UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

For the transition period from             to

          

Commission file number: 000-52106

 

 

SOUTHERN STAR ENERGY INC.

(Exact Name of Registrant as Specified in its Charter)

 

(832) 375-0330

(Registrant’s Telephone Number, including Area Code)

 

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

 

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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 the filing requirements for the past 90 days.      Yes       No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):

 

Large accelerated filer            Accelerated filer            Non-accelerated filer            Smaller Reporting Company   

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)     Yes       No

 

 

INDEX

 

 

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

 

Southern Star Energy Inc.

(An Exploration Stage Company)

Consolidated Balance Sheets

(in thousands)

 

The accompanying notes are an integral part of these consolidated financial statements.

 

Southern Star Energy Inc.

(An Exploration Stage Company)

Consolidated Statements of Operations

(unaudited)

(in thousands, except per share amounts)

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 

 

Southern Star Energy Inc.

(An Exploration Stage Company)

Consolidated Statements of Cash Flows

(unaudited)

 

The accompanying notes are an integral part of these consolidated financial statements.

 

Southern Star Energy Inc.

(An Exploration Stage Company)

Consolidated Statement of Stockholders’ Equity

Period from May 31, 2009 to August 31, 2009

(unaudited)

(in thousands)

 

			Common Shares						Additional Paid-in			Accumulated			Total Stockholders' Equity
			Number			Amount			Capital			Deficit			(Deficit)
			$			$			$			$			$
Balance – May 31, 2009				45,347			45			14,010			(18,833	)		(4,778	)
Stock-based compensation
(Note 6)				–			–			276			–			276
Net loss for the year				–			–			–			(1,030	)		(1,030	)
Balance – August 31, 200				45,347			45			14,286			(19,863	)		(5,532	)

 

On November 13, 2006, the Company effected a 7.5:1 forward stock split of the authorized, issued and outstanding common stock. On March 22, 2007, the Company effected a 1.5:1 forward stock split of the authorized, issued and outstanding common stock. All share amounts have been retroactively adjusted for all periods presented.

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 

Southern Star Energy Inc. was incorporated in the State of Nevada on February 7, 2005 under the name Surge Enterprises, Inc. Pursuant to a Restructuring Agreement dated November 6, 2006, the Company disposed of its interest in the Company’s wholly-owned subsidiary, Surge Marketing Corp. (“Surge Marketing”) (Note 9). On November 13, 2006 the Company changed its name to Southern Star Energy Inc.

 

On November 2, 2006, the Company commenced the business of the acquisition, exploration and development of oil and gas resources with the acquisition of an initial 20% interest in certain oil and gas leases located in Louisiana. The Company previously focused its business efforts on software sales and website development.

 

The Company has been in the exploration stage since completion of its restructuring in November, 2006 and has not yet realized any significant revenues from its planned operations. Previously, it was in the development stage, pursuant to Statements of Financial Accounting Standards (“SFAS”) No. 7 “Accounting and Reporting by Development Stage Enterprises”, and had not generated or sustained significant revenues. These financial statements have been prepared on a going concern basis, which implies the Company will continue to realize its assets and discharge its liabilities in the normal course of business. The Company is unlikely to pay dividends or generate significant earnings in the immediate or foreseeable future. The continuation of the Company as a going concern and the ability of the Company to emerge from the exploration stage are dependent upon its successful efforts to raise additional equity or debt financing to continue operations and generate sustainable significant revenue. There is no guarantee that the Company will be able to raise adequate equity financings or generate profitable operations. As at August 31, 2009, the Company has a working capital deficit of $12,608,000 and has incurred losses of $19,863,000 since inception. These factors raise substantial doubt regarding the Company’s ability to continue as a going concern. These financial statements do not include any adjustments to the recoverability and classification of recorded asset amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. Management of the Company has undertaken steps as part of a plan with the goal of sustaining Company operations for the remainder of the fiscal year and beyond. These steps include: (a) continuing efforts to raise additional capital and/or other forms of financing; and (b) controlling overhead and expenses. There can be no assurance that any of these efforts will be successful.

 

The unaudited interim consolidated financial statements have been prepared by the Company in accordance with generally accepted accounting principles in the United States for interim financial information and conforms with instructions to Form 10-Q of Regulation S-X and reflects all adjustments (all of which are normal and recurring in nature) that, in the opinion of management, are necessary for fair presentation of the interim periods presented. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for any subsequent quarter or for the entire year ending May 31, 2010. The preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States requires management to make certain estimates and assumptions that affect the amounts reported. Actual results could differ from these estimates. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States have been condensed or omitted. These unaudited interim consolidated financial statements and notes included herein should be read in conjunction with the Company’s audited consolidated financial statements and notes for the year ended May 31, 2009, included in the Company’s Annual Report on Form 10-K. The accounting principles applied in the preparation of these interim consolidated financial statements are consistent with those applied for the year ended May 31, 2009. Certain reclassifications have been made to prior period amounts to conform to current period presentation.

 

 

The Company utilizes the full-cost method of accounting for petroleum and natural gas properties. Under this method, the Company capitalizes all costs associated with acquisition, exploration and development of oil and natural gas reserves, including leasehold acquisition costs, geological and geophysical expenditures, lease rentals on undeveloped properties and costs of drilling of productive and non-productive wells into the full cost pool on a country by country basis. When the Company obtains proven oil and gas reserves, capitalized costs, including estimated future costs to develop the reserves proved and estimated abandonment costs, net of salvage, will be depleted on the units-of-production method using estimates of proved reserves. The costs of unproved properties are not amortized until it is determined whether or not proved reserves can be assigned to the properties. Until such determination is made the Company assesses annually whether impairment has occurred, and includes in the amortization base costs of drilling exploratory dry holes associated with unproved properties.

 

 

The Company applies a ceiling test to the capitalized cost in the full cost pool. The ceiling test limits such cost to the estimated present value, using a ten percent discount rate, of the future net revenue from proved reserves, based on current economic and operating conditions. Specifically, the Company computes the ceiling test so that capitalized cost, less accumulated depletion and related deferred income tax, do not exceed an amount (the ceiling) equal to the sum of: (A) The present value of estimated future net revenue computed by applying current prices of oil and gas reserves (with consideration of price changes only to the extent provided by contractual arrangements) to estimated future production of proved oil and gas reserves as of the date of the latest balance sheet presented, less estimated future expenditures (based on current cost) to be incurred in developing and producing the proved reserves computed using a discount factor of ten percent and assuming continuation of existing economic conditions; plus (B) the cost of property not being amortized; plus (C) the lower of cost or estimated fair value of unproven properties included in the costs being amortized; less (D) income tax effects related to differences between the book and tax basis of the property. For the quarter ended August 31, 2009, the Company utilized a natural gas price of $3.55 per mcf and an oil price of $66.78 per barrel in performing its ceiling test evaluation. Such prices represented prices subsequent to August 31, 2009, and resulted in no ceiling test impairments being recorded. Had prices in effect at August 31, 2009 been used in the ceiling test, impairments of approximately $843,000 would have been recorded and included in depletion, depreciation and amortization expense.

For unproven properties, the Company excludes from capitalized costs subject to depletion, all costs directly associated with the acquisition and evaluation of the unproved property until it is determined whether or not proved reserves can be assigned to the property. Until such a determination is made, the Company assesses the property at least annually to ascertain whether impairment has occurred. In assessing impairment the Company considers factors such as historical experience and other data such as primary lease terms of the property, average holding periods of unproved property, and geographic and geologic data. The Company adds the amount of impairment assessed to the cost to be amortized subject to the ceiling test.

 

During the drilling of the Boyce Pate 16-1 well, the Company incurred additional costs of approximately $1,716,000 resulting from a vendor using inappropriate cement while setting a plug after the drilling of the well. The vendor has agreed to reimburse us for the additional costs, of which our share totals approximately $686,000. The Company has been reimbursed $1,716,000 from the vendor and, accordingly, oil and gas property balances as August 31, 2009, have been reduced by approximately $686,000 for our share of amounts received.

