# Magnolia Oil & Gas Corp (MGY) FY 2022 MD&A

Verbatim Item 7 Management's Discussion and Analysis from Magnolia Oil & Gas Corp's 10-K for fiscal year 2022.

SEC filing source: https://www.sec.gov/Archives/edgar/data/1698990/000169899023000010/mgy-20221231.htm
Accession: 0001698990-23-000010
Filing date: 2023-02-16
Report date: 2022-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary. Published MD&A gate trimmed front/tail over-capture.
Confidence: high

Company profile: /company/MGY/
All MD&A years: /company/MGY/mda/
Previous year: /company/MGY/mda/fy2021/ (FY 2021)
Next year: /company/MGY/mda/fy2023/ (FY 2023)

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 2022 and 2021 items and year-to-year comparisons between 2022 and 2021. Discussions of 2020 items and year-to-year comparisons between 2021 and 2020 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, 2021.

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 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. The Company’s allocation of capital prioritizes reinvesting in its business to achieve moderate and predictable annual volume growth, balanced with returning capital to its shareholders through dividends and share repurchases.

Magnolia’s business model prioritizes prudent and disciplined capital allocation, free cash flow, and financial stability. The Company’s ongoing plan is to spend within cash flow on drilling and completing wells while maintaining low financial leverage. As of December 31, 2022, Magnolia operated two rigs. The Company’s gradual and measured approach toward the development of the Giddings area has created operating efficiencies leading to higher production growth in 2022.

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. As the global economy continues to recover from the effects of the COVID-19 pandemic, economic indicators have continued to strengthen. However, the economy is experiencing elevated inflation levels as a result of global supply and demand imbalances. Elevated inflation levels have resulted in increased capital and oilfield service costs and continued inflationary pressures and labor shortages could result in further increases to the Company’s operating and capital costs.

Business Overview

As of December 31, 2022, Magnolia’s assets in South Texas included 43,022 gross (23,259 net) acres in the Karnes area and 645,011 gross (458,756 net) acres in the Giddings area. As of December 31, 2022, Magnolia held an interest in approximately 2,131 gross (1,366 net) wells, with total production of 75.4 thousand barrels of oil equivalent per day (“Mboe/d”) for the year ended December 31, 2022. As of December 31, 2022, Magnolia was running a two-rig program.

Magnolia recognized net income attributable to Class A Common Stock of $893.8 million, or $4.71 per diluted common share, for the year ended December 31, 2022. Magnolia also recognized net income of $1,050.2 million, which includes noncontrolling interest of $156.4 million for the year ended December 31, 2022.

As of December 31, 2022, the Company’s board of directors had authorized a share repurchase program of up to 30.0 million shares of Class A Common Stock. The program does not require purchases to be made within a particular timeframe. During the year ended December 31, 2022, the Company repurchased 7.0 million shares of Class A Common Stock under the program at a weighted average price of $22.02, for a total cost of approximately $153.3 million. During the year ended December 31, 2022, the Company also repurchased 0.6 million shares of Class A Common Stock for $11.6 million from EnerVest Energy Institutional Fund XIV-C, L.P. outside of the share repurchase program.

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During the year ended December 31, 2022, outside of the share repurchase program, Magnolia LLC repurchased and subsequently canceled 7.9 million Magnolia LLC Units with an equal number of shares of corresponding Class B Common Stock for $187.3 million of cash consideration. During the same period, the Magnolia LLC Unit Holders redeemed 19.5 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, 2022, Magnolia owned approximately 89.8% of the interest in Magnolia LLC and the noncontrolling interest was 10.2%.

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:

•On February 16, 2022, Magnolia Operating, as borrower, amended and restated the original RBL Facility in its entirety, which will now mature in February 2026.

•During the second quarter of 2021, the Company amended the term of the Services Agreement to end on June 30, 2021.

•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.

