U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 2005
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______ to _______
Commission file number 0-25455
LEXINGTON RESOURCES, INC.
-----------------------------------------------------------------
(Exact name of small business issuer as specified in its charter)
NEVADA 88-0365453
- --------------------------------------------------------------------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation of organization) Identification No.)
7473 West Lake Mead Road
Las Vegas, Nevada 89128
(Address of Principal Executive Offices)
(702) 382-5139
(Issuer's telephone number)
n/a
(Former name, former address and former fiscal year,
if changed since last report)
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act 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 checkmark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
Applicable only to issuers involved in bankruptcy proceedings during the
preceding five years.
N/A
1
Check whether the Registrant filed all documents required to be filed by Section
12, 13 and 15(d) of the Exchange Act after the distribution of securities under
a plan confirmed by a court.
Yes [ ] No [ ]
Applicable only to corporate issuers
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date:
Class Outstanding as of November 14, 2005
- --------------------------------------------------------------------------------
Common Stock, $.00025 par value 17,603,405
Transitional Small Business Disclosure Format (check one)
Yes [ ] No [X]
2
Table of Contents for LEXINGTON RESOURCES, INC. Page
PART I. FINANCIAL INFORMATION
ITEM 1. INTERIM CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS ....................................... 4
INTERIM CONSOLIDATED STATEMENTS OF OPERATIONS ..................... 5
INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS...................... 6
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS ........... 7 - 25
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION OR PLAN OF OPERATION ................................. 26
ITEM 3. CONTROLS AND PROCEDURES ............................................ 38
PART II. OTHER INFORMATION ................................................. 39
ITEM 1. LEGAL PROCEEDINGS ................................................. 39
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS ......................... 39
ITEM 3. DEFAULTS UPON SENIOR SECURITIES ................................... 40
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ............... 40
ITEM 5. OTHER INFORMATION ................................................. 40
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K .................................. 40
SIGNATURES ................................................................. 41
3
PART 1. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
- -----------------------------
LEXINGTON RESOURCES, INC.
INTERIM CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2005
(Unaudited)
LEXINGTON RESOURCES, INC.
CONSOLIDATED BALANCE SHEETS
September 30, December 31,
2005 2004
- ------------------------------------------------------------ ------------ ------------
(unaudited)
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 1,011,538 $ 326,293
Accounts receivable 162,984 136,573
Prepaid expenses 12,000 --
Current portion of deferred finance fees and
discount on notes ( Note 7) 438,025 --
- ------------------------------------------------------------ ------------ ------------
1,624,547 462,866
- ------------------------------------------------------------ ------------ ------------
DEFERRED FINANCE FEE AND DISCOUNT ON NOTES (Note 7) 420,862 --
- ------------------------------------------------------------ ------------ ------------
PROPERTY AND EQUIPMENT (Note 4)
Oil and gas properties full cost method of accounting
Proved, net of accumulated depletion $405,969
(2004 - $161,328) 2,710,046 1,209,938
Unproved 2,348,949 1,419,447
- ------------------------------------------------------------ ------------ ------------
5,058,995 2,629,385
Other equipment, net of accumulated depreciation 2,499 2,997
- ------------------------------------------------------------ ------------ ------------
5,061,494 2,632,382
- ------------------------------------------------------------ ------------ ------------
$ 7,106,903 $ 3,095,248
============================================================ ============ ============
LIABILITIES AND STOCKHOLDER'S EQUITY
CURRENT LIABILITIES
Accounts payable and accrued liabilities $ 616,146 $ 228,819
Current portion of drilling obligations (Note 5) -- 617,000
Current portion of convertible notes (Note 7) 1,839,305 --
- ------------------------------------------------------------ ------------ ------------
2,455,451 845,819
CONVERTIBLE NOTES (Note 7) 1,215,443 --
DRILLING OBLIGATIONS (Note 5) -- 563,915
- ------------------------------------------------------------ ------------ ------------
3,670,894 1,409,734
- ------------------------------------------------------------ ------------ ------------
CONTINGENCIES AND COMMITMENTS (Notes 1, 4, 5, 7 & 10)
STOCKHOLDERS' EQUITY (Note 8)
Common stock $.00025 par value: 200,000,000 shares
authorized Preferred stock, $.001 par value:
75,000,000 shares authorized Issued and outstanding:
17,603,405 common shares (December 31, 2004 - 16,999,038) 4,550 4,250
Additional paid-in capital 14,887,912 8,947,604
Common stock purchase warrants 2,580,854 301,815
Accumulated deficit (14,037,307) (7,568,155)
- ------------------------------------------------------------ ------------ ------------
3,436,009 1,685,514
- ------------------------------------------------------------ ------------ ------------
$ 7,106,903 $ 3,095,248
============================================================ ============ ============
The accompanying notes are an integral part of these interim
consolidated financial statements.
4
LEXINGTON RESOURCES, INC.
INTERIM CONSOLIDATED STATEMENT OF OPERATIONS
(unaudited)
Three months Three months Nine months Nine months
Ended Ended Ended Ended
September 30, September 30, September 30, September 30,
2005 2004 2005 2004
------------ ------------ ------------ ------------
OIL AND GAS REVENUE $ 137,458 $ 211,549 $ 530,721 $ 305,756
------------ ------------ ------------ ------------
OPERATING EXPENSES
Depletion 104,761 105,628 244,641 112,186
Operating costs and taxes 58,612 14,458 180,073 21,641
------------ ------------ ------------ ------------
163,373 1120,086 424,714 133,827
------------ ------------ ------------ ------------
OPERATING PROFIT (LOSS) (25,915) 91,463 106,007 171,929
------------ ------------ ------------ ------------
OTHER EXPENSES
Consulting - stock based (Note 9) 1,138,238 -- 1,913,991 2,989,221
General and administrative 116,499 949,459 1,287,170 2,307,567
Interest and finance fees (Note 7) 3,365,248 23,924 3,373,998 50,309
------------ ------------ ------------ ------------
4,619,985 973,383 6,575,159 5,347,097
------------ ------------ ------------ ------------
NET LOSS FOR THE PERIOD (4,645,900) $ (881,920) $ (6,469,152) $ (5,175,168)
============ ============ ============ ============
BASIC NET LOSS PER SHARE $ (0.26) $ (0.06) $ (0.37) $ (0.35)
============ ============ ============ ============
WEIGHTED AVERAGE COMMON
OF SHARES OUTSTANDING 17,557,753 15,319,693 17,375,441 14,632,326
============ ============ ============ ============
The accompanying notes are an integral part of these interim
consolidated financial statements.
5
LEXINGTON RESOURCES, INC.
INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
For the Nine For the nine
month period month period
ended ended
September 30, September 30,
2005 2004
- ---------------------------------------------------- ----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss for the period $(6,469,152) $(5,175,168)
Adjustments to reconcile net loss to net cash
from operating activities:
Stock-based consulting fees 1,913,991 2,989,221
Non-cash compensation 153,708 19,167
Oil and gas depletion 244,641 112,186
Depreciation 498 332
Non-cash interest and finance costs 3,326,799 --
Changes in working capital assets and liabilities
Prepaid expenses (12,000) (6,550)
Accounts receivable (26,411) (185,500)
Accounts payable (195,226) 777,745
Accrued interest payable 16,140 24,453
Accrued and unpaid fees payable -- 30,000
- ---------------------------------------------------- ----------- -----------
NET CASH FLOWS USED IN OPERATING ACTIVITIES (1,047,012) (1,414,114)
- ---------------------------------------------------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of equipment -- (3,495)
Oil and gas properties (2,245,408) (2,247,539)
- ---------------------------------------------------- ----------- -----------
NET CASH FLOWS USED IN INVESTING ACTIVITIES (2,245,408) (2,251,034)
- ---------------------------------------------------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Drilling obligation (repayments) advances (1,180,915) 737,984
Advances payable -- 279,306
Convertible notes, net (Note 7) 4,645,950 500,000
Net proceeds on sale of common stock 512,630 3,281,075
- ---------------------------------------------------- ----------- -----------
NET CASH FLOWS FROM FINANCING ACTIVITIES 3,977,665 4,798,365
- ---------------------------------------------------- ----------- -----------
INCREASE (DECREASE) IN CASH 685,245 1,133,217
CASH, BEGINNING OF PERIOD 326,293 351,420
- ---------------------------------------------------- ----------- -----------
CASH, END OF PERIOD $ 1,011,538 $ 1,484,637
==================================================== =========== ===========
SUPPLEMENTAL CASH FLOW INFORMATION (Refer to Note 12)
The accompanying notes are an integral part of these interim
consolidated financial statements.
6
LEXINGTON RESOURCES, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2005
(unaudited)
- --------------------------------------------------------------------------------
NOTE 1: NATURE OF CONTINUED OPERATIONS AND BASIS OF PRESENTATION
- --------------------------------------------------------------------------------
By Share Exchange Agreement dated November 19, 2003, Lexington Resources, Inc.
("LRI" or "the Company"), a Nevada corporation, acquired 100% of the issued and
outstanding shares of Lexington Oil & Gas Ltd. Co. (an exploration stage
company) ("Lexington"), in exchange for 9,000,000 (3,000,000 pre January 26,
2004 3:1 forward split) restricted shares of common stock of the Company
representing 85% of the total issued and outstanding shares of the Company at
the time. In connection with this transaction, the Company changed its name to
Lexington Resources, Inc. (Refer to Note 3.)
This acquisition has been accounted for as a reverse acquisition with Lexington
being treated as the accounting parent and LRI, the legal parent, being treated
as the accounting subsidiary. Accordingly, the consolidated results of
operations of the Company include those of Lexington for the period from its
inception on September 29, 2003 and those of LRI since the date of the reverse
acquisition.
Lexington is an Oklahoma Limited Liability Corporation incorporated on September
29, 2003 formed for the purposes of the acquisition and development of oil and
natural gas properties in the United States, concentrating on unconventional gas
production initiatives that include coal bed methane gas acquisitions and
developments in the Arkoma Basin in the State of Oklahoma as well as Barnett
Shale targeted acquisitions and developments in the Dallas Fort Worth Basin in
the State of Texas. As planned principal operations commenced in 2004, the
Company is no longer considered to be an exploration stage company.
Going Concern
The consolidated financial statements have been prepared on the basis of a going
concern which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business. The Company has a working capital
deficiency of $830,904 at September 30, 2005, has incurred losses since
inception of $14,037,307 and further losses are anticipated in the development
of its oil and gas properties raising substantial doubt as to the Company's
ability to continue as a going concern. The ability of the Company to continue
as a going concern is dependent on raising additional capital to fund ongoing
research and development and ultimately on generating future profitable
operations. The Company currently has unfunded property acquisition obligations
as disclosed in Note 4. The Company will continue to fund operations with
advances and debt instruments, as well as further equity placements.
Unaudited Interim Financial Statements
The accompanying unaudited interim consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-QSB of Regulation
S-B. They do not include all information and footnotes required by United States
generally accepted accounting principles for complete financial statements.
However, except as disclosed herein, there have been no material changes in the
information disclosed in the notes to the financial statements for the year
ended December 31, 2004 included in the Company's Annual Report on Forms 10-KSB
and 10-KSB/A filed with the Securities and Exchange Commission. The interim
unaudited consolidated financial statements should be read in conjunction with
those financial statements included in the Form 10-KSB and 10-KSB/A. In the
7
NOTE 1: NATURE OF CONTINUED OPERATIONS AND BASIS OF PRESENTATION - continued
- --------------------------------------------------------------------------------
opinion of Management, all adjustments considered necessary for a fair
presentation, consisting solely of normal recurring adjustments, have been made.
Operating results for the nine months ended September 30, 2005 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2005.
NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
- --------------------------------------------------------------------------------
(a) Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiary, Lexington. Lexington was acquired by reverse
acquisition on November 19, 2003. All significant inter-company transactions and
account balances have been eliminated upon consolidation.
(b) Oil and Gas Properties
The Company follows the full cost method of accounting for its oil and gas
operations whereby all costs related to the acquisition of methane, petroleum,
and natural gas interests are capitalized. Under this method, all productive and
nonproductive costs incurred in connection with the exploration for and
development of oil and gas reserves are capitalized. Such costs include land and
lease acquisition costs, annual carrying charges of non-producing properties,
geological and geophysical costs, costs of drilling and equipping productive and
non-productive wells, and direct exploration salaries and related benefits.
Proceeds from the disposal of oil and gas properties are recorded as a reduction
of the related capitalized costs without recognition of a gain or loss unless
the disposal would result in a change of 20 percent or more in the depletion
rate. The Company currently operates solely in the U.S.A.
Depletion of proved oil and gas properties is computed on the
units-of-production method based upon estimates of proved reserves, as
determined by independent consultants, with oil and gas being converted to a
common unit of measure based on their relative energy content.
The costs of acquisition and exploration of unproved oil and gas properties,
including any related capitalized interest expense, are not subject to
depletion, but are assessed for impairment either individually or on an
aggregated basis. The costs of certain unevaluated leasehold acreage are also
not subject to depletion. Costs not subject to depletion are periodically
assessed for possible impairment or reductions in value. If a reduction in value
has occurred, costs subject to depletion are increased or a charge is made
against earnings for those operations where a reserve base is not yet
established.