 

The Company’s asset retirement obligations (“ARO”) in regards to Sentell Field relates to site restoration.

A reconciliation between the opening and closing ARO balance is provided below:

 

In accordance with SFAS No. 143 “Accounting for Asset Retirement Obligations,” the Company measured the ARO’s at fair value and capitalized this to the oil and gas property. The ARO’s will accrete to $171,000 until the time at which it is expected to be settled, being 7 years. A discount rate of 10% was used to calculate the present value of the ARO’s. The corresponding accretion at August 31, 2009, being $3,000 has been included in depletion, depreciation and amortization. Actual retirement costs will be recorded against the ARO’s when incurred. Any difference between the recorded ARO’s and the actual retirement costs incurred will be recorded as a gain or loss in the period of settlement.

 

 

 

 

 

On May 16, 2008, the Company and Macquarie Bank Limited (“Macquarie”) entered into a credit agreement (the “Macquarie Credit Agreement”) to receive advances up to $2,000,000 with a maturity date of September 13, 2008, which the Company received in full on May 20, 2008. The advances accrued interest at the lesser of the prime rate plus 2% and the highest lawful rate with interest payable on the last day of each month. Pursuant to the terms of the agreement, all proceeds from the sale of oil and gas by the Company were to be remitted to Macquarie while amounts are outstanding under the agreement. In connection with the Macquarie Credit Agreement, the Company issued the lender a warrant to purchase 750,000 shares of common stock at $1.00 per share until May 16, 2013. The Company recorded the fair value of the warrant of $486,000 as additional paid-in capital and recorded an equivalent discount, which to be expensed over the term of the agreement.

 

On July 11, 2008, the Company and Macquarie entered into a credit agreement (the “Amended Macquarie Credit Agreement”) to receive advances up to $25,000,000 with an initial borrowing base of $5,000,000. The Amended Macquarie Credit Agreement amends and restates the previous credit agreement described above in its entirety. On July 16, 2008, the Company received an advance of approximately $2,500,000 and received advances for the remaining $2,500,000 throughout the nine months ended February 28, 2009. The advances accrue interest at the lesser of the prime rate plus 2% and the highest lawful rate (5.25% at August 31, 2009). Interest payments must be made on the last day of each month and all interest and advances must be repaid by July 11, 2011, the maturity date. Pursuant to the terms of the Amended Macquarie Credit Agreement, all proceeds from the sale of oil and gas by the Company will be remitted to Macquarie while amounts are outstanding under the agreement.

 

The Amended Macquarie Credit Agreement is secured by a lien on substantially all of the Company’s assets, including the Company’s oil and gas properties and contains various positive covenants, including interest coverage ratio, current ratio and adjusted present value ratio covenants (as defined in the agreement), and certain negative covenants which prevent us from carrying out certain actions, including incurring specified debt or guaranties, suffering any change of control, merging into or consolidating with any other entity and declaring or paying any cash dividends or distributions. As of May 31, 2009, we were not in compliance with certain of these financial covenants.

 

On May 29, 2009, the Company and Macquarie executed a waiver letter amending the Credit Agreement (“Waiver Letter”). Under the terms of the Waiver Letter, until June 30, 2009, the Lender agreed to waive the Company’s compliance with certain sections of the Credit Agreement, which pertain to interest coverage ratio, current ratio, and adjusted PV ratio.

 

In consideration of this waiver, the Company agreed to pay Macquarie one hundred percent (100%) of the Net Operating Cash Flow (as defined in the Credit Agreement), to be applied against the entire outstanding balance of the loan until such time as the outstanding balance of the loan is paid off. The Company also agreed to obtain the written consent of Macquarie prior to incurring or agreeing to incur any cost or expense for capital expenditures of any kind. Finally, the Company released Macquarie from any action or failure to act in connection with the Credit Agreement or related documents occurring any time prior to May 29, 2009. The Waiver Letter expired June 30, 2009. The Company remains out of compliance with its interest coverage ratio, current ratio and adjusted present value ratio covenants.

 

In connection with the Amended Macquarie Credit Agreement, the Company issued the lender a warrant to purchase 750,000 shares of common stock at $1.00 per share until July 11, 2013 in exchange for the warrant to purchase 750,000 shares of common stock at $1.00 issued in connection with the Macquarie Credit Agreement. Also in connection with the credit agreement, the Company issued the lender a warrant to purchase 1,897,419 shares of common stock at $1.00 per share until July 11, 2013.

 

Pursuant to a financial services agreement and in connection with the Macquarie Credit Agreement, the Company paid Imperial Capital, LLC (“Imperial”) $60,000 of financing fees, $50,000 in additional expenses and was obligated to issue a warrant exercisable to purchase 100,000 shares of common stock at $1.00 per share. Additionally, in connection with the Amended Macquarie Credit Agreement, the Company paid Imperial a cash fee of $90,000 and issued a warrant to purchase 1,250,000 shares of the Company’s common stock at $1.00 per share until July 11, 2013. Furthermore, the Company will owe Imperial the amount of 3% of the gross proceeds of each funding in excess of the initial $5,000,000 borrowing base the Company receives under the Amended Macquarie Credit Agreement until Imperial has received the total fee of $750,000, of which $150,000 has been paid.

 

 

The issuance-date fair value of the warrants issued to Macquarie ($1,728,852) and Imperial ($940,908) have been recorded as deferred financing costs with a related adjustment to additional paid-in capital. Additionally, the Company incurred an additional $161,337 in legal and other direct costs in connection with the Amended Macquarie Credit Agreement that have been recorded as deferred financing costs. Such deferred financing costs are being amortized to financing costs over the three-year term of the agreement using a method that approximates the interest method.

 

 

During the quarter ended August 31, 2009, the Company incurred $40,000 for consultation services payable to a company wholly owned by a director of the Company, of which $20,000 remained unpaid at August 31, 2009. In addition, the Company paid $30,000 to a company for consulting services rendered to the Company by a director of the Company. Furthermore, the Company has accrued a liability in the amount of $10,000 payable to a director of the Company for consulting services rendered to the Company. These transactions are are recorded at the exchange amount, which is the consideration agreed to by the related parties.

 

On October 31, 2007, the Company approved the 2007 Stock Option Plan (the “Plan”) to issue up to 3,000,000 shares to eligible employees, officers, directors and consultants. Pursuant to the Plan, the Company has granted stock options to certain directors and consultants. On June 4, 2008, the Company amended the Plan to increase the number of shares issuable to 5,000,000.

During the quarter ended August 31, 2009, no stock options were granted, exercised or forfeited. The Company recognized $276,000 in stock-based compensation expense during the quarter ended August 31, 2009, related to stock options previously issued.

 

 

On November 13, 2006, the Company completed a 7.5:1 forward stock split on the basis of 7.5 new shares of common stock in exchange for every one old share of common stock outstanding. On March 22, 2007, the Company effected a 1.5:1 forward stock split of the authorized, issued and outstanding common stock. All per share amounts have been retroactively restated to reflect the forward stock split.

 

 

 

 

 

 

 

On November 6, 2006, the Company entered into a restructuring agreement (the “Restructuring Agreement”) with Southern Star Operating, Big Sky, Eric Boehnke (“Boehnke”), Troy Mutter (“Mutter”) and Frank Hollmann (“Hollmann”). Boehnke is the former President of the Company, and Mutter and Hollmann are former officers. Pursuant to the terms of the Restructuring Agreement, as amended, Big Sky, a private British Columbia company wholly-owned by Boehnke, agreed to assign to the Company its rights under a prospect acquisition agreement to purchase a 20% working interest in Sentell Field (Note 4). Prior to entering into the Restructuring Agreement, Big Sky had not made any payments or acquired any property pursuant to the prospect acquisition agreement. In conjunction with the Restructuring Agreement, the Company transferred its wholly-owned subsidiary, Surge Marketing, to Mutter and Hollmann in consideration for the transfer of 9,000,000 split-adjusted shares of common stock of the Company to Boehnke, and the return and cancellation of an aggregate of 54,937,500 split-adjusted shares of common stock of the Company held by Mutter and Hollman. On April 5, 2007, the shares were returned to treasury and cancelled.

