# Magnolia Oil & Gas Corp (MGY) FY 2021 MD&A

Verbatim Item 7 Management's Discussion and Analysis from Magnolia Oil & Gas Corp's 10-K for fiscal year 2021.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1698990/000169899022000007/mgy-20211231.htm
Accession: 0001698990-22-000007
Filing date: 2022-02-17
Report date: 2021-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/MGY/
All MD&A years: /company/MGY/mda/
Next year: /company/MGY/mda/fy2022/ (FY 2022)

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements and the related notes thereto.

This section of this Form 10-K generally discusses 2021 and 2020 items and year-to-year comparisons between 2021 and 2020. Discussions of 2019 items and year-to-year comparisons between 2020 and 2019 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2020.

Overview 

Magnolia Oil & Gas Corporation (the “Company” or “Magnolia”) is an independent oil and natural gas company engaged in the acquisition, development, exploration, and production of oil, natural gas, and natural gas liquid (“NGL”) reserves that operates in one reportable segment located in the United States. The Company's oil and natural gas properties are located primarily in Karnes County and the Giddings area in South Texas, where the Company primarily targets the Eagle Ford Shale and the Austin Chalk formations. Magnolia’s objective is to generate stock market value over the long term through consistent organic production growth, high full cycle operating margins, an efficient capital program with short economic paybacks, significant free cash flow after capital expenditures, and effective reinvestment of free cash flow.

Magnolia’s business model prioritizes free cash flow, financial stability, and prudent capital allocation, and is designed to withstand challenging environments. The Company’s ongoing plan is to spend within cash flow on drilling and completing wells while maintaining low leverage. As of December 31, 2021, Magnolia operated one rig exclusively in the Giddings area, and one rig in both the Karnes and Giddings areas. The Company is well positioned to reduce or increase operations given the significant flexibility within its capital program as the Company has no long-term service obligations.

COVID-19 Pandemic and Market Conditions Update

The COVID-19 pandemic and related economic repercussions have created significant volatility, uncertainty, and turmoil in the oil and natural gas industry. While oil and natural gas prices increased in 2021, demand and pricing may again decline if there is a resurgence of the outbreak across the U.S. or other locations across the world or as a result of any related social distancing guidelines, travel restrictions, vaccination protocols, and stay-at-home orders. The extent of any further impact of the pandemic, including the emergence and spread of variant strains of COVID-19, on Magnolia’s industry and business cannot be reasonably predicted at this time.

To protect the health and safety of its workers, Magnolia and its contractors have implemented protocols to attempt to reduce the risk of an outbreak of COVID-19, or variants of COVID-19, within the Company’s operations. The Company believes these protocols have not reduced production or efficiency in a significant manner. Magnolia’s board of directors is continuing to closely monitor the unfolding COVID-19 pandemic. Magnolia has been able to maintain a consistent level of effectiveness, including maintaining day-to-day operations, financial reporting systems, and internal control over financial reporting.

Business Overview

As of December 31, 2021, Magnolia’s assets in South Texas included 43,511 gross (23,785 net) acres in the Karnes area and 639,634 gross (447,478 net) acres in the Giddings area. As of December 31, 2021, Magnolia held an interest in approximately 2,011 gross (1,292 net) wells, with total production of 66.0 thousand barrels of oil equivalent per day (“Mboe/d”) for the year ended December 31, 2021. As of December 31, 2021, Magnolia was running a two-rig program. One rig drilled multi-well development pads exclusively in the Giddings area. The second rig drilled a mix of wells in both the Karnes and Giddings areas.

Magnolia recognized net income attributable to Class A Common Stock of $417.3 million, or $2.36 per diluted common share, for the year ended December 31, 2021. Magnolia also recognized net income of $559.7 million, which includes noncontrolling interest of $142.4 million for the year ended December 31, 2021.

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As of December 31, 2021, the Company’s board of directors had authorized a share repurchase program of up to 20.0 million shares of Class A Common Stock, and, in February 2022, the Company’s board of directors increased the share repurchase authorization by an additional 10.0 million shares of Class A Common Stock which increases total authorization to 30.0 million shares. The program does not require purchases to be made within a particular timeframe. During the year ended December 31, 2021, the Company repurchased 8.7 million shares of Class A Common Stock at a weighted average price of $14.45, for a total cost of approximately $125.6 million.

