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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 

 
FORM 10-Q
 

 
(Mark One)

x
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2014

OR

¨
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM ____________ TO ____________
 
COMMISSION FILE NUMBER: 000-54842

PEGASI ENERGY RESOURCES CORPORATION
(Exact name of registrant as specified in its charter)

Nevada
 
20-4711443
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification Number)

218 N. Broadway, Suite 204
Tyler, Texas 75702
(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: 903- 595-4139

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x  No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a small 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 o
 Accelerated filer o
 Non-accelerated filer o
 Smaller reporting company x
(Do not check if a smaller reporting company)
 
                                                                                    
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2) of the Act.  Yes ¨  No x

There were 70,539,499 shares of the registrant's common stock outstanding as of November 6, 2014.
 

TABLE OF CONTENTS
 
   
Page
PART I – FINANCIAL INFORMATION
     
Item 1.
3
Item 2.
16
Item 3.
23
Item 4.
23
     
PART II – OTHER INFORMATION
     
Item 1.
24
Item 1A.
24
Item 2.
24
Item 3.
24
Item 4.
24
Item 5.
24
Item 6.
24
     
25

 
PART I – FINANCIAL INFORMATION
 
Item 1. Financial Statements.

PEGASI ENERGY RESOURCES CORPORATION
CONSOLIDATED BALANCE SHEETS

   
September 30,
   
December 31,
 
   
2014
   
2013
 
 
 
(Unaudited)
       
Assets            
Current assets:
           
Cash and cash equivalents
  $ 962,310     $ 2,467,761  
Accounts receivable, trade
    413,236       300,132  
Accounts receivable, related parties
    35,502       26,584  
Joint interest billing receivable, related parties, net
    10,079       119,188  
Joint interest billing receivable, net
    13,360       42,302  
Other current assets
    39,447       45,718  
Total current assets
    1,473,934       3,001,685  
                 
Property and equipment:
               
Equipment
    67,435       66,855  
Pipelines
    982,132       946,012  
Leasehold improvements
    7,022       7,022  
Vehicles
    56,174       56,174  
Office furniture
    89,148       89,148  
Total property and equipment
    1,201,911       1,165,211  
Less accumulated depreciation
    (536,575 )     (473,163 )
Property and equipment, net
    665,336       692,048  
                 
Oil and gas properties:
               
Oil and gas properties, proved
    19,012,095       17,583,190  
Oil and gas properties, unproved
    13,874,909       14,298,503  
Capitalized asset retirement obligations
    600,423       503,253  
Total oil and gas properties
    33,487,427       32,384,946  
Less accumulated depletion and depreciation
    (2,324,620 )     (1,951,186 )
Oil and gas properties, net
    31,162,807       30,433,760  
                 
Other assets:
               
Restricted cash – drilling program
    427,079       90,559  
Certificates of deposit
    78,639       78,560  
Easements
    34,848       34,848  
Total other assets
    540,566       203,967  
                 
Total assets
  $ 33,842,643     $ 34,331,460  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
PEGASI ENERGY RESOURCES CORPORATION
CONSOLIDATED BALANCE SHEETS (continued)

   
September 30,
   
December 31,
 
   
2014
   
2013
 
   
(Unaudited)
       
Liabilities and Stockholders' Equity            
Current Liabilities:
           
Cash overdraft
  $ -     $ 255,628  
Accounts payable
    998,844       1,401,014  
Accounts payable, related parties
    3,319,838       2,924,089  
Revenue payable
    510,527       852,079  
Liquidated damages payable
    46,695       40,892  
Other payables
    40,078       59,627  
Current portion of notes payable
    7,896       8,703  
Total current liabilities
    4,923,878       5,542,032  
                 
Drilling prepayments
    427,079       90,559  
Notes payable
    2,945       9,190  
Notes payable, related parties
    8,160,646       8,160,646  
Interest payable, related parties
    2,765,895       2,291,652  
Asset retirement obligations
    794,301       674,092  
Total liabilities
    17,074,744       16,768,171  
                 
Commitments and contingencies (Note 9)
               
                 
Stockholders' equity:
               
Preferred stock: $0.001 par value; 5,000,000 shares authorized; none issued and outstanding
    -       -  
Common stock: $0.001 par value; 150,000,000 shares authorized; 70,539,499 and 68,169,923 shares issued and outstanding, respectively
    70,540       68,170  
Additional paid-in capital
    52,894,835       45,599,663  
Accumulated deficit
    (36,197,476 )     (28,104,544 )
Total stockholders' equity
    16,767,899       17,563,289  
                 
Total liabilities and stockholders' equity
  $ 33,842,643     $ 34,331,460  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
PEGASI ENERGY RESOURCES CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
 
   
Three Months
   
Nine Months
 
   
Ended September 30,
   
Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Revenues:
                       
Oil and gas
  $ 413,354     $ 463,359     $ 1,395,826     $ 1,233,603  
Condensate and skim oil
    10,021       10,448       19,210       41,782  
Transportation and gathering
    65,873       58,383       209,156       148,080  
Total revenues
    489,248       532,190       1,624,192       1,423,465  
                                 
Operating expenses:
                               
Lease operating expense
    185,208       198,458       625,614       612,258  
Pipeline operating expenses
    46,170       42,801       202,836       147,537  
Depletion and depreciation
    142,978       150,050       437,065       383,970  
General and administrative
    689,941       657,076       5,327,373       2,293,841  
Total operating expenses
    1,064,297       1,048,385       6,592,888       3,437,606  
Loss from operations
    (575,049 )     (516,195 )     (4,968,696 )     (2,014,141 )
                                 
Other income (expense):
                               
Interest income
    292       26       344       84  
Interest expense
    (159,017 )     (159,268 )     (476,172 )     (478,150 )
Warrant modification expense
    -       -       (2,642,266 )     -  
Other expense, net
    (2,364 )     (1,707 )     (6,142 )     (2,362 )
Total other expense, net
    (161,089 )     (160,949 )     (3,124,236 )     (480,428 )
                                 
Loss from operations before income tax expense
    (736,138 )     (677,144 )     (8,092,932 )     (2,494,569 )
                                 
Income tax expense
    -       -       -       (3,515 )
                                 
Net loss
  $ (736,138 )   $ (677,144 )   $ (8,092,932 )   $ (2,498,084 )
                                 
Basic and diluted loss per share:
                               
Basic and diluted loss per share
  $ (0.01 )   $ (0.01 )   $ (0.12 )   $ (0.04 )
                                 
Weighted average shares outstanding – basic and diluted
    70,537,160       63,718,401       69,857,752       63,314,324  
 
The accompanying notes are an integral part of these consolidated financial statements. 


