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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
(Mark One)
[X] Annual report pursuant to section 13 or 15(d) of the Securities Exchange
Act of 1934 for the fiscal year ended December 31, 2003 or
[ ] Transition report pursuant to section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from June 1, 2002 to
December 31, 2002
Commission file number 000-6814
U.S. ENERGY CORP.
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(Exact Name of Registrant as Specified in its Charter)
Wyoming 83-0205516
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
877 North 8th West
Riverton, WY 82501
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(Address of principal executive offices) (Zip Code)
Registrant's Telephone Number, including area code: (307) 856-9271
--------------
Securities registered pursuant to Section 12(b) of the Act:
NONE
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Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $0.01 PAR VALUE
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(Title of Class)
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 [X] NO [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12B-2 of the Act). YES [ ] NO [X]
The aggregate market value of the shares of voting stock held by
non-affiliates of the Registrant as of June 30, 2003, computed by reference to
the average of the bid and asked prices of the Registrant's common stock as
reported on Nasdaq Small Cap on that date, was $61,728,467.
Class Outstanding at March 24, 2004
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Common Stock, $0.01 par value 13,992,750 shares
Documents incorporated by reference: Portions of the documents listed below
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have been incorporated by reference into the indicated parts of this report as
specified in the responses to the referenced sections of this filing.
Proxy Statement for the Meeting of Shareholders to be held in June 2004,
into Part III of the filing.
Indicate by check mark if disclosure of delinquent filers, pursuant to Item
405 of Regulation S-K is not contained herein and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K [ ].
-1-
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K includes "forward-looking statements"
within the meaning of Section 21E of the Securities Exchange Act of 1934, as
amended (the "Exchange Act"). All statements other than statements of historical
fact included in this Report, are forward-looking statements, including without
limitation the statements under Management's Discussion and Analysis of
Financial Condition and Results of Operations and the disclosures about Rocky
Mountain Gas, Inc. and plans for developing its coalbed methane acreage. In
addition, whenever words like "expect," "anticipate" or "believe" are used, we
are making forward-looking statements.
Although we believe that our forward-looking statements are reasonable, we
don't know if our expectations will prove to be correct. Important future
factors that could cause actual results to differ materially from expectations
include: Domestic consumption rates and market prices for natural gas; the
amounts of gas we will be able to produce from our coalbed methane properties;
the availability of permits to drill and operate coalbed methane wells; whether
and when gas transmission lines will be built in reasonable proximity to the
coalbed methane properties; and whether and on what terms the capital necessary
to develop the properties can be obtained. The forward-looking statements should
be carefully considered in the context of all the information set forth in this
Annual Report.
PART I
ITEM 1 AND ITEM 2. BUSINESS AND PROPERTIES.
(A) GENERAL.
U.S. Energy Corp. is a Wyoming corporation (formed in 1966) in the business
of acquiring, exploring, developing and/or selling or leasing mineral
properties. In this Annual Report, "we," "Company" or "USE" refer to U.S. Energy
Corp. including subsidiaries unless otherwise specifically noted. Our fiscal
year ends December 31; this is the first full year of our new fiscal year (the
prior year ended May 31, and the last Annual Report was a transition report for
the seven months ended December 31, 2002 (filed April 1, 2003)).
In 2003, most of our business activity was devoted to the coalbed methane
("CBM") business, which is conducted through Rocky Mountain Gas, Inc ("RMG") a
subsidiary of the Company.
In 2003, RMG transferred certain of its CBM assets including a producing,
and several non-producing, CBM properties to Pinnacle Gas Resources, Inc.
("Pinnacle"), a newly-organized Delaware corporation. Other parties to this
transaction included CCBM, Inc. and its parent company Carrizo Oil & Gas, Inc.
("CRZO") of Houston Texas; and seven affiliates of Credit Suisse First Boston
Private Equity. As a result of the transaction, RMG became a 37.5% shareholder
of Pinnacle and RMG accounts for its investment on the equity method. RMG
recorded revenues from gas sales from mid-2002 until the transfer to Pinnacle
was completed in mid-2003. See "Transaction with Pinnacle Gas Resources, Inc."
On January 30, 2004, RMG acquired producing and non-producing CBM
properties located near Gillette, Wyoming, from Hi-Pro Production, LLC
("Hi-Pro"). These properties contain proven gas reserves. A portion of the
purchase price was paid with a loan from institutional lenders under a $25
million mezzanine lending facility, which was established in connection with the
Hi-Pro purchase; additional loans will be available to acquire more CBM
properties, subject to lenders' approval. In the first quarter of 2004, RMG
raised $1.8 million in working capital from institutional investors. See "Coal
Bed Methane - RMG Equity Financing."
-2-
RMG's properties are located in Wyoming and southeastern Montana. As of the
filing date of this Annual Report, RMG holds approximately 264,300 gross
(128,200 net) mineral acres of CBM properties. A limited amount of exploratory
drilling and testing was conducted on some of the non-producing properties in
2003, but in general, significant additional work is needed before we can
determine if those properties contain gas reserves. No prediction is made when
such determinations can be made.
In 2003, the Company sold an indirect subsidiary (Canyon Resources) which
owns commercial properties in Ticaboo, Utah. Canyon Resources was acquired in
the 1990s from a utility as part of an acquisition of uranium properties and a
uranium mill near Ticaboo, Utah. See "Oil And Gas, and Other Properties." The
uranium properties and mill, presently inactive, have not been sold. See
"Inactive Mining Properties - Uranium."
Historically, gas prices for production in the Powder River Basin (our area
of activity) have been lower than national prices due to limited pipeline
"takeaway capacity." This limitation was somewhat eased in late 2002 and 2003 by
new pipeline construction and enlargement of existing lines, and will be further
improved with more capacity in 2005. For example, a new large pipeline is
planned to be in service in January 2005, running from the Cheyenne hub in
Cheyenne, Wyoming, to Kansas. See "Gas Markets."
However, on both historical and seasonal bases, gas prices have been
volatile. A return to low gas prices, particularly if aggravated by the negative
price differential experienced by Powder River Basin producers, could adversely
impact not only the economics of current production but also the economics of
exploration projects as they move into production in the future.
USE and Crested originally were independent companies, with two common
affiliates (John L. Larsen and Max T. Evans; Mr. Evans died in February 2002).
In 1980, USE and Crested formed a joint venture ("USECC") to do business
together (unless one or the other elected not to pursue an individual project).
As a result of USE funding certain of Crested's obligations from time to time
(due to Crested's lack of cash on hand), Crested subsequently paid a portion of
this debt by issuing common stock to USE, Crested became a majority-owned
subsidiary of USE in fiscal 1993. In fiscal 2001, Crested issued another
6,666,666 shares of its common stock to reduce Crested's debt owed to USE by
$3.0 million, which increased USE's ownership of Crested to 71.5%. All the
operations of USE (and Crested) are in the United States.
In the first quarter 2004, USE obtained $350,000 of equity funding from an
accredited investor (100,000 restricted shares of common stock, three year
warrants to purchase 50,000 shares at $3.00 per share; and five year warrants to
purchase 200,000 shares at $3.00 per share). Proceeds will be used as working
capital.
Principal executive offices of USE are located in the Glen L. Larsen
building at 877 North 8th Street West, Riverton, Wyoming 82501, telephone
307-856-9271. RMG has a field office in Gillette, Wyoming.
Most of the Company's operations are conducted through subsidiaries, the
USECC Joint Venture with Crested, and jointly-owned subsidiaries of USE and
Crested.
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The Company's subsidiaries are:
Percent Primary
Subsidiary Owned by USE* Business Conducted
---------- ------------- ------------------
Plateau Resources Ltd. 100.0% Uranium (Utah) - inactive mill
- shut down
Motel/real estate - sold
Rocky Mountain Gas, Inc. 88.5% Coalbed methane - active
Energx, Ltd. 90.0% Gas - inactive - shut down
Crested Corp. 71.5% Uranium, gold and molybdenum
Properties (all inactive and
shut down), and exploration
activities on coalbed methane
properties
Sutter Gold Mining Company 78.5% Gold (California) - inactive -
Being reactivated
Four Nines Gold, Inc. 50.9% Contract Drilling/Construction
- inactive
USECC Joint Venture 50.0% Uranium (Wyoming, Utah), gold
and molybdenum,** all inactive
and shut down; real estate
management and coalbed methane
exploration
Yellowstone Fuels Corp. 35.9% Uranium (Wyoming) - inactive -
Shut down
Pinnacle Gas Resources, Inc. 37.5% CBM exploration and production
- active
* Includes ownership of Crested Corp. in RMG and Sutter.
** There are no plans to put the molybdenum property into production in
the foreseeable future. See "Inactive Mining Properties - Molybdenum
and Item 3, "Legal Proceedings".
Until September 11, 2000, USE, USECC and Kennecott Uranium Company
("Kennecott") owned the Green Mountain Mining Venture ("GMMV"), which held a
large uranium deposit and uranium mill in Wyoming. On September 11, 2000, USE
and Crested settled litigation with Kennecott involving the GMMV by selling
their interest in the GMMV and its properties back to Kennecott for $3,250,000,
receiving a royalty interest in the uranium properties and miscellaneous
equipment. The GMMV properties are shut down. Kennecott also assumed all
reclamation obligations on the GMMV properties; reclamation obligations for an
ion exchange facility located on properties outside the GMMV were not assumed by
Kennecott, see "Sheep Mountain Partners - Properties" below. Other uranium
properties and a uranium mill in southeast Utah are held by Plateau Resources
Ltd., a wholly-owned subsidiary of USE. The Utah uranium properties are shut
down.
Activities on the mineral properties held by Sutter Gold Mining Company
("SGMC") were shut down because the historical market price of gold did not
permit raising the necessary capital to build a mill and put the properties into
production. However, improved gold prices over the last 12 months have revived
the capital markets, particularly in Canada. See "Sutter Gold Mining Company,
below."
In coalbed methane, we compete against many companies, some of which are
much larger and better financed than the Company. The principal area of
competition is encountered in the financial ability to acquire good acreage
positions and drill wells to explore coalbed methane potential, then, if
warranted, drill production wells and install production equipment (gathering
systems, compressors, etc.).
We own a royalty interest in a molybdenum property in Colorado; the
property is owned by Phelps Dodge Corporation. We believe, at the present time,
that Phelps Dodge does not have a plan to place the molybdenum property into
production.
-4-
In the motel, real estate and airport operations area (significant as a
percentage of revenues for 2003, but not our primary business focus), we own and
manage an office building (where the Company's headquarters are located), and
small parcels of land, in Riverton, Wyoming, and a small amount of other land in
Wyoming and Colorado. An indirect subsidiary (Canyon Resources), owned a
townsite, motel, convenience store and other commercial facilities in Utah,
which was sold in August 2003, thus greatly reducing activities in this
commercial segment.
(B) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS.
During 2003, the seven months ended December 31, 2002, and the (former)
fiscal year ended May 31, 2002, for technical financial presentation purposes,
we operated in two business segments: (i) coalbed methane gas exploration (and
holding shut down mines and mineral properties); and (ii) commercial (motel,
real estate, and airport operations). While we technically had two segments in
this 31 month period, by December 31, 2003, all activities in minerals (except
coalbed methane) and commercial (motel/real estate/airport), had ceased or were
severely curtailed, and the motel/commercial properties in Utah had been sold.
As of the date of this Annual Report, the only current activities of a material
and recurring nature are in coalbed methane.
