UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended November 30, 2010
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from _____ to _______
Commission File Number: 333-146561
SYNERGY RESOURCES CORPORATION
-------------------------------------
(Exact Name of Registrant as Specified in its Charter)
Colorado 20-2835920
- ------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
20203 Highway 60, Platteville, Colorado 80651
--------------------------------------------------------
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number including area code: (970) 737-1073
N/A
----------------------------------------------------------------------
Former name, former address, and former fiscal year,
if changed since last report
Indicate by check mark whether the registrant (1) filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the past 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 [ ]
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
definition of "large accelerated filer", "accelerated filer" and "smaller
reporting company" in Rule 12b-2 of the Exchange Act. Yes [ ] No [ ]
Larger accelerated filer [ ] Accelerated filer [ ]
[ ]
Non-accelerated filer [ ] Smaller reporting company [X]
Indicate by check mark whether registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: 23,643,546 shares outstanding
as of January 11, 2011.
SYNERGY RESOURCES CORPORATION
Index
Page
Part I - FINANCIAL INFORMATION
Item 1. Financial Statements
Balance Sheets as of November 30, 2010 (unaudited)
and August 31, 2010 3
Statements of Operations for the three months ended
November 30, 2010 and 2009 (unaudited) 4
Statements of Cash Flows for the three months ended
November 30, 2010 and 2009 (unaudited) 5
Notes to Financial Statements (unaudited) 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 20
Item 4. Controls and Procedures 34
Part II - OTHER INFORMATION
Item 1. Legal Proceedings 33
Item 2. Unregistered Sales of Equity Securities and Use of
Proceeds 33
Item 3. Defaults Upon Senior Securities 33
Item 4. Submission of Matters to a Vote of Security Holders 33
Item 5. Other Information 33
Item 6. Exhibits 33
SIGNATURES 36
2
SYNERGY RESOURCES CORPORATION
BALANCE SHEETS
November 30, August 31,
2010 2010
----------- ---------
ASSETS (Unaudited)
Current assets:
Cash and cash equivalents $ 4,728,030 $ 6,748,637
Accounts receivable:
Oil and gas sales 573,514 377,675
Joint interest billing 1,712,694 1,930,810
Related party receivable 286,942 867,835
Inventory 364,484 387,864
Other current assets 76,839 12,310
----------- -----------
Total current assets 7,742,503 10,325,131
----------- -----------
Property and equipment:
Oil and gas properties, full cost method, net 13,824,090 12,692,194
Other property and equipment, net 155,714 150,789
----------- -----------
Property and equipment, net 13,979,804 12,842,983
----------- -----------
Debt issuance costs, net of amortization 1,417,677 1,587,799
Other assets 139,285 86,000
----------- -----------
Total assets $ 23,279,269 $24,841,913
============ ===========
LIABILITIES AND SHAREHOLDERS' (DEFICIT)
Current liabilities:
Accounts payable:
Trade $ 1,871,167 $ 3,015,562
Related party payable 1,522 554,669
Accrued expenses 919,339 517,921
----------- -----------
Total current liabilities 2,792,028 4,088,152
Asset retirement obligations 312,460 254,648
Convertible promissory notes, net of
debt discount 12,149,308 12,190,945
Derivative conversion liability 9,402,482 9,325,117
----------- -----------
Total liabilities 24,656,278 25,858,862
----------- -----------
Commitments and contingencies (See Notes 8 and 9)
Shareholders' (deficit):
Preferred stock - $0.01 par value,
10,000,000 shares authorized:
no shares issued and outstanding - -
Common stock - $0.001 par value, 100,000,000
shares authorized:
13,823,481 and 13,510,981 shares issued
and outstanding as of November 30, and
August 31, 2010, respectively 13,824 13,511
Additional paid-in capital 23,108,594 22,308,963
Accumulated (deficit) (24,499,427) (23,339,423)
----------- -----------
Total shareholders' (deficit) (1,377,009) (1,016,949)
----------- -----------
Total liabilities and shareholders'
(deficit) 23,279,269 24,841,913
========== ==========
The accompanying notes are an integral part of these financial statements.
3
SYNERGY RESOURCES CORPORATION
STATEMENTS OF OPERATIONS
for the three months ended November 30, 2010 and 2009
(unaudited)
2010 2009
---- ----
Revenues:
Oil and gas revenues $ 1,443,595 $ 52,786
Service revenues 7,442 -
----------- ----------
Total revenues 1,451,037 52,786
----------- ----------
Expenses:
Lease operating expenses 202,675 7,890
Depreciation, depletion, and amortization 584,981 28,206
General and administrative 652,543 281,132
----------- ----------
Total expenses 1,440,199 317,228
----------- ----------
Operating income (loss) 10,838 (264,442)
----------- ----------
Other income (expense):
Change in fair value of derivative
conversion liability (389,263) -
Interest expense, net (782,040) -
Interest income 461 2,773
----------- ----------
Total other income (expense) (1,170,842) 2,773
----------- ----------
Loss before taxes (1,160,004) (261,669)
Provision for income taxes - -
----------- ----------
Net loss $ (1,160,004) $ (261,669)
============ ===========
Net loss per common share:
Basic and Diluted $ (0.08) $ (0.02)
Weighted average shares outstanding:
Basic and Diluted 13,715,651 11,998,000
============ ===========
The accompanying notes are an integral part of these financial statements.
4
SYNERGY RESOURCES CORPORATION
STATEMENTS OF CASH FLOWS
for the three months ended November 30, 2010 and 2009
(unaudited)
2010 2009
---- ----
Cash flows from operating activities:
Net loss $(1,160,004) $ (261,669)
Adjustments to reconcile net loss to
net cash provided by (used in)
operating activities:
Depreciation, depletion, and
amortization 584,981 28,206
Amortization of debt issuance cost 170,122 -
Accretion of debt discount 420,923 -
Stock-based compensation 235,486 4,641
Change in fair value of derivative
liability 389,263 -
Changes in operating assets and
liabilities:
Accounts receivable 603,170 (881,290)
Inventory 23,380 432,049
Accounts payable 1,362,081 17,484
Accrued expenses 191,418 (13,608)
Other (117,814) (20,785)
------------ ---------
Total adjustments 3,863,010 (433,303)
------------ ---------
Net cash provided by (used in)
operating activities 2,703,006 (694,972)
------------ ---------
Cash flows from investing activities:
Acquisition of property and equipment (4,723,613) (899,348)
------------ ---------
Net cash used in investing activities (4,723,613) (899,348)
------------ ---------
Net decrease in cash and equivalents (2,020,607) (1,594,320)
Cash and equivalents at beginning of
period 6,748,637 2,854,659
------------ ---------
Cash and equivalents at end of period $ 4,728,030 $1,260,339
=========== ==========
Supplemental Cash Flow Information (See Note 12)
The accompanying notes are an integral part of these financial statements.
5
SYNERGY RESOURCES CORPORATION
NOTES TO FINANCIAL STATEMENTS
November 30, 2010
(unaudited)
1. Organization and Summary of Significant Accounting Policies
Organization: Synergy Resources Corporation (the "Company") represents the
result of a merger transaction on September 10, 2008, between Brishlin
Resources, Inc. ("Predecessor Brishlin"), a public company, and Synergy
Resources Corporation ("Predecessor Synergy"), a private company. The Company is
engaged in oil and gas acquisitions, exploration, development and production
activities, primarily in the area known as the Denver-Julesburg Basin. The
Company has adopted August 31st as the end of its fiscal year.