PEGASI ENERGY RESOURCES CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 
   
Nine Months Ended September 30,
 
   
2014
   
2013
 
Operating Activities
           
Net loss
  $ (8,092,932 )   $ (2,498,084 )
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
         
Depletion and depreciation
    437,065       383,970  
Accretion of discount on asset retirement obligations
    25,941       25,671  
Stock based compensation
    3,353,344       524,144  
Common stock issued for consulting services
    198,250       35,500  
Warrant modification expense
    2,642,266       -  
Gain on transfer of equipment
    (219 )     -  
Changes in operating assets and liabilities:
               
Accounts receivable, trade
    (113,104 )     (55,272 )
Account receivable, related parties
    (8,918 )     (9,082 )
Joint interest billing receivable, related parties, net
    39,993       1,248,417  
Joint interest billing receivable, net
    32,011       224,344  
Other current assets
    6,271       22,808  
Accounts payable
    (84,470 )     123,152  
Accounts payable, related parties
    395,749       345,057  
Revenue payable
    (341,552 )     281,521  
Interest payable, related parties
    474,243       474,237  
Liquidated damages payable
    5,803       4,862  
Other payables
    (19,549 )     33,177  
Net cash provided by (used in) operating activities
    (1,049,808 )     1,164,422  
                 
Investing Activities
               
Additions to certificates of deposit
    (79 )     (84 )
Purchases of property and equipment
    (39,769 )     (11,893 )
Purchase of oil and gas properties
    (852,797 )     (1,707,435 )
Net cash used in investing activities
    (892,645 )     (1,719,412 )
                 
Financing Activities
               
Payments on notes payable
    (7,052 )     (6,033 )
Cash overdraft
    (255,628 )     35,915  
Proceeds from sale of common stock, net of offering costs
    694,900       245,000  
Proceeds from exercise of warrants
    4,782       4,800  
Net cash provided by financing activities
    437,002       279,682  
                 
Net decrease in cash and cash equivalents
    (1,505,451 )     (275,308 )
Cash and cash equivalents at beginning period
    2,467,761       1,421,198  
Cash and cash equivalents at end of period
  $ 962,310     $ 1,145,890  
 
See Note 4 for supplemental cash flow and non-cash information.
 
The accompanying notes are an integral part of these consolidated financial statements
 
 
PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2014 AND 2013

1.  NATURE OF OPERATIONS
 
Pegasi Energy Resources Corporation (“PERC” or the “Company”) is an independent energy company engaged in the exploration for, and production of, crude oil and natural gas.   The Company’s strategy is to employ modern drilling and completion techniques to redevelop formations that have been proven by historical production to be hydrocarbon reservoirs in a mature field.  The Company is exclusively focused on the redevelopment of the Rodessa oilfield of East Texas.  First developed in the 1930’s, this field has historically been the domain of small independent operators and is not a legacy field for any major oil company.  The Company has been active in the region for over a decade, and in this time, it has developed a proprietary technical database from the Rodessa oilfield’s extensive drilling history, which gives the Company a superior insight into the multiple proven reservoirs that are available for development.  The drilling and production history of the oilfield has proven the productivity of multiple horizons, including the Rodessa, Pettit, Travis Peak, Cotton Valley, Bossier and Cotton Valley Limestone.

The Company’s development strategy, in what it has designated the “Cornerstone Project”, is to identify and exploit resources in and adjacent to existing or indicated producing areas within the mature Rodessa field. By focusing on a mature proven field, the Company believes that it can significantly reduce the geological risk of its projects.  The Company plans to develop and produce reserves at low cost and will take an aggressive approach to exploiting its contiguous acreage position by utilizing the latest “best in class” drilling and completion techniques.

PERC conducts its main exploration and production operations through its wholly-owned subsidiary, Pegasi Operating, Inc. ("POI").  It conducts additional operations through another wholly-owned subsidiary, TR Rodessa, Inc. ("TR Rodessa").  

TR Rodessa owns an 80% undivided interest in and operates a 40-mile natural gas pipeline and gathering system which is currently being used by PERC to transport its hydrocarbons to market.  Excess capacity on this system is used to transport third-party hydrocarbons.  
  
2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

a)  Basis of Presentation

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and the rules of the Securities and Exchange Commission (the “SEC”), and should be read in conjunction with PERC’s audited consolidated financial statements for the year ended December 31, 2013, and notes thereto, which are included in the Company’s annual report on Form 10-K filed with the SEC on March 24, 2014.  In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the Company’s consolidated financial position and the consolidated results of operations for the interim periods presented have been reflected herein.  The consolidated results of operations for interim periods are not necessarily indicative of the results to be expected for the full year.  The notes to consolidated financial statements, which would substantially duplicate the disclosures required in the Company’s 2013 annual consolidated financial statements, have been omitted.

We reclassified certain prior period amounts to conform to the current period presentation, specifically, the reclassification of interest payable, related parties, from current to noncurrent. These changes had no impact on total revenues, total operating expenses or net income for any period.

b)  Principles of Consolidation

The consolidated financial statements include the accounts of PERC and its wholly-owned subsidiaries.  All intercompany accounts and transactions have been eliminated.  In preparing the accompanying consolidated financial statements, management has made certain estimates and assumptions that affect reported amounts in the consolidated financial statements and disclosures.  Actual results may differ from these estimates.

 c)  Stock-based Compensation

The Company has accounted for stock-based compensation under the provisions of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 718-10, Compensation-Stock Compensation.  The Company recognizes stock-based compensation expense in the consolidated financial statements for equity-classified employee stock-based compensation awards based on the grant date fair value of the awards.  During the three months ended September 30, 2014 and September 30, 2013, the Company recognized $131,037 and $131,036, respectively, of stock-based compensation. During the nine months ended September 30, 2014 and September 30, 2013, the Company recognized $3,353,344 and $524,144, respectively, of stock-based compensation, which has been recorded as a general and administrative expense in the consolidated statements of operations. Non-employee share-based awards are accounted for based upon FASB ASC Topic 505-50, Equity-Based Payments to Non-Employees.
  