The principal products of operating units within each of the reportable
industry segments for the full year 2003, the seven months ended December 31,
2002 and the (former) fiscal year ended May 31, 2002 are shown below. For more
information, see note I to the financial statements.
INDUSTRY SEGMENTS PRINCIPAL PRODUCTS
Minerals: CBM Acquisition of coalbed methane properties,
Exploration and Production production of properties for coalbed methane.
(and shut down mineral This activity is material and recurring, and
properties) is our principal business focus. Sales and
leases of mineral-bearing properties and,
from time to time, the production and/or
marketing of uranium, gold and receipt of
advance royalties on molybdenum. Activities
in uranium, gold and molybdenum are shut down
as recurring activities. Gold properties are
being reactivated at the date of this Report.
Commercial: Operation of a motel and rental of real
Motel/Real Estate/ estate, operation of an aircraft fixed base
Airport FBO operation (fuel sales, flight instruction
and aircraft maintenance, which was shut down
in the (former) fiscal year 2002; and motel
and real estate activities (sold in 2003)).
Various contract services, including
managerial services for subsidiary companies,
continue.
-5-
C) NARRATIVE DESCRIPTION OF BUSINESS (INCLUDING ITEM 2 - PROPERTIES).
COALBED METHANE
GENERAL.
Rocky Mountain Gas, Inc. ("RMG") was incorporated in Wyoming on November 1,
1999 for business in the coalbed methane industry in Wyoming and Montana. RMG is
a subsidiary of the Company (owned 50.3% by the Company and 39.8% by Crested as
of December 31, 2003 (as of the date of this Annual Report, 49.4% by the Company
and 39.1% by Crested).
In 2003, RMG transferred all of its interest in certain coalbed methane
properties, including a producing property, to Pinnacle. At the same time,
Carrizo Oil & Gas, Inc.'s wholly owned subsidiary CCBM, Inc. ("CCBM") (with
which RMG has an agreement to jointly acquire and explore properties)
transferred to Pinnacle all of its interests in the same properties, and
affiliates of Credit Suisse First Boston contributed equity financing to
Pinnacle. See "Transaction with Pinnacle Gas Resources, Inc."
On January 30, 2004, RMG (through its wholly-owned, newly organized
subsidiary RMG I LLC, "RMGI") acquired coalbed methane properties in the Powder
River Basin of Wyoming. See "Acquisition of Producing and Non-Producing
Properties from Hi-Pro Production, LLC." Part of the purchase price was financed
under a $25 million mezzanine credit facility.
RMG I plans to drill five development wells on the Hi-Pro properties in
2004 and upgrade existing infrastructure to improve gas production, and, subject
to raising equity funding, drill up to 120 exploratory wells on undeveloped
Hi-Pro acreage in 2004 and 2005.
In addition, RMG plans to drill exploratory wells on the Castle Rock and
Oyster Ridge properties, and seek to acquire other producing coalbed methane
properties, primarily in Wyoming. Financing may be available under the mezzanine
credit facility for more acquisitions, if approved by the lenders. As of the
filing date of this Annual Report, RMG does not have any agreements to acquire
other producing properties.
RMG raised $1.8 million of equity financing in the first quarter of 2004.
As of the filing date of this Annual Report, RMG holds leases and options
on approximately 264,300 gross mineral acres of federal, state and private (fee)
land in the Powder River Basin ("PRB") of Wyoming and Montana and adjacent to
the Green River Basin of Wyoming, not including acreage held by Pinnacle.
As of the filing date of this Annual Report, there are 108 producing wells
on the properties bought by RMG from Hi-Pro Production, LLC. RMG owns an average
58% working interest (46.4% average net revenue interest, before deduction of
overriding royalty interests held by lenders) in these properties.
From RMG's inception, through December 31, 2003, 72 exploratory wells have
been drilled, almost all with funds provided by industry partner CCBM and former
industry partner SENGAI (see below). 43 of the wells were on properties
transferred to Pinnacle in mid-2003. The balance of 29 wells (15 of which have
been plugged and abandoned) are on properties held by RMG. Reserves have not
been established for any of the properties on which these wells were drilled.
The Castle Rock property in southeast Montana , and the Oyster Ridge
property adjacent to the Green River Basin (southwest Wyoming), are large
properties which will require the drilling of numerous exploratory wells and
extended dewatering for each group or "pod" of wells (possibly as much as 24
months after drilling and completion) before an assessment of reserves can be
made.
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Among the uncertainties we face in determining if our coalbed methane
investments will yield value are the following: Prices for gas sold in the
Powder River Basin are typically lower than national prices, and therefore, the
economics of Powder River Basin properties can be adversely affected more
readily by lower gas prices. The Hi-Pro properties, and all revenues therefrom,
are pledged to service $3,635,000 of debt. To continue exploration efforts,
additional capital (in addition to RMG's one-half of remaining balance under the
CCBM $5.0 million drilling commitment, which one half of remaining balance was
$305,100 at December 31, 2003) will be needed. Permitting issues for new wells
on undeveloped acreage may be delayed. An unfavorable confluence of these
uncertainties could result in a write-down of the carrying value of those
properties which don't produce enough gas at low prices to be economic; in a
write-down of the carrying value of other properties which need more wells
drilled and dewatered to establish or improve the economics of production;
and/or the delay (whether from lack of capital or permitting problems) in
establishing reserves for the larger prospects where many wells will have to be
drilled to assess their value.
Certain technical terms used in the oil and gas industry appear in this
Annual Report. The following are general definitions of those terms: Working
interests percentages of a mineral lease total 100%; the working interest owners
together (an aggregate of 100%) pay all of the costs to hold undeveloped leases,
drill and complete wells on leases, and produce minerals from the leased
property (including pump costs, gathering and transmission costs and marketing
costs). Net revenue interests are the percentages of production which the
working interest owners own, after deduction for payment of royalties to the
owners of the minerals under lease (private parties, the Bureau of Land
Management, or the State, as applicable). Owners of royalty interests pay none
of the costs to drill, complete, or operate wells on a lease. An overriding
royalty interest is carved out of the total net revenue interest; overriding
royalty interest holders pay none of the costs to hold, drill, or produce the
minerals. All owners pay their share of ad valorem and severance taxes.
TRANSACTION WITH PINNACLE GAS RESOURCES, INC.
On June 23, 2003, RMG, CCBM and its parent company Carrizo Oil & Gas, Inc.;
and seven affiliates of Credit Suisse First Boston Private Equity (the "CSFB
Parties") signed and closed agreements for a transaction with Pinnacle. The
transaction included: (1) the contribution to Pinnacle by RMG and CCBM of all of
their ownership of a portion of the CBM properties owned by RMG and CCBM, in
exchange for common stock and options to buy common stock in Pinnacle; and (2)
$17,640,000 cash to Pinnacle by the CSFB Parties for common stock and series A
preferred stock of Pinnacle, and warrants to purchase series A preferred stock
of Pinnacle.
Pinnacle is a private corporation. Only such information about Pinnacle, as
its board of directors elects to release, is available to the public. All other
information about Pinnacle is subject to confidentiality agreements between
Pinnacle, RMG, and the other parties to the June 2003 transaction.
At December 31, 2003, RMG's ownership in Pinnacle's common stock was 37.5%.
RMG's ownership of Pinnacle on a fully-diluted basis will change if the CSFB
Parties fund subsequent capital requests from Pinnacle and/or exercise their
warrants to buy equity in Pinnacle, and/or if RMG and/or CCBM exercise their
options to buy equity in Pinnacle, or other events occur. See the discussion
under Pinnacle Equity Transaction below.
Immediately following, and in connection with, the transaction, Pinnacle
acquired additional producing and non-producing CBM properties located in the
Powder River Basin of Wyoming from Gastar Exploration, Ltd. ("Gastar," listed on
the Toronto Stock Exchange), referred to below as the "Gastar acquisition."
The transaction and the follow-on Gastar acquisition provide (1) Pinnacle
the funded opportunity to explore and develop the contributed and acquired
assets, and to acquire and explore, and if warranted,
-7-
develop, additional CBM properties in Wyoming and Montana; and (2) RMG (through
its ownership interest in Pinnacle) the opportunity to benefit (on a passive
basis) from the continued development of the contributed assets and other
properties which Pinnacle may acquire in the future. Since June 2003, Pinnacle
has acquired additional acreage, and drilled numerous exploratory and
development wells.
RMG now has interests in approximately 264,300 gross (128,200 net) mineral
acres:(A) 173,400 gross (66,900 net) acres in the Castle Rock, Oyster Ridge, and
Baggs properties, which were not contributed to Pinnacle (these properties are
operated by RMG and held with its industry partner CCBM, Inc.); and (B) 52,700
gross (47,000 net) mineral acres acquired from Hi-Pro Production, LLC. The
acreage total does not reflect properties held by Pinnacle. The acreage total
for Oyster Ridge includes the proposed acquisition from Kerr McGee (38,184
gross, 11,455 fully diluted net). See "Oyster Ridge".
CCBM is a wholly-owned subsidiary of Carrizo Oil & Gas, Inc. ("Carrizo," a
Nasdaq listed company). Carrizo, CCBM and RMG entered into an agreement in July
2001 for CCBM to buy a 50% interest in, and fund exploration and development of,
RMG's CBM properties then owned. Prior to and in connection with the Pinnacle
transaction, CCBM paid RMG approximately $1.8 million cash to complete its
purchase of 50% of RMG's contributed CBM properties, thus enabling CCBM to
contribute its interests in the CBM properties to Pinnacle as having been fully
paid for. See "Continuing Operations of RMG, Continuing Agreement with CCBM, and
the AMI Agreement, After the Pinnacle Transaction" below.
- PINNACLE EQUITY TRANSACTION
Pinnacle is authorized to issue common stock (100 million shares, $0.01 par
value) and preferred stock (100 million shares, $0.01 par value). Pinnacle has
established series A preferred stock with the following provisions: Liquidation
preference of $100.00 per share; 10.5% compounded cumulative annual dividend
(12.5% after July 1, 2010); redeemable at Pinnacle's option after July 1, 2004
at a premium declining to par after July 1, 2009 (mandatory redemption if there
is a change in control of RMG or CCBM); and with voting rights (a) pari passu
with the common stock on regular matters, and (b) as a separate class, to
authorize changes in the series A preferred stock, to authorize issuance of
stock senior to or in parity with the series A preferred stock, to approve any
reorganization or merger of Pinnacle, to approve Pinnacle's sale of
substantially all its assets, and similar matters.
Pinnacle's board of directors has eight directors (two each from RMG and
CCBM, and four from the CSFB Parties).
The chart below summarizes (a) the contributions made by the parties to the
transaction at the closing, and (b) as of the closing, the subsequent
contributions which would be made by the CSFB Parties in response to future
capital requests from Pinnacle. As of the filing date of this Annual Report, as
a result of a capital request funded after the closing by the CSFB parties, RMG
owns 37.5% of the common stock of Pinnacle.
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Equity in Pinnacle
--------------------
Series A Equity Rights in Pinnacle
Parties Contribution Common Stock Preferred Stock Warrants(1) Options Common Stock(2)
------- --------------- -------------- --------------- ----------- -----------------------
RMG All CBM 75,000 shares -0- -0- 30,000 shares
properties
(except Castle
Rock, Baggs
and Oyster
Ridge)
CCBM All CBM 75,000 shares -0- -0- 30,000 shares
properties
(except Castle
Rock, Baggs
and Oyster
Ridge)
CSFB $ 17,640,000 50,000 shares 130,000 shares 130,000 -0-
Parties
CSFB $ 11,760,000(3) 120,000 shares 120,000 -0-
Parties
- ----------------------------------------
(1) At $100 per share of common stock.