Interim Financial Information: The interim financial statements included
herein have been prepared by the Company, without audit, pursuant to the rules
and regulations of the Securities and Exchange Commission ("SEC") as promulgated
in Item 210 of Regulation S-X. The Company prepares its financial statements in
accordance with accounting principles generally accepted in the United States of
America ("US GAAP"). Certain information and footnote disclosures normally
included in financial statements prepared in accordance with US GAAP have been
condensed or omitted pursuant to such SEC rules and regulations. The Company
believes that the disclosures included are adequate to make the information
presented not misleading, and recommends that these financial statements be read
in conjunction with the audited financial statements and notes thereto for the
year ended August 31, 2010.
In management's opinion, the unaudited financial statements contained
herein reflect all adjustments, consisting solely of normal recurring items,
which are necessary for the fair presentation of the Company's financial
position, results of operations, and cash flows on a basis consistent with that
of its prior audited financial statements. However, the results of operations
for interim periods may not be indicative of results to be expected for the full
fiscal year.
Reclassifications: Certain amounts previously presented for prior periods
have been reclassified to conform to the current presentation. The
reclassifications had no effect on net loss, accumulated deficit, net assets, or
total shareholders' equity.
Use of Estimates: The preparation of financial statements in conformity
with US GAAP requires management to make estimates and assumptions that affect
the reported amount of assets and liabilities, including oil and gas reserves,
and disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Management routinely makes judgments and estimates about the
effects of matters that are inherently uncertain. Management bases its estimates
and judgments on historical experience and on various other factors 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. Estimates and assumptions are
revised periodically and the effects of revisions are reflected in the financial
statements in the period it is determined to be necessary. Actual results could
differ from these estimates.
Cash and Cash Equivalents: The Company considers cash in banks, deposits
in transit, and highly liquid debt instruments purchased with original
maturities of three months or less to be cash and cash equivalents.
Inventory: Inventories consist primarily of tubular goods and well
equipment to be used in future drilling operations or repair operations and are
carried at the lower of cost or market.
6
Oil and Gas Properties: The Company uses the full cost method of
accounting for costs related to its oil and gas properties. Accordingly, all
costs associated with acquisition, exploration, and development of oil and gas
reserves (including the costs of unsuccessful efforts) are capitalized into a
single full cost pool. These costs include land acquisition costs, geological
and geophysical expense, carrying charges on non-producing properties, costs of
drilling and overhead charges directly related to acquisition and exploration
activities. Under the full cost method, no gain or loss is recognized upon the
sale or abandonment of oil and gas properties unless non-recognition of such
gain or loss would significantly alter the relationship between capitalized
costs and proved oil and gas reserves.
Capitalized costs of oil and gas properties are depleted using the
unit-of-production method based upon estimates of proved reserves. For depletion
purposes, the volume of petroleum reserves and production is converted into a
common unit of measure at the energy equivalent conversion rate of six thousand
cubic feet of natural gas to one barrel of crude oil. Investments in unevaluated
properties and major development projects are not amortized until proved
reserves associated with the projects can be determined or until impairment
occurs. If the results of an assessment indicate that the properties are
impaired, the amount of the impairment is added to the capitalized costs to be
amortized.
Under the full cost method of accounting, a ceiling test is performed each
quarter. The full cost ceiling test is an impairment test prescribed by SEC
regulations. The ceiling test determines a limit on the book value of oil and
gas properties. The capitalized costs of proved oil and gas properties, net of
accumulated depreciation, depletion, and amortization, the related deferred
income taxes, and the cost of unevaluated properties, may not exceed the
estimated future net cash flows from proved oil and gas reserves, less future
cash outflows associated with asset retirement obligations that have been
accrued plus the lower of cost or estimated fair value of unevaluated properties
not being amortized. Prices are held constant for the productive life of each
well. Net cash flows are discounted at 10%. If net capitalized costs exceed this
limit, the excess is charged to expense and reflected as additional accumulated
depreciation, depletion and amortization. The calculation of future net cash
flows assumes continuation of current economic conditions. Once impairment
expense is recognized, it cannot be reversed in future periods, even if
increasing prices raise the ceiling amount. No provision for impairment was
required for either the three months ended November 30, 2010 or 2009.
The oil and natural gas prices used to calculate the full cost ceiling
limitation are based upon a 12 month rolling average, calculated as the
unweighted arithmetic average of the first day of the month price for each month
within the 12 month period prior to the end of the reporting period, unless
prices are defined by contractual arrangements. Prices are adjusted for basis or
location differentials.
Oil and Gas Reserves: The determination of depreciation, depletion and
amortization expense, as well as the ceiling test calculation related to the
recorded value of the Company's oil and natural gas properties, will be highly
dependent on the estimates of the proved oil and natural gas reserves. Oil and
natural gas reserves include proved reserves that represent estimated quantities
of crude oil and natural gas which geological and engineering data demonstrate
with reasonable certainty to be recoverable in future years from known
reservoirs under existing economic and operating conditions. There are numerous
uncertainties inherent in estimating oil and natural gas reserves and their
values, including many factors beyond the Company's control. Accordingly,
reserve estimates are often different from the quantities of oil and natural gas
ultimately recovered and the corresponding lifting costs associated with the
recovery of these reserves.
7
Capitalized Overhead: A portion of the Company's overhead expenses are
directly attributable to acquisition and development activities. Under the full
cost method of accounting, these expenses, which totaled $64,720 for the three
months ended November 30, 2010 were capitalized in the full cost pool.
Capitalized Interest: The Company capitalizes interest on expenditures
made in connection with exploration and development projects that are not
subject to current amortization. Interest is capitalized during the period that
activities are in progress to bring the projects to their intended use. During
the three months ended November 30, 2010 and 2009, interest capitalized was
$119,739 and $16,152, respectively.
Debt Issuance Costs: Debt issuance costs of $2,041,455 were incurred in
connection with the convertible promissory notes issued during the year ended
August 31, 2010 (see Note 6). Amortization expense, which is being recognized
over the stated three year term, of $170,121 was recorded during the three
months ended November 30, 2010.
Fair Value Measurements: Fair value is the price that would be received to
sell an asset or be paid to transfer a liability in an orderly transaction
between market participants at the measurement date (exit price). The Company
uses market data or assumptions that market participants would use in pricing
the asset or liability, including assumptions about risk. These inputs can
either be readily observable, market corroborated or generally unobservable.
Fair value balances are classified based on the observability of the various
inputs (see Note 7).
Asset Retirement Obligations: The Company's activities are subject to
various laws and regulations, including legal and contractual obligations to
reclaim, remediate, or otherwise restore properties at the time the asset is
permanently removed from service. The fair value of a liability for the asset
retirement obligation ("ARO") is initially recorded when it is incurred if a
reasonable estimate of fair value can be made. This is typically when a well is
completed or an asset is placed in service. When the ARO is initially recorded,
the Company capitalizes the cost (asset retirement cost or "ARC") by increasing
the carrying value of the related asset. Over time, the liability increases for
the change in its present value (accretion of ARO), while the net capitalized
cost decreases over the useful life of the asset. The capitalized ARCs are
included in the full cost pool and subject to depletion, depreciation and
amortization. In addition, the ARCs are included in the ceiling test
calculation. Calculation of an ARO requires estimates about several future
events, including the life of the asset, the costs to remove the asset from
service, and inflation factors. The ARO is initially estimated based upon
discounted cash flows over the life of the asset and is accreted to full value
over time using the Company's credit adjusted risk free interest rate. Estimates
are periodically reviewed and adjusted to reflect changes.
Derivative Conversion Liability: The Company accounts for the embedded
conversion features in its convertible promissory notes in accordance with the
guidance for derivative instruments, which requires a periodic valuation of fair
value and a corresponding recognition of liabilities associated with such
derivatives. The recognition of derivative conversion liabilities related to the
issuance of convertible debt is applied first to the proceeds of such issuance
as a debt discount at the date of the issuance. Any subsequent increase or
decrease in the fair value of the derivative conversion liabilities is
recognized as a charge or credit to other income (expense) in the statements of
operations.