 
PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2014 AND 2013

d)  Net Loss per Common Share

Basic net loss per common share is calculated using the weighted average number of common shares outstanding during the period.  The Company uses the treasury stock method of calculating fully diluted per share amounts whereby any proceeds from the exercise of stock options or other dilutive instruments are assumed to be used to purchase common shares at the average market price during the period. The dilutive effect of convertible securities is reflected in diluted loss per share by application of the if-converted method. Under this method, conversion shall not be assumed for the purposes of computing diluted loss per share if the effect would be anti-dilutive. For the three and nine months ended September 30, 2014 and 2013, the Company had potentially dilutive shares of 50,668,290 and 40,357,536, respectively, that were excluded from the earnings per share calculation because their impact would be anti-dilutive. For the three and nine months ended September 30, 2014 and 2013, the diluted loss per share is the same as basic loss per share, as the effect of common stock equivalents is anti-dilutive.

e) Notes Payable, Related Parties

Notes payable, related parties totaling $8,160,646 consisted of the “Teton Renewal Note” in the amount of $6,987,646 dated June 23, 2011, including interest at 8%, with all principal due on the maturity date of June 1, 2015, secured by a stock pledge and security agreement and the “Teton Promissory Note” in the amount of $1,173,000 dated October 14, 2009, including interest of 6.25%, with all interest and principal due on the maturity date of June 1, 2015, unsecured. On June 24, 2014, amendments on both the Teton Renewal Note and the Teton Promissory Note were executed to extend the maturity date of the notes from June 1, 2015 to December 31, 2015, at which time all outstanding principal and accrued and unpaid interest of the notes will be due. The event of default section remains the same as in the prior amendments.

f) Certificates of Deposit

Certificates of deposit have been posted as collateral supporting a reclamation bond guaranteeing remediation of our oil and gas properties in Texas.  As of September 30, 2014 and December 31, 2013, the balance of the certificates of deposit totaled $78,639 and $78,560, respectively.

g) New Accounting Pronouncements

In May 2014, the FASB issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which supersedes nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-09 is to recognize revenue when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing GAAP.

The standard is effective for annual periods beginning after December 15, 2016, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). Management is currently evaluating the impact of the pending adoption of ASU 2014-09 on the Company’s consolidated financial statements and has not yet determined the method the Company will adopt by which it will implement the standard.

3.  FAIR VALUE OF FINANCIAL INSTRUMENTS
 
FASB ASC Topic 825, Financial Instruments, requires certain disclosures regarding the fair value of financial instruments.  Fair value of financial instruments is made at a specific point in time, based on relevant information about financial markets and specific financial instruments.  As these estimates are subjective in nature, involving uncertainties and matters of significant judgment, they cannot be determined with precision. Changes in assumptions can significantly affect estimated fair values.
 
FASB ASC Topic 820, Fair Value Measurement, defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required or permitted to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and it considers assumptions that market participants would use when pricing the asset or liability.
 
 
PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2014 AND 2013
 
FASB ASC Topic 820 establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. FASB ASC Topic 820 establishes three levels of inputs that may be used to measure fair value:
 
Level 1 - Level 1 applies to assets or liabilities for which there are quoted prices in active markets for identical assets or liabilities.
 
Level 2 - Level 2 applies to assets or liabilities for which there are inputs other than quoted prices included within Level 1 that are observable for the asset or liability such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data.
 
Level 3 - Level 3 applies to assets or liabilities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the assets or liabilities.

The following table sets forth our estimate of fair value of our financial instruments that are liabilities as of September 30, 2014:
 
   
Quoted Prices in
Active Markets for
Identical Assets 
(Level 1)
   
Significant Other
Observable Inputs
(Level 2)
   
Significant
Unobservable Inputs 
(Level 3)
   
Total
 
Nonrecurring
                       
Asset retirement obligation
  $ -     $ -     $ 794,301     $ 794,301  
 
The following table sets forth our estimate of fair value of our financial instruments that are liabilities as of December 31, 2013:

   
Quoted Prices in
 Active Markets for
Identical Assets 
(Level 1)
   
Significant Other
Observable Inputs
(Level 2)
   
Significant
Unobservable Inputs 
(Level 3)
   
Total
 
Nonrecurring
                       
Asset retirement obligation
  $ -     $ -     $ 674,092     $ 674,092  
 
The following table sets forth a summary of changes in fair value of our asset retirement obligation during the nine months ended September 30, 2014 and 2013:

   
2014
   
2013
 
Beginning Balance - January 1,
  $ 674,092     $ 628,668  
Accretion expense
    25,941       25,671  
Liabilities settled
    (49,586 )     -  
Revisions to estimates
    143,854       13,757  
Balance at September 30,
  $ 794,301     $ 668,096  
 
In accordance with the reporting requirements of FASB ASC Topic No. 825, the Company calculates the fair value of its assets and liabilities that qualify as financial instruments under this statement and includes this additional information in the notes to consolidated financial statements when the fair value is different than the carrying value of these financial instruments.  The estimated fair values of accounts receivable, accounts payable and accrued liabilities approximate their carrying amounts due to the relatively short maturity of these instruments.  The carrying value of long-term debt approximates market value due to the use of market interest rates.  
 
 
PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2014 AND 2013

4.  SUPPLEMENTAL CASH FLOW AND NON-CASH INFORMATION
 
The following non-cash transactions were recorded during the nine month period ended September 30:
 
   
2014
   
2013
 
             
Oil and gas assets financed through account payables
  $ 199,692     $ 613,168  
                 
Additions to/ revisions of estimates to asset retirement obligation
  $ 143,854     $ 13,757  
                 
Asset retirement obligation settled
  $ 49,586     $ -  
                 
Oil and gas properties purchased through issuance of common stock
  $ 404,000     $ -  
                 
Oil and gas properties financed through assumption of joint-interest billing receivable
  $ 69,116     $ -  
 
The following is supplemental cash flow information for the nine month period ended September 30:
 
   
2014
   
2013
 
Cash paid during the period for interest
  $ 1,929     $ 3,913  
Cash paid during the period for taxes
  $ -     $ 3,515  
 