 

 

On June 9, 2009, one of our vendors, Coastal Chemical Co., LLC filed suit in the 113th Judicial District of Harris County, Texas related to approximately $104,000 in claimed unpaid invoices. In addition, as of August 31, 2009, several vendors have filed liens against the Company related to claims for unpaid invoices for goods and services provided to the Company in Bossier Parish, Louisiana and in the state of Texas. Total claims related to these liens are approximately $3,696,000. The suit and liens are all based upon claims for non-payment for amounts which have been reflected in the Company’ accounts payable balances.

 

 

Effective this quarter, we implemented Statement of Financial Accounting Standards No. 165, Subsequent Events, or SFAS 165. The standard establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before the financial statements are issued. The adoption of SFAS 165 did not impact our financial position or results of operations. We evaluated all events or transactions that occurred after June 30, 2009 up through the date we issued these financial statements on October 15, 2009.

In December 2007, the FASB issued SFAS No. 141R, “Business Combinations”. This statement replaces SFAS 141 and defines the acquirer in a business combination as the entity that obtains control of one or more businesses in a business combination and establishes the acquisition date as the date that the acquirer achieves control. SFAS 141R requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date. SFAS 141R also requires the acquirer to recognize contingent consideration at the acquisition date, measured at its fair value at that date. This statement is effective for fiscal years and interim periods within those fiscal years, beginning on or after December 15, 2008 and earlier adoption is prohibited. The adoption of this statement did not have a material effect on the Company’s consolidated financial statements. 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements Liabilities –an Amendment of ARB No. 51”. This statement amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. This statement is effective for fiscal years and interim periods within those fiscal years, beginning on or after December 15, 2008 and earlier adoption is prohibited. The adoption of this statement did not have a material effect on the Company’s consolidated financial statements.

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles”. SFAS No. 162 is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with U.S. generally accepted accounting principles for nongovernmental entities. SFAS No. 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board Auditing amendments to AU Section 411, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles”.

 

In May 2008, the FASB issued FSP 14-1 “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement) “. FSP 14-1 requires the issuer of certain convertible debt instruments that may be settled in cash (or other assets) on conversion to separately account for the liability (debt) and equity (conversion option) components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. FSP 14-1 is effective for fiscal years beginning after December 15, 2008, on a retroactive basis. The adoption of this statement did not have a material effect on the Company’s consolidated financial statements.

On December 31, 2008, the SEC published the final rules and interpretations updating its oil and gas reporting requirements. Many of the revisions are updates to definitions in the existing oil and gas rules to make them consistent with the petroleum resource management system, which is a widely accepted standard for the management of petroleum resources that was developed by several industry organizations. Key revisions include changes to the pricing used to estimate reserves utilizing a 12-month average price rather than a single day spot price which eliminates the ability to utilize subsequent prices to the end of a reporting period when the full cost ceiling was exceeded and subsequent pricing exceeds pricing at the end of a reporting period, the ability to include nontraditional resources in reserves, the use of new technology for determining reserves, and permitting disclosure of probable and possible reserves. The SEC will require companies to comply with the amended disclosure requirements for registration statements filed after January 1, 2010, and for annual reports on Form 10-K for fiscal years ending on or after December 15, 2009. Early adoption is not permitted. The Company is currently assessing the impact that the adoption will have on the Company’s disclosures, operating results, financial position and cash flows.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the SEC did not, or are not believed by management to, have a material impact on the Company’s present or future consolidated financial statements.

 

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

As used in this Quarterly Report, and unless otherwise indicated, the terms “we”, “us”, “our” and “the Company” refer to Southern Star Energy Inc. (“Southern Star Energy”) and our wholly-owned subsidiary, Southern Star Operating Inc. (“Southern Star Operating”).

Forward-Looking Statements

The information in this Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (“Exchange Act”). These forward-looking statements involve risks and uncertainties, including statements regarding our capital needs, business plans and expectations. Such forward-looking statements involve risks and uncertainties regarding the anticipated results and developments in our operations in future periods, planned exploration and development of our property, plans related to our business, matters that may occur in the future and other factors. Forward-looking statements are made, without limitation, in relation to operating plans, property exploration, availability of funds, environmental issues and operating costs. Any statements contained herein that are not statements of historical facts may be deemed to be forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may”, “will”, “should”, “expect”, “plan”, “intend”, “anticipate”, “believe”, “estimate”, “predict”, “potential” or “continue”, the negative of such terms or other comparable terminology. Actual events or results may differ materially. In evaluating these statements, you should consider various factors, including the risks we outline from time to time in other reports we file with the Securities and Exchange Commission (“SEC”). These factors may cause our actual results to differ materially from any forward-looking statement. We disclaim any obligation to publicly update these statements, or disclose any difference between our actual results and those reflected in these statements. The information constitutes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

Cautionary Note Regarding Management’s Discussion and Analysis

This discussion and analysis should be read in conjunction with the accompanying consolidated financial statements and related notes. The discussion and analysis of the financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of any contingent liabilities at the financial statement date and reported amounts of revenue and expenses during the reporting period. On an on-going basis the Company reviews its estimates and assumptions. The estimates were based on historical experience and other assumptions that the Company believes to be reasonable under the circumstances. Actual results are likely to differ from those estimates under different assumptions or conditions, but the Company does not believe such differences will materially affect our financial position or results of operations. Critical accounting policies, the policies the Company believes are most important to the presentation of its financial statements and require the most difficult, subjective and complex judgments, are outlined below in “Critical Accounting Policies,” and have not changed significantly.

Overview

 

We are an exploration stage company engaged in the acquisition, exploration and exploitation of prospective oil and gas properties. We currently hold a 40% working interest in approximately 4,700 acres in an area north of Shreveport in Bossier Parish, Louisiana, commonly referred to as the Sentell Field. Initial drilling in the field has resulted in proved reserves of approximately 2.2 Bcfe (billions of cubic-feet equivalent) and net production of 500 MCFED (thousand cubic-feet equivalent per day). Southern Star Operating, our wholly owned subsidiary, is the operator of the field by virtue of a contract operating agreement. We are undertaking exploration activities and are in the early stages of developing the properties pursuant to the leasehold rights we have acquired within the Sentell Field. As partial owner of the working interest in and to the leasehold rights, we, together with the other interest holders, have the exclusive right to explore and exploit any oil and gas and mineral resources contained in the Sentell Field.

 

Through the contractual arrangements governing the acquisition of leasehold interests in Sentell Field, Meagher Oil and Gas, an independent leasing agent, acquired, then reassigned the 100% working interest in the leasehold

 

positions covering the Sentell Field to the following non-affiliated parties: Dynamic Resources Corp. holds a 20% working interest; Southern Star Energy holds a 40% working interest; and Ramshorn Investments, Inc. holds the remaining 40% working interest. The leases in the field are subject to a royalty interest of approximately 24%. As a result, the holders of the working interests are entitled to receive approximately 76% of any gross production revenues from the field and the holders of the royalty interest are entitled to the remaining 24%. The royalty interests are held by various individual lessors and other entities. The royalty interest holders are not responsible for any exploration, development or operating costs.

 

Fiscal Year 2010 Plan of Operations

 

We are an exploration stage oil and gas company. We estimate our operating expenditures for the fiscal year ending May 31, 2010, to be as follows:

 

 

We do not currently have sufficient capital to fund our estimated expenditures for the remainder of the fiscal year and intend to fund the expenditures through debt and/or equity financing and operating revenue. There can be no assurance that such financing will be available on acceptable terms, if at all. See, “Liquidity and Capital Resources,” below.