Revenue Recognition: Revenue is recognized for the sale of oil and natural
gas when production is sold to a purchaser and title has transferred. Revenues
8
from production on properties in which the Company shares an economic interest
with other owners are recognized on the basis of the Company's interest.
Provided that reasonable estimates can be made, revenue and receivables are
accrued, and differences between the estimates and actual volumes and prices, if
any, are adjusted upon settlement, which typically occurs sixty to ninety days
after production.
Major Customers and Operating Region: The Company operates exclusively
within the United States of America. Except for cash and equivalent investments,
all of the Company's assets are employed in and all of its revenues are derived
from the oil and gas industry.
The Company's oil and gas production is purchased by a few customers.
The table below presents the percentages of oil and gas revenue that was
purchased by major customers.
Three Months
Ended November 30,
-------------------
Major Customers 2010 2009
--------------- ---- ----
Company A 78% 0%
Company B 19% 0%
Company C 3% 100%
As there are other purchasers that are capable of and willing to
purchase the Company's oil and gas production and since the Company has the
option to change purchasers on its properties if conditions so warrant, the
Company believes that its oil and gas production can be sold in the market in
the event that it is not sold to the Company's existing customers, but in some
circumstances a change in customers may entail significant transition costs
and/or shutting in or curtailing production for weeks or even months during the
transition to a new customer.
Stock Based Compensation: Stock based compensation is measured at the
grant date based upon the estimated fair value of the award and the expense is
recognized over the required employee service period, which generally equals the
vesting period of the grant. The fair value of stock options is estimated using
the Black-Scholes-Merton option-pricing model. The fair value of restricted
stock grants is estimated on the grant date based upon the fair value of the
common stock.
Earnings Per Share Amounts: Basic earnings per share includes no dilution
and is computed by dividing net income (or loss) by the weighted-average number
of shares outstanding during the period. Diluted earnings per share reflect the
potential dilution of securities that could share in the earnings of the
Company. For the three months ended November 30, 2010, and 2009, diluted
earnings per share is equivalent to basic earnings per share, as all potentially
dilutive securities have an anti-dilutive effect on earnings per share. The
following potentially dilutive securities could dilute future earnings per
share:
November 30,
-----------------------------
2010 2009
------------- -------------
Convertible promissory notes 9,630,000 --
Accrued interest --
convertible into common stock 128,752
Warrants(1) 15,286,466 5,161,466
Employee stock options 4,270,000 4,100,000
---------- ---------
Total 29,315,218 9,261,466
========== =========
9
(1) Also as of November 30, 2010 and 2009, the Company had a contingent
obligation to issue 63,466 potentially dilutive securities, all of which
were excluded from the calculation because the contingency conditions had
not been met.
Income Taxes: Deferred income taxes are recorded for timing differences
between items of income or expense reported in the financial statements and
those reported for income tax purposes using the asset/liability method of
accounting for income taxes. Deferred income taxes and tax benefits are
recognized for the future tax consequences attributable to differences between
the financial statement carrying amounts of existing assets and liabilities and
their respective tax bases, and for tax loss and credit carry-forwards. Deferred
tax assets and liabilities are measured using enacted tax rates expected to
apply to taxable income in the years in which those temporary differences are
expected to be recovered or settled. The Company provides for deferred taxes for
the estimated future tax effects attributable to temporary differences and
carry-forwards when realization is more likely than not. If the Company
concludes that it is more likely than not that some portion or all of the
deferred tax asset will not be realized, the balance of deferred tax assets is
reduced by a valuation allowance.
The Company follows the provisions of the ASC regarding uncertainty in
income taxes. No significant uncertain tax positions were identified as of any
date on or before November 30, 2010. Given the substantial net operating loss
carry-forwards at both the federal and state levels, neither significant
interest expense nor penalties charged for any examining agents' tax adjustments
of income tax returns are anticipated as any such adjustments would very likely
simply adjust the net operating loss carry-forwards.
Recent Accounting Pronouncements: The Company evaluates the pronouncements
of various authoritative accounting organizations, primarily the Financial
Accounting Standards Board ("FASB"), the Emerging Issues Task Force ("EITF"),
and the SEC to determine the impact of new pronouncements on US GAAP and the
impact on the Company.
Effective September 1, 2010, the Company adopted ASU No. 2010-11 -
Derivatives and Hedging, which was issued in March 2010 and clarifies that the
transfer of credit risk that is only in the form of subordination of one
financial instrument to another is an embedded derivative feature that should
not be subject to potential bifurcation and separate accounting. Adoption of
this ASU had no material affect on the Company's financial position, results of
operations, or cash flows.
There were various other accounting standards updates recently issued,
most of which represented technical corrections to the accounting literature or
were applicable to specific industries, and are not expected to a have a
material impact on the Company's financial position, results of operations or
cash flows.
2. Accounts Receivable
Accounts receivable consist primarily of trade receivables from oil and
gas sales and amounts due from other working interest owners whom have been
billed for their proportionate share of well costs. For receivables from joint
interest owners, the Company typically has the right to withhold future revenue
disbursements to recover outstanding joint interest billings. As of November 30,
2010 and August 31, 2010, major customers (i.e. those with balances greater than
10% of total receivables) are shown in the following table:
10
As of As of
Accounts Receivable November 30, August 31,
from Major Customers: 2010 2010
-------------------- ----------- ----------
Company A 13% *
Company B 12% *
Company C * 100%
Company D 35% *
Company E 10% *
Company F 10% *
* less than 10%
3. Property and Equipment
Capitalized costs of property and equipment at November 30, 2010, and
August 31, 2010, consisted of the following:
As of As of
November 30, August 31,
2010 2010
------------ -----------
Oil and gas properties, full cost method:
Unevaluated costs, not subject to
amortization:
Lease acquisition and other costs $ 2,690,808 $ 848,696
Wells in progress 618,511 --
------------ -----------
Subtotal, unevaluated costs 3,309,319 848,696
Evaluated costs:
Producing and non-producing 12,231,905 12,992,594
Less, accumulated depletion (1,717,134) (1,149,096)
------------ -----------
Subtotal, evaluated costs 10,514,771 11,843,498
Oil and gas properties, net 13,824,090 12,692,194
Other property and equipment:
Vehicles 89,527 89,527
Leasehold improvements 32,917 32,329
Office equipment 51,397 36,821
Less, accumulated depreciation (18,127) (7,888)
------------ -----------
Other property and equipment, net 155,714 150,789
------------ -----------
Total property and equipment, net $13,979,804 $12,842,983
=========== ===========
The capitalized costs of evaluated oil and gas properties are depleted
using the unit-of-production method based on estimated reserves and the
calculation is performed quarterly. Production volumes for the quarter are
11
compared to beginning of quarter estimated total reserves to calculate a
depletion rate. For the three months ended November 30, 2010 and 2009, depletion
of oil and gas properties was $568,038 and $28,095, respectively, or $19.05 and
$25.69 per barrel of oil equivalent, respectively.
Periodically, the Company reviews its unevaluated properties and its
inventory to determine if the carrying value of either asset exceeds its
estimated fair value. The reviews for the three months ended November 30, 2010,
and 2009 indicated that asset carrying values were less than estimated fair
values and no reclassification to the full cost pool was required.
On a quarterly basis, the Company performs the full cost ceiling test. The
ceiling tests performed for the three months ended November 30, 2010, and 2009
did not reveal any impairments.
For the three months ended November 30, 2010, and 2009 depreciation of
other property and equipment was $10,239 and $111, respectively.