Estimated future removal and site restoration costs are provided over the life
of proven reserves on a units-of-production basis. Costs, which include
production equipment removal and environmental remediation, are estimated each
period by management based on current regulations, actual expenses incurred, and
technology and industry standards. The charge is included in the provision for
depletion and depreciation and the actual restoration expenditures are charged
to the accumulated provision amounts as incurred.
The Company applies a ceiling test to capitalized costs which limits such costs
to the aggregate of the estimated present value, using a ten percent discount
rate of the estimated future net revenues from production of proven reserves at
year end at market prices less future production, administrative, financing,
8
NOTE 1: NATURE OF CONTINUED OPERATIONS AND BASIS OF PRESENTATION - continued
- --------------------------------------------------------------------------------
site restoration, and income tax costs plus the lower of cost or estimated
market value of unproved properties. If capitalized costs are determined to
exceed estimated future net revenues, a write-down of carrying value is charged
to depletion in the period.
(c) Asset Retirement Obligations
The Company has adopted the provisions of SFAS No. 143, "Accounting for Asset
Retirement Obligations." SFAS No. 143 requires the fair value of a liability for
an asset retirement obligation to be recognized in the period in which it is
incurred if a reasonable estimate of fair value can be made. The associated
asset retirement costs are capitalized as part of the carrying amount of the
related oil and gas properties. As of September 30, 2005 management has
determined that there are no material asset retirement obligations.
(d) Earnings (loss) Per Share
Basic earnings (loss) per share is computed by dividing earnings (loss) for the
period by the weighted average number of common shares outstanding for the
period. Diluted earnings (loss) per share reflects the potential dilution of
securities by including other potential common stock, including convertible
preferred shares, in the weighted average number of common shares outstanding
for a period and is not presented where the effect is anti-dilutive. The
presentation is only of basic earnings (loss) per share as the effect of
potential dilution of securities has no impact on the current period's basic
earnings (loss) per share. Loss per share, as presented, has been restated to
reflect the forward stock split described in Note 7. The weighted average number
of shares outstanding prior to the reverse acquisition is deemed to be the
number of shares issued in connection with the reverse acquisition being
9,000,000 shares (3,000,000 pre January 26, 2004 3:1 forward split).
(e) Revenue Recognition
Oil and natural gas revenues are recorded using the sales method, whereby the
Company recognizes oil and natural gas revenue based on the amount of oil and
gas sold to purchasers, when title passes, the amount is determinable and
collection is reasonably assured.
(f) Financial Instruments
The fair values of cash, accounts receivable, accounts payable, accrued
liabilities, drilling obligations and advances due to related parties were
estimated to approximate their carrying values due to the immediate or
short-term maturity of these financial instruments. The Company's current and
planned operations are located in the States of Oklahoma and Texas, in the
United States, and as a result the Company is not subject to significant
exposure to market risks from changes in foreign currency rates.
The Company's financial instruments that are exposed to concentrations of credit
risk consist primarily of cash and accounts receivable. The Company's cash is
held at a major U.S. based financial institution. The Company manages and
controls market and credit risk through established formal internal control
procedures, which are reviewed on an ongoing basis.
The Company sells its gas to only two customers as there is currently
insufficient production for multiple purchasers. The Company manages and
controls this situation by ensuring it only deals with gas purchasers that are
reputable and are well established.
9
NOTE 1: NATURE OF CONTINUED OPERATIONS AND BASIS OF PRESENTATION - continued
- --------------------------------------------------------------------------------
(g) Concentration of Credit Risk
Substantially all of the Company's sales are to two parties. Consequently the
Company is exposed to a concentration of credit risk.
(h) Use of Estimates
The preparation of these consolidated financial statements requires the use of
certain estimates by management in determining the Company's assets,
liabilities, revenues and expenses. Actual results could differ from such
estimates. Depreciation, depletion and amortization of oil and gas properties
and the impairment of oil and gas properties are determined using estimates of
oil and gas reserves. There are numerous uncertainties in estimating the
quantity of reserves and in projecting the future rates of production and timing
of development expenditures, including future costs to dismantle, dispose, plug,
and restore the Company's properties. Oil and gas reserve engineering must be
recognized as a subjective process of estimating underground accumulations of
oil and gas that cannot be measured in an exact way. Proved reserves of oil and
natural gas are estimated quantities that geological and engineering data
demonstrate with reasonable certainty to be recoverable in the future from known
reservoirs under existing conditions.
(i) Stock-Based Compensation
In December 2002, the Financial Accounting Standards Board ("FASB") issued
Financial Accounting Standard No. 148, "Accounting for Stock-Based Compensation
- - Transition and Disclosure" ("SFAS No. 148"), an amendment of Financial
Accounting Standard No. 123 "Accounting for Stock-Based Compensation" ("SFAS No.
123"). The purpose of SFAS No. 148 is to: (1) provide alternative methods of
transition for an entity that voluntarily changes to the fair value based method
of accounting for stock-based employee compensation, (2) amend the disclosure
provisions to require prominent disclosure about the effects on reported net
income of an entity's accounting policy decisions with respect to stock-based
employee compensation, and (3) to require disclosure of those effects in interim
financial information. The disclosure provisions of SFAS No. 148 were effective
for the Company for the period ended December 31, 2003.
The Company has elected to continue to account for stock-based employee
compensation arrangements in accordance with the provisions of Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees",
("APB No. 25") and comply with the disclosure provisions of SFAS No. 123 as
amended by SFAS No. 148 as described above. In addition, in accordance with SFAS
No. 123 the Company applies the fair value method using the Black-Scholes
option-pricing model in accounting for options granted to consultants. Under APB
No. 25, compensation expense is recognized based on the difference, if any, on
the date of grant between the estimated fair value of the Company's stock and
the amount an employee must pay to acquire the stock. Compensation expense is
recognized immediately for past services and pro-rata for future services over
the option-vesting period.
(i) Stock-Based Compensation - continued
The following table illustrates the pro forma effect on net income and net
earnings per share as if the Company had accounted for its stock-based employee
compensation using the fair value provisions of SFAS No. 123 using the
assumptions as described in Note 4:
10
NOTE 1: NATURE OF CONTINUED OPERATIONS AND BASIS OF PRESENTATION - continued
- --------------------------------------------------------------------------------
Nine months ended Nine months ended
September 30, 2005 September 30, 2004
------------------ ------------------
Net loss for the period As reported $ (6,469,152) $ (5,175,168)
SFAS 123 compensation expense Pro-forma (841,307) (692,051)
------------------ ------------------
Net loss for the period Pro-forma $ (7,310,459) $ (5,867,219)
================== ==================
Pro-forma basic net loss per share Pro-forma $ (0.42) $ (0.40)
================== ==================
The Company accounts for equity instruments issued in exchange for the receipt
of goods or services from other than employees in accordance with SFAS No. 123
and the conclusions reached by the Emerging Issues Task Force in Issue No.
96-18. Costs are measured at the estimated fair market value of the
consideration received or the estimated fair value of the equity instruments
issued, whichever is more reliably measurable. The value of equity instruments
issued for consideration other than employee services is determined on the
earliest of a performance commitment or completion of performance by the
provider of goods or services as defined by EITF 96-18.
The Company has also adopted the provisions of the FASB Interpretation No.44,
Accounting for Certain Transactions Involving Stock Compensation - An
Interpretation of APB Opinion No. 25 ("FIN 44"), which provides guidance as to
certain applications of APB 25.
(j) Income taxes
The Company follows the liability method of accounting for income taxes. Under
this method, deferred tax assets and liabilities 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
balances. Deferred tax assets and liabilities are measured using enacted or
substantially enacted tax rates expected to apply to the taxable income in the
years in which those differences are expected to be recovered or settled. The
effect on deferred tax assets and liabilities of a change in tax rates is
recognized in income in the period that includes the date of enactment or
substantial enactment. A valuation allowance is provided for deferred tax assets
if it is more likely than not that the Company will not realize the future
benefit, or if future deductibility is uncertain.
(k) Cash and cash equivalents
The Company considers all highly liquid instruments with an original maturity of
three months or less at the time of issuance to be cash equivalents.
11
NOTE 3 - ACQUISITION OF LEXINGTON OIL & GAS LTD. CO. LLC ("Lexington")
- --------------------------------------------------------------------------------
By Share Exchange Agreement dated November 19, 2003, the Company acquired 100%
of the issued and outstanding shares of Lexington (an exploration stage
company), in exchange for 9,000,000 (3,000,000 pre January 26, 2004 3:1 forward
split) restricted shares of common stock of the Company. As a result of this
transaction the former stockholders of Lexington acquired approximately 85% of
the total issued and outstanding shares of the Company as at November 19, 2003,
resulting in a change in control of the Company.
During January, 2004, the parties to the Share Exchange Agreement, Orient
Exploration Ltd. ("Orient"), Douglas Humphreys ("Humphreys"), the Company,
Lexington, and Paluca Petroleum Inc. ("Paluca") re-evaluated the terms of the
original Share Exchange Agreement and upon further negotiations desired to
modify the terms of the original agreement in the best interest of all parties
such that: (i) 2,250,000 post forward split shares of restricted Common Stock of
the Company held of record by Humphreys were transferred to Orient in
consideration therefore; (ii) the Company assigned to Humphreys a 5% carried
working interest in every well drilled by the Company on the Wagnon Property;
(iii) the Company agreed to allow Humphreys to participate up to an additional
5% working interest in every well drilled by the Company on the Wagnon Property;
(iv) the Company agreed to transfer to Paluca certain assets previously acquired
by the Company (which included working interests and net revenue interests in
certain oil and gas leases located on the Doc Cole Property, the Atwood Booch
Sand Property, the Jeneva Property and the Sasakwa Gilcrease Sand Property).
Management of the Company decided not to proceed with the acquisition or
development of the described properties as set out in item (iv) due to
management's analysis that the properties did not contain the appropriate oil
and gas development elements that form part of the Company's current focus and
criteria for corporate oil and gas development initiatives.
This acquisition has been accounted for as a recapitalization using accounting
principles applicable to reverse acquisitions with Lexington being treated as
the accounting parent (acquirer) and Lexington Resources, Inc. being treated as
the accounting subsidiary (acquiree). The value assigned to the capital stock of
consolidated Lexington Resources, Inc. on acquisition of Lexington is equal to
the book value of the capital stock of Lexington plus the book value of the net
assets (liabilities) of Lexington Resources, Inc. as at the date of the
acquisition.
The book value of Lexington's capital stock subsequent to the reverse
acquisition is calculated and allocated as follows:
Lexington capital stock $ 300
Lexington Resources, Inc. net assets (liabilities) (1,430,969)
-----------
(1,430,669)
Charge to deficit on reverse acquisition 1,433,317
-----------
Consolidated stock accounts post reverse acquisition $ 2,648
===========
These consolidated financial statements include the results of operations of
subsidiary Lexington since September 29, 2003 (inception) and the results of
operations of parent Lexington Resources, Inc. since the date of the reverse
acquisition effective November 19, 2003. The Company's consolidated results of
operations for the period from January 1, 2003 to September 30, 2003 have been
reported in the Company's September 30, 2003 filing on Form 10-QSB.
12
NOTE 3 - ACQUISITION OF LEXINGTON OIL & GAS LTD. CO. LLC ("Lexington") - cont'd
- --------------------------------------------------------------------------------
In order to reflect the revised operating arrangement resulting from
modifications to the original terms of the Share Exchange Agreement, the
Humphreys Purchase and Sale Agreement and the Paluca Agreement both outlined in
the following sections were simultaneously executed.
Humphreys Purchase and Sale Agreement
On January 21, 2004, Orient and Humphreys, a director of the Company, entered
into a purchase and sale agreement (the "Humphreys Purchase and Sale
Agreement"). Pursuant to the terms and provisions of the Humphreys Purchase and
Sale Agreement: Humphreys agreed to transfer 2,250,000 shares of restricted
Common Stock of the Company held of record by Humphreys to Orient.
Paluca Agreement
On January 21, 2004, the Company, Lexington, Paluca, and Humphreys entered into
an agreement whereby: (i) the Company assigned to Humphreys a 5% carried working
interest in every well drilled by the Company on the Wagnon Property; (ii) the
Company agreed to allow Humphreys to participate up to an additional 5% working
interest in every well drilled by the Company on the Wagnon Property; (iii)
Humphreys agreed to waive any and all other claims, debts or obligations owed to
Humphreys by the Company or by Lexington, and (iv) the Company agreed to
transfer to Paluca certain assets previously acquired by the Company (which
included working interests and net revenue interests in certain oil and gas
leases located on the Doc Cole Property, the Atwood Booch Sand Property, the
Jeneva Property and the Sasakwa Gilcrease Sand Property).