5.  STOCK-BASED COMPENSATION

Stock Plans

The Company adopted the 2007 Stock Option Plan (the “2007 Plan”), 2010 Incentive Stock Option Plan (the “2010 Plan”) and the 2012 Incentive Stock Option Plan (the “2012 Plan”) for directors, executives, selected employees, and consultants to reward them for making major contributions to the success of the Company by issuing long-term incentive awards under these plans thereby providing them with an interest and incentive in the growth and performance of the Company.  The 2007 Plan reserves 1,750,000 shares of common stock for issuance by the Company as stock options.  The 2010 Plan reserves 5,000,000 shares of common stock for issuance by the Company as stock options, stock awards or restricted stock purchase offers.  The 2012 Plan reserves 10,000,000 shares of common stock for issuance by the Company as stock options, stock awards or restricted stock purchase offers

On May 19, 2014, the Company adopted the 2014 Incentive Stock Option Plan (the “2014 Plan”) for directors, executives, selected employees, and consultants to reward them for individual performance that contributes to the success of the Company by issuing options to purchase stock under the 2014 Plan thereby providing them with an interest in the growth and performance of the Company.  The 2014 Plan reserves 10,000,000 shares for common stock for issuance by the Company as stock options.

During the nine months ended September 30, 2014, the Company recognized stock-based compensation expense of $393,110 related to options granted in a prior year.

Stock Options Issued

On January 30, 2014, pursuant to the 2010 Plan and 2012 Plan, the Company issued stock options for 49,940 and 7,000,000 shares of common stock, respectively, at an exercise price of $0.79 per share to selected employees and consultants for their contributions to the success of the Company.  All of the options vested immediately upon issuance at January 30, 2014, and are exercisable at any time, in whole or part, until January 30, 2019. This issuance resulted in stock-based compensation of $2,381,979, which was calculated using the fair value of the options at grant date. 
 
 
PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2014 AND 2013

The following table details the significant assumptions used to compute the fair market values of stock options granted in a prior year which vested during the nine months ended September 30, 2014:
 
Risk free rates
    0.45 %
Dividend yield
    0 %
Expected volatility
    70.82 %
Remaining term (years)
   
2.5 years
 

Stock Options Modified

On January 30, 2014, pursuant to Board resolution, the Company changed the terms of certain options under the 2007 Plan and 2010 Plan, as shown in the table below, to extend the exercise term for two years from their current expiration date. 

   
Current Expiration Date
 
Modified Expiration Date
 
Option Issue Date
         
2007 Plan Granted 2007
 
12/31/2014
 
12/31/2016
 
2007 Plan Granted 2012
 
1/5/2017
 
1/5/2019
 
2010 Plan Granted 2010
 
12/24/2015
 
12/24/2017
 
2010 Plan Granted 2012
 
1/5/2017
 
1/5/2019
 
2010 Plan Granted 2012
 
4/30/2017
 
4/30/2019
 

The modification resulted in incremental stock-based compensation cost of $578,255, which was calculated as the difference in the fair value of the options immediately before and immediately after the modification using the Black-Scholes option pricing model.  The Company used the simplified method to determine the expected term on the options modified due to the lack of historical exercise data.  The following table details the significant assumptions used to compute the fair value of the option modifications:
 
   
Before
   
After
 
Risk free rates
   
0.07 to 0.24
%    
0.24to 0.48
%
Dividend yield
    0 %     0 %
Expected volatility
   
54.65to 58.06
%    
55.10to 73.49
%
Remaining term (years)
   
0.5 years to 1.63 years
     
1.5 years to 2.63 years
 
 
The weighted average grant date fair value price per share of options granted during the nine months ended September 30, 2014 was $0.34.  There were no options granted and vested during the nine months ended September 30, 2013.  As of September 30, 2014 and 2013, the Company had $0 and $524,144, respectively, of unrecognized compensation expense related to non-vested stock-based compensation arrangements.

A summary of option activity during the nine months ended September 30, 2014 is as follows:
 
   
Options
   
Weighted Average Exercise Price
 
Oustanding at December 31, 2013
    9,700,060     $ 0.57  
Options granted
    7,049,940       0.79  
Options exercised
    -       -  
Outstanding at September 30, 2014
    16,750,000     $ 0.66  
 

PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2014 AND 2013

A summary of stock options outstanding as of September 30, 2014 is as follows:
 
Exercise Price
   
Options Outstanding
   
Remaining Contractual Lives (Years)
   
Options Exercisable
 
$ 0.65       900,000       2.25       900,000  
$ 0.42       1,059,285       3.25       1,059,285  
$ 0.50       10,000       3.25       10,000  
$ 0.50       486,364       4.25       486,364  
$ 0.55       363,636       4.25       363,636  
$ 0.50       616,600       4.25       616,600  
$ 0.79       7,049,940       4.30       7,049,940  
$ 0.55       3,000,000       4.75       3,000,000  
$ 0.50       264,175       7.25       264,175  
$ 0.66       3,000,000       8.00       2,000,000  

Based on the Company's stock price of $0.36 at September 30, 2014, the options outstanding had an intrinsic value of $0.  

Total options exercisable at September 30, 2014 amounted to 15,750,000 shares and had a weighted average exercise price of $0.66.  Upon exercise, the Company issues the full amount of shares exercisable per the term of the options from new shares.  The Company has no plans to repurchase those shares in the future.  

The Company estimates the fair value of stock options using the Black-Scholes option pricing valuation model, consistent with the provisions of FASB ASC Topic 505 and FASB ASC Topic 718.  Key inputs and assumptions used to estimate the fair value of stock options include the grant price of the award, the expected option term, volatility of the Company’s stock, the risk-free rate and the Company’s dividend yield.  Estimates of fair value are not intended to predict actual future events or the value ultimately realized by grantees, and subsequent events are not indicative of the reasonableness of the original estimates of fair value made by the Company.  The Company uses the simplified method to determine the expected term on options issued.

6.  WARRANTS OUTSTANDING

Warrants Modified

During the first quarter of 2014, the Company offered holders of certain warrants an option to consider modification of the warrants.  The terms of the offer would (1) extend the exercise term of the warrants by three years, and (2) increase the exercise price of the warrants, which would be exercisable on a cash-only basis. The deadline for accepting this offer was March 31, 2014.

Pursuant to the 2014 modification agreement, the Company changed the terms of warrants to purchase an aggregate of 14,880,762 shares to increase their exercise price and to extend the exercise term by three years.  See the table below for a summary of the modifications for the various outstanding warrants.

