|• QUARTERLY REPORT • EXHIBIT 31.01 • EXHIBIT 31.02 • EXHIBIT 32.01 • EXHIBIT 32.02|
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended March 31, 2012
¨ 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: 000-53972
MESA ENERGY HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
5220 Spring Valley Road, Suite 525
Dallas, Texas 75254
(Address of principal executive offices) (zip code)
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company þ
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ.
As of May 14, 2012, there were 82,974,616 shares of the registrant’s common stock outstanding.
MESA ENERGY HOLDINGS, INC.
INDEX TO FINANCIAL STATEMENTS
PART 1. FINANCIAL INFORMATION
Item 1. Consolidated Interim Financial Statements
MESA ENERGY HOLDINGS, INC.
CONSOLIDATED BALANCE SHEETS
See accompanying notes to unaudited consolidated financial statements.
MESA ENERGY HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See accompanying notes to these unaudited consolidated financial statements.
MESA ENERGY HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to these unaudited consolidated financial statements.
MESA ENERGY HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 – ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Mesa Energy, Inc. (“MEI”) is a wholly owned subsidiary of Mesa Energy Holdings, Inc. (the “Company”). MEI’s predecessor entity, Mesa Energy, LLC, was formed in April 2003 as an exploration and production company in the oil and gas industry. MEI’s oil and gas operations are conducted through itself and its wholly owned subsidiaries. MEI acquired Tchefuncte Natural Resources, LLC (“TNR”) in July 2011. TNR owns interests in 80 wells and related surface production equipment in five fields located in Plaquemines and Lafourche Parishes in Louisiana. Mesa Gulf Cost Operating, LLC became the operator of all operated properties in Louisiana in October 2011. Mesa Operating, LLC, a wholly owned subsidiary, is a qualified operator in the states of Texas, Oklahoma, and Wyoming. MEI is a qualified operator in the State of New York and operates the Java Field. Our operating entities have historically employed, and will continue in the future to employ, on an as-needed basis, the services of drilling contractors, other drilling related vendors, field service companies and professional petroleum engineers, geologists and land men as required in connection with future drilling and production operations. See Note 2 for more information on the acquisition of TNR.
Basis of Presentation
The accompanying unaudited interim consolidated financial statements have been prepared by the Company in accordance with accounting principles generally accepted in the United States and the rules of the Securities and Exchange Commission. and should be read in conjunction with the audited consolidated financial statements and notes thereto contained in the Company’s latest annual report filed with the SEC on Form 10-K. In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial position and the results of operations for the interim periods presented have been reflected herein. The results of operations for interim periods are not necessarily indicative of the results to be expected for the full year. Notes to the unaudited interim consolidated financial statements that would substantially duplicate the disclosures contained in the audited consolidated financial statements for fiscal year 2011, as reported in the Form 10-K, have been omitted.
Principles of Consolidation
The consolidated financial statements include the Company’s accounts and those of the Company’s wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expense during each reporting period. Management believes these estimates and assumptions are reasonable; however, such estimates and assumptions are subject to a number of risks and uncertainties, which may cause actual results to differ materially from management’s estimates.
Loss Per Share
The Company’s loss per share is computed by dividing net loss by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects the potential dilution of securities, if any, that could share in the earnings of the Company and are calculated by dividing net loss by the diluted weighted average number of common shares. The diluted weighted average number of common shares is computed using the treasury stock method for common stock that may be issued for outstanding stock options and convertible debt. The following is a reconciliation of the numerator and denominator used for the computation of basic and diluted net loss per common share:
Recently Issued Accounting Pronouncements
The Company does not expect the adoption of any recently issued accounting pronouncements to have a significant impact on its financial position, results of operations or cash flows.
The Company has evaluated all transactions through the financial statement issuance date for subsequent event disclosure consideration.
NOTE 2 – ACQUISITION OF TCHEFUNCTE NATURAL RESOURCES, LLC.