Management Compensation Agreement
The Company and Lexington have negotiated a new compensation agreement ("New
Agreement") with Humphreys for his assistance in overseeing the drilling
operations and the completion, management of wells, and for his increasing role
in development of the Company on a performance basis. Under the covenants
provided under the New Agreement and within its effective term, Humphreys, or
his designate: (1) will receive compensation of $7,500 per month, effective
April 1, 2004; (2) will be assigned up to a 10% carried working interest of
Lexington's total interest in every well drilled by the Company on all
properties held by the Company, (3) will have the right to purchase up to an
additional 5% working interest of Lexington's total interest in all wells
drilled by the Company on its properties provided that funds for this
participation are paid prior to the commencement of drilling of said wells; and
(4) will receive a further 200,000 options in the Company to be granted at $3.00
per share exercisable for a five year term. These options were granted in July
2004. (Refer to Note 8.)
During the nine month period ended September 30, 2005 the Company recorded
additional compensation expense to Humphreys of $153,708 (September, 2004 -
$NIL) being the estimated value of his 10% carried interest in the Company's
well interests that were successfully developed in the period ended September
30, 2005. (Refer to Note 4.)
Humphreys is a director of the Company and is the Drilling Operations Manager of
Lexington, and also a director, General Manager, and 25% shareholder in Oak
Hills Drilling and Operating, LLC ("Oak Hills"), an oil and gas drilling and
well operating company based in Holdenville, Oklahoma that acts as designated
"operator" to Lexington since January 1, 2005. Humphreys is in charge of oil and
gas operations for Lexington in the United States. (Refer to Note 10.) The
previous operator in charge of drilling and operating of wells for Lexington was
Oakhills Energy, Inc.
13
NOTE 3 - ACQUISITION OF LEXINGTON OIL & GAS LTD. CO. LLC ("Lexington") - cont'd
- --------------------------------------------------------------------------------
Paluca Petroleum Inc. is a private Oklahoma based oil and gas services company
owned by Humphreys and his immediate family. Some of the services provided by
Humphreys to the Company are provided through this business entity. Mr.
Humphreys is also the President of Paluca.
NOTE 4 - PROPERTY AND EQUIPMENT
- --------------------------------------------------------------------------------
Property and equipment include the following:
September 30, December 31,
2005 2004
---------- ----------
Oil and gas properties: $ $
Proved, subject to depletion 3,116,015 1,371,266
Unproved, not subject to depletion 2,348,949 1,419,447
Accumulated depletion (405,969) (161,328)
---------- ----------
Net oil and gas properties 5,058,995 2,629,385
---------- ----------
Other equipment 3,495 3,495
Accumulated depreciation (996) (498)
---------- ----------
Net other property and equipment 2,499 2,997
---------- ----------
Property and equipment, net of accumulated
depreciation and depletion 5,061,494 2,632,382
========== ==========
The Company's oil and gas activities are currently conducted in the United
States. During the current period the Company incurred development costs of
$1,832,096 on its properties inclusive of carrying costs to Humphreys of
$153,708.
Wagnon Lease
By agreement dated October 9, 2003, Lexington acquired an interest in a section
of farm-out acreage with the intention to develop coal bed methane gas producing
wells in Pittsburg County, Oklahoma. Lexington holds an 80% working interest and
a 60.56% net revenue interest in approximately 590 gross acreage of a potential
gas producing property located in Pittsburg County, Oklahoma (the "Wagnon
Property"). The Company's interest relating to the Wagnon Property is subject to
farm-out agreements equating to a total 20% working interest between Paluca,
Oakhills Energy, Inc. and the lessee of the Wagnon Property. Drilling targets
are Hartshorne Coal bed methane gas zones.
A director and an officer of the Company were minority owners in Oakhills
Energy, Inc. in 2003. Their interest in Oakhills Energy, Inc. was purchased by
the majority shareholder on January 26, 2004.
During the year ended December 31, 2004, three horizontal gas wells (the
Kellster 1-5, Kyndal 2-2 and Bryce 3-2) have been put into production.
On March 15, 2005 the Company began drilling a fourth horizontal gas well on the
Wagnon Property (Calleigh 4-2). The well began producing on April 2, 2005.
During the period ended September 30, 2005 the Company has incurred $552,898 on
14
NOTE 4 - PROPERTY AND EQUIPMENT - continued
- --------------------------------------------------------------------------------
drilling expenditures relating to a total of four producing gas wells on the
Wagnon lease. (Refer to Note 5.)
Coal Creek Prospect
In March 2004 the Lexington obtained an option to purchase an undivided 95%
interest in approximately 2,500 net leasehold acres in 5 sections of the Coal
Creek Prospect located in Hughes and Pittsburg Counties, in the State of
Oklahoma. During the year ended December 31, 2004 the Company acquired 1,932 net
leasehold acres under the option. Lexington does not expect to acquire any
additional acreage under this option. Under the terms of the purchase of these
leases, Lexington has an undivided 95% working interest in the subject lands and
a minimum 78% net revenue interest. The terms of the leases are for two years.
Drilling targets are Hartshorne Coal bed methane gas zones.
On March 31, 2005 Lexington began drilling its first horizontal coal bed methane
gas well on the Coal Creek Prospect (Lex 1-34). The well began production in
April 2005. Lexington has approximately a 50% working interest in the well and
has accrued $496,526 in costs associated with the well for the period.
On April 14, 2005 Lexington began drilling its second horizontal coal bed
methane gas well on its Coal Creek Prospect (Braumbaugh 1-10). Lexington has
approximately a 22% working interest in the well and has accrued $142,471 in
costs associated with the well for the period. The well began production in May
2005.
On May 31, 2005 Lexington began drilling its third horizontal coal bed methane
gas well on its Coal Creek Prospect (Ellis 1-15). Lexington has approximately an
88% working interest in the well and has incurred $593,588 in costs associated
with the well for the period. The well is currently in drilling and development
stages.
In June through August 2005, the Company received loans totaling $1,165,000
which have been secured against the Coal Creek property. (Refer to Note 6.)
Those loans were paid in full on September 19, 2005.
Panther Creek Prospect
In March 2004 Lexington purchased a 3 year lease of approximately 300 acres
located in five separate sections to develop the Panther Creek Project in Hughes
County, Oklahoma. Lexington has an undivided 100% working interest in subject
lands and an approximate 81% net revenue interest. Part of the acreage in this
lease has been subject to three division pooling orders by Newfield Exploration
Mid-Continent, Inc. ("Newfield"), for three wells to be drilled and operated by
Newfield in which Lexington has elected to participate. Lexington's working
interests in the three wells to be drilled are proportionate to Lexington's
Panther Creek lease ownership in areas pooled by Newfield. Lexington working
interests in the three wells are estimated to be as follows; 25.78% (contingent
liability of $419,801 for a completed well based on Newfield Authority For
Expenditure "AFE), 10.94% (contingent liability of $159,655 for a completed well
based on Newfield AFE if drilled), and 4.06% (contingent liability of $58,521
for a completed well based on Newfield AFE if drilled). Newfield has up to
approximately the end of 2005 to drill the remaining two wells and may or may
not proceed with any individual well project at their election. Contingent
liability exists to Lexington for any well drilled by Newfield that Lexington
has elected to participate.
Newfield has proceeded with the drilling and completion of one of the wells in
which Lexington has leased acreage. The first of the three vertical wells
15
NOTE 4 - PROPERTY AND EQUIPMENT - continued
- --------------------------------------------------------------------------------
targeting a Woodford Shale gas zone, the POE 1-29, commenced drilling on
February 9, 2005 and began producing on March 21, 2005. Lexington has incurred
$485,071 for drilling and completion costs relating to the POE 1-29 as of
September 30, 2005.
South Lamar Prospect
By agreement dated April 21, 2004, Lexington acquired a 100% working interest,
78.5% net revenue interest, in three sections (960 acres) of farm-out acreage in
Hughes County, Oklahoma (the "South Lamar Prospect") with the intention to
develop coal bed methane gas producing wells and Caney Shale wells. The term of
the lease is two years. On July 26, 2004, Lexington acquired a further 183.98
acres in the South Lamar prospect and a 100% working interest and a 79% net
revenue interest in the additional acreage. The term of the lease is two years.
Lexington has begun site preparation on the first well (Goodson 1-23) to be
drilled on the property; but has since abandoned plans to drill this well.
H-9 Prospect
By agreement dated June 29, 2004, Lexington has obtained an option to purchase
an undivided 100% leasehold interest, 79.25% net revenue interest, in
approximately 4,600 net leasehold acres in approximately 38 sections of the H-9
Prospect located in Hughes and McIntosh Counties, in the State of Oklahoma.
Lexington concluded the purchase of the property on July 29, 2004. The terms of
leases acquired within the prospect are between three and four years.
On July 19, 2004 Lexington acquired an additional 325 acres of gas target
drillable acreage in the northeast portion of Hughes County, Oklahoma in the
vicinity of the approximate 4,600 acres of farm out leases under acquisition
(H-9) Prospect. Drilling targets that are included in the lease include
Hartshorne and Booch Coal gas zones with a 100% Working Interest and a 78.3% Net
Revenue Interest. The acquired lease is held by production. The term of the
lease is three years.
Middle Creek Prospect
By agreement dated October 28, 2004, Lexington has purchased an undivided 100%
leasehold interest, 70% net revenue interest, in 320 net leasehold acres in two
sections of the Middle Creek Prospect located in Hughes County, in the State of
Oklahoma. Drilling targets are the Caney Shale and Hartshorne coal bed methane
zones. The leasehold interest acquired is held by production.
Barnett Pathway Prospect On June 2, 2005 (amended on July 14, 2005) the Company
entered into an agreement whereby it has the option to purchase up to a 100 %
working interest in net revenue interests ranging between 70% and 75% in up to
3,687 acres of Barnett Shale gas targeted properties located in Jack and Palo
Pinto Counties in the State of Texas for between $450 and $500 per acre together
with a 30 month best efforts drilling commitment. On June 8, 2004 the Company
provided the seller a $100,000 non-refundable deposit. The first acquisition was
concluded on August 19, 2005 with the Company acquiring 2,325 acres.
16
NOTE 5: DRILLING OBLIGATIONS
- --------------------------------------------------------------------------------
During the period ended December 31, 2003 Lexington, the Company, and Oakhills
Energy, Inc. entered into drilling agreements with private investors (the
"Funding Investors") for the funding for the first three wells, the Kellster
1-5, the Kyndal 2-2 and the Bryce 3-2, located on the Wagnon Lease. The Funding
Investors subsequently each provided one-third of the Authorization For
Expenditure ("AFE") capital estimated at $360,000 for the drilling and
completion of each of the first three wells. As of June 30, 2005 a total of four
such drilling agreements with private investors had been entered into between
Funding Investors, the Company, and Lexington. The Company had received the
total required funding of $1,485,000 ( 2004 - $720,000) for the drilling and
completion of the four horizontal coal bed methane Wagnon Lease wells and has
successfully drilled and completed the Kellster 1-5, the Kyndal 2-2, the Bryce
3-2 and the Calleigh 4-2 wells. The terms of the drilling agreements of all
wells on the Wagnon Lease are the same for each well on the property. The
Calleigh 4-2 began production in April, 2005.
Wells to be drilled on the Wagnon Lease property carry royalty interests
totaling 25% to land owners and property interest holders and carried working
interests of 5% to a land owner, and 10% to a company related to a director of
the Company, Paluca Petroleum, Inc. (see Note 3 - Management Compensation
Agreement). Paluca Petroleum, Inc. also owns a non-carried working interest of
5% as part of capital participation funding provided by Paluca.
NOTE 5: DRILLING OBLIGATIONS
- --------------------------------------------------------------------------------
The Funding Investors are provided an 80% working interest, 60.56% net revenue
interest, in the wells until their invested capital for each well is repaid,
after which time the Funding Investors revert to an aggregate 20.1% working
interest, 15.075% net revenue interest, in the wells located on the Wagnon
Lease. Oakhills Energy, Inc., the previous operator responsible for drilling the
wells, will "back-in" to a reversionary 6.7% working interest after invested
capital is repaid to the Funding Investors in the wells located on the Wagnon
Lease and Lexington will back-in to a reversionary 53.2% working interest.
As of September 30, 2005, the Funding Investors have been fully repaid their
cumulative capital investment of $1,485,000 for the drilling of the Kellster
1-5, Kyndal 2-2, Bryce 3-2 and Calleigh 4-2 wells from February, 2004 to April,
2005. As a result, the Company's back-in working interest of 53.2% has vested in
the four wells.
NOTE 6: PROMISSORY NOTES
- --------------------------------------------------------------------------------
In June 2005 the Company obtained loans by way of promissory notes from two
shareholders of the Company totaling $1,100,000 ($600,000 and $500,000). During
the period an additional $65,000 had been advanced to the Company by one of the
shareholders. The terms of the loans were 5 years from the dates of issue with
an interest rate of 10%. Payments of blended principal and interest were payable
monthly over a 60 month amortization. In conjunction with the promissory note
advances, 233,000 warrants, valued at $271,028 (refer to Note 8), were issued
exercisable at $3.00 per share with exercise terms until May 31, 2010. The fair
value of the warrants has been credited to equity. A discount on the debt of
$271,028 was also recorded, to be accreted over the term of the debt. The
promissory notes were repayable at anytime without penalty, and were secured
against the Company's Coal Creek oil and gas property leases. As of September
30, 2005 the original loan principal of $1,165,000 was repaid as well as all
accrued interest of $31,058. The unamortized debt discount on settlement has
been included in interest and finance fees.