   
Current Exercise Price
   
Modified Exercise Price
   
Current Expiration Date
   
Modified Expiration Date
 
Warrant Issue Date
                       
Issued in 2007 and modified in 2012
  $ 0.50     $ 0.70    
12/22/14
   
12/22/2017
 
Issued in July 2011
  $ 0.60     $ 0.85    
7/28/2014
   
7/28/2017
 
Issued in Sept 2011
  $ 0.60     $ 0.85    
9/15/2014
   
9/15/2017
 
Issued in Sept 2012
  $ 1.00     $ 1.15     9/10/15   and 
 9/28/15
    9/10/18   and 
 9/28/18
 
Issued in Sept 2012 to placement agents
  $ 0.60     $ 0.70    
9/28/2017
   
9/28/2020
 
Issued in Sept 2013
  $ 0.50     $ 0.70    
12/22/2014
   
12/22/2017
 
Issued in Sept 2013
  $ 1.00     $ 1.10    
9/19/2016
   
9/19/2019
 
 
The modification resulted in warrant modification expense of $2,642,266, which was recorded in the quarter ended March 31, 2014. This modification was calculated as the difference in the fair value of the warrants immediately before and immediately after the modification using the Black-Scholes option pricing model.
 

PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2014 AND 2013

The following table details the significant assumptions used to compute the fair market value of the warrant modifications:
 
   
Before
   
After
 
Risk free rates
    0.08% to 0.99 %     0.99% to 2.07 %
Dividend yield
    0 %       0 %  
Expected volatility
    52.24 % to 83.24 %     78.94 % to 106.11 %
Remaining term (years)
   
0.35 years to 3.53 years
     
3.33 years to 6.53 years
 
 
Warrants Exercised

On February 11, 2014, the Company issued 6,380 shares of common stock to an investor holding modified 2007 Warrants who exercised 10,000 warrants on a cashless basis.

On April 2, 2014, the Company issued 23,226 shares of common stock to an investor holding modified 2007 Warrants who exercised 30,000 warrants on a cashless basis.

On July 28, 2014, the Company issued 7,970 shares of common stock to an investor holding 2011 Warrants who exercised 7,970 warrants for proceeds of $4,782.

A summary of warrant activity and shares issuable upon exercise of the warrants during the nine months ended September 30, 2014 is as follows:
 
   
Warrants
   
Shares Issuable Under Warrants
   
Weighted Average Exercise Price
 
Oustanding at December 31, 2013
    17,978,852       23,191,215     $ 0.66  
Warrants cancelled under modification
    (11,660,762 )     (14,880,762 )     0.63  
Warrants issued under modification
    11,660,762       14,880,762       0.84  
Warrants issued (see Note 7)
    781,000       781,000       0.70  
Warrants exercised
    (47,970 )     (87,970 )     0.52  
Outstanding at September 30, 2014
    18,711,882       23,884,245     $ 0.80  
 
The outstanding warrants at September 30, 2014 had an intrinsic value of $0.  All of the 18,711,882 warrants outstanding at September 30, 2014 are exercisable and expire at various dates between December 2014 and September 2020.

7.  STOCKHOLDERS’ EQUITY

On February 11, 2014, the Company issued 6,380 shares of common stock to an investor holding modified 2007 Warrants who exercised 10,000 warrants on a cashless basis.  See Note 6 for additional details.

On February 27, 2014, the Company completed a private placement transaction, pursuant to which it sold an aggregate of 781,000 units at $0.90 per unit to raise gross proceeds of $702,900 before deducting issuance costs of $8,000, resulting in net cash proceeds of $694,900. Each unit consisted of two shares of common stock and a warrant to purchase one share of common stock with an exercise price of $0.70 per share, resulting in 1,562,000 shares and 781,000 warrants.  The warrants are exercisable for a period of five years from the date of issuance.

On March 27, 2014, the Company issued 90,000 shares of common stock to a consultant valued at $72,000. These shares were valued using the closing market price on the date of the agreement.  This expense has been recorded as general and administrative expense in the consolidated statements of operations.

On April 2, 2014, the Company issued 23,226 shares of common stock to an investor holding modified 2007 Warrants who exercised 30,000 warrants on a cashless basis.  See Note 6 for additional details.

On April 11, 2014, a consultant voluntarily cancelled 25,000 shares of common stock of the total 50,000 shares originally issued in August 2013 due to their inability to engage new investors for the Company. The cancelled shares were originally valued at $17,250 and a credit of this amount has been recorded within general and administrative expense in the consolidated statements of operations.
 
 
PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2014 AND 2013
 
On May 1, 2014, the Company and Energi Drilling 2010A L.P. (“Energi”) entered into an agreement with respect to working interests in the following wells operated by the Company: (i) Haggard B; and the (ii) Morse #1-H well. The agreement also covered all of Energi’s rights to participate in future wells and work-overs of existing wells.  The Company purchased all of Energi’s right, title and interest in the wells and all of Energi’s participation rights in future wells and work-overs and released Energi from any receivables owed to the Company. In consideration for the buy-out and release of debt, the Company issued 505,000 fully-paid and non-assessable shares of common stock to Energi. These shares were valued at $404,000 using the closing market price on the date of the agreement.  

During the three months ended June 30, 2014, the Company issued 150,000 shares of common stock to a consultant valued at $113,500. These shares were valued using the closing market price on the date of the agreement.  This expense has been recorded as general and administrative expense in the consolidated statements of operations.

On July 1, 2014, the Company issued 50,000 shares of common stock to a consultant valued at $30,000. These shares were valued using the closing market price on the date of the agreement.  This expense has been recorded as general and administrative in the consolidated statements of operations.

On July 28, 2014, the Company issued 7,970 shares of common stock to an investor holding 2011 Warrants who exercised 7,970 warrants on a cash basis.  See Note 6 for additional details.