4. Interest Expense
The components of interest expense recorded for the three months ended
November 30, 2010, and 2009 consisted of:
Three Months Ended November 30,
--------------------------------
2010 2009
---- ----
Interest cost, convertible
promissory notes $ 310,734 $ --
Interest cost, bank loan payable -- 16,152
Accretion of debt discount 420,923 --
Amortization of debt issuance
costs 170,122 --
Less, interest capitalized (119,739) (16,152)
--------- ---------
Interest expense, net $ 782,040 $ --
========= =========
5. Asset Retirement Obligations
Upon completion or acquisition of a well, the Company recognizes
obligations for its oil and gas operations for anticipated costs to remove and
dispose of surface equipment, plug and abandon wells, and restore sites to their
original uses. The estimated present value of such obligations are determined
using several assumptions and judgments about the ultimate settlement amounts,
inflation factors, credit adjusted discount rates, timing of settlement, and
changes in regulations. Changes in estimates are reflected in the obligations as
they occur.
The following table summarizes the change in asset retirement obligations
for the three months ended November 30, 2010:
Asset retirement obligations, August 31, 2010 $ 254,648
Liabilities incurred 51,108
Liabilities settled --
Accretion 6,704
Revisions in estimated liabilities --
---------
Asset retirement obligations, November 30, 2010 $ 312,460
=========
12
6. Convertible Promissory Notes and Derivative Conversion Liability
During the fiscal year ended August 31, 2010, the Company received gross
proceeds of $18,000,000 from the sale of 180 Units at $100,000 per Unit. Each
Unit consists of one convertible promissory note ("Note") in the principal
amount of $100,000 and 50,000 Series C warrants (collectively referenced as a
"Unit"). The Notes bear interest at 8% per year, payable quarterly, and mature
on December 31, 2012. Each Series C warrant entitles the holder to purchase one
share of common stock at a price of $6.00 per share and expires on December 31,
2014.
Net proceeds of $16,651,023 from the sale of the Units were used primarily
to drill and complete oil and gas wells in the Wattenburg field, located in the
Denver-Julesburg Basin. The Notes are collateralized by any oil and gas wells
drilled, completed, or acquired with the proceeds from the offering.
The Notes are considered hybrid debt instruments containing a detachable
warrant and a conversion feature under which the proceeds of the offering are
allocated to the detachable warrants and the conversion feature based on their
fair values. The Series C warrants were determined to be a component of equity,
and the fair value of the warrants was recorded as additional paid in capital.
Since the warrants were recorded as a component of equity, the fair value of
$1,760,048 was estimated at inception and will not be re-measured in future
periods. The Notes contain a conversion feature, at an initial conversion price
of $1.60 and subject to adjustment under certain circumstances, which allow the
Note holders to convert the principal balance into a maximum of 11,250,000
common shares, plus conversion of accrued and unpaid interest into common
shares, also at $1.60 per share. The conversion feature was determined to be an
embedded derivative requiring the conversion option to be separated from the
host contract and measured at its fair value. At issuance, the estimated fair
value of the conversion feature was $3,455,809. The conversion option will
continue to be recorded at fair value each reporting period until settlement or
conversion, with changes in the fair value reflected in other income (expense)
in the statements of operations. The fair value of the conversion feature was
recorded as derivative conversion liability.
Allocation of value to the components created a debt discount of
$5,215,857, which is being accreted over the 36 month life of the Notes using
the effective interest method. The effective interest rate on the Notes is 19%.
The Company recorded accretion expense of $420,923 during the three months ended
November 30, 2010, which included $73,513 to record the effect of accelerated
accretion on early Note conversions.
In connection with the sale of the Units, the Company paid fees and
expenses of $1,348,977 and issued 1,125,000 Series D warrants to the placement
agent. The Series D warrants have an exercise price of $1.60 and an expiration
date of December 31, 2014. The warrants were valued at $692,478 using the
Black-Scholes-Merton option pricing model. The Company recorded $2,041,455 of
debt issuance costs, which is being amortized over the three year term of the
Notes. Amortization expense of $170,122 was recorded during the three months
ended November 30, 2010.
During the three months ended November 30, 2010, holders of convertible
promissory notes with a face amount of $500,000 converted principal into 312,500
shares of common stock at the conversion price of $1.60 per share. At the time
the Notes were converted, the estimated fair value of the derivative conversion
liability apportioned to the converted Notes totaled $311,898, which was
reclassified from derivative conversion liability to additional paid in capital.
13
Similarly, the unamortized debt discount apportioned to the converted Notes
totaled $110,953. The unamortized debt discount of $73,513 applicable to the
conversion option was charged to accretion of debt discount and the unamortized
debt discount of $37,440 applicable to the warrants was reclassified from debt
discount to additional paid in capital. As of November 30, 2010, Notes with a
principal amount of $15,408,000 were outstanding and the debt discount balance
was $3,258,692.
The fair value of the derivative conversion liability is adjusted each
quarter to reflect the change in value. The estimated fair value of the
derivative conversion liability as of November 30, 2010, was $9,402,482, and the
change in fair value of derivative conversion liability was $389,263 during the
three months ended November 30, 2010, including a change of $311,898 related to
the early conversion of Notes
7. Fair Value Measurements
Assets and liabilities are measured at fair value on a recurring basis for
disclosure or reporting, as required by ASC "Fair Value Measurements and
Disclosures".
A fair value hierarchy was established 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).
Level 1 - Quoted prices are available in active markets for identical
assets or 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 pricing information on an ongoing basis. Level 1 primarily
consists of financial instruments such as exchange-traded derivatives, listed
securities and US government treasury securities.
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, where substantially all of these
assumptions are observable in the marketplace 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 than objective sources. These inputs may be used with internally
developed methodologies that result in management's best estimate of fair value.
Level 3 includes those financial instruments that are valued using models or
other valuation methodologies, where substantial assumptions are not observable
in the marketplace throughout the full term of the instrument, cannot be derived
from observable data or are not supported by observable levels at which
transactions are executed in the marketplace. At each balance sheet date, the
Company performs an analysis of all applicable instruments and includes in Level
3 all of those whose fair value is based on significant unobservable inputs.
For the most part, the Company's financial instruments consisted of cash
and equivalents, accounts receivable, accounts payable, and accrued liabilities.
Due to the short original maturities and high liquidity of cash and equivalents,
accounts receivable, accounts payable, and accrued liabilities, carrying amounts
approximated fair values.
14
As permitted, the Company's convertible promissory notes are not carried
in the Company's financial statements at fair value. As compared to the $12.1
million then carrying value, the fair value of the Notes was estimated at
approximately $13.4 million as of November 30, 2010. Because the Notes are not
traded on a public exchange, the fair value reflects market-based
(over-the-counter) trades for debt with similar terms and maturities applied to
the discounted cash flow for the Notes maturity.
The Company's convertible promissory notes (see Note 6) contain an
embedded conversion option which is required to be separated and reported as a
derivative liability at fair value. The Company utilizes the Monte Carlo
Simulation ("MCS") model to value the derivative conversion liability. Inputs to
this valuation technique include the Company's quoted stock price and published
interest rates and credit spreads. Additional assumptions used as of November
30, 2010 were: an expected term of 2.1 years, volatility of 45.70%, which was
derived from the expected volatility of comparable companies, dividend yield of
0%, and a discount rate of 6.63%. All of the significant inputs are observable,
either directly or indirectly; therefore, the Company's derivative conversion
liability is included within the Level 2 fair value hierarchy. The derivative
conversion liability is re-measured each quarter to reflect the change in fair
value. The estimated fair value of the derivative conversion liability as of
November 30, 2010, was $9,402,482, and the change in fair value of derivative
conversion liability was $389,263 during the three months ended November 30,
2010, including a change of $311,898 related to the early conversion of Notes.