On July 22, 2011, the Company acquired 100% of the membership interests in Tchefuncte Natural Resources, LLC, which became a wholly-owned subsidiary of the Company. Assets acquired are comprised of five oil and gas fields in Plaquemines and Lafourche Parishes in Louisiana. In exchange for their members’ interests, the selling members of TNR received an aggregate of 21.2 million shares of the Company’s common stock valued at $2,968,000 based on the closing price of Mesa’s stock on July 22, 2011.
The following unaudited pro forma information assumes the acquisition of TNR occurred as of January 1, 2011. The pro forma results are not necessarily indicative of what actually would have occurred had the acquisition been in effect for the entire period presented.
NOTE 3 – FAIR VALUE MEASUREMENTS
The following tables set forth by level within the fair value hierarchy our financial assets and liabilities that were accounted for at fair value on a recurring basis as of March 31, 2012 and December 31, 2011.
The Company did not identify any other assets and liabilities that are required to be presented on the consolidated balance sheet at fair value. Additional information regarding our derivative instruments can be found in Note 4 – Commodity Derivative Instruments and Note 6 – Debt.
NOTE 4 – COMMODITY DERIVATIVE INSTRUMENTS
The Company has commodity derivative instruments for which it determined the fair value using period-end closing oil and gas prices, interest rates and volatility factors for the periods under each contract as of March 31, 2012. The details of the derivative instruments are summarized below:
Costless Gas Collar
Oil Fixed Price Swaps
Oil Basis Swap
The Company elected not to apply hedge accounting to these derivatives. At March 31, 2012, the Company recognized a short term derivative asset of $18,821 and a long-term derivative asset of $76,848, with the $843,281 decrease in fair value from December 31, 2011 reported in other income (expense) as unrealized loss on derivative instruments for the three months ended March 31, 2012. Net realized gains of $9,393 from settlements of these derivatives have been reported in other income (expense) as realized gain on commodity contracts during the three months ended March 31, 2012.
The Company also has a derivative liability associated with the value of the conversion features of its convertible debt which is discussed more fully in Note 6 - Debt.
NOTE 5 – PROPERTY, PLANT AND EQUIPMENT
Oil and Gas Properties
The Company’s oil and gas properties at March 31, 2012 are located in the United States.
The carrying values of the Company’s oil and gas properties by field, net of depletion and impairment, at March 31, 2012 and December 31, 2011 were:
Net proved oil and gas properties at March 31, 2012 were:
In the three months ended March 31, 2012, we plugged and abandoned two wells, the Southdown 2D and the LLDSB #7, retiring their costs comprising, solely, asset retirement costs for the Southdown 2D well and asset retirement costs and intangible drilling costs for the LLDSB #7. Costs of the LLDSB #7 well were retired after an unsuccessful attempt to convert it to a salt water disposal well resulted in an oil spill for which we incurred $216,214 of environmental remediation expense in addition to the expense of plugging and abandoning the well. See Note 7 – Asset Retirement Obligations for more discussion on the impact of the retirement of these two wells on their asset retirement obligations.
Support Facilities and Equipment
The Company’s support facilities and equipment serve its oil and gas production activities. The following table details these properties and equipment, together with their estimated useful lives:
Office Furniture Equipment, and Other
Support facilities and equipment and office furniture, equipment, and other are depreciated using the straight line method over their estimated useful lives.
NOTE 6 – DEBT
Convertible Promissory Notes
The Company had $349,915 and $461,740 of convertible promissory notes outstanding at March 31, 2012 and December 31, 2011, net of unamortized debt discount of $3,604 and $4,279, respectively. During the first quarter of 2012, Convertible Notes of $112,500 were converted into 900,000 common shares of the Company at $0.125 per share. On May 11, 2011, pursuant to the Omnibus Waiver and Modification Agreements provided by the three remaining holders, the convertible debt holders agreed to extend the maturity date of their outstanding note balances to July 31, 2013, amend the conversion price of $0.25 to $0.125 per share and subordinate their lien on the assets of the Company to F & M Bank in conjunction with the Company entering into the Credit Facility in order to acquire TNR. Management determined that the reduction of the conversion price created an embedded derivative with a $0 fair value on May 11, 2011. The fair value of the embedded derivative at March 31, 2012 and December 31, 2011 was $579,181 and $113,083, respectively.