8.  SEGMENT INFORMATION

The following information is presented in accordance with FASB ASC Topic 280, Segment Reporting.  The Company is engaged in exploration and production of crude oil and natural gas and pipeline transportation.  POI, a wholly-owned subsidiary of PERC, conducts the exploration and production operations.  TR Rodessa operates a 40-mile gas pipeline and gathering system which is used to transport hydrocarbons to market to be sold.  The Company identified such segments based on management responsibility and the nature of their products, services, and costs.  There are no major distinctions in geographical areas served as all operations are in the United States.  The Company measures segment profit (loss) as income (loss) from operations.  Business segment assets are those assets controlled by each reportable segment.  The following table sets forth certain information about the financial information of each segment as of September 30, 2014 and December 31, 2013 and for the three and nine months ended September 30, 2014 and 2013:
 
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2014
   
2013
   
2014
   
2013
 
Business segment revenue:
                       
Oil and gas sales
 
$
413,354
   
$
463,359
   
$
1,395,826
   
$
1,233,603
 
Condensate and skim oil
   
10,021
     
10,448
     
19,210
     
41,782
 
Transportation and gathering
   
65,873
     
58,383
     
209,156
     
148,080
 
Total revenues
 
$
489,248
   
$
532,190
   
$
1,624,192
   
$
1,423,465
 
                                 
Business segment profit (loss):
                               
Oil and gas sales
 
$
105,571
   
$
134,966
   
$
394,211
   
$
297,487
 
Condensate and skim oil
   
10,021
     
10,448
     
19,210
     
41,782
 
Transportation and gathering
   
425
     
(5,333
)
   
(61,358
)
   
(66,734
)
General corporate
   
(691,066
)
   
(656,276
)
   
(5,320,759
)
   
(2,286,676
)
Loss from operations
 
$
(575,049
)
 
$
(516,195
)
 
$
(4,968,696
)
 
$
(2,014,141
)
                                 
Depreciation and depletion:
                               
Oil and gas sales
 
$
122,575
   
$
129,935
   
$
376,001
   
$
323,858
 
Transportation and gathering
   
17,429
     
16,621
     
52,142
     
49,629
 
General corporate
   
2,974
     
3,494
     
8,922
     
10,483
 
Total depletion and depreciation
 
$
142,978
   
$
150,050
   
$
437,065
   
$
383,970
 
                                 
Capital expenditures:
                               
Oil and gas sales
                 
$
535,099
   
$
1,643,480
 
Transportation and gathering
                   
34,868
     
11,660
 
General corporate
                   
4,901
     
233
 
Total capital expenditures
                 
$
574,868
   
$
1,655,373
 
 
 
PEGASI ENERGY RESOURCES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2014 AND 2013
 
   
September 30,
   
December 31,
 
    2014     2013  
Business segment assets:
               
Oil and gas sales
  $ 32,190,469     $ 32,194,260  
Transportation and gathering
    721,313       717,450  
General corporate
    930,861       1,419,750  
Total assets
  $ 33,842,643     $ 34,331,460  
 
9.  COMMITMENTS AND CONTINGENCIES

Contingent Liabilities

In preparing financial statements at any point in time, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. The Company is involved in actions from time to time, which if determined adversely, could have a material negative impact on the Company's consolidated financial position, results of operations and cash flows. Management, with the assistance of counsel makes estimates, if determinable, of the Company’s probable liabilities and records such amounts in the consolidated financial statements. Such estimates may be the minimum amount of a range of probable loss when no single best estimate is determinable. Disclosure is made, when determinable, of any additional possible amount of loss on these claims, or if such estimate cannot be made, that fact is disclosed.

Along with the Company's counsel, management monitors developments related to legal matters and, when appropriate, makes adjustments to record liabilities to reflect current facts and circumstances.  Management has recorded a liability related to its registration rights agreement with investors that provides for the filing of a registration statement for the registration of the shares issued in the offering in December 2007, as well as the shares issuable upon exercise of related warrants.  The Company failed to meet the deadline for the effectiveness of the registration statement and therefore was required to pay liquidated damages of approximately $100,000 on the first day of effectiveness failure, or July 18, 2008.  An additional $100,000 penalty was required to be paid by the Company every thirty days thereafter, prorated for periods totaling less than thirty days, until the effectiveness failure was cured, up to a maximum of 18% of the aggregate purchase price, or approximately $1,800,000.  The Company’s registration became effective on August 21, 2008. 
 
At September 30, 2014, management reevaluated the status of the registration statement and determined an accrual of $46,695 was sufficient to cover any potential payments for liquidated damages and the related accrued interest.  The damages are reflected as liquidated damages payable of $46,695 and $40,892 in the accompanying consolidated balance sheets as of September 30, 2014 and December 31, 2013, respectively.   The difference of $5,803 was recorded as expense in the Other Income (Expense) section of the consolidated statements of operations.

10.  SUBSEQUENT EVENT

In preparing the accompanying financial statements, management of the Company has evaluated all subsequent events and transactions for potential recognition or disclosure through November 13, 2014, the date the financial statements were available for issuance.


ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

Forward Looking Statements

This Management's Discussion and Analysis of Financial Condition and Results of Operations include a number of forward-looking statements that reflect management's current views with respect to future events and financial performance. You can identify these statements by forward-looking words such as “may,” “will,” “expect,” “anticipate,” “believe,” “estimate” and “continue,” or similar words.  Those statements include statements regarding the intent, belief or current expectations of us and the management team as well as the assumptions on which such statements are based. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risk and uncertainties, and that actual results may differ materially from those contemplated by such forward-looking statements.

Readers are urged to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the Securities and Exchange Commission. Important factors currently known to Management could cause actual results to differ materially from those in forward-looking statements. We undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes in the future operating results over time. We believe that our assumptions are based upon reasonable data derived from and known about our business and operations. No assurances are made that actual results of operations or the results of our future activities will not differ materially from our assumptions. Factors that could cause differences include, but are not limited to, expected market demand for our products, fluctuations in pricing for materials, and competition.

Company Overview

We are an independent energy company engaged in the exploration for, and the production of, crude oil and natural gas.  Our strategy is to employ modern drilling and completion techniques to redevelop formations that have been proven by historical production to be hydrocarbon reservoirs in a mature field.  We are exclusively focused on the redevelopment of the Rodessa oilfield of East Texas.  First developed in the 1930’s, this field has historically been the domain of small independent operators and is not a legacy field for any major oil company.  We have been active in the region for over a decade, and in this time, we have developed a proprietary technical database from the Rodessa oilfield’s extensive drilling history, which gives us a superior insight into the multiple proven reservoirs that are available for development.  The drilling and production history of the oilfield has proven the productivity of multiple horizons, including the Rodessa, Pettit, Travis Peak, Cotton Valley, Bossier and Cotton Valley Limestone.  We have a longstanding commitment to this region where mineral ownership is highly fragmented and believe that the strength of our local relationships is a critical factor in acquiring mineral leases.  We currently hold interests in properties located in Cass and Marion Counties, Texas.