The following table sets forth by level within the fair value hierarchy
the Company's financial assets and financial liabilities as of November 30,
2010, and August 31, 2010, respectively, that were measured at fair value on a
recurring basis.
November 30,
2010 Level 1 Level 2 Level 3
-------------- --------- --------- --------
Derivative Conversion
Liability $9,402,482 $ -- $9,402,482 $ --
August 31,
2010 Level 1 Level 2 Level 3
-------------- --------- --------- --------
Derivative Conversion
Liability $9,325,117 $ -- $9,325,117 $ --
The Company also measures all nonfinancial assets and liabilities that are
not recognized or disclosed on a recurring basis. As discussed in Note 5, asset
retirement obligations and costs totaling $312,460 and $254,648, have been
accounted for as long-term liabilities and included in each property's asset
value at November 30, 2010 and August 31, 2010, respectively. The Level 3 inputs
used to measure the estimated fair value of the obligations include assumptions
and judgments about the ultimate settlement amounts, inflation factors, credit
adjusted discount rates, timing of settlement, and changes in regulations.
15
8. Related Party Transactions and Commitments
The Company's executive officers control three entities that have entered
into agreements to provide various services and office space to the Company. The
entities are Petroleum Management, LLC ("PM"), Petroleum Exploration and
Management, LLC ("PEM"), and HS Land & Cattle, LLC ("HSLC").
Effective June 11, 2008, the Company entered into an Administrative
Services Agreement with PM. The Company paid $10,000 per month for leasing
office space and an equipment yard located in Platteville, Colorado, and paid
$10,000 per month for office support services including secretarial service,
word processing, communication services, office equipment and supplies. The
Company paid $60,000 under this agreement for the three months ended November
30, 2009. Effective June 30, 2010, the Company terminated the agreement.
Effective July 1, 2010, the Company entered into a lease with HSLC, for
office space and an equipment yard located in Platteville, Colorado. The lease
requires monthly payments of $10,000 and terminates on June 30, 2011. The
Company paid $30,000 under this agreement for the three months ended November
30, 2010.
On October 1, 2010, the Company acquired certain oil and gas properties
located in the Wattenberg field, part of the D-J Basin, from PM and PEM for
$1,017,435. The oil and gas properties consist of 6 producing oil and gas wells
and 2 shut in oil wells as well as 15 drill sites and miscellaneous equipment.
The Company acquired a 100% working interest and 80% net revenue interest in the
properties.
In addition to the transactions described above, the Company undertook
various activities with PM and PEM that are related to the development and
operation of oil and gas properties. The Company purchased certain oil and gas
equipment, such as tubular goods and surface equipment, from PM. The Company
reimbursed PM for the original cost of the equipment. PEM is a joint working
interest owner of certain wells operated by the Company. PEM is charged for
their pro-rata share of costs and expenses incurred on their behalf by the
Company, and similarly PEM is credited for their pro-rata share of revenues
collected on their behalf. The following table summarizes the transactions with
PM and PEM during the three months ended November 30, 2010:
Balance due to PM for equipment, August 31, 2010 $ 538,698
Purchase of equipment from PM 1,710
Payments to PM for equipment (538,886)
---------
Balance due to PM for equipment, November 30, 2010 $ 1,522
=========
Joint interest billing balance due from PEM,
August 31, 2010 $ 867,835
Joint interest costs billed to PEM 162,296
Amounts collected from PEM (743,189)
---------
Joint interest billing due from PEM,
November 30, 2010 $ 286,942
=========
Balance due to PEM for revenues, August 31, 2010 $ 15,971
Revenues collected on behalf of PEM 139,973
Payments to PEM for revenues (155,944)
---------
Balance due to PEM for revenues, November 30, 2010 $ --
=========
16
9. Other Commitments and Contingencies
During the three months ended November 30, 2010, the Company agreed to
issue 100,000 common shares in exchange for services. The common shares were
valued at $210,000 based upon the quoted market price of the Company's common
stock on the effective date of the agreement. The entire value was recorded as
general and administrative expense during the three months ended November 30,
2010. The shares were issued subsequent to November 30, 2010.
10. Shareholders' Equity
Preferred Stock: The Company has authorized 10,000,000 shares of preferred
stock with a par value of $0.01 per share. These shares may be issued in series
with such rights and preferences as may be determined by the Board of Directors.
Since inception, the Company has not issued any preferred shares.
Common Stock: The Company has authorized 100,000,000 shares of common
stock with a par value of $0.001 per share.
Issued and Outstanding: The total issued and outstanding common stock at
November 30, 2010, is 13,823,481 common shares, representing an increase from
August 31, 2010 of 312,500 shares, as follows:
During the three months ended November 30, 2010, the Company issued
312,500 common shares pursuant to the conversion of Notes in the principal
amount of $500,000 at the contractual conversion price of $1.60 per share.
As of November 30, 2010, there were various warrants outstanding to
purchase 15,286,466 shares of common stock. The following table summarizes
information about the Company's issued and outstanding common stock warrants as
of November 30, 2010:
Remaining
Contractual
Number of Life Expiration Strike
Description Shares (in years) Date Proceeds
- ---------------------- --------- ------------ ---------- --------
Series A at $6.00 4,098,000 2.6 12/31/2012 $24,588,000
Series B at $10.00 1,000,000 2.6 12/31/2012 10,000,000
Series C at $6.00 9,000,000 4.6 12/31/2014 54,000,000
Series D at $1.60 1,125,000 4.6 12/31/2014 1,800,000
Placement Agent Warrants
at $1.80 63,466 2.6 12/31/2012 114,239
---------- -----------
15,286,466 3.4 $90,502,239
========== ============
The following table summarizes activity for common stock warrants for the
three month period ended November 30, 2010:
Weighted
Number of Average
Warrants Exercise Price
----------- --------------
Outstanding, August 31, 2010 15,286,466 $5.92
Granted -- --
Exercised -- --
----------
Outstanding, November 30, 2010 15,286,466 $5.92
==========
17
11. Stock-Based Compensation
Effective September 27, 2010, the Company granted employee stock options
to purchase 50,000 shares of common stock at an exercise price of $2.40 and a
term of ten years. The options vest over four years. These options were
determined to have a fair value of $63,126 using the assumptions outlined in the
table below.
For the grant of 100,000 common shares discussed in Note 9, the Company
recorded stock-based compensation expense of $210,000 for the three months ended
November 31, 2010. For the grant of various stock options that are currently in
the vesting phase, the Company recorded stock-based compensation expense of
$25,486 and $4,641 for the three months ended November 30, 2010 and 2009,
respectively. The estimated unrecognized compensation cost from unvested stock
options as of November 30, 2010, was approximately $316,000, which will be
recognized ratably through September, 2014.