Changes in the fair value of embedded derivative instruments for the three months ended March 31, 2012 and the year ended December 31, 2011 were as follows:
The fair value of the derivative conversion feature is estimated using the following principal assumptions for the binomial valuation model on the date of initial valuation:
Credit Facility and Notes Payable
The Company’s notes payable were as follows:
On July 22, 2011, MEI entered into a $25 million senior secured revolving line of credit (“Credit Facility") with F&M Bank and Trust Company (“F&M Bank”) that matures on July 22, 2013. Loans made under this credit facility are secured by TNR’s proved producing reserves (“PDP”) as well as guarantees provided by the Company, MEI, and the Company’s other wholly-owned subsidiaries. The Company is required to make monthly interest payments on the Credit Facility based on a variable interest rate. The interest rate is the F&M Bank Base Rate plus 1% subject to a floor of 5.75%. Interest is currently accruing at 5.75%. A 2.00% annual fee is applicable to letters of credit drawn under the Credit Facility.
The borrowing base is subject to two scheduled redeterminations each year. F&M Bank completed its first scheduled redetermination pursuant to the Credit Facility and increased the Company’s borrowing base from $10,500,000 to $13,500,000 in April 2012. The redetermination eliminated the Company’s obligation to make the remaining $150,000 Monthly Commitment Reduction payment required prior to the redetermination. Reporting requirements, loan covenants and events of default are customary for this type of Credit Facility. The Company was in compliance with all of the debt covenants as of March 31, 2012.
NOTE 7 – ASSET RETIREMENT OBLIGATIONS
The following table provides a reconciliation of the changes in the estimated asset retirement obligation for the quarter ended March 31, 2012 and for the year ended December 31, 2011.
In the first quarter of 2012 we plugged and abandoned two wells, the Southdown 2D and the LLDSB #7 recognizing a loss on settlement of asset retirement obligation of $116,394. See Note 5 – Property, Plant, and Equipment for more discussion on the LLDSB #7 well as regards the events leading up to the environmental remediation expense we incurred, not included in plugging and abandonment costs, which resulted in our plugging and abandoning this well.
NOTE 8 – INCOME TAXES
As of March 31, 2012, the Company has U.S. net operating loss carry forwards of approximately $4.6 million which begin to expire in 2028. The Company also has tax credit carry forwards of approximately $20,000 in alternative minimum tax credits which do not expire.
We recognize the financial statement effects of tax positions when it is more likely than not, based on the technical merits, that the position will be sustained upon examination by a taxing authority. Recognized tax positions are initially and subsequently measured as the largest amount of tax benefit that is more likely than not of being realized upon ultimate settlement with a taxing authority. We have not taken a tax position that, if challenged, would have a material effect on the consolidated financial statements or the effective tax rate for the three months ended March 31, 2012.
NOTE 9 – STOCKHOLDERS’ EQUITY
The Company is authorized to issue 300 million shares of common stock with a $0.0001 par value per share and 10 million shares of preferred stock with a $0.0001 par value per share. At March 31, 2012 and December 31, 2011, the Company had 80,674,616 and 79,531,616 shares issued and outstanding, respectively. No preferred stock has been issued by the Company.
Options to purchase 140,000 shares of common stock were granted in 2012 with an estimated fair value of $34,597. The following summarizes the values from and assumptions for the Black-Scholes option pricing model for stock options issued during the three months ended March 31, 2012:
The following table summarizes the Company’s employee stock option activity for the three months ended March 31, 2012:
Compensation expense related to stock options of $38,814 and $36,395 was recognized for the three months ended March 31, 2012 and 2011, respectively. At March 31, 2012, the Company had $83,011 of unrecognized compensation expense related to outstanding unvested stock options, which will be fully recognized over the next 2.0 years. No stock options have been exercised.
The following table summarizes the Company’s employee restricted stock activity, including activity for awards not granted under the 2009 Plan, for the three months ended March 31, 2012:
At March 31, 2012, the Company had $224,700 of unrecognized compensation expense related to outstanding restricted stock granted to employees, which is expected to be recognized over the next 1.4 years. Compensation expense related to restricted stock grants of $48,046 and $3,420 was recognized in the first three months of 2012 and 2011, respectively.