(2) Options to buy common stock at $100.00 per share, as increased by 10%
per annum compounded quarterly for the first 15,000 shares, and 20%
per annum for the second 15,000 shares.
(3) Commitment to fund subsequent capital requests from Pinnacle, not more
than $11,760,000, if made prior to July 1, 2004, for development work
on CBM wells, or (if approved by CSFB Parties) a property acquisition.
The commitment price is $980,000 for each 10,000 shares of series A
stock (coupled with warrants to purchase 10,000 shares of common
stock, exercisable at $100 per share).
As a result, RMG has recorded its 37.5% equity investment in pinnacle at
the carrying value of its coalbed methane properties of approximately $922,600.
Sanders Morris Harris Inc. ("SMH") of Houston, Texas acted as financial
advisor to RMG on the Pinnacle transaction. For its services in connection with
the transaction and the Gastar acquisition, SMH was paid $650,000 by Pinnacle.
As additional compensation for SMH's services, USE issued to SMH 50,000
restricted shares of common stock and warrants to purchase (until June 30, 2006)
another 50,000 restricted shares of common stock (at $5.00 per share). SMH did
not receive any equity or equity rights in Pinnacle in connection with the
transaction or the Gastar acquisition.
- GASTAR ACQUISITION
With proceeds from the CSFB financing, Pinnacle paid Gastar $6.2 million
for approximately 50% of Gastar's working interest in existing producing and
non-producing CBM properties which included 95 producing wells in the early
stages of dewatering and approximately 36,529 gross developed and undeveloped
acres. The majority of the leases are either part of or located adjacent to the
producing Bobcat property, which RMG and CCBM contributed to Pinnacle.
Pinnacle also agreed to fund up to $14.5 million of future drilling and
development costs on behalf of Gastar and Pinnacle prior to December 31, 2005,
on the properties purchased from Gastar.
-9-
- CONTINUING OPERATIONS OF RMG, CONTINUING AGREEMENT WITH CCBM, AND THE
AMI AGREEMENT AFTER THE PINNACLE TRANSACTION
RMG retained ownership, with CCBM, of the Castle Rock, Oyster Ridge, and
Baggs projects, totaling about 189,000 gross acres (currently about 173,400
gross acres net of 15,200 gross acres returned to Anadarko after the transaction
date and expiration of one lease). RMG and CCBM plan to continue exploration and
development activities on these properties as well as acquiring other properties
in Wyoming and Montana, under their July 2001 agreement (see "Carrizo - Purchase
and Sale Agreement"). Presently there are no agreements for RMG and CCBM to
acquire producing properties.
CCBM paid RMG approximately $1.8 million for CCBM's outstanding purchase
obligation (under the July 2001 agreement) on CCBM's interests in those
properties it contributed to Pinnacle. The balance on the note at December 31,
2003 was $836,200. The balance of CCBM's original purchase obligation is payable
in monthly installments of approximately $52,800 through November 2004 with a
balloon payment of $282,400 due on December 31, 2004.
In connection with the transaction with Pinnacle, RMG and Pinnacle signed a
transition services agreement, for Pinnacle to pay RMG to assist in setting up
operational accounting systems for Pinnacle through December 2003. The agreement
was terminated by RMG effective January 1, 2004.
Also in connection with the transaction, RMG, CCBM, Carrizo, USE and the
CSFB Parties signed an area of mutual interest ("AMI") agreement: Until June 23,
2008, Pinnacle has the right to acquire from the other parties up to 100% of any
interest in oil and gas leases, or interests therein or mineral interests or
rights to acquire same, which the other parties acquire, at the same price paid
or payable by the other parties, within the Powder River Basin in Montana and
Wyoming (excluding most of Powder River County, Montana). The original AMI
agreement between CCBM and RMG from July 2001 is superseded by the new AMI
agreement, except for areas outside the new AMI agreement territory, wherein the
original agreement is still in effect.
With respect to the properties acquired from Hi-Pro (see below), CCBM and
Pinnacle waived their rights to buy any of the producing or undeveloped acreage.
ACQUISITION OF PRODUCING AND NON-PRODUCING PROPERTIES FROM HI-PRO
PRODUCTION, LLC
On January 30, 2004, RMG I, LLC ("RMG I"), a wholly-owned subsidiary of
RMG, purchased coalbed methane properties from Hi-Pro for $6,800,000. This
transaction was closed after December 31, 2003. See the subsequent event
footnote to the financial statements in this Annual Report.
The purchased properties (all located in the Powder River Basin of Wyoming)
include 247 completed wells and 40,120 undeveloped fee acres. As of the filing
date for this Annual Report, 108 wells now are producing approximately 5.9
million cubic feet (Mmcf) of gas per day (approximately 3.1 Mmcf per day net to
RMG I). Net daily Mmcf sales are less than gross production, due to produced gas
being consumed to run compressors, and from adjustments by purchasers for
thermal content (gas is sold based on BTU heat content).
RMG I owns an average 58% working (average 46.4% net revenue) interest in
the producing wells and proved developed acreage, and a 100% working (average
80% net revenue) interest in all of the undeveloped acreage. The net revenue
interest percentage after deduction of the overriding royal interests held by
lenders (see "Mezzanine Credit Facility") are 44.66% for the producing and five
future wells to the Wyodak coal, and 78.0% for production from deeper coals and
all of the undeveloped acreage.
The transaction was structured as an asset purchase, with RMG I as the
purchaser, in connection with the establishment of a mezzanine credit facility
for up to $25,000,000 of secured loans to acquire and develop more proven
coalbed methane reserves. RMG may utilize RMG I for future acquisitions (none
are presently
-10-
under contract or agreement in principle). See "Mezzanine Credit Facility." A
substantial portion of the cash consideration paid to Hi-Pro was funded with the
initial advance on the credit facility. RMG I replaced Hi-Pro as the contract
operator for 89% of the wells that were acquired.
RMG negotiated the purchase based on the $7,113,000 present value,
discounted 10%, of gas reserves recoverable (and the estimated future net
revenues to be derived) from proved reserves in the Hi-Pro properties, as
estimated as of November 1, 2003 by Netherland Sewell and Associates, Inc. See
"Reserve Date" below for the estimate as of December 31, 2003.
The $6,800,000 purchase price reflects a deduction, negotiated by the
parties in January 2004, to account for the decrease in gas production from
October 2003 due to the impact on production from deferred maintenance on the
properties, and the expected cost of such maintenance work after closing.
- TERMS OF THE PURCHASE. The purchase price of $6,800,000 was paid:
X $ 776,700 cash by RMG.
X $ 588,300 net revenues from November 1, 2003 to December 31, 2003,
which were retained by Hi-Pro.(1)
X $ 500,000 by USE's 30 day promissory note (secured by 166,667
restricted shares of USE common stock, valued at $3.00 per share).
X $ 600,000 by 200,000 restricted shares of USE common stock (valued
at $3.00 per share).(2)
X $ 700,000 by 233,333 restricted shares of RMG common stock (valued
at $3.00 per share).(3)
X $3,635,000 cash, loaned to RMG I under the credit facility
---------- agreement. (4)
$6,800,000
(1) RMG paid all January operating costs at closing. Net revenues from the
purchased properties for January 2003 were credited to RMG I's
obligations under the credit facility agreement. These net revenues
were considered by the parties to be a reduction in the purchase price
which RMG otherwise would have paid at the January 30, 2004 closing.
(2) USE has agreed to file a resale registration statement with the SEC to
cover public resale of these 200,000 shares.
(3) From November 1, 2004 to November 1, 2006, the RMG shares shall be
convertible at Hi-Pro's sole election into restricted shares of common
stock of USE. The number of USE shares to be issued to Hi-Pro shall
equal (A) the number of RMG shares to be converted, multiplied by
$3.00 per share, divided by (B) the average closing sale price of the
shares of USE for the 10 trading days prior to notice of conversion.
The conversion right is exercisable cumulatively, as to at least
16,666 RMG shares per conversion.
(4) See "Mezzanine Credit Facility."
- PROPERTIES PURCHASED.
RESERVE DATA
Netherland Sewell and Associates, Inc. ("NSAI," Houston, Texas),
independent petroleum engineers, have prepared a report on the proved reserves,
as of December 31, 2003, estimating recoverable reserves from the Hi-Pro
properties, and the present value (discounted 10%) of future cash flow
therefrom. NSAI's report takes into account fixed pricing for some production in
2004 and 2005, reflects the reduction in RMG's net revenue interests due to the
overriding royalty interests held by lenders, and (except for fixed pricing in
2004 and 2005) is based on the Henry Hub Spot market price of $5.965 per mmbtu,
adjusted by lease for energy content, transportation fees and regional price
differentials on December 31, 2003, without price escalation.
-11-
NET PRESENT
RESERVES VALUE
(Mmcf) (discounted at 10%)
------ ---------------------
Proved Developed Producing 2,206.490 $4,589,600
Proved Developed Non-Producing 464.423 $1,084,800
Proved Undeveloped 733.780 $1,382,000
---------- ----------
Total 3,404.693 $7,056,400
========= ==========
The present value, discounted 10% value ("PV10 value") was prepared after
ad valorem and production taxes on a pre-income tax basis, and is not intended
to represent the current market value of the estimated gas reserves purchased
from Hi-Pro. The PV10 discount factor is not the same as the standardized
measure of present value calculations which are determined on an after-income
tax basis.
Reserves as of November 1, 2003 were calculated by NSAI based on actual
production up to June 30, 2003, with production decline curves to November 1,
2003 estimated based on that production, resulting in total net proven reserves
of 4,034.5 Mmcf. For estimates as of December 31, 2003, NSAI was supplied with
actual production data through that date. Because actual production was below
the production predicted for the same period by the November 1, 2003 decline
curves, the decline curves for the later report had a lower starting point on
January 1, 2004 and a steeper rate of decline. These new decline curves thus
predict lower future production (3,404.693 Mmcf net to RMG) as of December 31,
2003.
We expect production in 2004 from producing wells, and hence proven
reserves (after adjustments for actual gas produced), will increase as
maintenance work now in progress (which had been deferred by Hi-Pro in the last
two quarters of 2003) is completed in the second quarter 2004. The reduction in
the present value, discounted 10%, of proven reserves at November 1, 2003
($7,113,000) as compared to December 31, 2003 ($7,056,400) was less than 1%,
notwithstanding the decreased volume of reserves, due to the higher price at the
later date compared with prices used in the November 1, 2003 estimate ($4.50 per
mcf in 2003, $4.29 in 2004, and $4.25 in 2005).
There are numerous uncertainties inherent in estimating gas reserves and
their estimated values. Reservoir engineering is a subjective process of
estimating underground accumulations of gas that cannot be measured exactly.
Estimates of economically recoverable gas, and the future net cash flows which
may be realized from the reserves, necessarily depend on a number of variable
factors and assumptions, such as historical production from the area compared
with production from other areas, the assumed effects of regulations by
government agencies, assumptions about future gas prices and operating costs,
severance and excise taxes, development costs, and work-over and remedial costs.
The outcomes in fact may vary considerably from the assumptions.