17
NOTE 7: CONVERTIBLE NOTES
- --------------------------------------------------------------------------------
On September 16, 2005 the Company issued secured and Convertible Notes and
certain warrants pursuant to a private placement with certain accredited
investors, in reliance on Rule 506 promulgated under Section 4(2) of the
Securities Act, for gross proceeds of $5,260,000. Introduction and legal fees
associated with this financing were $614,050. Accordingly, the Company issued:
(i) An aggregate of $5,260,000 in secured, convertible two-year promissory
notes bearing 8% interest. The promissory notes are immediately convertible
into 5,260,000 shares of common stock on the basis of one share of common
stock for every $1 in value of notes;
(ii) For every two shares of its common stock purchasable in accordance with the
conversion provisions of the Convertible Notes, one Class A Warrant, for an
aggregate of 2,630,000 Class A Warrants, to purchase a share of its common
stock at an exercise price of $1.50 per share for a three-year term after
this registration statement has been declared effective by the SEC;
(iii)For every two shares of its common stock purchasable in accordance with
the conversion provisions of the Convertible Notes, one Class B Warrant,
for an aggregate of 2,630,000 Class B Warrants, to purchase an additional
share of our common stock at an exercise price of $1.25 per share for a
one-year term after this registration statement has been declared effective
by the SEC; and
(iv) 526,000 Finder's Warrants to purchase shares of the Company's common stock
at an exercise price of $1.00 per share for a term of three years after
this registration statement has been declared effective by the SEC.
The security granted is by a general security interest in all of the Company's
property.
Subsequent to the period ended September 30, 2005, on October 11, 2005, the
Company received an additional $600,000 in Convertible Note and warrant
financing under identical terms and conditions as mentioned above, bringing the
Company's total Convertible Note debt financing to $5,860,000. (See Note 13.)
In accordance with EITF 00-27 "Application of Issue No. 98-5 to Certain
Convertible Instruments" and EITF 98-5 "Accounting for Convertible Securities
with Beneficial Conversion Features or Contingently Adjustable Conversion
Ratios" the proceeds of the issuance have been allocated among the convertible
debt and the warrants issued based upon their relative fair values. The fair
value of the 5,786,000 warrants issued as of September 30, 2005 was determined
to be $5,727,450 by using the Black-Scholes option pricing model assuming an
expected life of 1 - 3 years, a risk-free interest rate of 3.85% - 3.96%, an
expected volatility of 140.8%, and a dividend yield of 0%. The fair value of the
convertible debt has been determined to be $7,574,400, based upon 5,260,000
shares of common stock at a market value of $1.44 per share. As a result: (a)
the intrinsic value of the beneficial conversion feature has been determined to
be $2,995,174 and has been charged to interest expense and recorded as
additional paid in capital; (b) the pro-rata fair value of the warrants has been
determined to be $2,264,826 and has been recorded as equity. The Company will
record further interest expense over the term of the Convertible Notes of
$2,264,826 resulting from the difference between the stated value and carrying
value at the date of issuance. The carrying value of the Convertible Notes will
be accreted to the face value of $5,260,000 to maturity. To September 30, 2005,
accrued interest of $16,140 has been included in convertible notes, and interest
expense of $43,435 has been accreted, thereby increasing the carrying value of
the Convertible Notes to $3,054,748.
18
NOTE 7: CONVERTIBLE NOTES - continued
- --------------------------------------------------------------------------------
Repayment of Promissory Notes and Accrued Interest
The Company is committed to repay convertible debenture holders outstanding
amounts of principal and interest accrued at 8% per annum on an aggregate face
value of $5,860,000 in Convertible Notes. 20 monthly principal and interest
payments are payable in either cash or shares of the Company's common stock at
the rate of $1.00 per share (the "Fixed Conversion Price") beginning on January
16, 2005 if the Company's share price is trading above $1.00 per share at the
date of payment. Commencing on the 4th month anniversary of the closing date of
the issue of the Convertible Notes (January 16, 2005), and on the first day of
each month thereafter, the Convertible Notes must be repaid in cash or shares in
the amount equal to 5% of the principal amount of the Notes together with all
accrued interest due and payable up to the repayment date. If the Company's
shares are trading at less than $1.00 per share at the date of repayment, then
the Company may repay monthly principal and interest due in either cash or
shares in the capital of the Company at a different rate than the Fixed
Conversion Price. If the volume weighted average share price (the "VWAP") of the
five trading days prior to a monthly payment date is less than the Fixed
Conversion Price, then the Company may pay the monthly amount in cash or
registered shares of our common stock at 75% of the VWAP for the five trading
days prior to the monthly payment date. The holders of the Convertible Notes
have a secured first interest in the assets of the Company.
Debt Repayment
The aggregate amount of principal and interest payments required in each of the
next two years to meet debt retirement provisions is as follows (includes debt
financing subsequent to the period ending September 30, 2005):
Year Principal Interest Total
---- --------- --------- ---------
$ $ $
2006 3,516,000 456,598 3,972,598
2007 2,344,000 70,127 2,414,127
--------- --------- ---------
5,860,000 526,725 6,386,725
========= ========= =========
================================================================================
Deferred Finance Fees and Discount on Notes
Deferred finance fees associated with this financing are comprised of:
(a) introduction and legal fees of $614,050; and
(b) $262,000 being the value of 200,000 shares issued to settle with a
former financier (Refer to Note 8). During the nine month period ended September
30, 2005, $17,163 of the deferred finance fees have been charged to interest
expense and the balance of $858,887 will be expensed over the remaining term of
the convertible debt.
NOTE 8: STOCKHOLDERS' EQUITY
- --------------------------------------------------------------------------------
The authorized capital of the Company consists of 200,000,000 voting common
shares with $0.00025 par value, and 75,000,000 non-voting preferred shares with
$0.001 par value.
Forward Stock Split
On January 26, 2004 the Company forward split its common shares on the basis of
three new shares for each common share outstanding. The par value and the number
of authorized but unissued shares of the Company's common stock was not changed
as a result of the forward stock split.
19
NOTE 8: STOCKHOLDERS' EQUITY - continued
- --------------------------------------------------------------------------------
Unless otherwise noted, all references to common stock, common shares
outstanding, average numbers of common shares outstanding and per share amounts
in these Financial Statements and Notes to Financial Statements prior to the
effective dates of the reverse and forward stock splits have been restated to
reflect the one-for-three hundred reverse split and the one-for-three forward
split on a retroactive basis.
Stock Issuances - 2005
On July 21, 2005 the Company issued 200,000 restricted common shares to C.K.
Cooper & Co., relating to a termination and settlement agreement regarding the
recent debt financing by the Company. The fair value of these shares at the date
of issuance was $1.31 per share bringing the total value to $262,000. The
calculated fair value respecting the issue of 200,000 common shares has been
recorded as an increase in equity and a charge to deferred finders fees which
will be expensed over the term of the promissory notes. The shares are subject
to subsequent registration rights. (Refer to Note 7.)
Stock Issuances - 2004
On January 22, 2004 the Company issued 1,200,000 post forward split shares of
its common stock, upon the exercise of 1,200,000 post forward share split stock
options at $0.167 per post forward share split share for proceeds of $200,000,
which was paid by way of offset of $200,000 originally advanced to the Company
by ICI which was assigned by Investor Communications International, Inc. ("ICI")
to International Market Trend, Inc. ("IMT") designated option holders as
described in Note 8.
On May 18, 2004 the Company issued 495,000 shares of its common stock, upon the
exercise of 495,000 stock options at $1.00 per share for proceeds of $495,000,
which was paid by way of offset of $495,000 originally advanced to the Company
by ICI, which was assigned to an IMT designated option holder, as described in
Note 8.
On June 25, 2004 the Company issued 320,000 shares of its common stock, upon the
exercise of 320,000 stock options at $3.00 per share for cash proceeds of
$960,000.
Private Placements - 2004
On September 9, 2004 the Company approved a financing of up to 4,150,000 units
of restricted common shares at a price of $1.47 per share plus a full share
purchase warrant exercisable at a price of $1.68 per share for each share
purchased (the "September Unit(s)"). The unexercised warrants expired on July
23, 2005, such date being six months from the effective date of registration of
the stock and warrants issued under the offering. Brokers' fees payable on the
September Units were: cash of 8% of gross proceeds, brokers' warrants equal to
4% of the gross proceeds (to be issued under the same terms as the warrants
issued under the offering), and a warrant exercise fee equal to 5% of proceeds
received as a result of the future exercise of the warrants by the investors. On
November 1, 2004 the Company completed the sale of an aggregate of 1,700,686
Units. The Company filed a registration statement (form SB-2) with the
Securities and Exchange Commission ("SEC") on December 15, 2004, covering the
resale of shares of common stock sold in the private placement or issuable upon
exercise of the warrants. Under the terms of the financing, the registration
statement is to become effective within 120 days after the filing date; the
registration statement went effective on January 24, 2005 in less than 42 days
from the filing date.
20
NOTE 8: STOCKHOLDERS' EQUITY - continued
- --------------------------------------------------------------------------------
As of December 31, 2004, 1,700,686 September Units had been sold for proceeds of
$2,319,264, net of an $180,746 agent fee which was charged to additional paid in
capital. Of the 1,700,686 units sold 376,318 were non-brokered and 1,324,368
were brokered. The fair value of the warrants was estimated to be $0.147 each
and $250,001 has been recorded as a separate component of stockholders' equity.
The fair value of the 46,353 broker warrants issued to date has been estimated
to be $0.147 per warrant and as a result, $6,814 has been recorded as a separate
component of stockholders' equity. The non-brokered units in the amount of
376,318 were issued upon: (1) settlement of a $500,000 convertible promissory
note and accrued interest of approximately $12,637 for 348,733 units; and (2)
pursuant to a non-brokered placee that paid $40,550 for 27,585 units.
Share Purchase Warrants
Share purchase warrants outstanding at September 30, 2005 are:
Weighted average
Range of exercise Weighted Number of warrants to remaining contractual
prices average price purchase shares life (in years)
- --------------------------------------------------------------------------------
$1.00 - $5.00 $1.52. 6,219,000 2.33
================================================================================
A summary of the Company's stock purchase warrants as of September 30, 2005, and
changes during the period ended is presented below:
------------------ ------------------ -----------------------
Weighted average Weighted average
Number of Warrants exercise price remaining contractual
per share life (in years)
------------------ ----------------- -----------------------
$
Outstanding at December 31, 2003 -
Granted May 3, 2004 200,000
Granted October 31, 2004 1,747,039
------------------ ----------------- -----------------------
Balance at December 31, 2004 1,947,039 2.02 0.60
Exercised (304,367)
Granted 6,019,000
Expired (1,442,672)
------------------ ----------------- -----------------------
Balance at September 30, 2005 6,219,000 2.22 2.09
================== ================= =======================
From May to August, 2005 the Company issued 233,000 warrants at $3.00 per unit
in conjunction with the issue of promissory notes totaling $1,165,000 to two
shareholders ($600,000 and $565,000) by the Company (see Note 6). The term of
these warrants is five years. The fair value of these warrants at the date of
grant was $271,028 as estimated using the Black-Scholes warrant pricing model
with an expected term of 5 years, a risk free interest rate of 3%, a dividend
yield of 0%, and an expected volatility of 159.69%. (Refer to Note 6).
21
NOTE 8: STOCKHOLDERS' EQUITY - continued
- --------------------------------------------------------------------------------
In the period ended June 30, 2005, 304,367 share purchase warrants were
exercised at $1.68 per purchase warrant providing $495,964 in proceeds to the
Company, net of brokers' fees of $15,373.
During the nine month period ended September 30, 2005 1,442,672 warrents expired
unexercised.
As a result of the warrants that expired and the warrants that were exercised
during the nine month period ended September 30, 2005, the Company charged
$256,815 to Additional Paid in Capital.
In September 2005, the Company issued: (a) 2,630,000 Class A Warrants
exercisable at $1.50 for 3 years; (b) 2,630,000 Class B Warrants exercisable at
$1.25 for 1 year; and (c) 586,000 Finder's warrants exercisable at $1.00
exercisable for 3 years in conjunction with the issue of promissory notes
totaling $5,260,000 (see Note 6).
NOTE 9: STOCK OPTION PLAN ("SOP")
- --------------------------------------------------------------------------------
As of September 30, 2005, 6,700,000 options under the Company's current SOP have
been granted and 3,765,000 have been exercised.
A summary of the Company's stock options as of September 30, 2005, and changes
during the period ended is presented below:
------------------ ----------------- -----------------------
Weighted average Weighted average
Number of exercise price remaining contractual
options per share life (in years)
------------------ ----------------- -----------------------
$
Outstanding at December 31, 2003 1,350,000 0.50 3.392
Exercised (2,015,000)
Granted 1,200,000
------------------ ----------------- -----------------------
Outstanding at December 31, 2004 535,000 1.64 4.26
Cancelled, (100,000)
Granted 2,600,000
Exercised (100,000)
------------------ ----------------- -----------------------
Outstanding at September 30, 2005 2,935,000 2.48 6.91
================== ================= =======================
In January 2004, 1,200,000 stock options (400,000 pre-forward split shares) were
exercised at $0.167 per share ($0.50 per pre-forward split share) for proceeds
of $200,000 which was paid by way of offset of $200,000 originally advanced to
the Company by ICI which was assigned by ICI to IMT designated option holders.