NOTE 13 – SUBSEQUENT EVENTS
In April 2012, options for 60,000 shares of restricted common stock were awarded to three employees pursuant to the 2009 Equity Incentive Plan as follows:
The fair value of the options at the grant date was determined, using a Black Scholes model, to be $11,486 using the assumptions in the table above.
On April 1, 2012, 200,000 shares of restricted stock with a fair value of $30,000 vested and were issued in connection with an Employment Services Agreement.
In April 2012, $262,500 of convertible debt was converted into 2,100,000 shares of common stock.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This report contains forward-looking statements. All statements other than statements of historical facts included in this Quarterly Report on Form 10-Q, including without limitation, statements in this Management’s Discussion and Analysis of Financial Condition and Results of Operations regarding our financial position, estimated working capital, business strategy, the plans and objectives of our management for future operations and those statements preceded by, followed by or that otherwise include the words “believe,” “expects,” “anticipates,” “intends,” “estimates,” “projects,” “target,” “goal,” “plans,” “objective,” “should” or similar expressions or variations on such expressions are forward-looking statements. We can give no assurances that the assumptions upon which the forward-looking statements are based will prove to be correct. Because forward-looking statements are subject to risks and uncertainties, actual results may differ materially from those expressed or implied by the forward-looking statements. There are a number of risks, uncertainties and other important factors that could cause our actual results to differ materially from the forward-looking statements, including, but not limited to, our inability to obtain adequate financing, insufficient cash flows and resulting illiquidity, our inability to expand our business, government regulations, lack of diversification, volatility in the price of oil and/or natural gas, increased competition, results of arbitration and litigation, stock volatility and illiquidity, our failure to implement our business plans or strategies and general economic conditions. A description of some of the risks and uncertainties that could cause our actual results to differ materially from those described by the forward-looking statements in this Quarterly Report on Form 10-Q appears in the section captioned “Risk Factors” in our 2011 Annual Report on Form 10-K.
Except as otherwise required by the federal securities laws, we disclaim any obligations or undertaking to publicly release any updates or revisions to any forward-looking statement contained in this Quarterly Report on Form 10-Q to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.
We are a growth-oriented exploration and production (E&P) company with a definitive focus on growing reserves and net asset value per share, primarily through the acquisition and enhancement of high quality producing properties and the development of highly diversified developmental drilling opportunities. We currently own producing oil and natural gas properties in Plaquemines and Lafourche Parishes in Louisiana as well as developmental properties in Wyoming County, NY.
The following discussion highlights the principal factors that have affected our financial condition as well as our liquidity and capital resources for the periods described and provides information which management believes is relevant for an assessment and understanding of the statements of financial position, results of operations and cash flows presented herein. This discussion should be read in conjunction with our unaudited financial statements, related notes and the other financial information included elsewhere in this report.
Producing Fields - Plaquemines and Lafourche Parishes, Louisiana
On July 22, 2011, MEI completed the acquisition of Tchefuncte Natural Resources, LLC (“TNR”), a Louisiana operator. Immediately prior to MEI’s closing of the TNR acquisition, TNR completed the acquisition of properties in four fields in south Louisiana from Samson Contour Energy E & P, LLC (“Samson”). TNR, now a wholly owned subsidiary of MEI, owns 100% working interests in the Lake Hermitage Field in Plaquemines Parish, Louisiana along with various working interests in producing properties in four additional fields in Plaquemines and Lafourche Parishes, Louisiana. The total net mineral acreage held by production in the five fields is approximately 7,189 acres.
We believe that by recompleting or otherwise returning several additional shut-in wells to production, improving operational efficiencies and optimization of the gas lift systems, a significant increase in production can be achieved in these fields. Two wells were successfully recompleted to uphole zones in the Lake Hermitage Field in the fourth quarter of 2011 with positive results. The recompletion of two additional wells is planned for the second quarter of 2012 with more recompletions to follow in the third and fourth quarters of 2012. In addition, we expect to accomplish a number of additional enhancements and upgrades to processing facilities and flow lines in 2012, all of which are to be funded out of cash flow. These efforts should significantly increase production and PDP reserves. An extensive geological and engineering evaluation of the Lake Hermitage Field is nearing completion and a similar evaluation of the other four fields is underway. In addition, our technical team has identified and is in the process of refining a number of proved undeveloped (“PUD”) drilling locations and we expect to drill the first of several developmental wells later this year. We are reviewing a number of deep targets with potential for farm out or joint venture with other operators and are actively pursuing additional acquisition opportunities in South Louisiana.