During the year ended December 31, 2021, outside of the share repurchase program, Magnolia LLC repurchased and subsequently canceled 13.0 million Magnolia LLC Units with an equal number of shares of corresponding Class B Common Stock for $171.7 million of cash consideration. During the same period, the Magnolia LLC Unit Holders redeemed 23.5 million Magnolia LLC Units (and a corresponding number of shares of Class B Common Stock) for an equivalent number of shares of Class A Common Stock and subsequently sold these shares to the public. Magnolia did not receive any proceeds from the sale of shares of Class A Common Stock by the Magnolia LLC Unit Holders. As of December 31, 2021, Magnolia owned approximately 78.4% of the interest in Magnolia LLC and the noncontrolling interest was 21.6%.

Results of Operations

Factors Affecting the Comparability of the Historical Financial Results

Magnolia’s historical financial condition and results of operations for the periods presented may not be comparable, either from period to period or going forward, as a result of the following factors:

•During the second quarter of 2021, the Company amended the term of the Services Agreement to end on June 30, 2021. As part of the termination and transition of the Services Agreement, the Company incurred $11.2 million for the year ended December 31, 2021, included in “General and administrative expenses” on the Company’s consolidated statements of operations.

•During the second quarter of 2021, the Company amended the Non-Compete (the “Second Non-Compete Amendment”), which modified the term of the Non-Compete to end on June 30, 2021, resulting in the Company accelerating the amortization of the intangible assets by $5.9 million.

•The 2026 Senior Notes issued under the Indenture, dated as of July 31, 2018 (the “Indenture”), were amended on April 5, 2021. This debt modification included approximately $1.1 million of one-time transaction fees which were expensed and $5.0 million in fees paid to holders of the 2026 Senior Notes, which were reflected as deferred financing costs reducing Long-term debt and will be amortized over the remaining term of the 2026 Senior Notes.

As a result of the factors listed above, the combined historical results of operations and period-to-period comparisons of these results and certain financial data may not be comparable or indicative of future results.

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Year Ended December 31, 2021 Compared to the Year Ended December 31, 2020

Oil, Natural Gas and NGL Sales Revenues. The following table provides the components of Magnolia’s revenues for the periods indicated, as well as each period’s respective average prices and production volumes. This table shows production on a boe basis in which natural gas is converted to an equivalent barrel of oil based on a ratio of six Mcf to one barrel. This ratio may not be reflective of the current price ratio between the two products.

[[GREPCENT_TABLE]]
[["","","Years Ended"],["(In thousands, except per unit data)","","December 31, 2021","","December 31, 2020"],["Production:"],["Oil (MBbls)","","11,190","","","11,610"],["Natural gas (MMcf)","","43,436","","","39,429"],["NGLs (MBbls)","","5,669","","","4,449"],["Total (Mboe)","","24,099","","","22,631"],["Average daily production:"],["Oil (Bbls/d)","","30,659","","","31,722"],["Natural gas (Mcf/d)","","119,003","","","107,728"],["NGLs (Bbls/d)","","15,532","","","12,156"],["Total (boe/d)","","66,025","","","61,833"],["Revenues:"],["Oil revenues","","$","747,896","","","$","421,520"],["Natural gas revenues","","172,648","","","70,416"],["Natural gas liquids revenues","","157,807","","","49,367"],["Total revenues","","$","1,078,351","","","$","541,303"],["Average Price:"],["Oil (per barrel)","","$","66.83","","","$","36.31"],["Natural gas (per Mcf)","","3.97","","","1.79"],["NGLs (per barrel)","","27.84","","","11.10"]]
[[/GREPCENT_TABLE]]

Oil revenues were 69% and 78% of the Company’s total revenues for the years ended December 31, 2021 and 2020, respectively. Oil production was 46% and 51% of total production volume for the years ended December 31, 2021 and 2020, respectively. Oil revenues for the year ended December 31, 2021 were $326.4 million higher than the year ended December 31, 2020. An 84% increase in average prices increased revenues for the year ended December 31, 2021 by $354.5 million compared to the same period in the prior year, while a 4% decrease in oil production reduced revenue $28.1 million.