•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 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, 2022 Compared to the Year Ended December 31, 2021

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, 2022","","December 31, 2021"],["Production:"],["Oil (MBbls)","","12,189","","","11,190"],["Natural gas (MMcf)","","50,660","","","43,436"],["NGLs (MBbls)","","6,874","","","5,669"],["Total (Mboe)","","27,506","","","24,099"],["Average daily production:"],["Oil (Bbls/d)","","33,394","","","30,659"],["Natural gas (Mcf/d)","","138,796","","","119,003"],["NGLs (Bbls/d)","","18,833","","","15,532"],["Total (boe/d)","","75,360","","","66,025"],["Revenues:"],["Oil revenues","","$","1,158,006","","","$","747,896"],["Natural gas revenues","","301,494","","","172,648"],["Natural gas liquids revenues","","234,993","","","157,807"],["Total revenues","","$","1,694,493","","","$","1,078,351"],["Average Price:"],["Oil (per barrel)","","$","95.01","","","$","66.83"],["Natural gas (per Mcf)","","5.95","","","3.97"],["NGLs (per barrel)","","34.18","","","27.84"]]
[[/GREPCENT_TABLE]]

Oil revenues were 68% and 69% of the Company’s total revenues for the years ended December 31, 2022 and 2021, respectively. Oil production was 44% and 46% of total production volume for the years ended December 31, 2022 and 2021, respectively. Oil revenues for the year ended December 31, 2022 were $410.1 million higher than the year ended December 31, 2021. A 42% increase in average prices increased revenues for the year ended December 31, 2022 by $315.3 million compared to the same period in the prior year, and a 9% increase in oil production increased revenue $94.8 million.

Natural gas revenues were 18% and 16% of the Company’s total revenues for the years ended December 31, 2022 and 2021, respectively. Natural gas production was 31% and 30% of total production volume for the years ended December 31, 2022 and 2021, respectively. Natural gas revenues for the year ended December 31, 2022 were $128.8 million higher than the year ended December 31, 2021. A 50% increase in average prices increased revenues for the year ended December 31, 2022 by $85.8 million compared to the same period in the prior year, and a 17% increase in natural gas production increased revenue $43.0 million.

NGL revenues were 14% and 15% of the Company’s total revenues for the years ended December 31, 2022 and 2021, respectively. NGL production was 25% and 24% of total production volume for the years ended December 31, 2022 and 2021, respectively. NGL revenues for the year ended December 31, 2022 were $77.2 million higher than the year ended December 31, 2021. A 23% increase in average prices increased revenues for the year ended December 31, 2022 by $36.0 million compared to the same period in the prior year, and a 21% increase in NGL production increased revenue $41.2 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, 2022","","December 31, 2021"],["Operating Expenses:"],["Lease operating expenses","","$","131,513","","","$","93,021"],["Gathering, transportation, and processing","","64,754","","","45,535"],["Taxes other than income","","94,031","","","55,834"],["Exploration expenses","","11,586","","","4,125"],["Asset retirement obligations accretion","","3,245","","","4,929"],["Depreciation, depletion and amortization","","243,152","","","187,688"],["Amortization of intangible assets","","\u2014","","","9,346"],["General and administrative expenses","","72,426","","","75,279"],["Total operating costs and expenses","","$","620,707","","","$","475,757"],["Other Income (Expense):"],["Interest expense, net","","$","(23,442)","","","$","(31,002)"],["Loss on derivatives, net","","\u2014","","","(3,110)"],["Other income, net","","6,543","","","85"],["Total other expense, net","","$","(16,899)","","","$","(34,027)"],["Average Operating Costs per boe:"],["Lease operating expenses","","$","4.78","","","$","3.86"],["Gathering, transportation, and processing","","2.35","","","1.89"],["Taxes other than income","","3.42","","","2.32"],["Exploration expenses","","0.42","","","0.17"],["Asset retirement obligations accretion","","0.12","","","0.20"],["Depreciation, depletion and amortization","","8.84","","","7.79"],["Amortization of intangible assets","","\u2014","","","0.39"],["General and administrative expenses","","2.63","","","3.12"]]
[[/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, 2022 were $38.5 million, or $0.92 per boe, higher than the year ended December 31, 2021 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, 2022 were $19.2 million, or $0.46 per boe, higher than the year ended December 31, 2021 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, 2022 were $38.2 million, or $1.10 per boe, higher than the year ended December 31, 2021 primarily due to an increase in oil, natural gas, and NGL revenues.