The PV10 value takes into account RMG I's contracts to sell 2,000 Mmbtu per
day in 2004 at a fixed price of $4.76 per Mmbtu, and 1,000 Mmbtu per day in 2005
at a fixed price of $4.14 per Mmbtu. From time to time, RMG I may sign fixed
price contracts for more production. In addition, gas market prices will vary,
possibly by significant amounts, throughout each year, and on an average basis
from year to year. For these reasons, the cash flow realized from production
likely will vary from the estimates of cash flow used to determine the PV10
value.
Estimates of the economically recoverable quantities of gas attributable to
any particular property, the classification of reserves as to proved developed
and proved undeveloped based on risk of recovery, and estimates of the future
net cash flows expected from the properties, as prepared by different engineers
or by the same engineers but at different times, may vary substantially, and the
estimates may be revised up or down as assumptions change.
In addition, it is likely that actual production volumes will vary from the
estimates.
-12-
The PV10 discount factor, which is required by the SEC for use in
calculating discounted future net cash flows for reporting purposes, is not
necessarily the most appropriate discount factor, based on interest rates in
effect in the financial markets, and risks associated with the gas business.
The business of exploring for, developing, or acquiring reserves is capital
intensive. To the extent operating cash flow is reduced and external capital
becomes unavailable or limited, RMG's ability to make the necessary capital
investment to maintain or expand the gas reserves asset base would be impaired.
There is no assurance future exploration, development, and acquisition
activities will result in additional proved reserves. Even if revenues increase
because of higher gas prices, increased exploration and development costs could
neutralize cash flows from the increased revenues.
- FUTURE PLANS FOR THE HI-PRO PRODUCTION PROPERTIES
In the second quarter of 2004, RMG I plans to drill five proven undeveloped
locations to the Wyodak coal, continue a remedial workover program on a number
of existing wells, and upgrade the gas gathering and pipeline facilities
included in the purchase. The workover program is estimated to cost $250,000 and
will be funded by the working interest partners. The drilling and gathering
upgrade is estimated to cost approximately $640,000, and is being funded with a
loan from the mezzanine credit facility. The programs are designed to enhance
production from current levels. After the 5 new wells to the Wyodak are drilled,
there will be no more undrilled locations on the currently producing properties
available for the Wyodak coal. The first coals of interest under the undeveloped
acreage are the Anderson and Canyon coals (for example under the Reno property);
the Wyodak coal is not present under the undeveloped acreage. In addition to the
5 new wells, RMG-I plans to hook up 2 additional wells that were previously
drilled by Hi-Pro and are in close proximity to the 5 new wells.
The Wyodak coal formation is 200 to 600 feet from surface. Existing
infrastructure for the Wyodak wells (gathering lines, compressors, and water
disposal) should significantly reduce drilling and completion costs for new
wells to the deeper Dannar and Moyer coals (1,100 to 1,800 feet). Subject to
raising capital, up to 120 wells could be drilled and completed to these deeper
coals in 2004 and 2005, all on locations now producing from the Wyodak. This
development activity is contingent upon obtaining future financing. We do not
expect that funding for this activity will be available through the mezzanine
credit facility.
No reserves have been established for the Dannar and Moyer coals. Because
no other operators are producing gas from or dewatering these coals in the
vicinity of the Hi-Pro properties, we expect several pods of wells will have to
be drilled and completed to these coals, with an extended dewatering period
(which could be up to 24 months), before significant gas production begins.
RMG is also developing plans to put five coalbed methane wells from the
Reno property on production during 2004. The Reno property was part of the
Hi-Pro acquisition. The target coals on the Reno property are the Anderson coal,
which is about 600-650 feet in depth and approximately 40 feet in thickness and
the Canyon coal which is about 700-850 feet in depth and 35 feet in thickness.
Four wells were previously drilled by Hi-Pro, at the Reno Property which
were completed in both the Anderson and Canyon coals, with slotted screening in
each. In addition, in March 2004, RMG I drilled a fifth well, which has been
completed in the Canyon coal. The shallower Anderson coal may be completed at a
later date. Four additional well locations exist at the Reno property based upon
80-acre spacing.
The Reno property consists of 760 gross and net acres, all on fee acreage.
It is located in Campbell County, Wyoming, approximately 50 miles south of
Gillette. RMG owns a 100% working interest in this property.
-13-
- MEZZANINE CREDIT FACILITY.
RMG I has signed a credit agreement with Petrobridge Investment Management,
LLC (Houston , Texas) as lead arranger, and institutional lenders, for up to
$25,000,000 of loans to RMG I. The loan commitment is through June 30, 2006. All
loans will have a three year term from funding date.
Funding to acquire and/or improve any project is subject to the lenders'
approval of the transaction and RMG I's development plan.
The first loan ($4,340,000 on January 29, 2004) under the credit facility
has been applied to the Hi-Pro asset purchase ($3,700,000) including transaction
costs and professional fees; and for a Phase I development program ($640,000).
Terms for all loans under the credit facility include the following:
X Principal is not amortized, but interest must be paid monthly. All
revenues from the properties owned by RMG I (including all current and
new wells) is paid to a lock box account controlled by the lenders,
from which is paid by the lenders, the lease operating costs, revenue
distributions, RMG I operating fees and RMG pumping fees (all approved
by the lenders). With the exception of operating and pumping fees, no
revenues will be available for RMG operations until all loans are paid
off.
X The loans are secured by all of RMG I's properties and by RMG's equity
interest in RMG I.
X The lenders, in the aggregate, receive an overriding royalty interest
of 3% of production from the wells producing when the acquisition was
closed, and 2% of production from new wells on an 8/8ths working
interest basis, proportionately reduced where less than 100% of the
working interest is owned by RMG I. For the Hi-Pro properties, the 3%
rate applies to all wells (producing and to be drilled) to the Wyodak
formation (an aggregate override of 1.74%), and 2% to all wells to
deeper formations (aggregate override to be determined based on
working interest ownership by well). Override payments to the lenders
are not applied to the loan balances. The percentage of overrides on
future properties may vary.
X Negative covenants: RMG I will not permit the ratio of (a) total debt
to EBITDA to exceed 2.00 to 1.00; (b) EBITDA to interest expense and
rents (lease expense) to be less than 3.00 to 1.00; c) current assets
to current liabilities to be less than 1.00 to 1.00; or (d) PV 10
(proved developed producing reserves) to total debt to be less than
1.00 to 1.00. All these ratios are to be determined quarterly. In
addition, RMG I shall not permit net sales volume of gas from its
properties to be less than 270 Mmcf, 230 Mmcf, 230 Mmcf and 210 Mmcf
for each quarter in 2004, or less than 180 Mmcf per quarter in 2005
and the first two quarters of 2006.
At closing of the Hi-Pro acquisition, USE issued to the participating
lenders three year warrants to purchase a total of 318,465 shares of common
stock of USE (subject to vesting) at $3.30 cash per share. At closing of the
Hi-Pro Acquisition, warrants on 63,693 shares vested. The remaining warrants
will vest at the rate of the right to buy one USE share for each $157 which RMG
I subsequently borrows under the credit facility. Regardless of when vested, all
warrants will expire on the earlier of January 30, 2007, or the 180th day after
USE notifies the warrant holders that USE' stock price has achieved or exceeded
$6.60 per share for a consecutive 15 business day period. USE has agreed to file
a registration statement with the SEC to cover public resale of the warrant
shares.
The preceding is a summary of some of the terms of the credit agreement,
and is qualified by the text of the agreement, filed with this Annual Report as
an exhibit.
-14-
- RMG EQUITY TRANSACTION
In the first quarter, RMG raised $1,800,000 of equity financing from the
sale of shares of Series A Preferred Stock in RMG, and warrants to purchase
shares of common stock of USE, to institutional investors. Proceeds are being
used for RMG working capital. The terms of the securities sold are:
X 600,000 shares of Series A Preferred Stock at $3.00 per share. The
Series A Preferred Stock bears a 10% cumulative annual dividend
(payable on March 1 of each year, beginning March 1, 2005), payable at
RMG's election in cash or shares of common stock of RMG (at $3.00 per
share) or shares of common stock of USE (at 90% of USE' volume
weighted average price for the five days, referred to as the "set
price"). The Series A Preferred Stock is convertible at the holder's
election into shares of common stock of RMG, at $3.00 per share, or
shares of common stock of USE at the set price, until February 2006,
at which time all Series A Preferred Stock shares not previously
converted shall automatically be converted into shares of common stock
of RMG. The Series A Preferred Stock carries a liquidation preference
of $4.05 per share.
X Warrants to purchase 150,000 shares of common stock of USE, at the set
price. The investors did not pay additional consideration for the
warrants issued in connection with the purchase of the Series A
Preferred Stock. The warrants are exercisable as to 25% of the
underlying shares beginning in May 2004, and an additional 25% of the
underlying shares on each of the six months, nine months, and twelve
months thereafter, at which time the warrants are exercisable for the
full number of underlying shares. USE may call the warrants for
exercise if USE's volume weighted average price (VWAP) for its stock
exceeds $6.00 for any consecutive 15 trading days; warrants not
exercised by the tenth trading day after a call notice is sent will be
cancelled.
X The number of shares of RMG or USE common stock issuable in payment of
dividends on, or conversion of, the Series A Preferred Stock, and the
number of shares of common stock of USE issuable on exercise of the
warrants, are subject to adjustment in certain events to protect the
holders from dilution. The first anti-dilutive provision is 'full
ratchet': If RMG or USE issue shares of common stock, or derivative
securities exercisable for or convertible into such shares of common
stock, at a price less than $3.00 per share for RMG stock or the set
price for USE stock, at any time until 30 days after a registration
statement (to be filed by USE) has been declared effective by the SEC
to permit the resale to the public by the holders of the USE common
stock issuable on payment of dividends, in conversion, and on exercise
of warrants, then the issue price for the dividends and conversions,
and the exercise price of the warrants (for RMG and USE common stock,
as applicable) shall be reduced (ratcheted down) to equal the lower
issue price, until the 30th day after the registration statement is
declared effective.
X The second anti-dilutive provision would take effect after that 30th
day: The issue price would be adjusted up to a fully weighted adjusted
price, and would continue to be adjusted for any other issuance by RMG
or USE of stock or derivative securities at a price less than $3.00 or
the set price, as applicable, until the Series A Preferred Stock is
converted to common stock or RMG or USE, or until the expiration of
the warrants, as applicable. As an example of fully weighted
anti-dilution protection, if RMG were to sell 3,200,000 shares of
common stock at $2.50 per share, the dividend and conversion price on
the Series A Preferred Stock would be $2.91.
The preceding is a summary of some of the terms of the Series A Preferred
stock designation, and the USE warrants, and is qualified by the text of the
documents filed with this annual report as exhibits.
VOLUMES, PRICES AND GAS OPERATING EXPENSE - BOBCAT PROPERTY (TRANSFERRED TO
PINNACLE GAS RESOURCES, INC. IN JUNE 2003)
This table shows RMG's 27.6% working (22% net revenue) sales volumes of gas
produced, average sales prices received for gas sold, and average production
costs for those sales, for the seven months ended
-15-
December 31, 2002, and for the year ended December, 2003, all from the Bobcat
property which was transferred to Pinnacle in June 2003.
Year Ended Seven Months Ended
December 31, 2003 December 31, 2002
------------------- -------------------
Sales volumes (mcf) 81,516 64,314
Average sales price per mcf(1) $3.71 $1.86
Average cost (per mcf)(2) $1.91 $1.91
(1) From time to time, we sold some of the production at a set price and
the balance at daily market prices. For the six months ended June 30,
2003, we sold 37.0% of our share of production at contract prices and
63.0% at the market. There were no gas sales after June 30, 2003.