Natural gas revenues were 16% and 13% of the Company’s total revenues for the years ended December 31, 2021 and 2020, respectively. Natural gas production was 30% and 29% of total production volume for the years ended December 31, 2021 and 2020, respectively. Natural gas revenues for the year ended December 31, 2021 were $102.2 million higher than the year ended December 31, 2020. A 122% increase in average prices increased revenues for the year ended December 31, 2021 by $86.3 million compared to the same period in the prior year, and a 10% increase in natural gas production increased revenue $15.9 million.

NGL revenues were 15% and 9% of the Company’s total revenues for the years ended December 31, 2021 and 2020, respectively. NGL production was 24% and 20% of total production volume for the years ended December 31, 2021 and 2020, respectively. NGL revenues for the year ended December 31, 2021 were $108.4 million higher than the year ended December 31, 2020. A 151% increase in average prices increased revenues for the year ended December 31, 2021 by $74.5 million compared to the same period in the prior year, and a 27% increase in NGL production increased revenue $33.9 million.

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Operating Expenses and Other Income (Expense). The following table summarizes the Company’s operating expenses and other income (expense) for the periods indicated.

[[GREPCENT_TABLE]]
[["","","Years Ended"],["(In thousands, except per unit data)","","December 31, 2021","","December 31, 2020"],["Operating Expenses:"],["Lease operating expenses","","$","93,021","","","$","79,192"],["Gathering, transportation, and processing","","45,535","","","35,442"],["Taxes other than income","","55,834","","","31,250"],["Exploration expenses","","4,125","","","567,333"],["Impairment of oil and natural gas properties","","\u2014","","","1,381,258"],["Asset retirement obligations accretion","","4,929","","","5,718"],["Depreciation, depletion and amortization","","187,688","","","283,353"],["Amortization of intangible assets","","9,346","","","14,505"],["General and administrative expenses","","75,279","","","68,918"],["Total operating costs and expenses","","$","475,757","","","$","2,466,969"],["Other Income (Expense):"],["Income from equity method investee","","$","\u2014","","","$","2,113"],["Interest expense, net","","(31,002)","","","(28,698)"],["Gain (loss) on derivatives, net","","(3,110)","","","565"],["Other income (expense), net","","85","","","3,363"],["Total other expense","","$","(34,027)","","","$","(22,657)"],["Average Operating Costs per boe:"],["Lease operating expenses","","$","3.86","","","$","3.50"],["Gathering, transportation, and processing","","1.89","","","1.57"],["Taxes other than income","","2.32","","","1.38"],["Exploration costs","","0.17","","","25.07"],["Impairment of oil and natural gas properties","","\u2014","","","61.03"],["Asset retirement obligations accretion","","0.20","","","0.25"],["Depreciation, depletion and amortization","","7.79","","","12.52"],["Amortization of intangible assets","","0.39","","","0.64"],["General and administrative expenses","","3.12","","","3.05"]]
[[/GREPCENT_TABLE]]

Lease operating expenses are the costs incurred in the operation of producing properties, including expenses for utilities, direct labor, water disposal, workover rigs, workover expenses, materials, and supplies. Lease operating expenses for the year ended December 31, 2021 were $13.8 million, or $0.36 per boe, higher than the year ended December 31, 2020 primarily due to an increase in costs including operating and maintenance costs, workover activities and additional non-operated activities.

Gathering, transportation, and processing costs are costs incurred to deliver oil, natural gas, and NGLs to the market. These expenses can vary based on the volume of oil, natural gas, and NGLs produced as well as the cost of commodity processing. The gathering, transportation, and processing costs for the year ended December 31, 2021 were $10.1 million, or $0.32 per boe, higher than the year ended December 31, 2020 primarily due to increased natural gas production and higher prices.