 

Capital Expenditures

 

By the close of fiscal 2008, our company had drilled six wells, including five successful Cotton Valley formation test wells, all of which are producing. We have also laid a 15,000 foot gathering system and central processing and metering facility to service the five producers.

 

Based on the satisfactory results of our deep Cotton Valley wells, the Company embarked on our 2009 program to continue to drill additional wells to define the core productive outlines of the Cotton Valley formation within our acreage. An additional critical objective of this program is to assess the presence and potential of the Haynesville Shale within our acreage position.

 

In late August 2008, the first of the new wells, the Cash Pointe Plantation 30-1 reached a total depth of 9,500 feet and successfully logged the Cotton Valley. Production casing has been run to total depth and the well is currently awaiting extension of the field gathering system prior to completion.

 

Following the successful drilling of the Cash Pointe well, the rig moved to our second location, the Atkins-Lincoln 17-2 well. This well was designed to assess both Cotton Valley as well as Haynesville potential. In October 2008, the Company announced that the Atkins-Lincoln 17-2 had reached a depth of 9,500 feet and encountered 68 feet of net effective gas pay in the Cotton Valley Formation. Subsequently, casing was set at 9,500 feet and we continued to drill to a total depth of 11,300 feet where we successfully logged the targeted Haynesville interval. The well encountered a gross productive interval of 327 feet of gas-filled porosity, indicating a thickening of the Haynesville productive interval under our leasehold.

 

After the successful discovery in the Haynesville Shale at the Atkins-Lincoln 17-2 location, we moved the rig approximately 1.5 miles south-southwest to the A.S. Burt 20-1 location. The Burt well was also designed as a combination Cotton Valley and Haynesville delineation well. At intermediate pipe depth, the results of the A.S. Burt 20-1 location were consistent with the Company’s earlier Cotton Valley locations. In November 2008, we reached total depth of 11,220 feet where once again we successfully logged the targeted Haynesville interval. The well encountered a gross productive interval of 249 feet of gas-filled porosity, further confirming the presence of a thick productive interval in the Haynesville Shale under our leasehold.

 

Each of the Company’s eight Cotton Valley wells has similar log characteristics, and six of these wells are currently flowing into sales lines. The sixth well is awaiting a pipeline connection. Both the A.S. Burt 20-1 and the Atkins-Lincoln 17-2 will be completed in the Haynesville Shale, pending thorough analysis and completion design.

 

 

16

 

 

In December 2008, we spud the Moore 20-1 well, the fourth well in our 2009 development program. The well successfully logged the Cotton Valley interval and came on production in late February 2009.

 

Based on the petrophysical results over the Haynesville Shale intervals in the Atkins-Lincoln 17-2 and the A.S. Burt 20-1 wells, the company revised its near term strategy to focus on exploiting these discoveries and follow up with a third location to further define the Haynesville potential.

 

On February 19, 2009, the Company spud its third Haynesville delineation well, the Boyce Pate 16-1. This well successfully encountered its Cotton Valley target, logging 66 feet of net gas pay in the Davis Sand intervals before the Company drilled ahead to further evaluate the well’s Haynesville potential. The Boyce Pate 16-1 well reached total depth of 11,200 feet on March 21, 2009. Wireline logging and mud log shows indicate the Boyce Pate 16-1 well encountered 177 feet of net porous Haynesville Shale over a gross interval of 395 feet.

 

We intend to continue developing the Sentell Field at a pace appropriate to conditions and capital constraints. Our 4,700-acre Sentell Field has the potential for about 50 Cotton Valley and 50 Haynesville wells positioned on 160-acre spacing. Numerous vertical and horizontal wells have been drilled, logged and put into production from the Haynesville formation within a 30-mile radius of our acreage in the Sentell Field. However, until we determine the extent of the productive limits of the project, we will not know the full extent of development costs to bring the acreage to production. We intend to complete step-out drilling to extend the productive limits of acreage.

 

Given the current pricing environment for oil and natural gas and the lack of available capital, our near-term attention will be directed at securing our leasehold position, allowing us to defer Haynesville and Cotton Valley development plans until oil and natural gas prices improve and the necessary capital becomes available. We estimate that our capital expenditures for the fiscal year ending May 31, 2010 will be approximately $1,700,000, consisting of concluding drilling operations on certain Cotton Valley and Haynesville wells, commencement of drilling an additional Haynesville well, additional stimulation work on certain Cotton Valley wells, infrastructure improvements, and leasehold acquisitions.

 

General and Administrative Expenses

 

We expect to incur general and administrative costs in the amount of approximately $1,800,000 during fiscal year 2010. General and administrative costs primarily include compensation arrangements with our employees and consultants, which are described in more detail below. Further, general and administrative costs including on-going legal, accounting and audit expenses to comply with our reporting responsibilities as a public company under the Exchange Act, insurance, rent, software, office supplies and office equipment.

 

Our company is operated by William David Gibbs as Chief Executive Officer, President, Secretary and Treasurer, Bruce Ganer as Vice President of Exploration and Development and Christopher H. Taylor, as Chief Financial Officer. On September 10, 2009, Mr. Doug Harwell submitted his resignation as operations manager to the Company, effective September 30, 2009.  Mr. Harwell's resignation was not the result of any disagreements with the Company.

 

Mr. Gibbs and Mr. Taylor are employees of the Company and Mr. Ganer provides his services through a management company pursuant to a written agreement, the terms of which are described below.  To reduce costs, we intend to continue to outsource our professional and personnel requirements when practical by retaining consultants on an as-needed basis.  Although we enter into consulting agremeents periodically, we have entered into several long term employment and consulting agreements, the terms of which are described below.

 

On February 15, 2007, the Company entered into a services agreement with Rylar & Associates, Inc., a consultant who provides consulting services in partial consideration for 375,000 shares of Common Stock. The Company is to issue 187,500 shares upon the generation of revenues from the Company’s Sentell Field property in excess of all costs reasonably incurred in relation to the drilling of the wells. The Company is also obligated to issue 187,500 shares to be held in escrow for a period of one year upon the Sentell Field generating more than 15 billion cubic feet equivalent of natural gas or having reserves greater than $75,000,000 calculated on a 10% discounted cash flow basis. As of August 31, 2009, no shares have been issued under this services agreement.

 

On February 27, 2007 the Company entered into a services agreement with Sierra Pine Resources (a company wholly-owned by Bruce Ganer, our Vice President of Exploration and Development), a consultant who provides consulting services in consideration for $140 per hour of services and 375,000 shares of the Company’s common stock. The Company is to issue 187,500 shares upon the generation of revenues from the Sentell Field in excess of all costs reasonably incurred in relation to the drilling of the well. The Company is also obligated to issue 187,500 shares to be held in escrow for a period of one year upon the Sentell Field generating more than 15 billion cubic feet

 

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equivalent of natural gas or having reserves greater than $75,000,000 calculated on a 10% discounted cash flow basis. As of August 31, 2009, no shares have been issued under this services agreement.

On May 3, 2007, the Company entered into a marketing agreement with RedChip Companies Inc. (“RedChip”) for an initial term of 12 months in consideration of $7,500 per month, and commencing August 1, 2007, an equivalent value of $5,000 per month payable in shares of the Company’s common stock, the value of which was to be determined based upon the closing price of the shares as reported by StockWatch Inc. on the first business day of each quarterly period. The shares were to be issued by the Company to RedChip on a quarterly basis no later than ten days after the first day of each subsequent quarter. On December 11, 2007, the Company issued 18,750 for $15,000 of consulting services shares pursuant to the consulting agreement and at May 31, 2008, $35,000 was included in common stock subscribed. During the year ended May 31, 2009, the Company issued 46,335 shares of common stock with a fair value of $36,000 pursuant to the agreement and subsequently terminated this agreement.