On February 2, 2004, an additional 1,000,000 share options were granted to
consultants and three directors, 500,000 exercisable at $1.00 and 500,000
exercisable at $3.00. The term of these options is five years. The fair value of
these options at the date of grant of $2,989,221 was estimated using the
Black-Scholes option pricing model with an expected life of 5 years, a risk free
interest rate of 3%, a dividend yield of 0%, and an expected volatility of 251%
and has been recorded as a consulting expense in the period. Of these options,
100,000 of the $3.00 options were granted to an officer/director of the Company
and 10,000 of the $1.00 options were granted to two directors.
In April 2004 the Company registered 500,000 common stock options exercisable at
$1.00 per share under an S-8 Registration Statement. On May 18, 2004, 495,000 of
these stock options were exercised at $1.00 per share for proceeds of $495,000
which was paid by way of offset of $495,000 originally advanced to the Company
by ICI which was assigned to a designated option holder.
22
NOTE 9: STOCK OPTION PLAN ("SOP") - continued
- --------------------------------------------------------------------------------
In June 2004 the Company registered 400,000 common stock options exercisable at
$3.00 per share under an S-8 Registration Statement. And, in June 2004, 320,000
of these stock options were exercised at $3.00 per share for cash proceeds of
$960,000.
By Directors' Resolution dated July 2, 2004, the Company increased the
authorized number of options under its SOP from 4,000,000 to 5,000,000.
On July 12, 2004, 200,000 stock options were granted at $3.00 per share to
Humphreys. The term of these options is five years. The fair value of these
options at the date of grant of $692,051 was estimated using the Black-Scholes
option pricing model with an expected life of 5 years, a risk free interest rate
of 3%, a dividend yield of 0%, and an expected volatility of 222% and in
accordance with the provisions of SFAS 148, has been disclosed on a pro-forma
basis in Note 2.
On February 1, 2005, 500,000 options were granted at $1.00 per share to IMT. The
term of these options is five years. The fair value of these options at the date
of grant of $646,054 was estimated using the Black-Scholes option pricing model
with an expected life of 5 years, a risk free interest rate of 3%, a dividend
yield of 0%, and an expected volatility of 239.25%.
On February 1, 2005, 100,000 existing S-8 options were granted at $0.16667 per
share to IMT. The term of these options is five years. The fair value of these
options at the date of grant of $129,699 was estimated using the Black-Scholes
option pricing model with an expected life of 5 years, a risk free interest rate
of 3%, a dividend yield of 0% and an expected volatility of 239.25%.
On May 23, 2005, 100,000 S-8 registered share options were exercised at $0.16667
per share for cash proceeds of $16,667.
On August 19, 2005, 1,150,000 options were granted at $1.25 per share to IMT.
The term of these options is five years. The fair value of these options at the
date of grant of $1,138,238 was estimated using the Black-Scholes option pricing
model with an expected life of 5 years, a risk free interest rate of 3%, a
dividend yield of 0%, and an expected volatility of 139.60%.
On August 19, 2005, 850,000 stock options were granted at $1.25 per share to
various officers and directors of the Company. The term of these options is five
years. The fair value of these options at the date of grant of $841,307 was
estimated using the Black-Scholes option pricing model with an expected life of
5 years, a risk free interest rate of 3%, a dividend yield of 0%, and an
expected volatility of 139.60%, and in accordance with the provisions of SFAS
148, has been disclosed on a pro-forma basis in Note 2.
NOTE 10: RELATED PARTY TRANSACTIONS
- --------------------------------------------------------------------------------
For the nine month period ended September 30, 2005
The Company previously entered into a contract with IMT, a private company that
performs a wide range of management, administrative, financial, and business
development services to the Company. The Company incurred $90,000 in fees to IMT
for the period ended September 30, 2005 (2005 - $60,000).
On February 1, 2005 IMT was granted 600,000 stock options (refer to Note 9).
On August 19, 2005 IMT was granted 1,150,000 stock options (refer to Note 9).
23
NOTE 10: RELATED PARTY TRANSACTIONS - continued
- --------------------------------------------------------------------------------
On November 9, 2004, the Company reached an agreement with Oak Hills Drilling
and Operating LLC ("Oakhills"), to drill a ten well program. Humphreys is a
director of the Company and is the Drilling Operations Manager of Lexington, and
also the General Manager, director, and 25% shareholder of Oakhills, an oil and
gas drilling and well operating company based in Holdenville, Oklahoma that acts
as "operator" to Lexington. Mr. Humphreys is in charge of oil and gas operations
for Lexington in the United States.
On September 23, 2005, the Company announced that it had entered into an
agreement in principle to acquire 100% of the issued and outstanding shares in
the capital of Oak Hills Drilling and Operating LLC, the Company's designated
oil and gas operator for 3,000,000 restricted common shares in the capital of
the Lexington. The transaction is subject to, among other things, (i) the prior
receipt by the Company of a valuation, acceptable to the independent members of
the Board of Directors of the Company, that determines the underlying value of
Oakhills, such that the resulting Purchase Price and the final number of Shares
issuable at closing may be adjusted upward or downward, accordingly, (ii) the
prior audit of Oakhills, (iii) mutual due diligence, (iv) the execution of a
formal agreement incorporating the terms and conditions of the agreement in
principle by November 15, 2005 and (v) the closing of the transaction on or
before December 31, 2005.
Humphreys has been assigned a 10% carried Working Interest in each well
successfully drilled on the Wagnon lease, as partial compensation for his
involvement in obtaining and facilitating the execution of the Farm-Out
Agreement and to compensate for his services relating to operation and
completion of wells to be located on the Wagnon Lease. In addition, under the
terms of Mr. Humphreys management contract, he has a 10% carried interest of
Lexington's interest in all wells drilled by the Company. The estimated value of
the 10% carried Working Interest of $153,707 (total to date $270,738) has been
recorded as additional compensation expense during the period ended September
30, 2005. Humphreys also has the right to purchase an additional 5% working
interest in each well drilled by the Company and has elected to do so for the
first four wells drilled on the Company's Wagnon lease. The original 5% cost to
participate in the wells by Humphreys was $60,000. As of September 30, 2005 the
Company was still owed $15,000 (December 31, 2004 - $22,500) and has recorded
the amount as a receivable from Humphreys as full payment for an additional 5%
working interest in each of the Kellster 1-5, the Kyndal 2-2, and the Bryce 3-2.
Refer to Notes 3, 5, and 9.
During the period ended September 30, 2005 the Company incurred $149,150 to its
officers for management fees (September 30, 2004 - $165,300).
On January 1, 2005, the Company appointed Oak Hills as its elected operator for
wells on its Wagnon Lease, and for further drilling to be conducted by
Lexington. Oak Hills Drilling and Operating, LLC replaces Oakhills Energy, Inc.
as its designated operator.
Refer to Note 3.
24
NOTE 11: INCOME TAXES
- --------------------------------------------------------------------------------
The Company has adopted FASB No. 109 for reporting purposes. As of September 30,
2005, the Company had net operating loss carry forwards of approximately
$4,300,000 that may be available to reduce future years' taxable income and will
expire between the years 2006 - 2025. Availability of loss usage is subject to
change of ownership limitations under Internal Revenue Code 382. Future tax
benefits which may arise as a result of these losses have not been recognized in
these financial statements, as their realization is determined not likely to
occur and accordingly, the Company has recorded a valuation allowance for the
deferred tax asset relating to these tax loss carry forwards.
The Company evaluates its valuation allowance requirements on an annual basis
based on projected future operations. When circumstances change and this causes
a change in management's judgment about the recoverability of future tax assets,
the impact of the change on the valuation allowance is generally reflected in
current income.
NOTE 12: SUPPLEMENTAL DISCLOSURE WITH RESPECT TO CASH FLOWS
- --------------------------------------------------------------------------------
Nine month period ended Nine month period ended
September 30, 2005 September 30, 2004
- -------------------------------- ----------------------- -----------------------
Cash paid during the period for:
Interest $ 47,199 $ -
Income taxes $ - $ -
- -------------------------------- ----------------------- -----------------------
NOTE 13: SUBSEQUENT EVENTS
- --------------------------------------------------------------------------------
On October 16, 2005 the Company received an additional 600,000 in convertible
promissory note debt financing per the same terms and conditions as the previous
debt. The Company issued 300,000 Class A Warrants to purchase a share of its
common stock at an exercise price of $1.50 per share for a three-year term after
this registration statement has been declared effective by the SEC and 300,000
Class B Warrants to purchase an additional share of our common stock at an
exercise price of $1.25 per share for a one-year term and 60,000 Finders'
Warrants at an exercise price of $1.00 for three years after this registration
statement has been declared effective by the SEC in connection with the
additional notes issued (refer to Note 7).
25
Statements made in this Form 10-QSB that are not historical or current
facts are "forward-looking statements" made pursuant to the safe harbor
provisions of Section 27A of the Securities Act of 1933 (the "Act") and Section
21E of the Securities Exchange Act of 1934. These statements often can be
identified by the use of terms such as "may," "will," "expect," "believe,"
"anticipate," "estimate," "approximate" or "continue," or the negative thereof.
We intend that such forward-looking statements be subject to the safe harbors
for such statements. We wish to caution readers not to place undue reliance on
any such forward-looking statements, which speak only as of the date made. Any
forward-looking statements represent management's best judgment as to what may
occur in the future. However, forward-looking statements are subject to risks,
uncertainties and important factors beyond our control that could cause actual
results and events to differ materially from historical results of operations
and events and those presently anticipated or projected. We disclaim any
obligation subsequently to revise any forward-looking statements to reflect
events or circumstances after the date of such statement or to reflect the
occurrence of anticipated or unanticipated events.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
OPERATION
GENERAL
Lexington Resources, Inc. is a corporation organized under the laws of the
State of Nevada (herein known as "we" or the "Company"). We currently trade on
the OTC Bulletin Board under the symbol "LXRS" and on the Frankfurt and Berlin
Stock Exchanges under the symbol "LXR"; WKN: A0BKLP.
CURRENT BUSINESS OPERATIONS
We are a natural resource exploration and production company currently
engaged in the acquisition and development of oil and gas properties in the
United States. We expect to weight our future development initiatives towards
gas production. We are committed to developing into a profitable independent oil
and gas producer through the systematical expansion of operations and the
acquisition of new drilling targets and organizing drilling and production
initiatives on leased properties.
Our wholly owned subsidiary, Lexington Oil & Gas Ltd. Co., an Oklahoma
limited liability company ("Lexington"), previously acquired a 590 gross acre
section of farm-out acreage in Pittsburg County, Oklahoma for the development
and production of coal bed methane gas (the "Wagnon Property"). We have drilled,
completed, and are producing gas from four wells drilled on the Wagnon Property
each with a back-in 53.2% working interest to Lexington.
We have also successfully drilled, completed, and are producing from two
further coal bed methane gas well interests located on our Coal Creek Project
with working interests of 50% and 22% respectively to Lexington that form part
of approximately 1,932 gross acres in the Coal Creek Project. In addition, we
have a 25% working interest in a third gas well, which has been drilled and
completed by Newfield Exploration Mid-Continent, Inc. and is currently
producing, on our Panther Creek Prospect, which consists of approximately 292
gross acres. In total, we have interests in six coal bed methane gas wells and
one Woodford Shale gas well, and estimated acreage suitable for the drilling of
further potential gas wells primarily targeting coal bed methane gas production.
We have conducted partial drilling of a fourth well on our Coal Creek Prospect
that has not reached the completion stage. We have an approximate 88.5% working
interest in this well bore.
26
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
OPERATION - continued
We have consummated the aggregate acquisition of approximately 9,450 gross
acres of primarily coal bed methane gas targeted prospects in the Arkoma Basin
in the State of Oklahoma, including 590 acres in our Wagnon Prospect, 1,932
gross leasehold acres in the Coal Creek Prospect, 292 gross acres in the Panther
Creek Prospect, 320 gross acres in the Middlecreek Prospect, 1,144 gross acres
in the South Lamar Prospect, and 4,925 gross acres in the H-9 Prospect. In
addition, we have committed to purchase up to a 100% working interest in up to
3,687 gross acres of Barnett Shale targeted gas leases in the Dallas/Fort Worth
Basin in the State of Texas of which we currently own 2,325 gross acres. We
currently have an aggregate of approximately 1,211 gross developed and 10,562
gross undeveloped acres pursuant to leases and/or concessions as more fully
described below. It is anticipated that our ongoing efforts, subject to adequate
funding being available, will continue to be focused on successfully concluding
negotiations for additional tracts of prime gas and oil producing domains, and
to implement additional drilling and production development initiatives through
the drilling of new wells to develop reserves and to provide revenues. We plan
to continue building and increasing a strategic base of proven reserves and
production opportunities within Oklahoma's Arkoma Basin, and the Dallas Fort
Worth Basin in the State of Texas.