Taxes other than income include production and ad valorem taxes. These taxes are based on rates primarily established by state and local taxing authorities. Production taxes are based on the market value of production. Ad valorem taxes are based on the fair market value of the mineral interests or business assets. Taxes other than income for the year ended December 31, 2021 were $24.6 million, or $0.94 per boe, higher than the year ended December 31, 2020 primarily due to an increase in oil, natural gas, and NGL revenues.

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Exploration costs are geological and geophysical costs that include seismic surveying costs, costs of unsuccessful exploratory dry wells, costs of expired or abandoned leases, and delay rentals. The exploration costs for the year ended December 31, 2021 were $563.2 million, or $24.90 per boe, lower than the year ended December 31, 2020, as a result of an impairment recorded for the quarter ended March 31, 2020 related to Magnolia’s unproved oil and natural gas properties due to the sharp decline in commodity prices. For more information, please see Note 4—Fair Value Measurements in the Company’s consolidated financial statements included in this Annual Report on Form 10-K.

For the year ended December 31, 2021, the Company did not recognize any impairments. For the year ended December 31, 2020, Magnolia recognized $1.4 billion of impairment included in “Impairment of oil and natural gas properties” in the consolidated statements of operations related to its proved oil and natural gas properties. The impairment was driven by the sharp decline in commodity prices. For more information, please see Note 4—Fair Value Measurements in the Company’s consolidated financial statements included in this Annual Report on Form 10-K.

Depreciation, depletion and amortization (“DD&A”) during the year ended December 31, 2021 was $95.7 million, or $4.73 per boe, lower than the year ended December 31, 2020 primarily as a result of lower asset property balances associated with proved property impairments recorded in the first quarter of 2020.

Amortization of intangible assets during the year ended December 31, 2021 was $5.2 million, or $0.25 per boe, lower than the year ended December 31, 2020, driven by fewer months of amortization during the year ended December 31, 2021 as compared to the same period in the prior year partially offset by the accelerated amortization of the intangible assets in the second quarter of 2021 as a result of the termination of the Non-Compete.

General and administrative (“G&A”) expenses during the year ended December 31, 2021 were $6.4 million, or $0.07 per boe, higher than the year ended December 31, 2020, primarily driven by increased corporate payroll expenses related to increased employee headcount offset by decreased service fee costs associated with the termination of the Services Agreement.

Interest expense, net, during the year ended December 31, 2021 was $2.3 million higher than the year ended December 31, 2020, driven by third-party costs associated with the debt modification pursuant to the amendment of the Indenture in the second quarter of 2021.

Gain (loss) on derivatives, net during the year ended December 31, 2021 was a $3.1 million loss as compared to a $0.6 million gain during the corresponding 2020 period. The change from a gain to a loss was primarily driven by the increase in natural gas prices period over period.

Other income (expense), net during the year ended December 31, 2021 was $3.3 million lower than the year ended December 31, 2020. The income in 2020 was a primarily due to a $5.1 million gain on sale of the Company’s 35% membership interest in Ironwood Eagle Ford Midstream, LLC, partially offset by a $1.4 million inventory write-down.

Liquidity and Capital Resources

Magnolia’s primary sources of liquidity and capital have been cash flows from operations. The Company’s primary uses of cash have been for acquisitions of oil and natural gas properties and related assets, development of the Company’s oil and natural gas properties, share repurchases, dividends, and general working capital needs.

The Company may also utilize borrowings under other various financing sources available to Magnolia, including its RBL Facility and the issuance of equity or debt securities and the timing of these offerings will depend upon various factors, including prevailing market conditions and the Company’s financial condition.

Material cash commitments include $24.0 million in interest payments paid each year through 2026. The Company anticipates its current cash balance, cash flows from operations, and its available sources of liquidity to be sufficient to meet the Company’s cash requirements. However, as the impact of COVID-19 on the economy evolves, the Company will continue to assess its liquidity needs. In the event of a sustained market deterioration, Magnolia may need additional liquidity, which would require the Company to evaluate available alternatives and take appropriate actions.