(2) Includes direct lifting costs (labor, repairs and maintenance,
materials and supplies, workover costs, insurance and property,
gathering, compression, marketing and severance taxes).
ACQUISITION AND EXPLORATION CAPITAL EXPENDITURES - ALL PROPERTIES THROUGH
DECEMBER 31, 2003
From inception on November 1, 1999 through December 31, 2003, RMG incurred
net acquisition (purchase price and holding costs) and exploration costs
(drilling and completion) on CBM properties of approximately $1,353,900, which
does not include approximately $2,194,900 funded by CCBM on RMG's behalf for
leasehold, drilling and completion costs. Unproved properties on the balance
sheet at December 31, 2003 reflect the reduction (by $5,143,000) to reflect the
reduction of the full cost price as a result of principal payments made by CCBM
under its agreement with RMG and by payments from other industry partners. The
foregoing data does not include $922,600 spent by RMG on properties transferred
to Pinnacle. The $922,600 was recorded at December 31, 2003 as an investment in
Pinnacle.
The following table shows certain information regarding the gross costs
incurred by RMG. Costs associated with the Hi-Pro acquisition after December 31,
2003 are not included.
Year Ended Seven Months Ended Year Ended
December 31, December 31, May 31,
------------- ------------------- -----------
2003 2002 2002
------------- ------------------- -----------
Acquisition costs $ 107,100 $ 936,200 $ 192,600
Development 158,300 97,200 87,400
------------- ------------------- -----------
$ 265,400 $ 1,033,400 $ 280,000
============= =================== ===========
The acquisition costs included amounts paid for properties, delay rentals,
lease option payments, and general and administrative costs directly
attributable to the acquisitions.
The recorded amounts for acquisition and exploration of $265,400,
$1,033,400, and $280,000 represent 1.1%, 3.6%, and 1.0% of total assets at
December 31, 2003, December 31, 2002, and May 31, 2002, respectively.
We use the full-cost method of accounting for gas properties. Under this
method, all acquisition and exploration costs are capitalized in a "full-cost
pool" as incurred. Depletion of the pool will be recorded using the
unit-of-production method. To the extent capitalized costs in the full-cost pool
(net of depreciation, depletion and amortization and related deferred taxes)
exceed the present value (using a 10% discount rate) of
-16-
estimated future net pre-tax cash flows from proved gas reserves as established
by reserve reports, the excess costs will be charged to operations.
All acquisition and exploration costs for a property are capitalized until
such time as reserves can be established, or not, for the property. If no
reserves are established, those capitalized costs will be transferred to the
amortization basis and be subject to an impairment testTo the extent reserves
are established for an exploration property to be less than such costs, the
costs will be written-down to the amount of present value of the reserves. In
this event, assets would decrease and expenses would increase. Once incurred, a
write-down of gas properties can't later be reversed.
In addition, if future exploration work (in particular the larger
prospects) is delayed because of lack of capital or permitting delays, or both,
with the result that it cannot be established whether or not proved reserves
exist on the properties, the exploration costs for those properties would be
written-off.
COALBED METHANE PROPERTIES
As of the filing of this Annual Report, we hold leases and options to
develop approximately 264,300 gross mineral acres (including 69,895 acres under
options - see "Oyster Ridge" below) under leases from the United States Bureau
of Land Management, the states of Wyoming and Montana, and private landowners.
Table 1 shows the total gross and net lease acres held in each prospect, and the
amount of such acreage held by RMG and by companies with which RMG has
agreements (CCBM, Inc. and Quaneco, L.L.C.). These agreements are summarized
under "Carrizo - Purchase and Sale Agreement" and "Quaneco - Agreement." Acreage
data assumes CCBM completes its obligations; CCBM will own its 50% working
interest in wells drilled under CCBM's drilling fund commitment, but if CCBM
does not complete its purchase obligations, CCBM would be entitled to a reduced
working interest in the remaining undrilled acreage.
CCBM currently has purchase rights to acquire a 6.25% working interest in
the Castle Rock prospect, and owns a 6.25% working interest in eight wells in
Castle Rock, which were drilled by Suncor Energy Natural Gas America, Inc.
("SENGAI"). RMG's and CCBM's interests in the Castle Rock prospect, as shown in
Table 1, reflect the completion of SENGAI's drilling program in late calendar
2001. SENGAI elected not to exercise its option under an Option and Farmin
Agreement on February 8, 2002.
Prospects are evaluated for coal potential using available public and
industry data, taking into account proximity to other positions held by RMG and
existing or planned gas transmission lines, and whether drilling and production
permits can be obtained and the costs thereof. The final decision to acquire a
prospect is made by the executive officers of RMG. Well drilling and testing is
done by outside contract drilling companies. Drilling results (cores, gas and
water flow rates, and other data) are evaluated by RMG staff, using customary
technical methods, to determine if any coal zones encountered in the well should
be completed for production. Completion requires setting casing pipe down to the
coal zone(s), installing pumps, and installing and setting up the necessary
surface equipment (for example, water disposal lines and water holding tanks
and/or holding ponds for evaluation wells, pending production permitting), and
dewatering the well sufficiently so production can start. The decision whether
to complete the well is made by the executive officers of RMG.
Table 1 reflects RMG's, Quaneco's and CCBM's acreage position as of the
filing of this Annual Report. Table 1 does not reflect the reduction in net
acreage held by RMG if Anadarko Petroleum, Inc. exercises its options to back-in
for a 25% working interest on 31,711 gross acres or Kerr McGee exercises its
option to back-in for a 40% working interest on 38,184 gross acres within the
Oyster Ridge prospect. Also, 69,895 of the acres shown as held in Oyster Ridge
assume we continue to earn acreage under the drill-to-earn-acreage provisions of
the option agreements with Anadarko and Kerr McGee. See "Description of
Prospects - Oyster Ridge" below.
-17-
TABLE 1
- --------------------------------------------------------------------------------
Project
and Date Gross Lease Net Lease RMG Net Quaneco Net CCBM Net
Acquired Acres Acres Acres Acres Acres
- --------------------------------------------------------------------------------
Castle Rock 123,840 111,567 48,811 55,784 6,973
Jan. 2000
Oyster Ridge 87,642 87,642 32,380 0 32,380
Dec. 1999
Baggs North 120 120 60 0 60
Jan. 2000
Hi-Pro 52,740 51,938 46,974 0 0
Jan.2003
- --------------------------------------------------------------------------------
TOTAL 264,342 251,267 128,225 55,784 39,413
- --------------------------------------------------------------------------------
We own a 43.75% working interest (35% net revenue interest) in the Castle
Rock prospect on 123,840 gross and 111,567 net acres in southeast Montana. CCBM
can purchase a 6.25% working interest in our acreage (6,973 net acres) of the
Castle Rock prospect if they meet certain payment obligations. In July 2001, we
sold a 50% working interest in all our coalbed methane leases, except at Castle
Rock, to CCBM for $7,500,000, plus other consideration. The acreage data in
Table 1 reflects these transactions.
CCBM agreed to pay up to $5,000,000 for drilling and completing CBM wells
on the properties owned by RMG and CCBM. We have a carried working interest in
all of the wells drilled on properties owned in July 2001 (after the Pinnacle
transaction, those properties consist of the Castle Rock, Baggs, and the Oyster
Ridge property (not including the Kerr-McKee earn-in acreage)). To date, CCBM
has not indicated whether they will participate in the Kerr McGee acreage under
the AMI agreement as it is still under review by CCBM under the AMI review
timeline. CCBM has the right to participate as to 50% of the working interest we
acquire in properties RMG or RMG I acquires in the future; if CCBM elects to
participate, RMG or RMG I would not have a carried interest in wells on future
properties.
A total of 72 wells have been drilled on RMG acreage through December 31,
2003: 5 in (former) fiscal year 2001; 53 in (former) fiscal year 2002; 12 in the
seven months ended December 31, 2002; and 2 in 2003. 43 of the wells were
drilled on properties transferred to Pinnacle in mid-2003. Nineteen of the wells
were drilled by SENGAI in Castle Rock under the terms of a option and farmin
agreement. Eleven of those 19 wells were stratigraphic wells and have been
plugged by SENGAI; 8 of those 19 wells were completed and are owned by RMG
(93.75% working interest) and CCBM (6.25% working interest), as Quaneco opted
out of maintaining a working interest in the 8 wells. Other than the Castle Rock
wells, RMG and CCBM both have a 50% working interest in all of these wells (see
Table 2 below).
As of December 31, 2003, CCBM and RMG have spent approximately $2,194,900
of the $2,500,000 drilling fund CCBM is committed to spend on RMG's behalf. This
reflects a reduction of $391,000 for RMG's participation in two of Carrizo's
Gulf Coast wells. We are relying on the $305,100 balance to pay for continued
drilling and completion work on the Castle Rock and Oyster Ridge properties, as
to which RMG will have a carried working interest with no financial obligation
of RMG for drilling and completion costs until the drilling fund is exhausted.
For other properties we acquire in which CCBM elects to participate, CCBM would
bear 50% of drilling and completion costs for their 50% working interest.
Future annual financial obligations for coalbed methane properties consist
of approximately $173,100 gross in rental fees to the lessors for 2004 ($81,800
net to RMG).
Table 2 lists the number of wells drilled, the total exploration costs and
the remaining number of wells currently permitted for drilling as of December
31, 2003. Wells permitted for drilling on the Hi-Pro properties are shown;
exploration costs and numbers of wells drilled by Hi-Pro Production are not
shown.
-18-
TABLE 2
FY 2001 FY 2002 New Year 2002 FY 2003
Prospect 6/1/00-5/31/01 6/1/01-5/31/02 6/1/02-12/31/02 1/1/03-12/31/03 TOTAL Remaining
Wells $ Wells $ Wells $ Wells $ Wells $ Permits
- ---------------------------------------------------------------------------------------------------------------------------
Castle
Rock 3* $283,900 19** $2,500,000 $ 4,300 0 0 22 $2,788,200 5
- ---------------------------------------------------------------------------------------------------------------------------
Oyster
Ridge 2 150,500 5 464,200 3,400 0 0 7*** 618,100 4
- ---------------------------------------------------------------------------------------------------------------------------
Hi-Pro n/a n/a n/a n/a n/a n/a n/a 0 n/a n/a 9
- ---------------------------------------------------------------------------------------------------------------------------
TOTAL 5 434,400 24 2,964,200 7,700 0 0 29 3,406,300 18
* one well has been plugged and abandoned
** drilled by SENGAI, 11 have been plugged and abandoned
*** includes 3 wells that have been plugged and abandoned
CARRIZO - PURCHASE AND SALE AGREEMENT. On July 10, 2001, RMG closed a
Purchase and Sale Agreement with CCBM, Inc., a Delaware corporation which is
wholly-owned by Carrizo Oil & Gas, Inc., Houston, Texas (NMS "CRZO"). The
agreement between CCBM and RMG is intended to finance the further exploration of
the properties held in Montana and Wyoming, and to acquire and develop more
properties.
RMG assigned CCBM an undivided 50% interest in all of RMG's then current
coalbed methane properties (with the exception of Castle Rock of which only a
6.25% working interest was assigned) for a purchase price of $7,500,000 by a
promissory note payable in principal amounts of $125,000 per month plus interest
at an annual rate of 8%, over 41 months (starting July 31, 2001) with a balloon
payment due on the forty-second month. This note was reduced in connection with
CCBM's contribution of properties to Pinnacle (see "Transaction with Pinnacle
Gas Resources, Inc. - Continuing Operations of RMG, Continuing Agreement with
CCBM, and the AMI Agreement, after the Pinnacle Transaction"), and the balance
on the note is secured with a 50% undivided interest in the remaining properties
(Oyster Ridge and Baggs North (but not Hi-Pro).