 

On June 18, 2007, the Company entered into a services agreement with Imperial Capital Ltd. (“Imperial”), a financial advisor, to provide services related to assisting the Company in financing activities. Upon entering into the $2,000,000 Credit Agreement with Macquaire Bank Limited (“Macquarie”) in May 2008, the Company paid $60,000 of financing fees and was obligated to issue a warrant exercisable to purchase 100,000 shares of common stock at $1.00 per share. Additionally, in connection with the Amended Credit Agreement with Macquarie, the Company paid to Imperial $90,000 in cash, agreed to pay Imperial in cash the amount of 3% of the gross proceeds of each funding in excess of the initial $5 million borrowing base which the Company receives under the Macquarie credit agreement until Imperial has received $750,000 ($150,000 of which has been paid), and issued to Imperial a warrant to purchase 1,250,000 shares of common stock of the Company. On August 8, 2008, the Company terminated this agreement.

 

On October 1, 2007, we appointed Bruce Ganer as our Vice President of Exploration and Development. Effective November 22, 2007, we entered into a consulting agreement between our company and Sierra Pine Resources International, Inc., a company wholly-owned by Bruce Ganer, whereby Sierra Pine agreed to provide consulting services to our company in consideration for, among other things, the payment of $10,000 per month, certain incentive bonuses as set forth in the consulting agreement and the grant of a stock option to purchase up to 750,000 shares of our common stock at a price of $1.09 per share, exercisable until November 22, 2011 (one-third of the options will vest on each of the first three anniversaries of November 22, 2007). On February 26, 2008, the Company reduced the exercise price of the options to $0.70 per share, resulting in an increase to stock-based compensation expense.

 

In November 2007, the Company entered into a consulting agreement with William David Gibbs to serve as the CEO and president of the Company and provide consulting services in consideration for $200 per hour of services to a maximum of $1,500 per day and $30,000 per month and options exercisable to purchase 1,500,000 shares of the Company’s common stock at $1.20 per share for 5 years (one-third of the options vest on each of the first three anniversaries of November 27, 2007). On February 26, 2008, the Company reduced the exercise price of the options to $0.70 per share, resulting in an increase to stock-based compensation expense. On May 1, 2008, Mr. Gibbs ceased to be a consultant and entered into an employment agreement with the Company to serve as the Company’s president and CEO. Mr. Gibbs will be retained as CEO and president in consideration for, among other things, a base salary of $240,000 per year and incentive bonuses as set forth in the employment agreement. On June 4, 2008, we entered into a stock option agreement with Mr. Gibbs granting him the right to purchase up to an aggregate of 1,000,000 shares of our common stock at an exercise price of $1.00 per share exercisable for a period of five years pursuant to our Stock Option Plan (one-third of the options vest on each of the first three anniversaries of June 4, 2008). On January 5, 2009, the Company awarded to Mr. Gibbs a bonus payment of $60,000, less any applicable statutory deductions, in order to recognize Mr. Gibbs’ contribution to the Company as its president and the progress made by the Company in 2008.

 

On November 22, 2007, we entered into a consulting agreement with Larry Keller, whereby Larry Keller agreed to provide consulting services to our company for a consulting fee of $175 per hour and the grant of a stock option to purchase up to 500,000 shares of our common stock at a price of $1.09 per share, exercisable until November 22, 2009 (half of the options vested on November 22, 2007 and half vested on November 22, 2008). On May 30, 2008, we paid a cash bonus of approximately $25,000 per well upon the successful completion of our company’s following three wells: Atkins-Lincoln 18-1; Atkins et al. 8-1; and Atkins-Lincoln 18-2.

 

On January 1, 2008, we entered into a consulting agreement with Big Sky Management Ltd., whereby Big Sky Management agreed to provide management services to our company. Big Sky Management has agreed to provide the services through its employee and our director Eric Boehnke in consideration for the payment, by our Company, of $10,000 per month.

 

 

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On May 20, 2008, the Company entered into a consulting agreement with Enercom, Inc., an investor communications consulting firm that will provide investor communications services on behalf of the Company in consideration for a minimum of $3,000 per month. This agreement was cancelled effective June 30, 2009.

 

Effective June 16, 2008, we entered into an agreement with Douglas M. Harwell, whereby we agreed to employ Mr. Harwell as our operations manager. Mr. Harwell will be retained as our operations manager in consideration for, among other things: (i) a base salary of $160,000 per year; (ii) incentive bonuses as set forth in the employment agreement; and (iii) the grant of a stock option to purchase up to 250,000 shares of our common stock at a price of $1.00 per share, exercisable until June 16, 2013 (one-third of the options will vest on each of the first three anniversaries of June 16, 2008). Effective September 30, 2009, Mr. Harwell resigned his position as operations manager of the Company. Mr. Harwell’s resignation had the effect of terminating his employment agreement and stock option agreement and rendering his stock options void and of no effect. At the time of Mr. Harwell’s resignation, none of the stock options had been exercised.

 

Effective September 22, 2008, we entered into an agreement with Christopher H. Taylor, whereby we agreed to employ Mr. Taylor as our chief financial officer. Mr. Taylor will be retained as our chief financial officer in consideration for, among other things: (i) a base salary of $180,000 per year; (ii) incentive bonuses as set forth in the employment agreement; and (iii) the grant of a stock option to purchase up to 350,000 shares of our common stock at a price of $0.82 per share, exercisable until September 22, 2013 (one-third of the options will vest on each of the first three anniversaries of September 22, 2008).

 

Effective October 27, 2008, we entered into an agreement with Deborah Null, whereby we agreed to employ Ms. Null as our land manager. Ms. Null was retained as our land manager in consideration for, among other things: (i) a base salary of $130,000 per year; (ii) incentive bonuses as set forth in the employment agreement; and (iii) the grant of stock options exercisable to purchase up to 100,000 shares of our common stock at a price of $0.60 per share, exercisable until October 27, 2013. Effective December 18, 2008, Ms. Null resigned her position as land manager of the Company. Ms. Null’s resignation had the effect of terminating her employment agreement and stock option agreement and rendering her stock options void and of no effect. At the time of Ms. Null’s resignation, none of the stock options had vested.

 

Debt Service

 

We expect to incur $263,000 in interest expenses for the fiscal year ending May 31, 2010. These interest expenses are related to debt outstanding under our credit facility with Macquarie Bank Limited and assume the interest rate remains 5.25%, our current interest rate. Should we be determined to be in default under our credit facility, our interest rate could increase to 9.25%. We remain out of compliance with our interest coverage ratio, current ratio and adjusted present value ratio covenants under our credit facility.  We do not anticipate paying any principal on the credit facility until the maturity date of July 11, 2011. We expect interest expense to increase if we obtain additional debt financing in the future.

 

Results of Operations

 

The Company has been in the exploration stage since completion of its restructuring in November 2006 and has not yet realized any significant revenues from its planned operations. The Company is unlikely to generate significant earnings in the immediate or foreseeable future. The continuation of the Company as a going concern and the ability of the Company to emerge from the exploration stage are dependent upon its successful efforts to raise additional equity financing to continue operations and generate sustainable significant revenue. There is no guarantee that the Company will be able to raise adequate equity or debt financings or generate profitable operations.

 

Quarter ended August 31, 2009 compared to quarter ended August 31, 2008

 

Net Loss. We reported a net loss of $1,030,000 for the quarter ended August 31, 2009 compared to a net loss of $3,521,000 for the quarter ended August 31, 2008. The decrease in net loss is due primarily to full cost ceiling impairments in the amount of $1,949,000 recognized in the quarter ended August 31, 2008, as well as decreases in production costs, general and administrative costs and accretion of debt costs.

 

Revenues. We reported revenues from the production of oil and natural gas of $97,000 for the quarter ended August 31, 2009, compared to $776,000 in revenues for the quarter ended August 31, 2008. The decrease in revenues is attributable to significant declines in oil and natural gas prices accompanied by decreases in oil and natural gas production volumes.