As of December 31, 2021, the Company had $400.0 million of principal debt related to the 2026 Senior Notes outstanding and no outstanding borrowings related to the RBL Facility. As of December 31, 2021, the Company has $817.0 million of liquidity comprised of the $450.0 million of borrowing base capacity of the RBL Facility, which was reaffirmed on October 15, 2021, and $367.0 million of cash and cash equivalents. As of December 31, 2021, the Company’s Adjusted Consolidated Net Tangible Asset, as calculated in accordance with the Company’s Indenture relating to its 2026 Senior Notes, was approximately $3.0 billion.

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Cash and Cash Equivalents

At December 31, 2021, Magnolia had $367.0 million of cash and cash equivalents. The Company’s cash and cash equivalents are maintained with various financial institutions in the United States. Deposits with these institutions may exceed the amount of insurance provided on such deposits. However, the Company regularly monitors the financial stability of its financial institutions and believes that the Company is not exposed to any significant default risk.

Sources and Uses of Cash and Cash Equivalents

The following table presents the sources and uses of the Company’s cash and cash equivalents for the periods presented:

[[GREPCENT_TABLE]]
[["","","Years Ended"],["(In thousands)","","December 31, 2021","","December 31, 2020"],["Sources of cash and cash equivalents"],["Net cash provided by operating activities","","$","788,477","","","$","310,121"],["Proceeds from sale of equity method investment","","\u2014","","","27,074"],["","","$","788,477","","","$","337,195"],["Uses of cash and cash equivalents:"],["Acquisitions, other","","$","(18,345)","","","$","(73,702)"],["Additions to oil and natural gas properties","","(236,426)","","","(197,858)"],["Changes in working capital associated with additions to oil and natural gas properties","","13,568","","","(24,354)"],["Class A Common Stock repurchases","","(125,641)","","","(28,681)"],["Class B Common Stock purchases and cancellations","","(171,671)","","","\u2014"],["Non-compete settlement","","(42,073)","","","\u2014"],["Dividends paid","","(14,131)","","","\u2014"],["Distributions to noncontrolling interest holders","","(7,207)","","","(680)"],["Other","","(12,130)","","","(1,992)"],["","","(614,056)","","","(327,267)"],["Increase in cash and cash equivalents","","$","174,421","","","$","9,928"]]
[[/GREPCENT_TABLE]]

Sources of Cash and Cash Equivalents

Net Cash Provided by Operating Activities

Operating cash flows are the Company’s primary source of liquidity and are impacted, in the short term and long term, by oil and natural gas prices. The factors that determine operating cash flows are largely the same as those that affect net earnings or net losses, with the exception of certain non-cash expenses such as DD&A, the non-cash portion of exploration expenses, impairment of oil and natural gas properties, asset retirement obligations accretion, and deferred income tax expense.

Net cash provided by operating activities totaled $788.5 million and $310.1 million for the years ended December 31, 2021 and 2020, respectively. During the year ended December 31, 2021, cash provided by operating activities was positively impacted by increased oil, natural gas, and NGL prices partially offset primarily by additional costs associated with the termination of the Services Agreement and higher operating expenses.

Uses of Cash and Cash Equivalents

Acquisitions

The Company made individually immaterial bolt-on acquisitions during the year ended December 31, 2021. During the year ended December 31, 2020, the Company completed various leasehold and property acquisitions, primarily comprised of a $69.7 million acquisition of certain non-operated oil and natural gas assets located in Karnes and DeWitt Counties, Texas.

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Additions to Oil and Natural Gas Properties

The following table sets forth the Company’s capital expenditures for the years ended December 31, 2021 and 2020.

[[GREPCENT_TABLE]]
[["","","Years Ended"],["(In thousands)","","December 31, 2021","","December 31, 2020"],["Drilling and completion","","$","231,904","","","$","194,891"],["Leasehold acquisition costs","","4,522","","","2,967"],["Total capital expenditures","","$","236,426","","","$","197,858"]]
[[/GREPCENT_TABLE]]

As of December 31, 2021, Magnolia was running a two-rig program. One rig drilled multi-well development pads in the Giddings area. The second rig drilled a mix of wells in both the Karnes and Giddings areas. The activity during the year ended December 31, 2021 was largely driven by the number of operated and non-operated drilling rigs. The number of operated drilling rigs is largely dependent on commodity prices and the Company’s strategy of maintaining spending to accommodate the Company’s business model. The Company’s ongoing plan for 2022 is to continue to spend within cash flow on drilling and completing wells while maintaining low leverage.