CCBM has the right to participate in other properties RMG may acquire under
an area of mutual interest ("AMI") agreement. This agreement has been modified
by the AMI agreement signed in connection with the Pinnacle transaction; CCBM
waived its right to participate in the Hi-Pro acquisition. For information on
the original AMI agreement, see "Carrizo - Purchase and Sale Agreement" in the
Annual Report (Form 10-K/A1) for the former fiscal year ended May 31, 2002.
In addition to its one-half share of revenues in proportion to its one-half
share of the working interest, CCBM was entitled to a credit (applied as a
prepayment of the purchase price for the undivided 50% interest in RMG's
acreage), equal to 20% of RMG's net revenue interest from wells drilled with the
$5,000,000 drilling budget, until the amount of that credit in favor of CCBM
equals $1,250,000. At the formation of Pinnacle, CCBM paid RMG approximately
$1.8 million to complete is purchase value on the contracts properties. The
payment of $1.8 million was a reduction to the principal on the original $7.5
million note from CCBM. The $1.25 million that CCBM was to recover from 20% of
RMG's revenue interest on the contributed properties was netted against the
total purchase price on the contributed properties which yielded the $1.8
million cash payment. CCBM is not entitled to any additional disproportionate
revenue distributions.
QUANECO - AGREEMENT. On January 3, 2000, RMG purchased a 50% working
interest and 40% net revenue interest in the Castle Rock and Kirby prospects in
the Powder River Basin of southeast Montana consisting of approximately 185,000
net mineral acres from Quaneco, L.L.C. (formerly Quantum Energy, L.L.C.,
Cleveland, Ohio and Oklahoma City, Oklahoma). The acreage includes 88,409 net
acres of Bureau of Land Management ("BLM") land; 14,916 net acres of state land
(Montana), and 82,775 net acres of fee land.
-19-
In fiscal 2000 and 2001, RMG paid Quaneco the cash purchase price of $5,500,000
for the acreage plus a drilling commitment of $2,500,000. RMG and CCBM
transferred their interests in the Kirby prospect to Pinnacle in mid-2003.
For information on the Quaneco agreement, see "Quaneco Agreement" in the
Annual Report (Form 10-K/A1) for the (former) fiscal year ended May 31, 2002.
DESCRIPTION OF PROSPECTS
Leases of federal mineral rights are obtained from the United States Bureau
of Land Management and expire from 2004 to 2009, unless RMG establishes
production on the lease, in which event the lease is held so long as coalbed
methane or other gas or oil is produced. A royalty interest of 12.5% on the
production is paid to the BLM. State leases expire from 2004 to 2009 in Wyoming
and Montana, unless RMG establishes production on the lease, in which event the
lease is held so long as coalbed methane or other gas or oil is produced. The
royalty paid to the State of Wyoming is from 12.5 % to 16.67%, and 12.5% to the
State of Montana. Annual renewal fees for non-producing Federal leases is $1.50
to $2.00 per acre, and $1.00 and $2.75 for non-producing Wyoming and Montana
leases.
An environmental group has filed a lawsuit against the BLM, RMG and others,
challenging the validity of numerous BLM leases in the Powder River Basin of
Montana. See Item 3, Legal Proceedings ("Rocky Mountain Gas Litigation").
Leases on private (fee) land for coalbed methane and conventional gas
expire at various times from 2004 to 2011, unless production is established, in
which event the lease is held so long as there is production. The landowner is
paid a royalty from production of 12.5% to 20.0% , depending on the lease terms.
Table 3 presents total acreage (developed and undeveloped) held by RMG at
December 31, 2003, and the Hi-Pro acreage as of the filing date of this Annual
Report.
TABLE 3
Net Net Net
Net Leased Leased Leased
Gross Net Leased from from from
Leased Leased from State of State of Private
Prospect Acres Acres BLM Wyoming Montana Owners
------- ------- -------- ------- ------- ------
Castle Rock 123,840 111,567 55,104 0 10,860 45,603
Oyster Ridge* 20,306 20,306 17,107 639 0 2,560
Baggs North 120 120 0 120 0 0
Hi-Pro (undeveloped) 40,120 40,120 0 112 0 40,008
------- ------- ------ ----- ------ ------
Total Undeveloped Acres 184,386 172,113 72,211 871 10,860 88,171
Hi-Pro (developed) 12,620 11,818 460 280 0 11,078
------- ------- ------ ----- ------ ------
Total Acres 197,006 183,931 72,671 1,151 10,860 99,249
======= ======= ====== ===== ====== ======
*Does not include 29,151 acres under option from Anadarko Petroleum and
38,184 acres under option from Kerr McGee. See "Description of Properties -
Oyster Ridge."
-20-
RMG's properties and mineral leases of BLM, state and fee lands require
annual cash payments of approximately $173,100 during 2004. CCBM is obligated
for $59,600 of the $173,100 required to keep undeveloped coalbed methane leases
in effect.
CASTLE ROCK: The Castle Rock project consists of 123,840 gross and 111,567
net acres located in the northeastern portion of the Powder River Basin of
Montana, west of Broadus, Montana. Coals present are in the Tongue River member
of the Fort Union formation and appear comparable to coals currently being
developed by other operators south of the Castle Rock acreage near the
Montana/Wyoming border. Currently, there are no pipelines in this area.
OYSTER RIDGE: The Oyster Ridge project consists of two acreage positions:
(1) 49,457 gross and net acres located in southwestern Wyoming in the Ham's Fork
Coal Field adjacent to the Green River Basin; RMG and CCBM have a 100% working
interest (50% each) in 20,765 acres within this play, which is held with
Anadarko Petroleum, Inc. Oyster Ridge; and (2) 38,184 gross and net acres held
by Kerr-McGee Rocky Mountain Corporation, which are at the north and south ends
of the Anadarko acreage.
The area is prospective for coalbed methane production from two primary
Cretaceous age coals, the Frontier and the Adaville. The Kern River pipeline,
which services southern California, crosses the property. Through December 31,
2003, $799,500 has been spent on drilling and completion at Oyster Ridge.
(1) Anadarko Petroleum, Inc. is successor to Union Pacific Land Resources
Corporation, which sold the acreage subject to UPLRC's back-in option to third
parties, from whom RMG acquired the acreage in December 1999.
The agreement with Anadarko is a drill-to-earn-acreage agreement: We must
drill at least four wells each year, each on a new section (640 acres), to earn
a lease on each drilled section, and also to keep in force previously earned
leases in the 31,711 acres area. Wells drilled by our seller, and by us (with
CCBM), have earned 2,560 acres, which are included in the 20,306 acres leased
presently.
Another 29,151 gross acres in the Oyster Ridge project are subject to an
option held by Anadarko Petroleum, Inc. to participate as a 25% working interest
owner on all wells drilled each year. Anadarko has not yet elected to
participate, and has no working interest in the wells drilled to date on this
prospect. If Anadarko elects to participate in the future, working interest
ownership in affected wells would be 37.5% RMG, 37.5% CCBM, and 25% Anadarko.
(2) Effective March 31, 2004, RMG signed a letter of intent to enter into
an earn-in agreement to acquire a 60% working interest from Kerr-McGee Rocky
Mountain Corporation ("KM") in 38,184 gross and net mineral acres held by KM
under federal and Wyoming state leases. When executed, the earn-in agreement
will be for a total of six years, with three phases: drilling commitment, pilot
program, and development program. The earn-in agreement is expected to be
executed by March 31, 2004. The following is a summary of terms.
Drilling Commitment. On or before September 30, 2004, RMG will drill,
complete and attempt to produce for at least 30 days (at its sole expense) two
coalbed methane wells (one to the Frontier coal seams and one to the Adaville
Cretaceous coal seams), to earn 60% of KM's working and net revenue interest in
the 640 acre section surrounding each well, down to the deepest depth drilled.
Drilling and completion costs for the two wells will be a minimum of $300,000.
RMG will receive all production revenues from each well until RMG reaches payout
(total drilling and completion costs) from the wells, at which time KM will
begin to participate for its 40% working interest. KM's leases will be delivered
to RMG with a 82.5% net revenue interest.
-21-
Pilot Program. If RMG determines the drilling program results to be
favorable, in its exclusive judgment, a pilot program for four wells (at RMG's
sole expense) will be initiated by September 30, 2005.
Development Program. If RMG determines the pilot program results to be
favorable, in its exclusive judgment, RMG will notify KM by December 31, 2005 of
its election to commit to a development program. If this commitment is made, RMG
shall drill at least 10 wells per year on KM lands beginning in 2006. Each well
will earn for RMG a 60% working interest in the 640 acre section surrounding the
well, and each lease will be delivered to RMG with a 82.5% net revenue interest.
KM may elect to participate for a 40% working interest in any development well.
If KM elects not to participate in the first well in the section, KM will be
deemed to relinquish the 40% working (and associated net revenue) interest in
the well until RMG reaches payout. If KM elects not to participate in the second
well in any section previously earned by RMG, then KM shall have relinquished
all of its interest in the entire section.
RMG will be the operator for each stage of the KM project.
As of the filing date of this Annual Report, CCBM has not determined
whether to participate with us in the Kerr-McGee earn-in agreement. However, our
net acreage calculations assume that CCBM will participate.
BAGGS NORTH: This prospect contains 120 gross and net acres located in
Carbon County, Wyoming. This State lease is located 7 miles north of Baggs,
Wyoming. RMG holds a 50% working interest in this prospect. To date, RMG has not
conducted any significant exploration on the property.
GENERAL INFORMATION ABOUT COALBED METHANE.
Methane is the primary commercial component of natural gas produced from
conventional gas wells. Methane also exists in its natural state in coal seams.
Natural gas produced from conventional wells generally contains other
hydrocarbons in varying amounts which require the natural gas to be processed.
Methane gas produced from coalbeds generally contains only methane and is
pipeline-quality gas after simple water dehydration.
Coalbed methane ("CBM") production is similar to conventional natural gas
production in terms of the physical producing facilities. However, the
subsurface mechanisms that allow gas movement to the wellbore are very
different. Conventional natural gas wells require a porous and permeable
reservoir, hydrocarbon migration and a natural structural or stratigraphic trap.
Coalbed methane is stored in four ways: 1) as free gas within the micropores
(pores with a diameter of less than .0025 inch) and cleats (set of natural
fractures in the coal; 2) as dissolved gas in water within the coal; 3) as
absorbed gas held by molecular attraction on surfaces of macerals (organic
constituents that comprise the coal mass), micropores, and cleats in the coal;
and 4) as absorbed gas within the molecular structure of the coal molecules.
Coals at shallower depth with good cleat development contain significant amounts
of free and dissolved gas while the percentage of absorbed methane generally
increases with increasing pressure (depth) and coal rank. Coalbed methane gas is
released by pressure changes when the water in the coal is removed. In contrast
to conventional gas wells, new coalbed methane wells initially produce water for
several months. As the formation water pressure decreases, methane gas is
released from the structure.
-22-
Methane production is a direct result of reducing the hydrostatic (water)
pressure in the coal formation. Three principal stages are involved:
X Drill wells (typically eight or more in a 'pod') down to the same coal
formation, in contiguous 80 acre spacing per well; test the water in
the formation and test coal samples taken from the formation. Water
testing determines if the geochemical environment of the coal seam is
conducive to the formation of CBM.