Lake Hermitage Field – Plaquemines Parish, Louisiana
The Company owns a 100% working interest in each of the eighteen wells in the Lake Hermitage Field. Current net production is approximately 220 BOE/D from seven producing wells and a total of 3,578 mineral acres is held by production in the field. Ten wells are currently shut-in pending evaluation for workover and/or future recompletion in uphole zones. The remaining well has been permitted for conversion to a salt water disposal well which would reduce expenses and allow us to handle more fluid on a daily basis. An attempt in the first quarter to convert the LLDSB # 7 to a salt water disposal well was unsuccessful and it has been plugged and abandoned. There are three processing facilities and tank batteries in the field. The high gravity crude oil produced at Lake Hermitage is transported out of the field by barge.
A significant improvement in efficiency has been achieved in the Lake Hermitage Field by the installation of higher capacity equipment and by optimization of the gas lift system. In addition, two wells were successfully recompleted to uphole zones in the fourth quarter of 2011. The recompletion of two additional wells is planned for the second quarter of 2012 with more recompletions to follow in the third and fourth quarters of 2012.
An extensive geological and engineering evaluation of the field has identified fifty-eight potential drilling locations, nine of which are proved undeveloped (“PUD”) locations with multiple stacked pay zones. We expect to drill the first of several developmental wells in this field later this year.
Bay Batiste Field, Plaquemines Parish, Louisiana
The Company owns an average 61% working interest in seven wells in the Bay Batiste Field. Current net production is approximately 80 BOE/D from one producing well. The other six wells are currently shut-in pending evaluation for future workover or recompletion in uphole zones. Approximately 74 net mineral acres are held by production by the producing well. The salt water disposal well and two production facilities have plenty of excess capacity to handle production from recompleted wells or from third party operators nearby. Access to markets is excellent.
Larose Field – Lafourche Parish, Louisiana
Various working interests, some of which are non-operated, are owned by the Company in eight wells in the Larose Field. Current net production is approximately 80 BOE/D from three producing wells and approximately 439 net mineral acres are held by production in the field. Five wells are currently shut-in pending evaluation for future workover or recompletion in uphole zones. The processing facilities and tank batteries are well located and have plenty of excess capacity. Access to pipelines and crude oil markets is excellent.
Valentine Field – Lafourche Parish, Louisiana
The Company owns an average 90% working interest in forty-four wells in the Valentine Field. Current net production is approximately 400 BOE/D from fourteen producing wells and approximately 3,082 net mineral acres are held by production in the field. There are four salt water disposal wells in the field and twenty-six wells are currently shut-in pending evaluation for future workover or recompletion in uphole zones. The processing facilities and tank batteries are strategically located throughout the field and have plenty of excess capacity. A field operations center is centrally located in the field. Access to pipelines and crude oil markets is excellent.
Evaluation of the existing well bores and overall field operations is in progress and we expect to begin an initial round of recompletions and workovers in 2012. In addition to numerous recompletion and workover opportunities, there is offset developmental drilling potential as well as deep gas potential. All of those potential opportunities are currently being evaluated.
SE Manila Village Field – Plaquemines Parish, Louisiana
The Company owns a non-operated working interest in two wells operated by Hilcorp in the Manila Village Field. 16.88 net mineral acres are held by production in the field. The wells are shut-in at this time.