Our development strategy, in what we have designated the “Cornerstone Project”, is to identify and exploit resources in and adjacent to existing or indicated producing areas within the mature Rodessa field. By focusing on a mature proven field, we believe that we can significantly reduce the geological risk of our projects.  We plan to develop and produce reserves at low cost and will take an aggressive approach to exploiting our contiguous acreage position by utilizing the latest “best in class” drilling and completion techniques.

Plan of Operations

Our corporate strategy can be thought of in terms of the acquisition of leases and the development of resources on leased acreage.

Acquisition of Leases in the Cornerstone Project area
 
As of September 30, 2014, our leasehold position was approximately 26,517 gross acres and 15,800 net acres, of which our working interest is approximately 9,416 net acres.

·  
Supporting Our Drilling Program.  Our priority is drilling, and consequently, our leasing program’s primary objective is to support our planned drilling program by securing holdout leases in those units where we plan to drill over the next twelve months and renewing leases that are due to expire in those units where we plan to drill.

·  
Acquiring Additional Drilling Locations.  We have an extensive proprietary database that we use to identify additional drilling locations and target acreage for acquisition in the Cornerstone Project area.  Most properties in the project area are held by smaller independent companies that lack the resources and expertise to develop them fully.  We intend to pursue these opportunities to selectively expand our portfolio of properties.  Acreage additions will complement our existing substantial acreage position in the area and provide us with additional drilling opportunities.

 
Development of Resources in the Cornerstone Project area
 
Our acreage is located in a region that has historically proven highly productive. There are multiple target formations available for development on our leased acreage. These include the gas and condensate bearing Travis Peak, the oil and gas bearing upper Cotton Valley sands, the oil bearing Bossier sands and the oil bearing Cotton Valley Limestone. Approximately three quarters of our net leased acreage is currently undeveloped (approximately 6,904 undeveloped net acres of a total of 9,416 net acres as of September 30, 2014).
 
·  
Horizontal Wells Targeting the Bossier/Cotton Valley Limestone.  Our priority is to drill horizontal wells targeting the Bossier/Cotton Valley Limestone.  The low permeability oil bearing Bossier and Cotton Valley Limestone formations are amenable to development using the latest horizontal drilling and dynamic multi-stage fracking techniques that have proven successful in the Bakken Shale in North Dakota and elsewhere.  Our first horizontal well, the Morse #1-H, was drilled with a 2,000 foot horizontal section. This well was completed with a fivestage frack and recorded an average production rate of 281 Bbl/day of high quality crude oil in its first five days of production. The production rate has subsequently decreased and we recorded an average production rate of 17 Bbl/day of crude oil in September 2014.  This decrease has been irregular and we have observed several instances of unexpected, sustained surges in production, typically resulting in a doubling of production volumes over three-day periods.  These surges in production lead us to believe that the reservoir is capable of greater production, and that the Morse #1-H well’s production rate has been compromised by the gas lift system and/or by an obstruction in the well bore. We plan to perform a workover of the well, which may involve the installation of a mechanical pump to replace the gas lift system within the next 90 days, subject to the approval of our working interest partners. We expect that it would take approximately 30 days to install such a mechanical pump system. We believe that the successful production of oil from the Morse #1-H supports our development strategy for the Bossier/Cotton Valley Limestone. We have learned much from the drilling, completion and production of the Morse #1-H well that will enable us to improve the design and execution of our next planned horizontal well. Having proven our development model, we now plan to drill wells with longer laterals involving 15 frack stages to improve the well economics. We estimate that the drilling and completion costs of such wells will be approximately $7-$9 million. We are not currently capitalized to drill a program of such wells and are actively engaged in securing the financing needed to fund a drilling program to develop the Bossier/Cotton Valley Limestone.

·  
Vertical Wells. Our secondary priority is to drill vertical wells to develop shallower formations, such as the Travis Peak and Cotton Valley. The Haggard A & B wells, which offset the Norbord #1 discovery of 2010 and were completed in 2013 and 2012, respectively, fall into this category and have proven highly productive of gas and condensate. We recently concluded a participation agreement with Pacific World Energy (PWE) for the drilling of up to 10 wells on our leased acreage in Marion County. Under the terms of the participation agreement, PWE pays the full cost of drilling and completing each well and, if the well is successful, PWE earns an initial 80% working interest in the production from that well as well as the leases related to such well. Once PWE has recovered 125% of the well costs, its working interest will decrease to 63.3%. The initial two wells will be vertical wells, and following their completion, PWE will have the option to finance further vertical wells and/or horizontal wells, with each productive well earning them the same working interest rights as the first two wells. On October 1, 2014, we spudded the first vertical well of this program, the Huntington #4.  Drilling reached a final depth of 9,300 ft, production casing of 4 ½” was set and cemented at 9,300 ft and the drilling rig was released on October 27, 2014. Analysis of the well log identified in excess of 175' of gross pay over multiple Cotton Valley and Travis Peak zones.
 
Consolidated Results of Operations

Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013

Summarized Consolidated Results of Operations
 
               
Increase
 
   
2014
   
2013
   
(Decrease)
 
Total revenues
 
$
489,248
   
$
532,190
   
$
(42,942
)
Total operating expenses
   
1,064,297
     
1,048,385
     
15,912
 
Loss from operations
   
(575,049
)
   
(516,195
)
   
58,854
 
Total other expenses, net
   
(161,089
)
   
(160,949
)
   
140
 
Net loss
 
$
(736,138
)
 
$
(677,144
)
 
$
58,994
 
 
Revenues:  Total revenues for the quarter ended September 30, 2014 were $489,248, compared to $532,190 for the quarter ended September 30, 2013. The decrease of $42,942 in total revenues for the quarter ended September 30, 2014 as compared to the quarter ended September 30, 2013 was primarily driven by a decrease of $105,891 in oil revenue, which was partially offset by increases of $55,885 in gas revenue and $7,490 in transportation and gathering revenue.
 

Oil revenue for the quarter ended September 30, 2014 was $191,352, compared to $297,243 for the quarter ended September 30, 2013. The $105,891 decrease represented a 36% decline in oil revenue, which was driven by a 28% decrease in oil sales volume and a 10% decline in the realized oil sales price. The production rate of the Morse #1-H well declined 433 Bbls in the comparative quarters, resulting in a decrease of $53,618 in oil sales revenue.  In addition, the production rates of the Bramlett and the Wyatt King wells also declined for the comparative quarters, resulting in an additional $36,713 decrease in oil sales revenue.