Oak Hills Drilling and Operating LLC
On November 9, 2004, we entered into an agreement with Oak Hills Drilling
and Operating LLC ("Oak Hills") to drill a ten well program (the "Drilling
Agreement"). Oak Hills is a wholly-owned subsidiary of Oak Hills Drilling and
Operating International, Inc., a Nevada corporation ("Oak Hills International").
Mr. Douglas Humphreys, one of our directors, is currently the sole director and
officer of both Oak Hills and Oak Hills International. We entered into the
Drilling Agreement to eliminate wait times for proceeding with planned drilling
initiatives due to high drilling demand and thus limited rig availability and to
ensure continuous availability of a dedicated drilling rig and crew.
On September 23, 2005, we entered into an agreement in principle to acquire
100% of the total issued and outstanding shares of Oak Hills for not less than
the issuance of 3,000,000 shares of our restricted common stock at a deemed
issuance price of $1.50 per share, and not less than $4,500,000 in aggregate
consideration (the "Agreement"). The Agreement is subject to certain conditions
precedent including but not limited to the following: (i) the prior receipt by
us of a valuation acceptable to the independent members of our Board of
Directors that determines the underlying value of Oak Hills, such that the
resulting purchase price and final number of shares of restricted common stock
issuable at closing may be accordingly adjusted upward or downward; (ii) the
prior audit of Oak Hills; and (iii) mutual due diligence. As of the date of this
Quarterly Report, we believe that a final definitive agreement will be entered
into by the end of the year and the closing of the transaction will take place
on or before December 31, 2005. The date for the originally anticipated
definitive agreement of November 15, 2005 will not be met as scheduling for the
completion of the audit of Oak Hills has not been finalized. The date of
finalization of the audit of Oak Hills may affect the timing of the closing
date.
Oil and Gas Properties
As of the date of this Quarterly Report, we have not reported nor filed any
reserve estimates with any Federal agencies, but have commenced production from
certain properties as more fully described below. During 2004, we obtained an
independent reserve and economic evaluation report regarding the Wagnon Property
27
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
OPERATION - continued
that was conducted by Fletcher Lewis Engineering, Inc. of Oklahoma but have not
updated the reserve and economic evaluation report for 2005 for the inclusion of
Coal Creek and Panther Creek well interests.
In accordance with the terms and provisions of the consulting agreement
with Douglas Humphreys, our director and Drilling Operations Manager (the
"Consulting Agreement"), we will assign to Paluca Petroleum Inc. ("Paluca"), an
affiliate of our director, Douglas Humphreys, 10% of our working interest as a
carried working interest in each well drilled on our lease prospects.
The following is a description of our oil and gas properties.
Wagnon Property
We hold an 80% working interest and a 60.56% net revenue interest in
approximately 590.2 gross acres of a gas lease located in Pittsburg County,
Oklahoma (the "Wagnon Property"). The gas lease was acquired from Oak Hills
Energy, Inc. ("Oak Hills Energy"), which acquired the lease pursuant to a
farm-out agreement with Quinton Rental & Repair Services, Inc. (the "Wagnon
Farm-Out Agreement"). Our interest relating to the Wagnon Property is subject to
farm-out agreements equating to a total 20% working interest between Paluca
Petroleum Inc. ("Paluca"), an affiliate of one of our directors, Douglas
Humphreys, Oak Hills Energy, and the lessee of the Wagnon Property.
During 2004 and 2005, we have drilled, completed, and put four wells into
production on this prospect, the Kellster #1-5, the Kyndal #2-2, the Bryce #3-2,
and the Calleigh #4-2. The last well drilled on the Wagnon Prospect was
completed on April 2, 2005 when the Calleigh #4-2 coal bed methane gas well
commenced production. It is estimated that up to a total of five wells may be
drilled on the Wagnon Property.
We previously entered into funding agreements for the Kellster #1-5, Kyndal
#2-2, Bryce #3-2, and Calleigh #4-2 wells (collectively, the "Funding
Agreements"). Pursuant to the Funding Agreements, the private investors were
provided with an 80% working interest and a 60.56% net revenue interest in the
wells until their respective invested capital in each well is repaid, after
which time the private investors will revert to an aggregate 20.1% working
interest and a 15.075% net revenue interest. Oak Hills Energy, the original
driller and operator of the wells, will "back-in" to a reversionary 6.7% working
interest after invested capital is repaid to the private investors and we will
"back-in" to a reversionary 53.2% working interest. Pursuant to the further
terms and provisions of the Funding Agreements, all wells to be drilled on the
Wagnon Property carry royalty interests totaling 25% to landowners and property
interest holders and carried working interests of 5% to a landowner, as well as
a 10% carried working interest to Paluca. Paluca also owns a non-carried working
interest of 5% as part of capital participation funding provided by Paluca. As
of September 30, 2005, we have received the total required funding of $1,485,000
under the Funding Agreements for drilling and completion of the four horizontal
coal bed methane gas wells on the Wagnon Property. As of September 30, 2005, the
private investors have been repaid an aggregate of $1,485,000 of their
$1,485,000 investment under the Funding Agreements. Therefore, our back-in
working interest of 53.2% in each of the four wells on the Wagnon Property has
vested and the private investors have reverted in an aggregate 20.1% working
interest and a 15.075% net revenue interest.
28
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
OPERATION - continued
Coal Creek Prospect
During 2004, we obtained an option to purchase an undivided 95% interest in
approximately 2,500 net leasehold acres in five sections located in Hughes and
Pittsburg Counties, State of Oklahoma (the "Coal Creek Prospect"). On March 12,
2004, we entered into a two-year lease for approximately 1,536 gross acres in
the Coal Creek Prospect pursuant to which we have an undivided 95% working
interest and a minimum 79% net revenue interest. On May 20, 2004, we entered
into a two-year lease pursuant to which we acquired an additional 372 acres of
the Coal Creek Prospect with a minimum 95% working interest and a 78% net
revenue interest. On August 20, 2004, we entered into a two-year lease pursuant
to which we acquired an additional 23 acres of the Coal Creek Prospect with a
minimum 95% working interest and a 79% net revenue interest. As of the date of
this Quarterly Report, the total acreage acquired in the Coal Creek Gas Prospect
is approximately 1,932 gross leasehold acres.
On March 31, 2005, we began drilling the first well on our Coal Creek
Prospect, the Lex #1-34, of which we have a 50% working interest. The Lex #1-34
well has been completed and is currently in production. On April 15, 2005, we
began drilling a second well on the Coal Creek Project, the Brumbaugh #1-10
well, of which we have a 22% working interest. The Brumbaugh #1-10 well has been
completed and began production in May 2005. It is estimated that interests in
twelve to sixteen wells may be drilled on lease acreage owned by us that forms
part of the Coal Creek Prospect.
On May 31, 2005, we began drilling a third coal bed methane well on the
Coal Creek Prospect, the Ellis #1-15, of which we have an 88.5% working
interest. Drilling of this well has encountered a shallow "Bartlesville Sand" as
zone that produced a significant gas flair upon testing of the zone. The zone
was logged, underwent economic and geological study to assess commercial
potential of the new, non-CBM gas zone, and we attempted completion in the
Bartlesville Sand zone without success due to intrusion of water from a salt
water disposal well. As a result, procedures are under evaluation for the
completion of the well in the originally targeted, Hartshorne CBM gas zone that
management believes is unaffected by the intrusion of water.
In accordance with the terms and provisions of the consulting agreement
with Douglas Humphreys (the "Consulting Agreement"), we have assigned to Paluca
as an earned carried interest 10% of our working interest as a carried working
interest in each well completed on the Coal Creek Gas Prospect.
During June to August 2005, we obtained loans in the aggregate amount of
$1,165,000, which loans were secured against our interests in the Coal Creek
Prospect (the "Coal Creek Loans"). As of September 30, 2005, we had repaid the
Coal Creek Loans in the aggregate principal amount of $1,165,000 and accrued
interest of $41,058, thus discharging the security interest against our Coal
Creek Prospect. See "Part II. Other Information. Item 2. Changes in Securities
and Use of Proceeds."
Panther Creek Prospect
On March 12, 2004, we entered into a three-year lease of approximately 292
acres located in five separate sections in the Panther Creek coal bed methane
gas prospect located in Hughes County, State of Oklahoma (the "Panther Creek
Prospect"). We have a 100% working interest and an approximate 81% net revenue
interest in the acreage acquired in the Panther Creek Prospect.
29
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
OPERATION - continued
A portion of the acreage in the Panther Creek Prospect is subject to three
division pooling orders by Newfield Exploration Mid-Continent Inc., a subsidiary
of Newfield Exploration Company ("Newfield"), for three wells to be drilled and
operated by Newfield in which we have elected to participate. On January 25,
2005, we entered into the joint operating agreement with Newfield to participate
in the proposed wells to be drilled (the "Joint Operating Agreement"). Pursuant
to the terms and provisions: (i) Newfield shall drill and operate the first well
and explore other zones up to 8,500 feet in depth; (ii) we have an approximate
25% working interest in the first completed well; (iii) we have an approximate
10.94% working interest in the second proposed well; (iv) we have an approximate
4.06% working interest in the third proposed well; and (v) Newfield has up to
approximately the end of fiscal year 2005 to drill such wells.
On February 9, 2005, Newfield commenced drilling on the first well, the POE
#1-29 and, as of March 21, 2005, the POE #1-29 gas well commenced production
from a Woodford Shale gas zone. As of the date of this Quarterly Report,
Newfield had proposed the drilling of a second horizontal test well in which we
would have a 10.94% working interest. The Company has elected not to participate
in the well based on management's analysis of the proposal by Newfield and
amendments thereto.
South Lamar Prospect
On April 21, 2004, we entered into a two-year lease agreement to acquire a 100%
working interest and a 78.5% net revenue interest in 960 gross undeveloped acres
to develop coal bed methane gas wells in Hughes County, State of Oklahoma (the
"South Lamar Prospect"). On July 26, 2004, we acquired a further 183.98 gross
acres in the South Lamar Prospect pursuant to which we hold a 100% working
interest and a 79% net revenue interest. We have previously prepared the drill
site for the first proposed well on this prospect, the Goodson #1-24 well. As of
the date of this Quarterly Report, the Company decided not to proceed with the
drilling of the planned "Goodson #1-23" coal bed methane Hartshorne Coal
targeted gas well pending reassessment of costs and techniques utilized to drill
and complete wells. Cost escalations relating to the drilling and completion of
horizontal CBM wells by the Company have increased at least 40% since 2004
affecting potential investment returns to the Company. Various well drilling and
completion related cost reduction techniques are under evaluation by management.
Middlecreek Prospect
On May 24, 2004, we entered into an agreement to acquire an undivided 100%
working interest and a 70% net revenue interest in 320 gross leasehold acres
located in two sections in the Middlecreek Prospect located in Hughes County,
State of Oklahoma (the "Middlecreek Prospect"). Rights to drill all geological
zones are included and primary gas targets include the Caney shale and
Hartshorne coal zones with further possibilities in the Booch, Stuart, and
Savannah zones. The Middlecreek Prospect includes a 2,000 foot gas pipeline and
pipeline right of way.
H-9 Prospect
On June 29, 2004, we entered into an option agreement to purchase a
leasehold interest and a net revenue interest in approximately 4,600 net
leasehold acres located in approximately 38 sections of the H-9 Prospect in
Hughes and McIntosh counties, State of Oklahoma (the "H-9 Prospect"). On July
29, 2004, we entered into three to four year lease agreements to acquire an
undivided 100% leasehold interest and a 79.25% net revenue interest in the 4,600
30
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
OPERATION - continued
gross leasehold acres on the H-9 Prospect. On July 19, 2004, we entered into
another three-year lease to acquire a 100% leasehold interest and a 78.25% net
revenue interest in an additional 325 gross acres of gas target drillable
acreage on the H-9 Prospect.
Barnett Shale Project
On June 2, 2005, as amended July 14, 2005, we entered into a definitive
agreement with a Texas-based limited partnership (the "Barnett Agreement"),
regarding a gas well horizontal drilling venture in the Jack, Wise, and Palo
Pinto Counties in the State of Texas (the "Barnett Shale Project"). Pursuant to
the terms and provisions of the Barnett Agreement: (i) we will be able to
acquire a working interest of between 75% to 100% in the wells to be drilled on
the Barnett Shale Project with net revenues interests ranging from 70% to 75%,
and to increase the initial acreage up to approximately 3,700 net leasehold
acres; (ii) we paid a non-refundable deposit of $100,000 with the balance of the
funds due by August 19, 2005, which $100,000 deposit shall be credited against
the total purchase price to be paid by us for the working interest in up to
3,687 net leasehold acres; (iii) we will pay our pro-rata share of net leasehold
acres we acquire; (iv) in the event we purchase the maximum 100% working
interest, we will receive a minimum 70% net revenue interest on the leases
without any carried interest to the Texas limited partnership, with the
remaining net revenue interest to be reserved as an overriding royalty interest
for the Texas limited partnership; (v) in the event we purchase a 75% working
interest, we will receive a 56.25% net revenue interest on the leases and we
will carry for the Texas limited partnership a 10% working interest in the
drilling, completion and equipping of the pipeline on all wells drilled on the
acreage purchased by us; (vi) we will be responsible for our pro-rata share of
acreage costs; and (vii) our contract operator, Oak Hills, will be the operator
for the project.