Capital Requirements

As of December 31, 2021, the Company’s board of directors had authorized a share repurchase program of up to 20.0 million shares of Class A Common Stock, and, in February 2022, the Company’s board of directors increased the share repurchase authorization by an additional 10.0 million shares of Class A Common Stock which increases total authorization to 30.0 million shares. The program does not require purchases to be made within a particular timeframe and whether the Company undertakes these additional repurchases is ultimately subject to numerous considerations, market conditions, and other factors. During the years ended December 31, 2021 and 2020, the Company repurchased 8.7 million and 4.5 million shares under this authorization, for a total cost of approximately $125.6 million and $28.7 million, respectively.

During the year ended December 31, 2021, Magnolia LLC repurchased and subsequently canceled 13.0 million Magnolia LLC Units with an equal number of shares of corresponding Class B Common Stock for $171.7 million of cash consideration. As of December 31, 2021, Magnolia owned approximately 78.4% of the interest in Magnolia LLC and the noncontrolling interest was 21.6%.

In January 2021, the Company amended the Non-Compete such that, rather than delivering an aggregate of 4.0 million shares of Class A Common Stock upon the two and one-half year and the four year anniversaries of July 31, 2018 (the “Closing Date”), the Company would deliver (i) the cash value of approximately 2.0 million shares of Class A Common Stock and approximately 0.4 million shares of Class A Common Stock on the two and one-half year anniversary of the Closing Date and (ii) an aggregate of 1.6 million shares of Class A Common Stock on the four year anniversary of the Closing Date, in each case subject to the terms and conditions of the Non-Compete. On February 1, 2021, as consideration for compliance with the Non-Compete, the Company paid $17.2 million in cash and issued 0.4 million shares of Class A Common Stock. As part of the Second Non-Compete Amendment, the Company paid $24.9 million in cash in lieu of delivering the remaining 1.6 million shares of Class A Common Stock.

On August 2, 2021, the Company’s board of directors declared a semi-annual interim cash dividend of $0.08 per share of Class A Common Stock totaling approximately $14.2 million, of which $14.1 million was paid as of December 31, 2021. In addition, $4.8 million was distributed to the Magnolia LLC Unit Holders. The amount and frequency of future dividends is subject to the discretion of the Company’s board of directors and primarily depends on earnings, capital expenditures, debt covenants, and various other factors.

Critical Accounting Policies and Estimates

Magnolia prepares its financial statements and the accompanying notes in conformity with accounting principles generally accepted in the United States of America, which require management to make estimates and assumptions about future events that affect the reported amounts in the financial statements and the accompanying notes. Magnolia identifies certain accounting policies as critical based on, among other things, their impact on the portrayal of Magnolia’s financial condition, results of operations, or liquidity and the degree of difficulty, subjectivity, and complexity in their deployment. Critical accounting policies cover accounting matters that are inherently uncertain because the future resolution of such matters is unknown. Management routinely discusses the development, selection, and disclosure of each of the critical accounting policies. The following is a discussion of Magnolia’s most critical accounting policies and estimates.

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Reserves Estimates

Proved oil and natural gas reserves are those quantities of oil, natural gas, and NGLs which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible—from a given date forward, from known reservoirs, and under existing economic conditions, operating methods, and government regulations—prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation. The project to extract the hydrocarbons must have commenced, or the operator must be reasonably certain, that it will commence within a reasonable time. Estimated proved developed oil and natural gas reserves can be expected to be recovered through existing wells with existing equipment and operating methods or where the cost of the required equipment is relatively minor compared to the cost of a new well.