Exploration expenses are geological and geophysical costs that include seismic surveying costs, costs of expired or abandoned leases, and delay rentals. The exploration expenses for the year ended December 31, 2022 were $7.5 million, or $0.25 per boe, higher than the year ended December 31, 2021, due to the purchase of seismic licenses and increased seismic surveying costs.

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Depreciation, depletion and amortization (“DD&A”) during the year ended December 31, 2022 was $55.5 million, or $1.05 per boe, higher than the year ended December 31, 2021 due to increased production and a higher depreciable cost basis.

For the year ended December 31, 2022, the Company did not recognize any amortization of intangible assets, because the intangible assets were fully amortized in June 2021 as a result of the termination of the Non-Compete. During the year ended December 31, 2021, the Company recognized $9.3 million of amortization of intangible assets.

General and administrative expenses during the year ended December 31, 2022 were $2.9 million, or $0.49 per boe, lower than the year ended December 31, 2021, primarily driven by the reduction in costs related to the termination of the Services Agreement on June 30, 2021, partially offset by higher corporate payroll expenses related to increased employee headcount and professional service fees.

Interest expense, net, during the year ended December 31, 2022 was $7.6 million lower than the year ended December 31, 2021, driven by higher interest income realized during the year.

Other income, net during the year ended December 31, 2022 was $6.5 million. This is primarily comprised of the receipt of an earnout payment in the second quarter of 2022 associated with the sale of the Company’s 35% membership interest in Ironwood Eagle Ford Midstream, LLC in 2020.

Income tax expense. The following table summarizes the Company’s income tax expense for the periods indicated.

[[GREPCENT_TABLE]]
[["","","For the Years Ended"],["(In thousands)","","December 31, 2022","","December 31, 2021"],["Current income tax expense","","$","72,358","","","$","8,851"],["Deferred income tax benefit","","(65,720)","","","\u2014"],["Income tax expense","","$","6,638","","","$","8,851"]]
[[/GREPCENT_TABLE]]

For the year ended December 31, 2022, income tax expense was $2.2 million lower than the year ended December 31, 2021, comprised of movements in both current and deferred income taxes. Current income tax expense increased $63.5 million year over year due to higher taxable income, a higher controlling interest, and a lower utilization of net operating loss carryforwards. The increase in current income tax expense was offset by the $65.7 million increase in deferred income tax benefit from the release of the valuation allowance against the Company’s deferred tax assets.

Valuation allowances for deferred tax assets are recognized when it is more likely than not that some or all of the benefit from the deferred tax assets will not be realized. As of December 31, 2022, the Company’s total deferred tax assets were $162.8 million. Management assessed whether it is more likely than not that the Company will generate sufficient taxable income to realize its deferred income tax assets. In making this determination, the Company considered all available positive and negative evidence and made certain assumptions. The Company considered, among other things, the overall business environment, its historical earnings and losses, current industry trends, and its outlook for future years. As of December 31, 2022, the Company concluded that it is more likely than not that it will be able to realize all of its deferred tax assets and that a valuation allowance is no longer necessary. See Note 11—Income taxes in the Notes to the Company’s consolidated financial statements included in this Annual Report on Form 10-K for further detail.

Liquidity and Capital Resources

Magnolia’s primary source of liquidity and capital has been its cash flows from operations. The Company’s primary uses of cash have been for development of the Company’s oil and natural gas properties, returning capital to shareholders, bolt-on acquisitions of oil and natural gas properties, 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 through public offerings or private placements, to fund Magnolia’s acquisitions and long-term liquidity needs. Magnolia’s ability to complete future offerings of equity and debt securities and the timing of these offerings will depend upon various factors, including prevailing market conditions and the Company’s financial condition.

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Material cash commitments include $24.0 million in interest payments paid each year through 2026, along with contractual obligations discussed in Note 10—Commitments and Contingencies in the Notes to the Company’s consolidated financial statements included in this Annual Report on Form 10-K. 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. 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, 2022, 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, 2022, the Company has $1,125.4 million of liquidity comprised of the $450.0 million of borrowing base capacity of the RBL Facility, and $675.4 million of cash and cash equivalents. As of December 31, 2022, 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 $5.9 billion.