On September 25, 2005, we acquired our first lease in the Barnett Shale
Project. We acquired approximately 2,325 net leasehold acres for $1,107,000. We
anticipate that this acquisition will provide us with up to 16 additional
horizontal Barnett Shale gas drilling sites with access to existing pipeline
networks. We anticipate, that subject to financing, that the first well will be
spudded in November-December 2005 and that all drilling on the acquired acreage
will be completed in less than two years.
31
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
OPERATION - continued
Wells Developed on Oil and Gas Properties
As of the date of this Quarterly Report, the following table summarizes
wells and working interests in wells under current development initiatives:
- ---------------- ----------------- -------------------- ------------------------
Company Well Name Interest Status
Lease/Prospect
- ---------------- ----------------- -------------------- ------------------------
Wagnon Kellster #1-5 53.2% Back WI APO Producing
- ---------------- ----------------- -------------------- ------------------------
Wagnon Kyndal #2-2 53.2% Back WI APO Producing
- ---------------- ----------------- -------------------- ------------------------
Wagnon Bryce #3-2 53.2% Back WI APO Producing
- ---------------- ----------------- -------------------- ------------------------
Wagnon Calleigh #4-2 53.2% Back WI APO Producing
- ---------------- ----------------- -------------------- ------------------------
Panther Creek POE #1-29 25.7% WI Producing
- ---------------- ----------------- -------------------- ------------------------
Coal Creek LEX #1 50.1% WI Producing
- ---------------- ----------------- -------------------- ------------------------
Coal Creek Brumbaugh #1-10 22.2% WI Producing
- ---------------- ----------------- -------------------- ------------------------
Coal Creek Ellis #1-15 88.5% WI Under analysis for
drilling and completion
techniques
- ---------------- ----------------- -------------------- ------------------------
South Lamar Goodson #1-23 87.5% WI Site abandoned, division
pooling order lapsed
- ---------------- ----------------- -------------------- ------------------------
To date, we have committed to interests in eight gas wells, seven of which
are producing. We estimate that we have additional available acreage suitable
for the drilling of a further seventy to one hundred, primarily coal bed methane
gas wells in the state of Oklahoma and 16 Barnett Shale wells in the state of
Texas.
RESULTS OF OPERATION
Nine-Month Period Ended September 30, 2005 Compared to Nine-Month Period Ended
September 30, 2004
Our net loss for the nine-month period ended September 30, 2005 was
approximately ($6,469,152) compared to a net loss of ($5,175,168) during the
nine-month period ended September 30, 2004 (an increase of $1,293,984).
During the nine-month period ended September 30, 2005, we generated
$530,721 in oil and gas revenue compared to $305,756 in oil and gas revenue
generated during the same period in 2004 (an increase of $224,965), resulting
primarily from the sale of gas produced from an increasing number of coal bed
methene gas well interests brought into production. Depletion and operating
costs and taxes of $244,641 and $180,073, respectively, increased during the
nine-month period ended September 30, 2005 compared to depletion and operating
costs and taxes of $112,186 and $21,641, respectively, incurred in the same
period in 2004. The increase in depletion and operating expenses and taxes
during the nine-month period ended September 30, 2005 from the nine-month period
ended September 30, 2004 was primarily the result of the increase in operating
costs and estimated depletion resulting from the increased number of operating
32
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
OPERATION - continued
wells. Gross profit of $106,007 generated during the nine-month period ended
September 30, 2005 was further reduced by an aggregate of $6,575,159 from other
expenses incurred, resulting in a net loss of ($6,469,152). The gross profit of
$171,929 generated during the nine-month period ended September 30, 2004 was
reduced by an aggregate of $5,347,097 from other expenses incurred, resulting in
a net loss of ($5,175,168).
During the nine-month period ended September 30, 2005, we incurred other
expenses in the aggregate amount of $6,575,179 compared to $5,347,097 incurred
during the same period in 2004 (an increase of $1,228,082), which consisted of:
(i) general and administrative expenses of $1,287,170 (2004: $2,307,567); (ii)
consulting fees - stock based compensation relating to the fair value of stock
options granted to consultants of $1,913,991 (2004: $2,989,221); and (iii)
interest and finance fees expense of $3,373,998 (2004: $50,309). The increase in
other expenses incurred during the nine-month period ended September 30, 2005
compared to the same period during 2004 resulted primarily from the increase in
interest and finance fees expense associated with the promissory notes issued in
September 2005. General and administrative expenses generally include corporate
overhead, financial and administrative contracted services, marketing, and
consulting costs.
Of the $6,575,159 incurred as other expenses during the nine-month period
ended September 30, 2005, an aggregate of $90,000 was incurred payable to
International Market Trend ("IMT") for amounts due and owing for operational,
administrative and financial services rendered during the nine-month period
ended September 30, 2005. On November 10, 2003, we entered into a consulting
agreement with IMT (the "Consulting Agreement"), whereby IMT performs a wide
range of management, administrative, financial, and business development
services for us. On February 1, 2005, we granted to IMT an aggregate of 500,000
stock options exercisable at $1.00 per share for a period of five years. On
February 1, 2005, we granted to IMT an aggregate of 100,000 stock options
registered under an S-8 Registration Statement exercisable at $0.16667 per share
for a period of five years. On August 19, 2005, we also granted to IMT an
aggregate of 1,150,000 stock options exercisable at $1.25 per share for a period
of five years.
Of the $6,575,159 incurred as other expenses during the nine-month period
ended September 30, 2005, an aggregate of $149,150 was incurred to our officers
for management fees. Furthermore, $153,708 was recorded as additional
compensation expense to one of our directors, Mr. Humphreys, relating to the
estimated valuation of his 10% carried working interest in our wells developed
during the nine-month period ended September 30, 2005. On July 12, 2004, we
entered into a consultation agreement (the "Humphreys Consultation Agreement")
with Lexington Oil & Gas and Mr. Humphreys. Pursuant to the Humphreys
Consultation Agreement, Mr. Humphreys assists in overseeing the drilling
operations and the completion and management of our wells. Mr. Humphreys
compensation pursuant to the terms and provisions of the Humphreys Consultation
Agreement is: (i) $7,500 per month; (ii) the assignment of up to 10% carried
working interest of the Company's working interest in every well drilled on all
properties held by us; (iii) the right to purchase up to an additional 5%
working interest in all wells drilled by us on our properties provided that
funds for this participation are paid prior to the commencement of drilling of
said wells; and (iv) grant of 200,000 Stock Options to purchase shares of our
common stock at an exercise price of $3.00 per share (which were granted July
2004). The Humphreys Consultation Agreement can be terminated at any time with
ninety days written notice by either party.
33
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
OPERATION - continued
As discussed above, the increase in net loss during the nine-month period
ended September 30, 2005 compared to the nine-month period ended September 30,
2004 is attributable primarily to the increase in interest and finance fees
expense. Our net loss during the nine-month period ended September 30, 2005 was
approximately ($6,469,152) or ($0.37) per share compared to a net loss of
($5,175,168) or ($0.35) during the nine-month period ended September 30, 2004.
The weighted average number of shares outstanding was 17,375,441 for the
nine-month period ended September 30, 2005 compared to 14,632,326 for the
nine-month period ended September 30, 2004 (which had been restated in
accordance with the forward stock split of three-for-one shares of common stock
effected January 26, 2004).
Three-Month Period Ended September 30, 2005 Compared to Three-Month Period Ended
September 30, 2004
Our net loss for the three-month period ended September 30, 2005 was
approximately ($4,645,900) compared to a net loss of ($881,920) during the
three-month period ended September 30, 2004 (an increase of $3,763,980).
During the three-month period ended September 30, 2005, we generated
$137,458 in oil and gas revenue compared to $211,549 in oil and gas revenue
generated during the same period in 2004 (a decrease of $74,091), resulting
primarily from the sale of gas produced from coal bed methane gas wells on the
Wagnon Property. Oil and gas revenue decreased during the three-month period
ended September 30, 2005 compared to the same period during 2004 primarily as a
result of well production decreases relating to the installation and management
of well dewatering systems, and lower than anticipated operating performance
from the Company's interest in Newfield's POE #1-29 previously estimated and
accrued. Depletion and operating costs and taxes of $104,761 and $58,612,
respectively, increased in the aggregate during the three-month period ended
September 30, 2005 compared to depletion and operating costs and taxes of
$105,628 and $14,458, respectively, incurred during the same period in 2004. The
increase in depletion and operating expenses and taxes during the three-month
period ended September 30, 2005 from the three-month period ended September 30,
2004 was primarily the result of the increase in well operating costs and
estimated depletion resulting from the increased number of operating wells. The
operating loss of ($25,915) generated during the three-month period ended
September 30, 2005 was further reduced by an aggregate of $4,619,985 from other
expenses incurred, which resulted in a net loss of ($4,645,900). The operating
profit of $91,463 generated during the three-month period ended September 30,
2004 was reduced by an aggregate of $973,383 from other expenses incurred, which
resulted in a net loss of ($881,920).
During the three-month period ended September 30, 2005, we incurred other
expenses in the aggregate amount of $4,619,985 compared to $973,383 incurred
during the same period in 2004 (an increase of $3,646,602), which consisted of:
(i) general and administrative expenses of $116,499 (2004: $949,459); (ii)
consulting fees - stock based compensation relating to the fair value of stock
options granted to consultants of $1,138,238 (2004: $-0-); and (iii) interest
and finance fees expense of $3,365,248 (2004: $23,924). The increase in other
expenses incurred during the three-month period ended September 30, 2005
compared to the same period during 2004 resulted primarily from the increase in
interest and finance fees expense.
As discussed above, the increase in net loss during the three-month period
ended September 30, 2005 compared to the three-month period ended September 30,
2004 is attributable primarily to the increase in interest and finance fees
34
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
OPERATION - continued
expense. Our net loss during the three-month period ended September 30, 2005 was
approximately ($4,645,900) or ($0.26) per share compared to a net loss of
($881,920) or ($0.06) during the three-month period ended September 30, 2004.
The weighted average number of shares outstanding was 17,557,753 for the
three-month period ended September 30, 2005 compared to 15,319,693 for the
three-month period ended September 30, 2004 (which had been restated in
accordance with the forward stock split of three-for-one shares of common stock
effected January 26, 2004).
LIQUIDITY AND CAPITAL RESOURCES
Our financial statements have been prepared assuming that we will continue
as a going concern and, accordingly, do not include adjustments relating to the
recoverability and realization of assets and classification of liabilities that
might be necessary should we be unable to continue in operation.
Nine-Month Period Ended September 30, 2005
As of the nine-month period ended September 30, 2005, our current assets
were $1,624,547 and our current liabilities were $2,455,451, which resulted in a
working capital deficit of $830,904. As of the nine-month period ended September
30, 2005, our total assets were $7,106,903 consisting of: (i) $1,011,538 in cash
and cash equivalents; (ii) $162,984 in accounts receivable; (iii) $12,000 in
prepaid expenses; (iv) $858,887 in deferred charges; (v) $2,710,046 carrying
value of proved oil and gas properties (net of accumulated depletion); (vi)
$2,348,949 carrying value of unproved oil and gas properties; and (vii) $2,499
in other property and equipment (net of accumulated depreciation). As of the
nine-month period ended September 30, 2005, our total liabilities were
$3,670,894 consisting of: (i) $616,146 in accounts payable and accrued
liabilities; and (ii) $3,054,748 in current and non-current portion of
promissory notes.
Stockholders' equity increased from $1,685,514 for fiscal year ended
December 31, 2004 to $3,436,009 for the nine-month period ended September 30,
2005.
We have not generated positive cash flows from operating activities. For
the nine-month period ended September 30, 2005, net cash flows used in operating
activities was ($1,047,012) compared to net cash flows used in operating
activities for the nine-month period ended September 30, 2004 of ($1,141,114).
Net cash flows used in operating activities for the nine-month period ended
September 30, 2005 consisted primarily of a net loss of ($6,469,152). Net cash
flows used in operating activities was adjusted by $1,913,991 to reconcile the
non-cash expense of the grant of stock options and by $244,641 to reconcile the
non-cash expense of oil and gas depletion.
Net cash flows used in investing activities was ($2,245,408) for the
nine-month period ended September 30, 2005 compared to net cash flows used in
investing activities for the nine-month period ended September 30, 2004 of
($2,251,034), which primarily pertained to the acquisition of the oil and gas
properties.
Net cash flows from financing activities was $3,977,665 for the nine-month
period ended September 30, 2005 compared to net cash flows from financing
activities for the nine-month period ended September 30, 2004 of $4,798,365. Net
cash flows from financing activities for the nine-month period ended September
30, 2005 consisted of $4,645,950 (2004: $500,000) in convertible notes (net of
35
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
OPERATION - continued
introduction and legal fees), $512,630 net proceeds on sale of common stock
(2004: $3,281,075), and $-0- in drilling advances (2004: $279,306), which
amounts were adjusted, respectively, by ($1,180,915) in repayment of drilling
advances.