The assumptions used in valuing stock options for the three months ended
November 30, 2010 were as follows:
Expected term (in years) 6.00
Expected volatility 53.18%
Risk free rate 1.62%
Expected dividend yield 0.00%
The following table summarizes activity for stock options for the period
from August 31, 2010 to November 30, 2010:
Weighted
Number of Average
Shares Exercise Price
---------- --------------
Outstanding, August 31, 2010 4,220,000 $ 5.36
Granted 50,000 $ 2.40
Exercised -- --
---------
Outstanding, November 30, 2010 4,270,000 $ 5.32
---------
The following table summarizes information about issued and outstanding
stock options as of November 30, 2010:
Remaining Weighted
Number Contractual Average Aggregate
Exercise of Life Exercise Number Intrinsic
Price Shares (in years) Price Exercisable Value
- --------- -------- ---------- -------- ---------- ----------
$10.00 2,000,000 2.6 $10.00 2,000,000 --
$1.00 2,000,000 2.6 $ 1.00 2,000,000 $2,799,800
$3.00 100,000 8.1 $ 3.00 10,000 --
$2.50 120,000 9.6 $ 2.50 -- --
$2.40 9.8 $ 2.40
50,000 10,000 --
--------- --------- ----------
4,270,000 2.9 $ 5.32 4,020,000 $2,799,800
========= ========= ==========
18
12. Supplemental Schedule of Information to the Statements of Cash Flows
The following table supplements the cash flow information presented in the
financial statements for the three months ended November 30, 2010 and 2009:
Three Months Ended
November 30,
------------------
2010 2009
---- ----
Supplemental cash flow information:
Interest paid $320,840 $ 25,027
Income taxes paid -- --
Non-cash investing and financing activities:
Conversion of promissory notes into
common stock $500,000 --
Accrued capital expenditures $386,816 $1,376,785
Asset retirement costs and obligations $51,108 --
13. Subsequent Events
On January 11, 2011, the Company completed the sale of 9,000,000 shares of
common stock to private investors. The shares were sold at a price of $2.00 per
share. Net proceeds to the Company from the sale of the shares were
approximately $16,700,000 after deductions for the placement agents' commissions
and expenses. The Company relied upon the exemption provided by Rule 506 of the
Securities and Exchange Commission in connection with the sale of these
securities. The shares of common stock sold to date have not been, and any
additional shares which may be sold will not be, registered under the Securities
Act of 1933 and may not be offered or sold in the United States absent
registration or an applicable exemption from registration.
Between December 1, 2010, and the date of this report, holders of
convertible promissory notes with a face amount of $1,150,175 plus accrued
interest of $1,930 elected to convert the Notes into 720,065 shares of common
stock at the conversion price of $1.60 per share.
Effective December 29, 2010, the Company issued 100,000 shares of common
stock to satisfy amounts accrued as of November 30, 2010, and discussed as a
commitment in Note 9.
19
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operation
Introduction
The following discussion and analysis was prepared to supplement information
contained in the accompanying financial statements and is intended to provide
certain details regarding the financial condition as of November 30, 2010, and
the results of operations for the three months ended November 30, 2010, and
2009. It should be read in conjunction with the unaudited financial statements
and notes thereto contained in this report as well as the audited financial
statements included in the Form 10-K for the fiscal year ended August 31, 2010.
Overview
We are an independent oil and gas operator in Colorado and are focused on
the acquisition, development, exploitation, exploration and production of oil
and natural gas properties primarily located in the Wattenberg field in the
Denver-Julesburg ("D-J") Basin in northeast Colorado. We commenced active
operations in September 2008 and have grown significantly during the last two
years. As of August 31, 2009, we had two productive wells (net wells of 0.6). As
of August 31, 2010, we had twenty-four productive wells and fourteen wells in
the process of completion (net wells of 19). As of December 31, 2010, we have 50
productive wells, including 2 shut-in wells (net wells of 29).
As of November 30, 2010, we had estimated proved reserves of 660,881 Bbls
of oil and 4,399,963 Mcf of gas.
We currently hold an acreage position of 21,578 gross acres and 13,633 net
acres under lease.
Our growth plans for 2011 include additional drilling activities,
acquisition of existing wells, and recompletion of wells that provide good
prospects for improved stimulation techniques. As cash flow from operations is
not sufficient to fund our growth plans, we will be required to seek additional
financing. Implementation of our growth plans will be dependent upon the amount
of financing we are able to obtain.
Recent Developments
On January 11, 2011, we closed on the sale of 9,000,000 shares of common
stock to private investors. The shares were sold at a price of $2.00 per share.
Net proceeds from the sale of the shares were approximately $16,700,000 after
deductions for the sales commissions and expenses.
In December 2010, we acquired four producing wells in an area that is
adjacent to our Pratt lease. We paid cash consideration of $400,000 and assigned
the lease rights on 340 net acres in northern Weld County to the seller.
Potential Acquisition of Oil and Gas Properties from Petroleum Exploration &
Management
We have a nonbinding letter of intent with Petroleum Exploration &
Management LLC ("PEM"), a company owned by Ed Holloway and William E. Scaff,
Jr., two of our officers, to potentially acquire oil and gas properties located
in the Wattenberg Field of the D-J Basin.
The assets under purchase consideration include 88 gross wells (87
producing and 1 shut-in) and oil and gas leases covering 6,968 gross acres in
the D-J Basin. We have not completed our evaluation of the value of the assets
20
but we estimate that it could range between approximately $14.0 million and
$17.0 million. Our evaluation will include consideration of the estimated proved
reserves of the oil and gas properties, the value of undeveloped leases, and the
potential advantages to the Company of adding these properties to our existing
oil and gas assets. We will consider whether new well stimulation technologies
developed since these wells were drilled could be applied to increase the future
value of the properties.
Through the date of this report we had not reached any agreement with Mr.
Holloway and Mr. Scaff as to the amount we may pay for PEM's oil and gas
properties, or how the purchase price will be structured (which may include a
combination of cash, shares of our common or preferred stock, or debt). It is
our intention not to assume any of PEM's liabilities. However, we may find it
advantageous to assume certain of PEM's liabilities, in which case we would need
to pay the liabilities as they became due, but the price we would pay for PEM's
properties would be reduced.
PEM is currently undergoing an audit of its financial statements and
obtaining an independent reserve analysis. Certain members from our Board of
Directors are serving as an independent acquisition committee to review the
potential transaction.
Proceeding with the acquisition would be contingent upon numerous factors,
including satisfactory completion of due diligence, approval of disinterested
directors and shareholders, determination that the purchase was fair, and
availability of suitable financing.
RESULTS OF OPERATIONS
For the three months ended November 30, 2010, compared to the three months ended
November 30, 2009
Material changes of certain items in our statements of operations included
in our financial statements for the comparative periods are discussed below.
For the three months ended November 30, 2010, we reported a net loss of
$1,160,004, or $0.08 per share, compared to a net loss of $261,669, or $0.02 per
share, for the three months ended November 30, 2009. The comparison between the
two years was primarily influenced by increasing revenues and expenses
associated with the 36 wells completed during the 2010 drilling program which
provided operating income of $10,838 in 2010 compared to an operating loss of
$264,442 in 2009. Improved operating income was offset by costs related to the
$18 million financing transaction that closed in March 2010.
Oil and Gas Production and Revenues - For the three months ended November
30, 2010, we recorded total oil and gas revenues of $1,443,595 compared to
$52,786 for the three months ended November 30, 2009, as summarized in the
following table:
21
Three Months Ended November 30,
--------------------------------
2010 2009
-------- --------
Production:
Oil (Bbls) 15,939 795
Gas (Mcf) 83,306 1,793
Total production in BOE 29,823 1,094
Revenues:
Oil $1,153,779 $46,205
Gas 289,816 6,581
---------- -------
Total $ 1,443,595 $52,786
=========== =======
Average sales price:
Oil (Bbls) $ 72.39 $ 58.12
Gas (Mcf) $ 3.48 $ 3.67
"Bbl" refers to one stock tank barrel, or 42 U.S. gallons liquid volume in
reference to crude oil or other liquid hydrocarbons. "Mcf" refers to one
thousand cubic feet. A BOE (i.e. barrel of oil equivalent) combines Bbls of oil
and Mcf of gas by converting each six Mcf of gas to one Bbl of oil.
Net oil and gas production for the three months ended November 30, 2010
was 29,823 BOE, or 328 BOE per day. The significant increase in production from
the comparable period in the prior year reflects the additional wells that began
production over the past twelve months. The change in average sales price is a
function of worldwide commodity prices, which have increased the realized sales
price of oil by 25% and decreased the realized sales price of natural gas by 5%.