Java Field Natural Gas Development Project – Wyoming County, New York
On August 31, 2009, we acquired the Java Field, a natural gas development project targeting the Marcellus Shale present in the Appalachian basin in Wyoming County in western New York. The acquisition included 19 producing natural gas wells and their associated leases/units, two surface tracts of land totaling approximately 36 acres and two pipeline systems, including a 12.4 mile pipeline and gathering system that serves the existing field as well as a separate 2.5 mile system located northeast of the field. Our average net revenue interest (NRI) in the leases is approximately 78%. Production from the wells is nominal but serves to hold the acreage for future development. In late 2009, we evaluated a number of the existing wells in order to determine the viability of the re-entry of existing wellbores for plug-back and recompletion of the wells in the Marcellus Shale. As a result of this evaluation, we selected the Reisdorf Unit #1 and the Ludwig #1 as our initial targets and these two wells were recompleted in the Marcellus Shale and fracked in May and June of 2010. The initial round of testing and analysis provided a solid foundation of data that strongly supports further development of the Marcellus in western New York. Formation pressures and flow-back rates were much higher than expected providing a clear indication of the potential of the resource. We now believe that shallow horizontal drilling, as is currently being done successfully at this depth in the Fayetteville Shale in northern Arkansas, is ultimately what is needed to maximize the resource.
The State of New York has placed a moratorium on high volume frac stimulation in order to develop new permitting rules. The new permitting rules have not been completed and there can be no assurance when such permitting rules will be issued or what restrictions such permits might impose on producers. Accordingly, we are unable to continue with our development plans in New York for the time being. Unless the moratorium is removed and new permitting rules provide for the economic development of these properties, production on these properties will remain marginally economic. Accordingly, management made a determination to fully impair the properties as of December 31, 2010.
A recent report released by the New York Department of Environmental Conservation proposes to remove the moratorium in all areas of the state other than in the New York City and Syracuse watersheds and to implement new permitting rules for drilling and fracking horizontal wells. Although these measures have yet to be formally adopted, we believe that this report constitutes significant progress and that its final adoption could ultimately allow us to proceed with the next phase of development of the property and the expansion of our acreage position in western New York.
Mineral Acreage Leasing - Garfield and Major Counties, Oklahoma
We believe that diversification is vitally important to a rapidly growing E & P company and we recently made the determination that we need to pursue additional expandable and repeatable drilling opportunities, primarily for oil, in other plays. After extensive evaluation, we have focused our efforts on the Mississippian Limestone and the Woodford Shale in north central Oklahoma.
Oklahoma is a great place to develop a drilling program. It is relatively close to Dallas, is a very oil friendly state and has good availability of services and a moderate climate. The Mississippian Limestone in Oklahoma is a proven zone that has been drilled vertically in that area for many years so there is a lot of well control information available. The emerging horizontal play is mature enough to have a substantial amount of public information available, yet early enough that acreage can still be acquired at moderate prices. This is an opportunity to establish a repeatable drilling program with room to run in an area with a high drilling success rate. All in all, we believe this area offers all of the positive attributes that we are looking for.
The Mississippian Limestone in the area of interest is at vertical depths of approximately 7,000’ and is 300’ to 400’ thick. The Woodford Shale, which would be a secondary objective in any well drilled, is immediately below the Mississippian appears to be oil bearing and is 50 to 100’ thick. Potential reserves in the Mississippian on a per well basis are estimated to be 200,000 to 400,000 barrels per well with recoverable barrels per section estimated to be as much as 2,600,000 BOE. The Woodford would add to that number. A multi-stage frac is required using acid, fresh water and a simple sand proppant. The Mississippian produces some water, so disposal wells will likely be required. The oil is light, sweet crude with a gravity of 40 to 45 dg.
We have identified specific areas of interest where we believe open acreage can be acquired at a reasonable cost and have commenced a grass-roots acreage acquisition effort. Because the acquisition of leases is a competitive and time consuming process, we may elect to farm-in leases or to purchase leases from other oil and natural gas companies. In most cases, the assignor of such leases and/or lease brokers or finders will reserve an overriding royalty interest (an “ORRI”), and may also retain a portion of the working interest.
On rare occasions, the mineral owner or current lease holder may elect to joint venture with us and participate for his royalty interest in the drilling unit. In this event, our working interest ownership would be reduced by the amount retained by the third party. In all other instances, we anticipate owning a 100% working interest in newly drilled wells.