PLAN OF OPERATION
During the nine-month period ended September 30, 2005, we completed the
sale of a secured and convertible note private placement (the "Private
Placement") with certain accredited investors (each an "Investing Note Holder")
for aggregate proceeds of $5,260,000 pursuant to the terms and conditions of
certain subscription agreement as entered into between us and each such
Investing Note Holder. Subsequently, we also received an additional $600,000 in
convertible note and warrant financing under identical terms and conditions,
bring our aggregate convertible debt financing to $5,860,000. See "Material
Commitments" and "Part II. Other Information. Item 2. Changes in Securities and
Use of Proceeds."
Furthermore, during fiscal year 2004, we completed a private placement
offering of an aggregate of 1,700,686 Units at a purchase price of $1.47 per
Unit for net proceeds of approximately $2,319,264. Included in the net proceeds
was the exchange of two of our outstanding promissory notes in the aggregate
principal amount of $500,000 plus accrued interest of $12,637 for Units,
resulting in the issuance of 376,318 Units. Each Unit consists of one share of
our common stock and one warrant to purchase a share of our common stock at an
exercise price of $1.68 (the "September Warrants"). The September Warrants from
the offering were exercisable for a term of 180 days after the Registration
Statement was declared effective on January 21, 2005 creating an expiry term of
July 23, 2005. During the first and second quarters of 2005, an aggregate of
304,367 September Warrants were exercised for aggregate proceeds of $495,964,
net of $15,373 in brokers' fees. The remaining 1,396,319 September Warrants have
expired.
Existing working capital, further advances and possible debt instruments,
anticipated warrant exercises, further private placements, and anticipated cash
flow are expected to be adequate to fund our operations over the next six
months. We have no lines of credit or other bank financing arrangements.
Generally, we have financed operations to date through the proceeds of the
private placement of equity and debt securities. In connection with our business
plan, management anticipates additional increases in operating expenses and
capital expenditures relating to: (i) oil and gas operating properties; (ii)
drilling initiatives; (iii) property acquisitions' and (iv) working capital and
administration. We intend to finance these expenses with further issuances of
securities, debt and or advances, and revenues from operations. Thereafter, we
expect we will need to raise additional capital and increase its revenues to
meet long-term operating requirements.
Additional issuances of equity or convertible debt securities will result
in dilution to our current shareholders. Further, such securities might have
rights, preferences or privileges senior to our common stock. Additional
financing may not be available upon acceptable terms, or at all. If adequate
funds are not available or are not available on acceptable terms, we may not be
able to take advantage of prospective new business endeavors or opportunities,
or existing agreements which could significantly and materially restrict our
business operations.
36
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
OPERATION - continued
The independent auditors' report accompanying our December 31, 2004 and
December 31, 2003 consolidated financial statements contains an explanatory
paragraph expressing substantial doubt about our ability to continue as a going
concern. The consolidated financial statements have been prepared "assuming that
we will continue as a going concern," which contemplates that we will realize
our assets and satisfy our liabilities and commitments in the ordinary course of
business.
MATERIAL COMMITMENTS
In accordance with the terms and provisions of the Private Placement with
certain Investing Note Holders for aggregate proceeds of $5,860,000, we issued
an aggregate of $5,860,000 in secured, convertible two-year promissory notes
bearing 8% interest to the Investing Note Holders (collectively, the
"Convertible Promissory Notes"). See "Part II. Other Information. Item 2 Changes
in Securities and Use of Proceeds".
We are committed to repay the Investing Note Holders outstanding amounts of
principal and interest accrued at 8% per annum on an aggregate face value of
$5,860,000 in Convertible Notes. Twenty monthly principal and interest payments
are payable either in cash or shares of our common stock at the rate of $1.00
per share (the "Fixed Conversion Price") beginning on January 16, 2005 if our
share price is trading above $1.00 per share at the date of payment. Commencing
on the fourth month anniversary of the closing date of the issue of the
Convertible Notes (September 16, 2005), and on the first date of each month
thereafter, the Convertible Notes must be repaid in cash or shares in the amount
equal to 5% of the principal amount of the Convertible Notes together with all
accrued interest due and payable up to the repayment date. If our shares of
common stock are trading at less than $1.00 per share at the date of repayment,
then we may repay monthly principal and interest due in either cash of shares of
common stock at a different rate than the Fixed Conversion Price. If the volume
weighted average share price (the "VWAP") of the five trading days prior to a
month payment date is less than the Fixed Conversion Price, then we may pay the
monthly amount in cash or registered shares of our common stock at 75% of the
VWAP for the five trading days prior to the month payment date. The holders of
the Convertible Notes have a secured first interest in our assets.
OFF-BALANCE SHEET ARRANGEMENTS
As of the date of this Quarterly Report, we do not have any off-balance
sheet arrangements that have or are reasonably likely to have a current or
future effect on our financial condition, changes in financial condition,
revenues or expenses, results of operations, liquidity, capital expenditures or
capital resources that are material to investors. The term "off-balance sheet
arrangement" generally means any transaction, agreement or other contractual
arrangement to which an entity unconsolidated with us is a party, under which we
have: (i) any obligation arising under a guaranteed contract, derivative
instrument or variable interest; or (ii) a retained or contingent interest in
assets transferred to such entity or similar arrangement that serves as credit,
liquidity or market risk support for such assets.
37
ITEM III. CONTROLS AND PROCEDURES
An evaluation was conducted under the supervision and with the
participation of our management, including Grant Atkins, our President and Chief
Executive Officer, and Vaughn Barbon, our Treasurer and Chief Financial Officer,
of the effectiveness of the design and operation of our disclosure controls and
procedures as at September 30, 2005. Based on that evaluation, Messrs. Atkins
and Barbon concluded that our disclosure controls and procedures were effective
as of such date to ensure that information required to be disclosed in the
reports that we file or submit under the Securities Exchange Act of 1934, as
amended (the "Exchange Act"), is recorded, processed, summarized and reported
within the time periods specified in Commission rules and forms. Such officers
also confirm that there was no change in our internal control over financial
reporting during the nine-month period ended September 30, 2005 that has
materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.
Audit Committee Report
The Board of Directors has established an audit committee. The members of
the audit committee are Mr. Steven Jewett, Mr. Doug Humphreys, and Mr. Norman
MacKinnon. Two of the three members of the audit committee are "independent"
within the meaning of Rule 10A-3 under the Exchange Act. The audit committee was
organized in April 2004 and operates under a written charter adopted by our
Board of Directors.
The audit committee has reviewed and discussed with management our
unaudited financial statements as of and for the nine-month period ended
September 30, 2005. The audit committee has also discussed with Dale Matheson
Carr-Hilton LaBonte the matters required to be discussed by Statement on
Auditing Standards No. 61, Communication with Audit Committees, as amended, by
the Auditing Standards Board of the American Institute of Certified Public
Accountants. The audit committee has received and reviewed the written
disclosures and the letter from Dale Matheson Carr-Hilton LaBonte required by
Independence Standards Board Standard No. 1, Independence Discussions with Audit
Committees, as amended, and has discussed with Dale Matheson Carr-Hilton LaBonte
their independence.
Based on the reviews and discussions referred to above, the audit committee
has recommended to the Board of Directors that the unaudited financial
statements referred to above be included in our Quarterly Report on Form 10-QSB
for the nine-month period ended September 30, 2005 filed with the Securities and
Exchange Commission.
38
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Management is not aware of any legal proceedings contemplated by any
governmental authority or any other party involving us or our properties. As of
the date of this Quarterly Report, no director, officer or affiliate is (i) a
party adverse to us in any legal proceeding, or (ii) has an adverse interest to
us in any legal proceedings. Management is not aware of any other legal
proceedings pending or that have been threatened against us or our properties.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
CONVERITBLE NOTES
In accordance with the terms and provisions of the Private Placement with
certain Investing Note Holders for aggregate proceeds of $5,860,000, we issued:
(i) an aggregate of $5,860,000 in secured, convertible two-year promissory notes
bearing 8% interest to the Investing Note Holders (collectively, the
"Convertible Promissory Notes"); (ii) for every two shares of our common stock
purchasable in accordance with the conversion provisions of the Convertible
Promissory Notes, one Class A Warrant, for an aggregate of 2,930,000 Class A
Warrants, to purchase a share of our common stock at an exercise price of $1.50
per share for a three-year term after a registration statement has been declared
effective by the Securities and Exchange Commission; (iii) for every two shares
of our common stock purchasable in accordance with the conversion provisions of
the Convertible Notes, one Class B Warrant, for an aggregate of 2,930,000 Class
B Warrants, to purchase an additional share of our common stock at an exercise
price of $1.25 per share for a one-year term after a registration statement has
been declared effective by the Securities and Exchange Commission; and (iv)
586,000 finder's Warrants to purchase shares of our common stock at an exercise
price of $1.00 per share for a term of three-years after the registration
statement has been declared effective by the Securities and Exchange Commission.
COAL CREEK LOANS
From June through August 2005, we obtained loans in the aggregate amount of
$1,165,000, which loans were secured against our interests in the Coal Creek
Prospect (the "Coal Creek Loans"). As of September 30, 2005, we have repaid the
Coal Creek Loans in the aggregate principal amount of $1,165,000 and accrued
interest of $41,058, thus discharging the security interest against our Coal
Creek Prospect. We also issued 233,000 warrants exercisable at $3.00 per share
with exercise terms until May 31, 2010.
EXERCISE OF SHARE PURCHASE WARRANTS
As of the date of this Quarterly Report, we have issued an aggregate of
304,367 shares of common stock to shareholders pursuant to the exercise of the
September Warrants. During fiscal year 2004, we completed the sale of an
aggregate of 1,700,686 Units at a purchase price of $1.47 per Unit for net
proceeds of approximately $2,319,264. Included in the net proceeds was the
exchange of two of our outstanding promissory notes in the aggregate principal
amount of $500,000 plus accrued interest of $12,637 for Units, resulting in the
issuance of 376,318 Units. Each Unit consisted of one share of our common stock
and one warrant to purchase a share of our common stock at an exercise price of
$1.68.
As of the date of this Quarterly Report, an aggregate of 304,367 September
Warrants were exercised for aggregate proceeds of $495,964, net of $15,373 in
brokers' fees. The 304,367 shares of common stock were issued to the
39
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS - continued
shareholders in reliance on the registration provisions of the Securities Act of
1933, as amended, in accordance with the terms of the Registration Statement.
The September Warrants were exercisable until July 23, 2005 and unexercised
warrants have expired.
EXERCISE OF STOCK OPTIONS
During the nine-month period ended September 30, 2005, an aggregate of
100,000 Stock Options were exercised at $0.16667 per share for cash proceeds of
$16,667. The shares of common stock were issued to the shareholder in accordance
with the S-8 Registration Statement.
Amendment to Stock Option Plan
We current have one equity compensation plan, our amended Stock Option Plan
(the "Amended SOP") dated August 19, 2005, which provides for the issuance of
stock options for services rendered to us. Our Board of Directors is vested with
the power to determine the terms and conditions of the stock Options. The
Amended Stock Option Plan includes 7,500,000 shares. As of December 31, 2004,
4,200,000 stock options under our previous stock option plan had been granted
and 3,665,000 stock options had been exercised which, by adoption of the amended
SOP, now form part of our Amended SOP. During the nine month period ended
September 30, 2005, we have granted an aggregate of 2,600,000 additional stock
options under our Amended Stock Option Plan as follows: (i) 500,000 stock
options at an exercise price of $1.00 per share, 100,000 stock options at an
exercise price of $0.1667 both granted on February 1, 2005 exercisable for a
period of five years, and (ii) 2,000,000 stock options at an exercise price of
$1.25 granted on August 19, 2005 exercisable for a period of five years.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
No report required.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No report required.
ITEM 5. OTHER INFORMATION
No report required.
ITEM 5. OTHER INFORMATION
No report required.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Exhibits:
31.1 Certification of Chief Executive Officer pursuant to Securities
Exchange Act of 1934 Rule 13a-14(a) or 15d-14(a).
31.2 Certification of Chief Financial Officer pursuant to Securities
Exchange Act of 1934 Rule 13a-14(a) or 15d-14(a).
32.1 Certifications pursuant to Securities Exchange Act of 1934 Rule 13a-
14(b) or 15d-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
40
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K - continued
Reports on Form 8-K:
Report on Form 8-K Item 5.01 filed on February 18, 2005. Report on Form 8-K
Item 1.01 filed on June 8, 2005. Report on Form 8-K Item 3.02 filed on
September 20, 2005. Report on Form 8-K Item 1.01 filed on September 23,
2005. Report on Form 8-K Item 1.01 filed on September 29. 2005.
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
LEXINGTON RESOURCES, INC.
Dated: November 14, 2005 By: /s/ Grant Atkins
---------------------------
Grant Atkins, President and
Chief Executive Officer
Dated: November 14, 2005 By: /s/ Vaughn Barbon
---------------------------
Vaughn Barbon, Chief Financial
Officer
41