We do not currently engage in any commodity hedging activities, although
we may do so in the future.
Service revenue- For the three months ended November 30, 2010, we recorded
revenue generated from the management of wells owned by third parties of $7,442.
Lease Operating Expenses - As summarized in the following table, our lease
expenses include the direct operating costs of producing oil and natural gas and
taxes on production and properties:
Three Months ended November 30,
--------------------------------
2010 2009
-------- --------
Production costs $ 61,876 $ 5,316
Severance and ad valorem taxes 140,799 2,574
-------- -------
Total production expenses $202,675 $ 7,890
======== =======
Per BOE:
Production costs $ 2.07 $ 4.86
Severance and ad valorem taxes 4.72 2.35
-------- -------
Total per BOE $ 6.80 $ 7.21
======== =======
22
Production costs tend to increase or decrease primarily in relation to the
number of wells in production, and, to a lesser extent, on fluctuation in oil
field service costs and changes in the production mix of crude oil and natural
gas. Production costs may vary substantially among wells depending on the
methods of recovery employed and other factors, such as workover operations,
maintenance and repair, labor and utilities. Taxes tend to increase or decrease
primarily based on the value of oil and gas sold. As a percent of revenues,
production costs were 14% in the three months ended November 30, 2010, and 15%
in the respective period in 2009.
Depreciation, Depletion, and Amortization ("DDA") - DDA expense is
summarized in the following table:
Three Months ended November 30,
--------------------------------
2010 2009
-------- -------
Depletion $568,038 $ 28,095
Depreciation and amortization 16,943 111
-------- --------
Total DDA $584,981 $ 28,206
======== ========
Depletion per BOE $ 19.05 $ 25.69
The determination of depreciation, depletion and amortization expense is
highly dependent on the estimates of the proved oil and natural gas reserves.
The capitalized costs of evaluated oil and gas properties are depleted using the
units-of-production method based on estimated reserves. Production volumes for
the quarter are compared to beginning of quarter estimated total reserves to
calculate a depletion rate. For the three months ended November 30, 2010,
production volumes of 29,823 BOE and estimated net proved reserves of 1,357,000
BOE were the basis of the depletion rate calculation. For the three months ended
November 30, 2009, production volumes of 1,094 BOE and estimated net proved
reserves of 10,700 BOE were the basis of the depletion rate calculation.
General and Administrative - The following table summarizes the components
of general and administration expenses:
Three Months ended November 30,
--------------------------------
2010 2009
-------- -------
Stock based compensation $ 235,486 $ 4,641
Other general and administrative 481,777 276,491
Capitalized general and administrative (64,720) --
--------- --------
Totals $ 652,543 $281,132
========= ========
The stock-based compensation recorded in general and administrative
expenses related to the issuance of stock grants and stock options to officers,
directors, consultants, and employees. The expense recorded for stock grants is
based on the market value of the common stock on the date of grant. When stock
options are issued we estimate their fair value using the Black-Scholes-Merton
option-pricing model. The estimated fair value is recorded as a non-cash expense
on a pro-rata basis over the vesting period.
23
Other general and administrative expenses, which include salaries,
benefits, professional fees, and other corporate overhead, increased
approximately $205,000 during the current three-month period over the comparable
quarter in the prior year due to the growth in our business. The following items
contributed to the increase. Salaries and benefits increased by $130,000 as we
increased the number of employees from three to seven, reservoir engineering
fees increased by approximately $30,000, and we incurred additional professional
fees of approximately $40,000 related to increased requirements of our business.
Certain general and administrative expenses are directly related to the
acquisition and development of oil and gas properties. Those costs were
reclassified from general and administrative expense into capitalized costs in
the full cost pool.
Other Income (Expense) - The issuance of $18,000,000 of convertible
promissory notes and Series C warrants during the year ended August 31, 2010,
generated a significant increase in other expenses for the three months ended
November 30, 2010, compared to the three months ended November 30, 2009.
Interest expense of $310,734 was recognized during the three months ended
November 30, 2010. Accretion of debt discount was $420,923 during the three
months ended November 30, 2010, and amortization of debt issuance costs was
$170,122.
The notes contain a conversion feature, at an initial conversion price of
$1.60 and subject to adjustment under certain circumstances, which allow the
noteholders to convert the $18,000,000 principal balance into a maximum of
11,250,000 common shares, plus conversion of accrued and unpaid interest into
common shares, also at $1.60 per share. This conversion feature, considered an
embedded derivative and recorded as a liability at its estimated fair value,
when marked-to-market, over time is reflected as a non-cash item in the
statement of operations. A non-cash expense of $389,263 was reflected in the
statement of operations for the three months ended November 30, 2010 to
represent the change in the fair value of the derivative conversion liability
during the period.
Income Taxes - Our effective tax rate is currently zero. We have reported
a net loss every year since inception and for tax purposes have a net operating
loss carry forward ("NOL") of approximately $10 million. The NOL is available to
offset future taxable income, if any. At such time, if ever, that we are able to
demonstrate that it is more likely than not that we will be able to realize the
benefits of our tax assets, we will recognize the benefits in our financial
statements.
LIQUIDITY AND CAPITAL RESOURCES
During the year ended August 31, 2010, we received gross proceeds of
$18,000,000 from the sale of 180 Units at $100,000 per Unit. Each Unit consists
of one convertible promissory note in the principal amount of $100,000 and
50,000 Series C warrants. The Notes bear interest at 8% per year, payable
quarterly, and mature on December 31, 2012. Each Series C warrant entitles the
holder to purchase one share of our common stock at a price of $6.00 per share
and expires on December 31, 2014.
Net proceeds of $16,651,023 from the sale of the Units were used primarily
to drill and complete 36 oil and gas wells in the Wattenburg field. The Notes
are collateralized by any oil and gas wells drilled, completed, or acquired with
the proceeds from the sale of the Units.
Our sources and (uses) of funds for the three months ended November 30,
2010, and 2009 are shown below:
24
Three Months ended November 30,
--------------------------------
2010 2009
-------- -------
Cash provided by (or used in) operations $ 2,703,006 $ (694,972)
Acquisition of oil and gas properties, and
equipment (4,723,613) (899,348)
----------- -----------
Net decrease in cash $(2,020,607) $(1,594,320)
=========== ===========
Net cash provided by operating activities was $2,703,006 for the three
months ended November 30, 2010, while operating activities used net cash of
$694,972 for the three months ended November 30, 2009. Non-cash expenses had a
$1,800,775 and $32,847 impact on net loss for the three months ended November
30, 2010 and 2009, respectively. Changes in working capital items caused by the
timing of payments and receipts of cash had an impact of $2,062,235 and
$(466,150) for the three months ended November 30, 2010 and 2009, respectively.
Cash payments for the acquisition of oil and gas properties, drilling
costs, and other development activities for the three months ended November 30,
2010, and 2009, were $4,723,613 and $899,348, respectively. These amounts differ
from the amounts reported as the increase in capitalized costs during the
period, which differences reflect the timing of when the capital expenditure
obligations are incurred and when the actual cash payment is made. A
reconciliation of the differences is summarized in the following table:
Three Months ended November 30,
--------------------------------
2010 2009
-------- -------
Cash payments $ 4,723,613 $ 899,348
Accrued costs, beginning of period (3,446,439) --
Accrued costs, end of period 386,816 1,376,785
Asset retirement obligation 51,108 --
----------- -----------
Increase in capitalized costs $ 1,715,098 $ 2,276,133
=========== ===========
In addition to completion activities on the wells drilled during the 2010
drilling program, capital expenditures for the three months ended November 30,
2010, included the acquisition of eight existing wells and fifteen drill sites
and associated equipment for a purchase price of $1,017,435. We believe that
these wells are good candidates for enhanced recovery techniques. Subsequent to
November 30, 2010, we acquired four producing wells for cash of $400,000 plus an
assignment of certain leasehold interests in northern Weld County.