Adjusted EBITDA as a Non-GAAP Performance Measure
In evaluating our business, management believes earnings before interest, taxes, depreciation, depletion, amortization and accretion, unrealized gains and losses on financial instruments, gains and losses on sales of assets and stock-based compensation expense ("Adjusted EBITDA") is a key indicator of financial operating performance and is a measure of our ability to generate cash for operational activities and future capital expenditures. Adjusted EBITDA is not a GAAP measure of performance. We use this non-GAAP measure primarily to compare our performance with other companies in our industry and as a measure of our current liquidity. We believe that this measure may also be useful to investors for the same purposes and as an indication of our ability to generate cash flow at a level that can sustain or support our operations and capital investment program. Investors should not consider this measure in isolation or as a substitute for income from operations, or cash flow from operations determined under GAAP, or any other measure for determining operating performance that is calculated in accordance with GAAP. In addition, because Adjusted EBITDA is not a GAAP measure, it may not necessarily be comparable to similarly titled measures that may be disclosed by other companies.
The following is a reconciliation of our net income in accordance with GAAP to our Adjusted EBITDA for the three-month periods ending March 31, 2012 and 2011:
Results of Operations
Quarter Ended March 31, 2012 Compared to Quarter Ended March 31, 2011
Revenue from sales of oil and natural gas were $4,394,812 in the first quarter of 2012 as compared to $18,409 in the first quarter of 2011. This increase in revenues reflects additional sales volumes from producing wells acquired in the TNR Acquisition. Average natural gas prices decreased $0.62/Mcf to $2.84/Mcf in the first quarter of 2012 from an average price of $3.46/Mcf in the first quarter of 2011. The average price of oil in the first quarter of 2012 was $113.22/Bbl. Prior to the TNR Acquisition, the Company had no oil production or sales. Natural gas sales volumes increased during the first quarter of 2012 to 2,240 Mcf per day from 58 Mcf per day during the first quarter of 2011. Oil sales volumes during the first quarter of 2012 were 367 Bbls per day. The increase in volumes is also attributable to the addition of producing properties resulting from the Company’s acquisition of TNR.
Operating income. As a result of the above described revenues and expenses, we recognized operating income of $748,045 in the first quarter of 2012 as compared to an operating loss of $147,555 in the first quarter of 2011.
Interest expense. Interest expense decreased to $177,364 for the three months ended March 31, 2012, from $249,008 for the three months ended March 31, 2011. The decrease was primarily a function of reduced outstanding convertible debt in the first quarter of 2012 versus the first quarter of 2011, despite interest on debt acquired subsequent to the first quarter of 2011, principally the outstanding Credit Facility and other related fees paid to F&M Bank. The Company also recorded $111,974 of induced debt conversion expense charged to interest expense during the quarter ended March 31, 2011 and did not incur any of these expenses in the 2012 quarter.
Unrealized losses on changes in derivative value. The unrealized loss on change in derivatives – commodity contracts for the three months ended March 31, 2012 and 2011 was $843,281 and $0, respectively. Unrealized losses in the first quarter of 2012 were primarily the result of increases in oil prices relative to the fixed oil prices in our swap derivatives. The unrealized loss on change in derivatives – convertible debt for the three months ended March 31, 2012 and 2011 was $765,013 and $0, respectively. The unrealized loss associated with the convertible debt derivative represented the change in the potential liability for issuing shares with a higher value than the conversion price upon conversion of convertible debt into common stock.
Realized gain on changes in derivatives – commodity contracts. Cash settlements from hedging our sales of oil and gas production were $9,393 in the first quarter of 2012 as compared to $0 in the first quarter of 2011. The increase is attributable to our hedging program, implemented in accordance with covenants associated with our credit facility with F&M Bank.
Income tax benefit. Income tax benefit for the first quarter of 2012 increased to $353,848 from $0 in the first quarter of 2011 resulting from the elimination of our tax valuation allowance and recognition, at December 31, 2011, of a deferred income tax asset.
Net loss. Our net loss for the three months ended March 31, 2012 was $665,762 ($0.01 per basic and diluted share). Our net loss for the three months ended March 31, 2011 was $396,563 ($0.01 per basic and diluted share), due to unrealized noncash losses on change in derivative values in the first quarter of 2012, despite increased first quarter 2012 operating income over first quarter 2011 operating income.