 

 

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Depletion, depreciation and amortization. Depletion, depreciation and amortization for the quarter period ended August 31, 2009 was $53,000. Depletion, depreciation and amortization recorded for the quarter ended August 31, 2008 was $2,277,000, including impairments of oil and gas properties of $2,202,000 as a result of the ceiling test evaluation.

 

General and administrative. For the quarter ended August 31, 2009, we recorded general and administrative expenses of $676,000 compared to $990,000 for the quarter ended August 31, 2008. The decrease was primarily attributable to decreases in professional fees and stock-based compensation. We anticipate that our general and administrative expenses will continue at or above these levels as we anticipate that our business activities may increase in future periods.

 

Production costs. We recorded production costs of $91,000 for the quarter ended August 31, 2009 compared to $280,000 in production costs for the quarter ended August 31, 2008. The decrease in production costs is primarily attributable to decreased water disposal costs. Production costs may increase in future periods as a result of our current drilling program, under which we project we will drill additional wells, assuming adequate financing is available on acceptable terms, if at all.

 

Accretion of discount on debt. In the quarter ended August 31, 2009, no accretion of discount on debt was recorded. In the quarter ended August 31, 2008, we recorded accretion of discount on debt of $425,000, which represents the remainder of the discount recorded in connection with the $2,000,000 credit agreement entered into in May 2008 with Macquarie Bank Limited.

 

Financing costs. We also recognized financing costs of $238,000 in the quarter ended August 31, 2009, which represents a portion of the financing costs related to the $25,000,000 Credit Agreement entered into in July 2008. The Credit Agreement is discussed further under ‘Liquidity and Capital Resources’ below. In connection with the Credit Agreement, we recorded deferred financing costs of $2,831,000 which will be amortized to financing costs using a method approximating the interest method over the three-year term of the Credit Agreement. We recorded financing costs of $132,000 for the quarter ended August 31, 2008. We anticipate we will raise additional capital during the fiscal year ending May 31, 2010, which could result in an increase in financing costs. There can be no assurance that additional financing will be available on acceptable terms, if at all.

 

Interest expense. For the quarter ended August 31, 2009, we recognized $69,000 in interest expense related to debt outstanding under our agreement with Macquarie Bank Limited. For the quarter ended August 31, 2008, we recorded interest expense of $43,000. Interest expense may increase during the fiscal year ending May 31, 2010, if we obtain additional debt financing. There can be no assurance that our borrowing base with Macquarie will be increased (see “Liquidity and Capital Resources,” below), or that additional debt financing will be available on acceptable terms, if at all.

 

Liquidity and Capital Resources

 

As of August 31, 2009, we had a working capital deficiency of approximately $12,608,000 and had incurred losses of $19,682,000 since inception. As of August 31, 2009, we had current assets of $2,720,000 and current liabilities of $15,328,000. The current liabilities consisted of accounts payable and accrued liabilities, net revenue payable to working interest partners and royalty interest owners, exploration advances, bank debt and amounts due to related parties.

 

To date, we have had negative cash flows from operations and we have been dependent on sales of our equity securities and debt financing to meet our cash requirements. Declining gas prices are anticipated to have an adverse effect on revenue and cash flow. We expect this situation to continue for the foreseeable future. We anticipate that we will have negative cash flows during the next twelve month period.

 

From September through November 2007, several debt holders converted certain convertible debentures which eliminated our interest payable on such securities. On September 18, 2007, we issued a 10% $1,300,000 convertible debenture to Gobbet Management Inc. The debenture, which was due September 18, 2009, was converted into shares of common stock of our company at a conversion price of $0.50 per share. On November 16, 2007, Gobbet Management converted the principal amount of $1,300,000 plus $21,306 in interest into 2,642,611 shares of common stock of our company. We issued the 2,624,611 shares of common stock on December 21, 2007 and the remaining 18,000 shares of common stock on April 14, 2008. On November 16, 2007, Sovereign Services Limited

 

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converted the principal amount of $800,000 plus interest of $77,778 pursuant to a 10% convertible debenture due December 1, 2008, into 2,633,333 shares of common stock of our company. We issued the 2,633,333 shares of common stock on December 21, 2007. On November 16, 2007, Sovereign Services converted the principal amount of $600,000 plus interest of $63,333 pursuant to a 10% convertible debenture due November 1, 2008, into 265,333 shares of common stock of our company. We issued the 265,333 shares of common stock on December 21, 2007.

 

Credit Facility

 

On July 11, 2008, the Company entered into a senior secured revolving credit agreement with Macquarie Bank Limited and certain lenders to receive advances up to $25,000,000 with an initial borrowing base of $5,000,000. This Amended and Restated Senior First Lien Secured Credit Agreement (dated July 11, 2008) (“Credit Agreement”) amended and restated the $2,000,000 Senior First Lien Secured Credit Agreement between the Company and Macquarie Bank Limited, dated May 16, 2008, in its entirety.

 

On July 16, 2008, we closed the first draw down under the Credit Agreement with Macquarie Bank Limited (individually and as Administrative Agent) (“Administrative Agent”) and the various participating lenders (the “Lenders”). The Credit Agreement matures on July 11, 2011.

 

Borrowings under the Credit Agreement may be used exclusively for the development of the properties listed in the Credit Agreement, general corporate purposes (as approved by the Administrative Agent), and the payment of the Administrative Agent’s costs associated with the loan. Upon closing, we drew an advance of $2.5 million, leaving $2.5 million available under the initial borrowing base. Prior to the advance, we had a working capital deficit of approximately $2,218,000, incurred primarily due to drilling expenses on two wells and a workover program on three other wells during the fiscal year ended May 31, 2008. We used the initial advance of $2.5 million to pay off the working capital deficit accumulated from that program. In the period from August 2008 to January 2009, we drew down an additional $2.5 million against the initial borrowing base to fund our 40% working interest share of the estimated costs of drilling and completing new Sentell Field wells. At August 31, 2009, we had no availability remaining under the initial borrowing base of the credit facility. The borrowing base will be redetermined no less than every six months, based upon the Administrative Agent’s review of the most recent reserve report (prepared by our engineers and setting forth our projected recoverable reserves of our company). Reserve reports are due to the Administrative Agent on or before each January 15 and July 15 until the maturity date. Within 30 days following receipt of the reserve report, the Administrative Agent will, in its sole discretion, make a determination of the borrowing base, which will be effective until the next redetermination date. The Administrative Agent will determine the borrowing base in accordance with its customary lending practices based on the maximum revolving loan amount supportable by our properties.

 

Under the terms of the Credit Agreement, advances comprising the revolving loan accrue interest at the applicable contract rate on the outstanding borrowed and unpaid principal amount of the loan. The contract rate is a per annum rate equal to the lesser of prime rate plus 2% or the highest lawful rate. The prime rate means the greater of (i) the prime rate of interest specified by the Wall Street Journal and (ii) the Federal Funds Rate plus 0.50% per annum. The contract rate was 5.25% at August 31, 2009.

 

Pursuant to the terms of the Credit Agreement, all proceeds from the sale of oil and gas from our properties, if any, will be remitted to the Administrative Agent via payment into a project account. The Administrative Agent will then create a sub-account on its internal books and credit to that account all funds deposited as payments into the project account. We have authorized the Administrative Agent to debit the sub-account for the payment of all obligations under the Credit Agreement when due.

As collateral security for all of our obligations to the Administrative Agent and each of the Lenders under the Credit Agreement and other related documents, we granted to the Administrative Agent (for the benefit of the Lenders) a first priority mortgage lien in all of our real and personal property subject to certain permitted encumbrances.