There were no cash flows from financing activities during either of the
three month periods ended November 30, 2010, or 2009. However, On January 11,
2011 we completed the sale of 9,000,000 shares of our common stock in a private
offering. The shares were sold at a price of $2.00 per share. Net proceeds to us
from the sale of the shares were $16,700,000 after deductions for sales
commissions and expenses.
In non-cash transactions during the three months ended November 30, 2010,
holders of convertible promissory notes, sold during the year ended August 31,
2010, with a principal amount of $500,000 converted the notes into 312,500
shares of our common stock ($1.60 conversion price), leaving notes with a
principal amount of $15,408,000 outstanding at November 30, 2010. Between
December 1, 2010 and the date of this report, holders of convertible promissory
25
notes with a face amount of $1,150,745 plus accrued interest of $1,930 converted
the Notes into 718,859 shares of our common stock (conversion price of $1.60 per
share).
Our operating cash requirements are expected to approximate $350,000 per
month, which amount includes salaries and other corporate overhead of $150,000,
debt servicing costs of $100,000, and lease operating expenses of $100,000.
Through November 30, 2010, we were beginning to generate meaningful cash flow
from operations, and we expect that the revenue from wells placed into
production in the last six months will further improve our cash flow during
fiscal 2011.
Our primary need for cash in fiscal 2011 will be to fund our acquisition
and drilling program. Our tentative capital expenditure budget approximates
$27,000,000, subject to significant adjustment for drilling success, acquisition
opportunities, operating cash flow, and available capital resources. As we do
not currently have access to sufficient capital resources to fund our tentative
expenditures, we will be required to seek additional funding. Our budget is
tentatively allocated to acquisition of proved and unproved properties of
approximately $12,000,000 (either from PEM or unrelated third parties) and
drilling activities of approximately $15,000,000, which include drilling new
wells and reworking existing wells.
We plan to generate profits by drilling or acquiring productive oil or gas
wells. However, we may need to raise some of the funds required to drill new
wells through the sale of our securities, from loans from third parties or from
third parties willing to pay our share of drilling and completing the wells. We
may not be successful in raising the capital needed to drill or acquire oil or
gas wells. Any wells which may be drilled by us may not produce oil or gas in
commercial quantities.
TREND AND OUTLOOK
The factors that will most significantly affect our results of operations
include (i) activities on properties that we operate, (ii) the marketability of
our production, (iii) our ability to satisfy our substantial capital
requirements, (iv) completion of acquisitions of additional properties and
reserves, (v) competition from larger companies and (vi) prices for oil and gas.
Our revenues will also be significantly impacted by our ability to maintain or
increase oil or gas production through exploration and development activities.
It is expected that our principal source of cash flow will be from the
production and sale of oil and gas reserves which are depleting assets. Cash
flow from the sale of oil and gas production depends upon the quantity of
production and the price obtained for the production. An increase in prices will
permit us to finance our operations to a greater extent with internally
generated funds, may allow us to obtain equity financing more easily or on
better terms, and lessens the difficulty of obtaining financing. However, price
increases heighten the competition for oil and gas prospects, increase the costs
of exploration and development, and, because of potential price declines,
increase the risks associated with the purchase of producing properties during
times that prices are at higher levels.
A decline in oil and gas prices (i) will reduce our cash flow which in
turn will reduce the funds available for exploring for and replacing oil and gas
reserves, (ii) will increase the difficulty of obtaining equity and debt
financing and worsen the terms on which such financing may be obtained, (iii)
will reduce the number of oil and gas prospects which have reasonable economic
terms, (iv) may cause us to permit leases to expire based upon the value of
potential oil and gas reserves in relation to the costs of exploration, (v) may
result in marginally productive oil and gas wells being abandoned as
non-commercial, and (vi) may increase the difficulty of obtaining financing.
However, price declines reduce the competition for oil and gas properties and
correspondingly reduce the prices paid for leases and prospects.
26
Other than the foregoing, we do not know of any trends, events or
uncertainties that will have had or are reasonably expected to have a material
impact on our sales, revenues or expenses.
CRITICAL ACCOUNTING POLICIES
There have been no changes in our critical accounting policies since
August 31, 2010, and a detailed discussion of the nature of our accounting
practices can be found in the section titled "Critical Accounting Policies" in
Part II, Item 7 of our Annual Report on Form 10-K for the year ended August 31,
2010.
CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS
This report contains "forward-looking statements" within the meaning of
the Private Securities Litigation Reform Act of 1995. These statements are
subject to risks and uncertainties and are based on the beliefs and assumptions
of management and information currently available to management. The use of
words such as "believes", "expects", "anticipates", "intends", "plans",
"estimates", "should", "likely" or similar expressions, indicates a
forward-looking statement.
The identification in this report of factors that may affect our future
performance and the accuracy of forward-looking statements is meant to be
illustrative and by no means exhaustive. All forward-looking statements should
be evaluated with the understanding of their inherent uncertainty.
Factors that could cause our actual results to differ materially from
those expressed or implied by forward-looking statements include, but are not
limited to:
o The success of our exploration and development efforts;
o The price of oil and gas;
o The worldwide economic situation;
o Any change in interest rates or inflation;
o The willingness and ability of third parties to honor their
contractual commitments;
o Our ability to raise additional capital, as it may be affected by
current conditions in the stock market and competition in the oil and
gas industry for risk capital;
o Our capital costs, as they may be affected by delays or cost overruns;
o Our costs of production;
o Environmental and other regulations, as the same presently exist or
may later be amended;
o Our ability to identify, finance and integrate any future
acquisitions; and
o The volatility of our stock price.
Item 4. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
An evaluation was carried out under the supervision and with the
participation of our management, including our Principal Financial Officer and
Principal Executive Officer, of the effectiveness of our disclosure controls and
procedures as of the end of the period covered by this report on Form 10-Q.
Disclosure controls and procedures are procedures designed with the objective of
ensuring that information required to be disclosed in our reports filed under
the Securities Exchange Act of 1934, such as this Form 10-Q, is recorded,
processed, summarized and reported, within the time period specified in the
Securities and Exchange Commission's rules and forms, and that such information
27
is accumulated and is communicated to our management, including our Principal
Executive Officer and Principal Financial Officer, or persons performing similar
functions, as appropriate, to allow timely decisions regarding required
disclosure. Based on that evaluation, our management concluded that, as of
November 30, 2010, our disclosure controls and procedures were effective.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting
during the quarter ended November 30, 2010, that materially affected or are
reasonably likely to materially affect our internal control over financial
reporting.
28
PART II
Item 1. Legal Proceedings.
None.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
During the three months ended November 30, 2010, holders of convertible
promissory notes in the principal amount of $500,000 converted the notes into
312, 500 shares of the Company's common stock. The Company relied upon the
exemption provided by Section 3(a)(9) of the Securities Act of 1933 in
connection with the issuance of these shares.
Item 3. Default Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Securities Holders.
None.
Item 5. Other Information.
None.
Item 6. Exhibits
a. Exhibits
31.1 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 for Ed Holloway.
31.2 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of
2002 for Frank L. Jennings.
32 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of
2002 for Ed Holloway and Frank L. Jennings.
29
SIGNATURES
Pursuant to the requirements 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.
SYNERGY RESOURCES CORPORATION
Date: January 12, 2011
By: /s/ Ed Holloway
-----------------------------------
Ed Holloway, President and Principal
Executive Officer
Date: January 12, 2011
By: /s/ Frank L. Jennings
-----------------------------------
Frank L. Jennings, Principal Financial
and Accounting Officer