1 (File No. 333-134750))

 
 
3.2
Second Amended and Restated Agreement of Limited Partnership of Eagle Rock Energy Partners, L.P. (incorporated by reference to Exhibit 3.1 of the registrant's current report on Form 8-K filed with the Commission on May 25, 2010)
 
 
3.3
Certificate of Limited Partnership of Eagle Rock Energy GP, L.P. (incorporated by reference to Exhibit 3.3 of the registrant's registration statement on Form S-1 (File No. 333-134750))


3.4
Limited Partnership Agreement of Eagle Rock Energy GP, L.P. (incorporated by reference to Exhibit 3.4 of the registrant’s registration statement on Form S-1 (File No. 333-134750))
 
 
3.5
Certificate of Formation of Eagle Rock Energy G&P, LLC (incorporated by reference to Exhibit 3.5 of the registrant's registration statement on Form S-1 (File No. 333-134750))
 
 
3.6
Third Amended and Restated Limited Liability Company Agreement of Eagle Rock Energy G&P, LLC (incorporated by reference to Exhibit 42 of the registrant's current report on Form 8-K filed with the Commission on July 30, 2010)



3.7
Amendment No. 1 to the Second Amended and Restated Agreement of Limited Partnership of Eagle Rock Energy Partners, L.P. (incorporated by reference to Exhibit 4.1 of the registrant's current report on Form 8-K filed with the Commission on July 30, 2010)
 
 
10.1
Amendment to Brookeland Gas Facilities Gas Gathering and Processing Agreement by and between Anadarko E&P Company LP and Eagle Rock Operating, L.P. (incorporated by reference to Exhibit 10.1 of the registrant's Current Report on Form 8-K filed on October 3, 2012)
 
 
10.2
Gas Gathering and Processing Agreement by and between BP America Production Company and Eagle Rock Field Services, L.P., dated as of October 1, 2012 (incorporated by reference to Exhibit 10.1 of the registrant's Current Report on Form 8-K filed on October 1, 2012)
 
 
10.3
Confidentiality and Noncompete Agreement by and between Eagle Rock Energy G&P, LLC and Joseph A. Mills dated August 3, 2012 (incorporated by reference to Exhibit 10.2 of the registrant's Current Report on Form 10-Q filed on August 3, 2012)


10.4
Confidentiality and Noncompete agreement by and between Eagle Rock Energy G&P, LLC and Jeffrey P. Wood dated August 3, 2012 (incorporated by reference to Exhibit 10.3 of the registrant's Current Report on Form 10-Q filed on August 3, 2012)


10.5
Confidentiality and Non-Solicitation Agreement by and between Eagle Rock Energy G&P, LLC. and Charles C. Boettcher
dated August 3, 2012 (incorporated by reference to Exhibit 10.4 of the registrant's Current Report on Form 10-Q filed on August 3, 2012)


10.6
Confidentiality and non-solicitation agreement by and between Eagle Rock Energy Partners, L.P. and Joseph Schimelpfening
dated August 3, 2012 (incorporated by reference to Exhibit 10.5 of the registrant's Current Report on Form 10-Q filed on August 3, 2012)


10.7
Confidentiality and Non-Solicitation Agreement by and between Eagle Rock Energy G&P, LLC and Steven Hendrickson
dated August 3, 2012 (incorporated by reference to Exhibit 10.6 of the registrant's Current Report on Form 10-Q filed on August 3, 2012)
 
 
10.8
Registration Rights Agreement dated as of July 13, 2012 among Eagle Rock Energy Partners, L.P., Eagle Rock Energy Finance Corp., the Guarantors named therein and the Initial Purchasers named therein (incorporated by reference to Exhibit 4.3 of the registrant's Current Report on Form 8-K filed on July 13, 2012)
 
 
10.9
Purchase Agreement dated as of July 10, 2012 among Eagle Rock Energy Partners, L.P., Eagle Rock Energy Finance Corp., the Guarantors named therein and the Initial Purchasers named therein (incorporated by reference to Exhibit 10.1 of the registrant's Current Report on Form 8-K filed on July 13, 2012)
 
 
31.1*
Certification of Periodic Financial Reports by Joseph A. Mills in satisfaction of Section 302 of the Sarbanes-Oxley Act of 2002
 
 
31.2*
Certification of Periodic Financial Reports by Jeffrey P. Wood in satisfaction of Section 302 of the Sarbanes-Oxley Act of 2002
 
 
32.1**
Certification of Periodic Financial Reports by Joseph A. Mills in satisfaction of Section 906 of the Sarbanes-Oxley Act of 2002
 
 
32.2**
Certification of Periodic Financial Reports by Jeffrey P. Wood in satisfaction of Section 906 of the Sarbanes-Oxley Act of 2002
 
 
101.INS*
XBRL Instance Document
 
 
101.SCH*
XBRL Taxonomy Extension Schema Document
 
 
101.CAL*
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
101.DEF*
XBRL Taxonomy Extension Definition Linkbase Document
 
 
101.LAB*
XBRL Taxonomy Extension Label Linkbase Document
 
 
101.PRE*
XBRL Taxonomy Extension Presentation Linkbase Document

*
Filed herewith
**
Furnished herewith