Proved undeveloped reserves are proved reserves that are expected to be recovered from new wells on undrilled acreage or from existing wells where a relatively major expenditure is required for recompletion. Reserves on undrilled acreage are limited to those that are directly offsetting development spacing areas that are reasonably certain of production when drilled, unless evidence using reliable technology exists that establishes reasonable certainty of economic producibility at greater distances. Undrilled locations can be classified as undeveloped reserves only if a plan has been adopted indicating that they are scheduled to be drilled within five years, unless the specific circumstances justify a longer time. All of Magnolia’s proved undeveloped reserves as of December 31, 2021, that are included in this Annual Report, are planned to be developed within one year.

Despite the inherent imprecision in these engineering estimates, Magnolia’s reserves are used throughout the Company’s financial statements. For example, since Magnolia uses the unit-of-production method to amortize its oil and natural gas properties, the quantity of reserves could significantly impact Magnolia’s DD&A expense. A material adverse change in the estimated volumes of reserves could result in property impairments. Finally, these reserves are the basis for Magnolia’s supplemental oil and natural gas disclosures.

Reserves are calculated using an unweighted arithmetic average of commodity prices in effect on the first day of each of the previous 12 months, held flat for the life of the production, except where prices are defined by contractual arrangements. These historical prices often do not approximate the average price that the Company expects to receive for its oil and natural gas production in the future. Operating costs, production and ad valorem taxes, and future development costs are based on current costs with no escalation. Actual costs may be materially higher or lower than the costs utilized in the estimate.

Magnolia has elected not to disclose probable and possible reserves or reserve estimates in this filing.

Long-lived Asset Impairments

Long-lived assets used in operations are assessed for impairment whenever changes in facts and circumstances indicate a possible significant deterioration in future cash flows expected to be generated by an asset group. Individual assets are grouped for impairment purposes based on a judgmental assessment of the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets. If there is an indication that the carrying amount of an asset may not be recovered, the asset is assessed by management through an established process in which changes to significant assumptions such as prices, volumes, and future development plans are reviewed. If, upon review, the sum of the undiscounted pre-tax cash flows is less than the carrying value of the asset group, the carrying value is written down to estimated fair value. Because there usually is a lack of quoted market prices for long-lived assets, the fair value of impaired assets is assessed by management using the income approach.

Under the income approach, the fair value of each asset group is estimated based on the present value of expected future cash flows. The income approach is dependent on a number of factors including estimates of forecasted revenue and operating costs, proved reserves, the success of future exploration for and development of unproved reserves, discount rates, and other variables. Key assumptions used in developing a discounted cash flow model described above include estimated quantities of crude oil and natural gas reserves; estimates of market prices considering forward commodity price curves as of the measurement date; and estimates of operating, administrative, and capital costs adjusted for inflation. The resulting future cash flows are discounted using a discount rate believed to be consistent with those applied by market participants. Although the fair value estimate of each asset group is based on assumptions the Company believes to be reasonable, those assumptions are inherently unpredictable and uncertain, and actual results could differ from the estimate.

During the first quarter of 2020, Magnolia recorded impairments of $1.9 billion related to proved and unproved properties as a result of a sharp decline in commodity prices. Proved property impairment of $1.4 billion is included in “Impairment of oil and natural gas properties” and unproved property impairment of $0.6 billion is included in “Exploration expenses” on the Company’s consolidated statements of operations for the year ended December 31, 2020. Proved and unproved properties that were impaired had aggregate fair values of $0.8 billion and $0.3 billion, respectively. The fair values of these oil and natural gas properties were measured using the income approach calculated using a discounted future cash flow model. Significant inputs associated with the

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calculation of discounted future net cash flows include estimates of future commodity prices based on NYMEX strip pricing adjusted for price differentials, estimates of proved oil and natural gas reserves and risk adjusted probable and possible reserves, estimates of future expected operating and capital costs, and a market participant based weighted average cost of capital of 10% for proved property impairments and 12% for unproved property impairments. Negative revisions of estimated reserves quantities, increases in future cost estimates, or sustained decreases in oil or natural gas prices could lead to a reduction in expected future cash flows and possibly an additional impairment of long-lived assets in future periods.