 

The Credit Agreement contains various positive covenants, including interest coverage ratio, current ratio and adjusted present value ratio covenants (as defined in the Credit Agreement), and certain negative covenants which prevent us from carrying out certain actions, including incurring specified debt or guaranties, suffering any change of control, merging into or consolidating with any other entity, declaring or paying any cash dividends or distributions. At August 31, 2009, the Company was not in compliance with its interest coverage ratio, current ratio and adjusted present value ratio covenants. We have notified Macquarie of these deficiencies and Macquarie has continued to fulfill our monthly funding requests knowing we are out of compliance. The Company has initiated and

 

 

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continues to pursue efforts to remedy the noncompliance. While we expect such efforts to be successful, there can be no assurance that we will be able to remedy the noncompliance.

 

On May 29, 2009, the Company and Macquarie executed a waiver letter amending the Credit Agreement (“Waiver Letter”). Under the terms of the Waiver Letter, until June 30, 2009, the Lender agreed to waive the Company’s compliance with certain sections of the Credit Agreement, which pertain to interest coverage ratio, current ratio, and adjusted PV ratio.

 

In consideration of this waiver, the Company agreed to pay the Macquarie one hundred percent (100%) of the Net Operating Cash Flow (as defined in the Credit Agreement), to be applied against the entire outstanding balance of the loan until such time as the outstanding balance of the loan is paid off. The Company also agreed to obtain the written consent of the Macquarie prior to incurring or agreeing to incur any cost or expense for capital expenditures of any kind. Finally, the Company released Macquarie from any action or failure to act in connection with the Credit Agreement or related documents occurring any time prior to May 29, 2009. The Waiver Letter expired June 30, 2009. The Company remains out of compliance with its interest coverage ratio, current ratio and adjusted present value ratio covenants.

 

Available Capital

 

We incurred a net loss of $1,030,000 for the quarter ended August 31, 2009 as compared to a net loss of $3,521,000 for the quarter ended August 31, 2008. We anticipate that losses will continue in the fiscal year ending May 31, 2010 due to lower oil and gas prices. We had current cash on hand as at August 31, 2009 of approximately $1,603,000.

 

As we anticipate that our estimated operating expenditures for the coming fiscal year will be $3,763,000, we do not have sufficient working capital to enable us to complete our drilling program of exploration wells or to finance our normal operations for the next fiscal year. Accordingly, we plan on undertaking additional financing activities throughout the course of the fiscal year. We estimate that approximately $700,000 will be derived from operations in the Sentell Field. However, the decrease in oil and natural gas prices has adversely affected our revenues and may continue to do so, which may increase our reliance on debt and equity financing.

 

Additionally, we estimate that we will be required to raise at least $3,100,000 through the issuance of equity securities or through additional debt financing. Additional draw-downs on the credit facility will depend upon the success of our future financings and the availability of credit under the credit facility. We are seeking to increase our borrowing base under the credit facility. There can be no assurance that we will be successful in raising the required capital or that actual cash requirements will not exceed our estimates.

 

Given that we have not achieved profitable operations to date, our cash requirements are subject to numerous contingencies and risk factors beyond our control, including operational and development risks, competition from well-funded competitors, and our ability to manage growth. We can offer no assurance that our company will generate cash flow sufficient to achieve profitable operations or that our expenses will not exceed our projections. If our expenses exceed estimates, we will require additional monies during the next fiscal year to execute our business plan.

 

There are no assurances that we will be able to obtain funds required for our continued operation. There can be no assurance that additional financing will be available to us when needed or, if available, that it can be obtained on commercially reasonable terms. Unprecedented disruptions in the current credit and financial markets have had a significant material adverse impact on a number of financial institutions and have limited access to capital and credit for many companies. These disruptions could, among other things, make it more difficult for the Company to obtain, or increase its cost of obtaining, capital and financing for its operations.

If we are not able to obtain additional financing on a timely basis, we will not be able to meet our other obligations as they become due and we will be forced to scale down or perhaps even cease the operation of our business.

 

There is substantial doubt about our ability to continue as a going concern as the continuation of our business is dependent upon obtaining further long-term financing, successful exploration and development of our oil and gas properties and, finally, achieving a profitable level of operations. The issuance of additional equity securities by us could result in a significant dilution in the equity interests of our current stockholders. Obtaining additional commercial loans, assuming those loans would be available, or drawing on our revolving credit agreement with

 

 

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Macquarie Bank Limited, will increase our liabilities and future cash commitments.

 

Future Financings

 

The recent unprecedented events in global financial markets have had a profound impact on the global economy. Many industries, including the oil and natural gas industry, are impacted by these market conditions. Some of the key impacts of the current financial market turmoil include contraction in credit markets resulting in a widening of credit risk, devaluations and high volatility in global equity, commodity, natural resources and foreign exchange markets, and a lack of market liquidity. A continued or worsened slowdown in the financial markets or other economic conditions, including but not limited to, consumer spending, employment rates, business conditions, inflation, fuel and energy costs, consumer debt levels, lack of available credit, the state of the financial markets, interest rates, and tax rates may adversely affect the Company’s growth and profitability.

 

Specifically:

 

 

These factors could have a material adverse effect on the Company’s financial condition and results of operations.

 

We anticipate that additional funding, when required, will be in the form of equity financing from the sale of our common stock or through debt financing. However, we cannot provide investors with any assurance that we will be able to raise sufficient funding from the sale of our common stock or through debt financing on commercially reasonable terms to fund operations. We do not currently have any arrangements in place for any future equity financing. For debt financing, the Company has a credit agreement with Macquarie Bank Limited that currently has a borrowing base of $5,000,000, none of which is available as of August 31, 2009, and a maximum limit of $25,000,000, as disclosed above under “Liquidity and Capital Resources”.

 

Capital Expenditures

 

We control our capital expenditures as the operator of the Sentell Field, which allows us to monitor and pace capital expenditures. In response to the global decline in product prices and restricted capital availability, we have curtailed our 2010 capital program. For the fiscal year ending May 31, 2010, our current plans include:

 

 

Off-Balance Sheet Arrangements

 

Our company has no outstanding derivative financial instruments, off-balance sheet guarantees, interest rate swap transactions or foreign currency contracts. Our company does not engage in trading activities involving non-exchange traded contracts.

 

Critical Accounting Policies

 

The preparation of financial statements in conformity with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying disclosures of our company. Although these estimates are based on management’s knowledge of current events and actions that our company may undertake in the future, actual results may differ from such estimates.

 

Going Concern

 

The Company has been in the exploration stage since completion of its restructuring in November, 2006 and has not yet realized any significant revenues from its planned operations. Previously, it was in the development stage,

 

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pursuant to Statements of Financial Accounting Standards (“SFAS”) No. 7 “Accounting and Reporting by Development Stage Enterprises”, and had not generated or sustained significant revenues. The accompanying financial statements have been prepared on a going concern basis, which implies the Company will continue to realize its assets and discharge its liabilities in the normal course of business. The Company is unlikely to pay dividends or generate significant earnings in the immediate or foreseeable future. The continuation of the Company as a going concern and the ability of the Company to emerge from the exploration stage are dependent upon its successful efforts to raise additional equity financing to continue operations and generate sustainable significant revenue. There is no guarantee that the Company will be able to raise adequate equity financings or generate profitable operations. As at August 31, 2009, the Company has a working capital deficit of $12,608,000 and has incurred losses of $19,863,000 since inception. The accompanying financial statements do not include any adjustments to the recoverability and classification of recorded asset amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. These factors raise substantial doubt regarding the Company’s ability to continue as a going concern.

Oil and Gas Properties

 

The Company utilizes the full-cost method of accounting for petroleum and natural gas properties. Under this method, the Company capitalizes all costs associated with acquisition, exploration and development of oil and natural gas reserves, including leasehold acquisition costs, geological and geophysical expenditures, lease rentals on undeveloped properties and costs of drilling of productive and non-productive wells into the full cost pool on a country by country basis. When the Company obtains proven oil and gas reserves, capitalized costs, including estimated future costs to develop the reserves proved and estimated abandonment costs, net of salvage, will be depleted on the units-of-production method using estimates of proved reserves. The costs of unproved properties are not amortized until it is determined whether or not proved reserves can be assigned to the properties. Until such determination is made the Company assesses annually whether impairment has occurred, and includes in the amortization base drilling exploratory dry holes associated with unproved properties.