X Install gathering lines to hook up and put wells on pump to "dewater"
the coal formation. Hydrostatic pressure must be reduced to about 50%
of initial pressure before enough data is obtained (water flow rates,
CBM gas flows) to determine how much CBM the wells may produce. This
dewatering stage may take 6 to 18 months, and in some instances 24
months (where there is no dewatering of the coal seam occurring from
wells drilled by others on adjacent properties).
X Installing (or have a transmission company install) a compressor and
transport line to carry produced gas to a gas transmission line for
sale to end users. Gas production starts gradually then continues to
grow in volume as hydrostatic pressure is reduced; optimal production
won't occur until hydrostatic pressure is reduced approximately 90%
from initial levels.
COALBED METHANE WELL PERMITTING
Operators drilling for coalbed methane are subject to many rules and
regulations and must obtain drilling, water discharge and other permits from
various governmental agencies depending on the type of mineral ownership and
location of the property. Intermittent delays in the permitting process can
reasonably be expected throughout the development of all RMG projects. As with
all governmental permit processes, there is no assurance that permits will be
issued in a timely fashion or in a form consistent with the plan of operations.
Drilling and production operations on our Powder River Basin leases in
Wyoming and Montana are subject to environmental rules, requirements and permits
issued by various federal authorities for drilling and operating on all land,
regardless of ownership, and state and local regulatory agencies for land owned
by the state or in fee by private interests. The primary Federal agency with
related responsibilities is the Bureau of Land Management of the U.S. Department
of the Interior ("BLM") which has imposed environmental limitations and
conditions on coalbed methane drilling, production and related construction
activities on federal leases in the PRB. These conditions and requirements are
imposed through Records of Decision ("ROD") issued pursuant to Environmental
Impact Statements ("EIS"). The BLM may also impose site-specific conditions on
development activities, such as drilling and the construction of rights-of-way,
before it approves required applications for permits to drill and plans of
development.
In April 2003 the BLM issued Records of Decision finalizing two impact
statements: The Powder River Basin Oil and Gas EIS (PRB-EIS) for the Wyoming
portion of the basin, and the Statewide Oil and Gas EIS and Proposed Amendment
for the Powder River and Billings Resource Management Plans in Montana.
Together, the impact statements authorize the development of some 77,000 coalbed
methane gas wells in the Powder River Basin, most of which would be drilled on
the Wyoming side of the basin.
With the EIS completed, the BLM will be able to consider drilling or
development proposals in the geographic areas studied, however, before any
permits are approved, the BLM will conduct an additional round of environmental
review to identify site-specific environmental impacts and appropriate
mitigation measures. Three lawsuits have been filed challenging the Record of
Decisions, however, no stays have been issued. (See I.3. Legal Proceedings,
Rocky Mountain Gas, Inc.)
-23-
The state-based environmental agencies primarily concern themselves with
the issuance of permits related to drilling, land, air quality and water
discharge. The primary state-based agencies for which coalbed methane operators
are subject to include:
X Wyoming Department of Environmental Quality ("WDEQ")
X Wyoming Oil and Gas Conservation Commission ("WOGCC")
X Montana Department of Environmental Quality ("MDEQ")
X Montana Board of Oil and Gas Conservation ("MBOGC")
While the BLM is primarily responsible for issuing broadly based EISs for
each state, its jurisdiction over related matters and the actual issuance of
drilling permits is primarily reserved for federal leases. Permits for drilling
on state or fee owned land are issued by the WOGCC and MBOGC.
In contrast to Wyoming, Montana authorities have been very slow in
undertaking CBM environmental studies and granting permits to drill wells. In
fact, to date, only the Redstone (Fidelity) project is producing CBM gas in
Montana. With the exception of a relatively small number of drilling permits
available from earlier issuance (including those held by RMG which have allowed
some drilling on the Castle Rock project), a drilling moratorium had been in
effect during the last three years, prior to the approval of the two
environmental impact statements.
The DEQs are primarily responsible for issuing air quality and water
discharge permits, among other things. Water disposal has been and is expected
to continue to be a significant issue, particularly with respect to coalbed
methane gas production, which typically entails substantial water production at
least during the dewatering phase of completion of a new well. The primary issue
of concern is the salinity content in the produced water, which is measured by
the sodium absorption ratio ("SAR"), which, depending upon a location, can range
from slightly less than that in surface water to a substantially greater amount.
Due to the discrepancies of the SAR content found in water from coalbed methane
wells, the disposal of this water is tightly regulated. If the SAR content is
low, the water can be used for irrigation, livestock drinking water or even as a
water supply for cities. If the SAR content is higher, the water quality does
not merit use for drinking water or irrigation and, under these measures, the
DEQ has outlined various other methods of water disposal. Man-made ponds may
also be built right beside the wells, enabling the wells to drain their water
into the ponds (called surface discharge). Additionally, there might be
drainages which the produced water can flow into. Finally, the water might be
reinjected through wells into the ground below levels from which the water was
produced. Thus far, the vast majority of associated water produced has been
discharged on the surface, primarily captured in reservoirs and ponds and
allowed to evaporate.
Overall, RMG has not experienced any difficulty in obtaining air quality
and water discharge permits from the WDEQ, and those permits are in place for
the Hi-Pro properties. RMG has not has applied for such permits in Montana.
The following summarizes permits now in place.
-24-
Table 4
Expiration
Prospect Remaining Permits or Renewal Date
-------- ------------------ -----------------
Castle Rock 5 May - July 2004
Hi-Pro 9 August - September 2004
Oyster Ridge 4 September 2004
------------------
Total 18
Drilling permits issued by the State of Wyoming allow one year for drilling
completion; permits issued by the State of Montana allow six months.
Once drilled, all wells in Wyoming are subject to a National Pollution
Discharge Elimination System ("NPDES") permit relating to water testing and
discharge. All wells in the Castle Rock prospect remain subject to the Montana
Board of Oil and Gas Commission approval. Upon completion of drilling, wells are
subject to monthly reporting regarding status and production to the respective
state agencies in which they are located.
Due to the low pressure characteristics of the coalbeds, the production of
coalbed methane is dependent on the installation of multi-stage compression
facilities. Gas is gathered from the wells, and transported to a low level
compression station, then on to a high level compression station and finally to
the transmission pipeline. The water is commonly collected through another
pipeline from each of the wells and pumped into a surface reservoir.
Companies involved in coalbed methane production generally outsource gas
gathering, compression and transmission. RMG and industry partners have and will
likely continue to outsource their compression and gathering to third parties at
fixed charges per mcf transported.
GAS MARKETS
Gas production from the Powder River Basin is significant. Since this area
is sparsely populated, most of the gas must be exported to distant markets. The
existing Wyoming pipeline infrastructure is already substantial and continues to
expand with gathering systems and intrastate lines, yet is ultimately dependent
on large interstate pipelines. With the exception of a portion of the gathering
systems, this pipeline system is typically owned and operated by independent
mid-stream energy companies, rather than oil and gas operators. The pipelines
generally will not be financed and constructed until appropriate amounts of gas
have been proven and committed for transport on the new lines. While the total
current take away capacity from the PRB is approximately 1.25 billion cubic feet
per day (Bcfd), excess capacity over current production rates does not exist in
all locations and not all producers have a ready market for the sale of their
gas at all times. Some major producers in the region reserve portions of
pipeline capacity beyond their current requirements, resulting in less than
stated maximum capacity being available for other producers. In addition, total
stated capacity is unavailable at times as pipelines are shut down for
maintenance or construction activities.
Based on the existing pipeline systems and the gas sales markets in its
area of operations in Wyoming, RMG expects that, at least for the next few
years, the markets in which it sells its gas, and the spot prices to which it
will be subject, will be dependent upon three major sales points:
X The Colorado Interstate Gas ("CIG") station near Cheyenne in
southeastern Wyoming, which primarily feeds regional markets or
markets in the Midwest.
-25-
X The Ventura market ("Ventura") located in Ventura, Iowa, which prices
gas on the Northern Border pipeline where it interconnects with
Northern Natural Gas and feeds markets in the Northern Plains and
Midwest.
X The Opal market ("Opal") in southwestern Wyoming, which delivers to
the Kern River pipeline for delivery to Utah, Nevada, Arizona and
California.
PIPELINES THAT SERVE THE CIG MARKET
Two large diameter intrastate pipelines, the Fort Union and the Thunder
Creek, were constructed in the Basin in 1999, and gathering system
infrastructure has continued to grow significantly. These two major intrastate
pipelines currently provide almost 1.1 Bcfd capacity, flowing south out of the
Basin to the CIG Hub in Southeast Wyoming.
- Fort Union. The Fort Union Gas Gathering pipeline consists of a 106
-----------
mile,24 inch, 434 Mmcfd capacity line completed in August 1999 and a
20" pipeline with a capacity of 200 Mmcfd completed in September 2001.
It is believed that capacity could be increased by another 200 Mmcfd
by adding additional compression to this line.
- Thunder Creek. Thunder Creek Gas Services pipeline is a 126-mile, 24
--------------
inch pipeline which commenced operations on September 1, 1999 with a
capacity of 450 Mmcfd.
The Hi-Pro production is delivered to the Thunder Creek pipeline where it
is carried south and delivered to the CIG market.
El Paso Corporation's subsidiary Cheyenne Plains Gas Pipeline Co. received
approval from the Federal Energy Regulatory Commission in March 2004 for
construction of a new 380 mile pipeline from Cheyenne, Wyoming to Greensburg,
Kansas, with a capacity of 560 Mmcf per day. Cheyenne Plains has announced its
intent to apply to the FERC for permission to enlarge the line to handle 760
Mmcf per day. This line, with the enlarged capacity, is expected by Cheyenne
Plains to be in-service in January 2005, and may help narrow the negative price
differential for CIG prices compared to national prices.
PIPELINES THAT SERVE THE VENTURA MARKET
There are currently only two significant pipelines capable of transporting
gas out of the Basin to the north, the Bitter Creek pipeline, which connects
with the Northern Border interstate pipeline and the Glasslands pipeline.
However, one additional line that is well along in its planning stages, would
also deliver gas to the Northern Border pipeline. Descriptions are as follows:
X Bitter Creek. The Bitter Creek pipeline is owned by Williston Basin
-------------
Interstate Pipeline Company ("WBI"), a subsidiary of MDU Resources
Group, Inc. It was completed in 2001 with initial capacity of 150
Mmcfd.
X Grasslands. In response to the need for expandable access to the
----------
Ventura market, the Grasslands pipeline, also owned by WBI, went into
service in November 2003. It is a 245 mile, 16 inch line with an
initial capacity of 80 Mmcfd and expandable to 200 Mmcfd.
-26-
THE OPAL MARKET
The Opal market, in southwestern Wyoming, is a major pipeline connection
point, with several intrastate and interstate lines connecting to the major
interstate Kern River line (with a recently enlarged capacity of 1.73 Bcfd,
delivering to markets in Utah, Nevada, Arizona and California. If the Oyster
Ridge property is put into production, gas could be sold into this market.
GAS PRICES
Historically, spot gas prices received by producers at the Ventura, CIG and
Opal markets have generally been at discounts to the NYMEX front month contract
and Henry Hub spot cash prices, although with lesser discounts during the winter
months. Prices at CIG can trade at a further discount to the Ventura prices, and
again with an even higher discount during the second and third quarters, because
CIG is partially based on local demand which can drop outside the heating
season, while Ventura serves larger national markets and is highly correlated to
Chicago market prices.