Cash and Cash Equivalents

At December 31, 2022, Magnolia had $675.4 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, 2022","","December 31, 2021"],["SOURCES OF CASH AND CASH EQUIVALENTS"],["Net cash provided by operating activities","","$","1,296,687","","","$","788,477"],["USES OF CASH AND CASH EQUIVALENTS"],["Acquisitions","","$","(90,126)","","","$","(18,345)"],["Additions to oil and natural gas properties","","(465,139)","","","(236,426)"],["Changes in working capital associated with additions to oil and natural gas properties","","37,987","","","13,568"],["Class A Common Stock repurchases","","(164,913)","","","(125,641)"],["Class B Common Stock purchases and cancellations","","(187,273)","","","(171,671)"],["Non-compete settlement","","\u2014","","","(42,073)"],["Dividends paid","","(75,198)","","","(14,131)"],["Distributions to noncontrolling interest owners","","(29,362)","","","(7,207)"],["Other","","(14,204)","","","(12,130)"],["Net uses of cash and cash equivalents","","(988,228)","","","(614,056)"],["NET CHANGE IN CASH AND CASH EQUIVALENTS","","$","308,459","","","$","174,421"]]
[[/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, stock based compensation, amortization of deferred financing costs, the non-cash portion of exploration expenses, impairment of oil and natural gas properties, asset retirement obligations accretion, and deferred taxes.

Net cash provided by operating activities totaled $1,296.7 million and $788.5 million for the years ended December 31, 2022 and 2021, respectively. During the year ended December 31, 2022, cash provided by operating activities was positively impacted by increased oil, natural gas, and NGL prices partially offset by higher operating expenses.

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Uses of Cash and Cash Equivalents

Acquisitions

During the year ended December 31, 2022, the Company completed various leasehold, mineral rights, and property acquisitions of certain oil and natural gas assets totaling $90.1 million, subject to customary closing adjustments. The Company made individually immaterial bolt-on acquisitions during the year ended December 31, 2021.

Additions to Oil and Natural Gas Properties

The following table sets forth the Company’s capital expenditures for the years ended December 31, 2022 and 2021.

[[GREPCENT_TABLE]]
[["","","Years Ended"],["(In thousands)","","December 31, 2022","","December 31, 2021"],["Drilling and completion","","$","459,837","","","$","231,904"],["Leasehold acquisition costs","","5,302","","","4,522"],["Total capital expenditures","","$","465,139","","","$","236,426"]]
[[/GREPCENT_TABLE]]

As of December 31, 2022, Magnolia was running a two-rig program. The activity during the year ended December 31, 2022 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 is to continue to spend within cash flow on drilling and completing wells while maintaining low financial leverage.

Capital Requirements

As of December 31, 2022, the Company’s board of directors had authorized a share repurchase program of up to 30.0 million shares of Class A Common Stock. 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, 2022 and 2021, the Company repurchased 7.0 million and 8.7 million shares under this authorization, for a total cost of approximately $153.3 million and $125.6 million, respectively.

During the year ended December 31, 2022, the Company also repurchased 0.6 million shares of Class A Common Stock for $11.6 million from EnerVest Energy Institutional Fund XIV-C, L.P. outside of the share repurchase program.

During the year ended December 31, 2022, Magnolia LLC repurchased and subsequently canceled 7.9 million Magnolia LLC Units with an equal number of shares of corresponding Class B Common Stock for $187.3 million of cash consideration. As of December 31, 2022, Magnolia owned approximately 89.8% of the interest in Magnolia LLC and the noncontrolling interest was 10.2%.

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.

During the year ended December 31, 2022, the Company declared cash dividends to holders of its Class A Common Stock totaling $75.4 million, of which $75.2 million was paid as of December 31, 2022. Additionally, $14.3 million was distributed to the Magnolia LLC Unit Holders. During the year ended December 31, 2021, the Company declared cash dividends to holders of its Class A Common Stock totaling $14.2 million, of which $14.1 million was paid as of December 31, 2021. Additionally, $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.

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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.

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, 2022, 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 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

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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 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.