 

The Company applies a ceiling test to the capitalized cost in the full cost pool. The ceiling test limits such cost to the estimated present value, using a ten percent discount rate, of the future net revenue from proved reserves, based on current economic and operating conditions. Specifically, the Company computes the ceiling test so that capitalized cost, less accumulated depletion and related deferred income tax, do not exceed an amount (the ceiling) equal to the sum of: (A) The present value of estimated future net revenue computed by applying current prices of oil and gas reserves (with consideration of price changes only to the extent provided by contractual arrangements) to estimated future production of proved oil and gas reserves as of the date of the latest balance sheet presented, less estimated future expenditures (based on current cost) to be incurred in developing and producing the proved reserves computed using a discount factor of ten percent and assuming continuation of existing economic conditions; plus (B) the cost of property not being amortized; plus (C) the lower of cost or estimated fair value of unproven properties included in the costs being amortized; less (D) income tax effects related to differences between the book and tax basis of the property.

 

For unproven properties, the Company excludes from capitalized costs subject to depletion, all costs directly associated with the acquisition and evaluation of the unproved property until it is determined whether or not proved reserves can be assigned to the property. Until such a determination is made, the Company assesses the property at least annually to ascertain whether impairment has occurred. In assessing impairment the Company considers factors such as historical experience and other data such as primary lease terms of the property, average holding periods of unproved property, and geographic and geologic data. The Company adds the amount of impairment assessed to the cost to be amortized subject to the ceiling test.

Recent Accounting Pronouncements

Effective this quarter, we implemented Statement of Financial Accounting Standards No. 165, Subsequent Events, or SFAS 165. The standard establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before the financial statements are issued. The adoption of SFAS 165 did not impact our financial position or results of operations. We evaluated all events or transactions that occurred after June 30, 2009 up through the date we issued these financial statements on October 15, 2009. 

 

In December 2007, the FASB issued SFAS No. 141R, “Business Combinations”. This statement replaces SFAS 141 and defines the acquirer in a business combination as the entity that obtains control of one or more businesses in a business combination and establishes the acquisition date as the date that the acquirer achieves control. SFAS 141R requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date. SFAS 141R also requires the acquirer to

 

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recognize contingent consideration at the acquisition date, measured at its fair value at that date. This statement is effective for fiscal years and interim periods within those fiscal years, beginning on or after December 15, 2008 and earlier adoption is prohibited. The adoption of this statement did not have a material effect on the Company’s consolidated financial statements. 

 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements Liabilities –an Amendment of ARB No. 51”. This statement amends ARB 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. This statement is effective for fiscal years and interim periods within those fiscal years, beginning on or after December 15, 2008 and earlier adoption is prohibited. The adoption of this statement did not have a material effect on the Company’s consolidated financial statements.

 

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles”. SFAS No. 162 is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with U.S. generally accepted accounting principles for nongovernmental entities. SFAS No. 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board Auditing amendments to AU Section 411, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles”.

 

In May 2008, the FASB issued FSP 14-1 “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement) “. FSP 14-1 requires the issuer of certain convertible debt instruments that may be settled in cash (or other assets) on conversion to separately account for the liability (debt) and equity (conversion option) components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. FSP 14-1 is effective for fiscal years beginning after December 15, 2008, on a retroactive basis. The adoption of this statement did not have a material effect on the Company’s consolidated financial statements.

 

On December 31, 2008, the SEC published the final rules and interpretations updating its oil and gas reporting requirements. Many of the revisions are updates to definitions in the existing oil and gas rules to make them consistent with the petroleum resource management system, which is a widely accepted standard for the management of petroleum resources that was developed by several industry organizations. Key revisions include changes to the pricing used to estimate reserves utilizing a 12-month average price rather than a single day spot price which eliminates the ability to utilize subsequent prices to the end of a reporting period when the full cost ceiling was exceeded and subsequent pricing exceeds pricing at the end of a reporting period, the ability to include nontraditional resources in reserves, the use of new technology for determining reserves, and permitting disclosure of probable and possible reserves. The SEC will require companies to comply with the amended disclosure requirements for registration statements filed after January 1, 2010, and for annual reports on Form 10-K for fiscal years ending on or after December 15, 2009. Early adoption is not permitted. The Company is currently assessing the impact that the adoption will have on the Company’s disclosures, operating results, financial position and cash flows.

 

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the AICPA, and the SEC did not, or are not believed by management to, have a material impact on the Company’s present or future consolidated financial statements.

Significant changes in number of employees.

As of August 31, 2009, we employed William David Gibbs as our President, Chief Executive Officer (“CEO”), and Director, Christopher H. Taylor as our Chief Financial Officer, Douglas M. Harwell as our Operations Manager, and Rae Lynn Wertz as our Manager of Administration. Subsequent to August 31, 2009, Mr. Harwell resigned his position as Operations Manager effective September 30, 2009. We have no other employees and conduct most of our business through agreements with consultants and third parties. We do not anticipate any significant changes to the number of Company employees.

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Contractual Obligations

The Company has had no material changes to its contractual obligations as disclosed in the Company’s Annual Report on Form 10-K for the year ended May 31, 2009.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

Not Applicable.

 

Item 4. Disclosure Controls and Procedures

 

At the end of the period covered by this report on Form 10-Q for the quarter ended August 31, 2009, an evaluation was carried out under the supervision of and with the participation of the Company’s management, including the CEO and CFO, of the effectiveness of the design and operations of the Company’s disclosure controls and procedures (as defined in Rule 13a - 15(e) and Rule 15d - 15(e) under the Exchange Act). Based on that evaluation the CEO and the CFO have concluded that the Company’s disclosure controls and procedures were adequately designed and effective in ensuring that: (i) information required to be disclosed by the Company in reports that it files or submits to the SEC under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in applicable rules and forms and (ii) material information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to our management, including our CEO and CFO, as appropriate, to allow for accurate and timely decisions regarding required disclosure.

 

Changes in Internal Control over Financial Reporting

 

There were no changes in our internal control over financial reporting (as defined in Rule 13(a)-15(f) or 15(d)-15(f)) that occurred during the period covered by this quarterly report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

 

26

 

 

PART II — OTHER INFORMATION

 

Item 1. Legal Proceedings

 

On June 9, 2009, one of our vendors, Coastal Chemical Co., LLC filed suit in the 113^th Judicial District of Harris County, Texas related to approximately $104,000 in claimed unpaid invoices. In addition, since May 31, 2009, several vendors have filed liens against the Company related to claims for unpaid invoices for goods and services provided to the Company in Bossier Parish, Louisiana and the state of Texas. Total claims related to these liens are approximately $3,696,000.

 

Except for the above, we are not involved as a plaintiff in any material proceeding or pending litigation. There are no proceedings in which any of our directors, officers or affiliates, or any registered or beneficial shareholder, is an adverse party or has a material interest adverse to our interest.

 

Item 1A. Risk Factors

 

There have been no material changes from the risk factors as previously disclosed in our Form 10-K for the year ended May 31, 2009 which was filed with Securities and Exchange Commission on August 31, 2009.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

None.

 

Item 3. Defaults Upon Senior Securities

 

None.

 

Item 4. Submission of Matters to a Vote of Security Holders

 

None.

 

Item 5. Other Information 

 

None.

 

Item 6. Exhibits

 

 

 

 

 

 

 

 

 

 

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

SOUTHERN STAR ENERGY INC.

 

 

By: /s/ William David Gibbs

William David Gibbs

Chief Executive Officer

(On behalf of the Company and as Principal Executive Officer)

 

Date:  October 15, 2009

 

 

By: /s/ Christopher H. Taylor
Christopher H. Taylor

Chief Financial Officer

(Principal Financial and Accounting Officer)

 

Date:  October 15, 2009

 

 

 

 

 

 

 

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