Liquidity and Capital Resources
As of March 31, 2012, we had working capital of $3,622,220. As of December 31, 2011, we had working capital of $3,104,453. The increase in the working capital was attributable to:
Cash and Accounts Receivable
At March 31, 2012, we had cash and cash equivalents of $3,824,842, compared to $3,182,392 at December 31, 2011. Cash increased by $642,450 due to cash from operations of $1,115,917 that was partially offset by uses of $473,467 investing and financing activities.
Accounts payable and accrued expenses increased to $2,636,148 at March 31, 2012, from $2,629,472 at December 31, 2011, primarily due to an increased level of operating and capital expenditure activity associated with additional wells and facilities acquired with the purchase of TNR.
As of March 31, 2012, the outstanding balance of principal on debt, net of discount, was $5,685,739, a net decrease of $404,674 from the outstanding balance of $6,090,413, as of December 31, 2011. The decrease was primarily due to repayment of $300,000 on the F&M Bank Credit Facility and the conversion of $112,500 of convertible notes to common stock during the quarter ended March 31, 2012.
For the three months ended March 31, 2012, the net cash provided by operating activities was $1,115,917, which was used to fund our capital expenditures and Credit Facility repayments for the period. We expect to fund operations and the capital expenditure budget for the next twelve months out of cash flow and, absent another significant acquisition, do not anticipate the need for additional sources of capital.
Off-Balance Sheet Arrangements
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 is material to investors.
Item 3. Quantitative and Qualitative Disclosures about Market Risk.
Not required under Regulation S-K for “smaller reporting companies.”
Item 4. Controls and Procedures
a) Evaluation of disclosure controls and procedures.
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934 as of March 31, 2012. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.
Based on management’s evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as a result of the material weaknesses described below, as of March 31, 2012, our disclosure controls and procedures are not presently designed at a level to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. The material weaknesses, which relate to internal control over financial reporting, that were identified are:
We are committed to improving our accounting and financial reporting functions. As part of this commitment, we are considering the engagement of additional employees and have engaged consultants to assist in the preparation and filing of financial reports.
We will continue to monitor and evaluate the effectiveness of our disclosure controls and procedures and our internal controls over financial reporting on an ongoing basis and are committed to taking further action and implementing additional enhancements or improvements, as necessary and as funds allow.
(b) Changes in internal control over financial reporting.
We regularly review our system of internal control over financial reporting and make changes to our processes and systems to improve controls and increase efficiency, while ensuring that we maintain an effective internal control environment. Changes may include such activities as implementing new, more efficient systems, consolidating activities, and migrating processes.
PART II – OTHER INFORMATION
Item 1. Legal Proceedings
We are currently not a party to any material legal proceedings or claims.
Item 1A. Risk Factors
Not required under Regulation S-K for “smaller reporting companies.”
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
On February 15, 2012, Brio Capital, LP elected to convert $50,000 of its Convertible Promissory Note resulting in the issuance of 400,000 shares.
On February 17, 2012, Chestnut Ridge Partners, LP elected to convert $62,500 of its Convertible Promissory Note resulting in the issuance of 500,000 shares.
The above offerings and sales were deemed to be exempt under either rule 506 of Regulation D and Section 4(2) or Rule 902 of Regulation S of the Securities Act of 1933, as amended. No advertising or general solicitation was employed in offering the securities. The offerings and sales were made to a limited number of persons, all of whom were accredited investors or business associates of ours, and transfer was restricted by us in accordance with the requirements of the Securities Act of 1933. In addition to representations by the above-referenced persons, we have made independent determinations that all of the above-referenced persons were accredited or sophisticated investors, and that they were capable of analyzing the merits and risks of their investment, and that they understood the speculative nature of their investment. Except as expressly set forth above, the individuals and entities to which we issued securities as indicated in this section are unaffiliated with us.
Item 3. Defaults Upon Senior Securities
Item 4. Mine Safety Disclosures
Item 5. Other Information
Item 6. Exhibits
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.