The negative price differential in the prices realized by Powder River
Basin producers in 2003, as compared to prices realized on the national gas
market, ranged from 10% to 45% (higher outside the heating season). The negative
price differential in the fourth quarter 2003 and first quarter 2004 narrowed in
comparison to the fourth quarter 2002. However, there is no guarantee that
increased capacity will eliminate the negative price differential or even
significantly reduce it.
INACTIVE MINING PROPERTIES - URANIUM
GENERAL. We have interests in several uranium-bearing properties in Wyoming
and Utah and in a uranium processing mill in southeastern Utah (the "Shootaring
Mill" in Garfield County). All the uranium-bearing properties are in areas which
produced significant amounts of uranium in the 1970s and 1980s. At some future
date, we could sell, develop and/or operate these properties (directly or
through a subsidiary company or a joint venture) with companies having the
necessary capital to mine and mill the uranium bearing material to produce
uranium concentrates ("U3O8") for sale to public utilities that operate nuclear
powered electricity generating plants. Currently there is no operating uranium
mill in Wyoming and it would take a substantial increase in the market price of
uranium concentrate over a period of time before a company with the financial
wherewithal would build a mill and place the deposits in production. Therefore,
until uranium oxide prices improve significantly, the uranium properties will
remain shut down.
At the dates of the consolidated balance sheets in this Report, there are
no values carried on the balance sheets for uranium properties.
SHEEP MOUNTAIN - WYOMING
Unpatented lode mining claims, underground and open pit uranium mines and
mining equipment in the Crooks Gap area are located on Sheep Mountain in Fremont
County, Wyoming. From December 21, 1988 to June 1, 1998, these properties were
held by Sheep Mountain Partners ("SMP"). On June 1, 1998, the Company received
back from SMP all of the Sheep Mountain mineral properties and equipment, in
partial settlement of certain disputes with Nukem, Inc. ("Nukem") and its
subsidiary Cycle Resource Investment Corp. ("CRIC"). The judgment against Nukem
impressing the CIS uranium supply contracts in a constructive trust with SMP
remains unresolved. See "Legal Proceedings."
We have recorded reclamation liabilities for the SMP properties. All
historical costs in the SMP properties were offset against a monetary award
which was received from Nukem during fiscal 1999.
-27-
UTAH
Plateau Resources Limited ("Plateau") is a wholly-owned subsidiary of USE.
In 2003, reclamation work on uranium properties (the Tony M, Velvet, and Woods
Complex) in San Juan County, Utah was completed.
PLATEAU'S SHOOTARING CANYON MILL AND PROPERTIES
In August 1993, USE purchased from Consumers Power Company ("CPC"), all of
the outstanding stock of Plateau which owns the Shootaring Canyon uranium
processing mill and support facilities in southeastern Utah (the "Shootaring
Mill") for a nominal cash consideration. The Shootaring Mill holds a source
materials license from the NRC. In the purchase of the stock from CPC, we agreed
to various obligations, as disclosed in USE's 1998 Form 10-K at pages 15 and 16.
The Shootaring Mill is located in southeastern Utah and occupies 19 acres
of a 265 acre plant site. The mill was designed to process 750 tpd, but only
operated on a trial basis for two months in mid-summer of 1982. In 1984, Plateau
placed the mill on standby because CPC had canceled the construction of an
additional nuclear energy plant.
For information on the Shootaring mill facility and related real estate
property at Ticaboo, please see "Plateau's Shootaring Canyon Mill and
Properties" in the annual report (Form 10-K/A1) for the former fiscal year ended
May 31, 2002.
THE GREEN MOUNTAIN MINING VENTURE ("GMMV") PROJECT
For information on the GMMV agreement, see "Green Mountain Mining Venture"
in the annual report (Form 10-K/A1) for the (former) fiscal year ended May 31,
2002.
SHEEP MOUNTAIN PARTNERS ("SMP")
SMP PARTNERSHIP. In February 1988, USE acquired uranium mines, mining
equipment and mineralized properties (Sheep Mountain Mines) at Crooks Gap in
south-central Fremont County, Wyoming, from Western Nuclear, Inc. These Crooks
Gap mining properties are adjacent to the Green Mountain uranium properties.
USECC mined and milled uranium ore from one of the underground Sheep Mines
during fiscal 1988 and 1989. In December 1988, USECC sold 50 percent of the
interests in the Crooks Gap properties to Nukem's subsidiary Cycle Resource
Investment Corporation ("CRIC") for cash. The parties thereafter contributed the
properties to and formed Sheep Mountain Partners ("SMP"), in which USECC
received an undivided 50 percent interest. SMP is a Colorado general partnership
formed on December 21, 1988, between USECC and Nukem, Inc. then of Stamford, CT
("Nukem") through its wholly-owned subsidiary CRIC.
SMP was directed by a management committee, with three members appointed by
USECC and three members appointed by Nukem/CRIC. The committee has not met since
1991 as a result of the SMP arbitration/litigation. During fiscal 1991, disputes
arose between the SMP partners which resulted in litigation. See Item 3, Legal
Proceedings.
PROPERTIES. USE, Crested and/or USECC own 98 unpatented lode mining claims
and a 644 acre Wyoming State Mineral Lease in the Crooks Gap area.
An ion exchange plant located on the properties (to remove natural soluble
uranium from mine water) was reclaimed and the plant disposed of at the
Sweetwater Mill impoundment facility in fiscal 2002.
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Permits to operate existing mines (now shut down) on the Crooks Gap
properties had been issued by the State of Wyoming, but amendments would be
needed to re-open them. A NPDES water discharge permit under the Clean Water Act
has been obtained; monitoring and treatment of water removed from the mines and
discharged in nearby Crooks Creek is generally required. However, for the last
three years, USECC has not discharged wastewater into Crooks Creek, and the
water instead is being discharged into the USECC McIntosh Pit at the Sweetwater
mill owned by Kennecott (the Sweetwater mill had been part of the Green Mountain
Mining venture).
INACTIVE MINING PROPERTIES - GOLD
SUTTER GOLD MINING COMPANY. In fiscal 1991, USE acquired an interest in
Sutter properties located in the Mother Lode Mining District of Amador County,
California. The entire Lincoln Project (which is the name we use for the
properties) is owned by Sutter Gold Mining Company, a Wyoming corporation
("SGMC"), and a majority-owned subsidiary of USE.
This property has never been in production. Persistent low prices for gold
made financing difficult, and in fiscal 1999 resulted in a substantial write
down of the SGMC properties.
Due to the depressed gold prices in the past, litigation (since resolved)
and lack of funding, SGMC has deferred the start of construction of a gold mill
complex and extension of existing underground workings. A tourist visitors
center has been set up (see below) and leased to a third party for $1,500 per
month plus a 4% gross royalty on revenues. There is one caretaker employee at
the Sutter operation. The conditional use permit is being kept current as
necessary to allow for possible mining activities on the properties in the
future.
In 1998 and 1999, the Company took impairments (write-downs) in the amounts
of $1,500,000 and $10,718,800, respectively, of the carrying value of the gold
properties. These two impairments wrote off almost 85% of our investment in
these properties. As a result of low market prices for gold at the time, we
determined that we could not produce gold from these properties at a profit. The
impairments taken in 1998 and 1999 resulted in no value for mine exploration,
and the remaining assets relating to this property include raw land which is no
longer needed for mining activity, and buildings and equipment. A significant
portion of the raw land has been sold.
We have not obtained a final feasibility study to support a determination
that the Sutter property contains proven or probable reserves of gold.
In late 2003, SGMC signed a letter of intent for an acquisition of SGMC by
Globemin Resources Inc., a British Columbia corporation listed on the TSX-V.
Completion of the acquisition is subject to negotiation and execution of a share
exchange agreement, approval by the TSX-V, Canadian regulatory authorities, and
the boards of directors and if necessary, shareholders of SGMC and Globemin. If
the acquisition is consummated, a majority of the stock of Globemin would be
owned by the (former) SGMC shareholders. Globemin thereafter would seek to raise
financing in Canada to begin mining the Lincoln Project and build a mill.
PROPERTIES. SGMC holds approximately 435 acres of surface and mineral
rights: (87 acres of surface rights (owned), 73 acres of surface rights
(leased), 146 acres of mineral rights (leased), and 289 acres of mineral rights
(owned), all on patented mining claims near Sutter Creek, Amador County,
California. The properties are located in the western Sierra Nevada Mountains at
from 1,000 to 1,500 feet in elevation; year round climate is temperate. Access
is by California State Highway 16 from Sacramento to California State Highway
49, then by paved county road approximately .4 mile outside of Sutter Creek.
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Surface and mineral rights holding costs, and property taxes, will be
approximately $130,000 and $9,900 for 2004.
The leases are for varying terms and require rental fees, annual royalty
payments and payment of real property taxes and insurance.
PERMITS. The Amador County Board of Supervisors has issued a Conditional
Use Permit ("CUP") allowing mining of the SGM and milling of production, subject
to conditions relating to land use, environmental and public safety issues, road
construction and improvement, and site reclamation. Applications will be made in
the second quarter of 2004 to California regulatory authorities for a waste
water discharge permit to allow the Company to utilize mill tails as mine
backfill and to store tails in a surface fill unit.
VISITORS CENTER. In fiscal 2000, SGMC spent approximately $298,000 for
surface infrastructure related to improving access to the mine site, and to a
lesser extent tourist related improvements. The visitors center is being
operated by a third party. The visitors center is an exhibit of the pictures and
memorabilia from mining operations on other properties in the Sutter district in
the nineteenth century, and a guided tour of the underground workings at the
Lincoln Project. Revenues from this tourist operation were $48,800 for 2003,
$49,200 for the seven months ended December 31, 2002, and $41,200 in (former)
fiscal year 2002, and are included in "real estate" in the consolidated
statements of operations included in this report. These revenues offset a
majority of costs for holding the Sutter properties.
MOLYBDENUM
As a holder of royalty, reversionary and certain other interests in
properties located at Mt. Emmons near Crested Butte, Colorado, USE and Crested
are entitled to receive annual advance royalties of 50,000 pounds of molybdenum,
or cash equivalent. AMAX Inc. (which was acquired by Cyprus Minerals Company and
was renamed Cyprus Amax Minerals Company in November 1993, then later acquired
later by Phelps Dodge) delineated a deposit of molybdenum containing
approximately 146,000,000 tons of mineralization averaging 0.43% molybdenum
disulfide on the properties of USE and Crested.
Advance royalties are required to be paid in quarterly installments until:
(i) commencement of production; (ii) failure to obtain certain licenses,
permits, etc., that are required for production; or (iii) AMAX's return of the
properties to USE and Crested. The advance royalty payments reduce the operating
royalties (6% of gross production proceeds) which would otherwise be due out of
production. There is no obligation to repay the advance royalties if the
property is not placed in production. USE recognized $108,500 advance royalty
revenues in (former) fiscal 2001. Phelps Dodge ceased making payments in July
2001.
USE and Crested also are entitled to receive $2,000,000 if the Mt. Emmons
properties are put into production and, in the event of a sale of Mt. Emmons
Mining Company (which owns the properties) or of its interest in the properties,
USE and Crested are entitled to receive 15% of the first $25,000,000 of sale
proceeds.
AMAX Inc. and its successor companies have sought to put the Mt. Emmons
molybdenum property into production for 20 years.