Gas revenue for the quarter ended September 30, 2014 was $222,001, compared to $166,116 for the quarter ended September 30, 2013. This 34% increase of $55,885 was due to an 11% increase in the realized gas sales price and a 19% increase in gas sales volume. There was a quarter on quarter increase in gas production from the Haggard B well of 11,850 MCF, which resulted in $49,848 of additional gas revenue. This was due to our buyout in May 2014 of one investor’s working interest in this well. We received a realized sales price of $3.87 per MCF for the three months ended September 30, 2014, compared to $3.48 for the same period in 2013.

Transportation and gathering revenue increased to $65,873 for the quarter ended September 30, 2014 from $58,383 for the quarter ended September 30, 2013, due primarily to an increase in the volume of transported gas and increased charges per MCF.

Expenses:  Total operating expenses for the quarter ended September 30, 2014 were $1,064,297, compared to $1,048,385 for the quarter ended September 30, 2013.  This change was primarily a result of an increase in general and administrative expenses that were partially offset by a decrease in lease operating expenses.
 
·  
General and Administrative Expense:  There was a $32,865 increase in general and administrative expense to $689,941 for the quarter ended September 30, 2014, from $657,076 for the quarter ended September 30, 2013, primarily due to an increase of $31,000 in consulting fees related to an investor relations agreement entered into in late March 2014.

·  
Lease Operating Expense:  Total lease operating expense for the quarter ended September 30, 2014 was $185,208, compared to $198,458 for the quarter ended September 30, 2013, resulting in a decrease of $13,250, mainly due to the plugging of the Norbord well in early 2014.  The Norbord had lease operating expenses of $14,448 for the quarter ended September 30, 2013 and none for the quarter ended September 30, 2014.

Other Income (Expenses):  Total other expenses for the quarter ended September 30, 2014 were $161,089, compared to $160,949 for the quarter ended September 30, 2013.

Net Loss:  As a result of the above described revenues and expenses, we incurred a net loss of $736,138 for the quarter ended September 30, 2014, as compared to a net loss of $677,144 for the quarter ended September 30, 2013.

Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013

Summarized Consolidated Results of Operations
  
               
Increase
 
   
2014
   
2013
   
(Decrease)
 
Total revenues
 
$
1,624,192
   
$
1,423,465
   
$
200,727
 
Total operating expenses
   
6,592,888
     
3,437,606
     
3,155,282
 
Loss from operations
   
(4,968,696
)
   
(2,014,141
)
   
2,954,555
 
Total other expense, net
   
(3,124,236
)
   
(480,428
)
   
2,643,808
 
Income tax expense
   
-
     
(3,515
)
   
(3,515
Net loss
 
$
(8,092,932
)
 
$
(2,498,084
)
 
$
5,594,848
 
 
Revenues:  Total revenues for the nine months ended September 30, 2014 were $1,624,192, compared to $1,423,465 for the nine months ended September 30, 2013. The increase of $200,727 in total revenues for the nine months ended September 30, 2014 as compared to the nine months ended September 30, 2013 was primarily driven by increases in gas revenue of $334,694 and transportation and gathering revenues of $61,076, which were partially offset by decreases in oil revenue of $172,471 and condensate and skim oil sales of $22,572.

Oil revenue for the nine months ended September 30, 2014 was $650,391, compared to $822,862 for the nine months ended September 30, 2013. This decrease of $172,471 represented a 21% decrease during the first nine months of 2014 from the same period in 2013.  The Morse #1-H well had a decrease of $174,360 in period to period revenue, which is attributable to the overall decline of 1,617 Bbls in its production rates in the comparable periods.
 

Gas revenue for the nine months ended September 30, 2014 was $745,435, compared to $410,741 for the nine months ended September 30, 2013.  This 81% increase of $334,694 in gas revenue was primarily a result of a 54% increase in production volume, as well as an 18% increase in the average gas sales price. There was an increase in gas production revenue of $184,253 from the Haggard A well during the nine months ended September 30, 2014, primarily due to the increase in our interest in the well following the completion of title work during the second quarter of 2014.  In addition, for the nine months ended September 30, 2014, there was an increase of $143,881 in gas production revenue on the Haggard B well due to the buyout in May 2014 of one of our investor’s working interest in this well. We received a realized sales price of $4.33 per MCF for the nine months ended September 30, 2014, compared to $3.67 for the same period in 2013.

Transportation and gathering revenue increased $61,076 to $209,156 for the nine months ended September 30, 2014, compared to $148,080 for the nine months ended September 30, 2013, resulting from increased pipeline volumes and increased charges per MCF.  

Condensate and skim oil sales amounted to $19,210 and $41,782 for the nine months ended September 30, 2014 and September 30, 2013, respectively. Condensate and skim oil are by-products from drilling and are only sold when a sufficient amount has been collected, resulting in fluctuations from period to period.
 
Expenses:  Total operating expenses for the nine months ended September 30, 2014 were $6,592,888, compared to $3,437,606 for the nine months ended September 30, 2013.  This increase of $3,155,282 was primarily due to increased general and administrative expenses resulting from non-cash stock-based compensation expenses incurred during the nine months ended September 30, 2014.

·  
General and Administrative Expenses:  There was a $3,033,532 increase in general and administrative expenses, to $5,327,373 for the nine months ended September 30, 2014 from $2,293,841 for the nine months ended September 30, 2013. The primary reason for the increase was stock-based compensation expense of $3,353,344 incurred during the nine months ended September 30, 2014, compared to only $524,144 in stock-based compensation expense incurred in the nine months ended September 30, 2013, an increase of $2,829,200. The compensation expense resulted from the issuance of stock options to selected employees, executives, and directors, as well as a term modification of certain previously issued stock options.

In addition, investor relations consulting fees of $264,750 were incurred during the nine months ended September 30, 2014, whereas only $35,500 of such fees was incurred during the nine months ended September 30, 2013.  We engaged an investor relations firm in late March 2014 to assist us with the implementation and maintenance of ongoing programs to increase the investment community’s awareness of our activities and to stimulate their interest in our company. 

·  
Pipeline Operating Expense:  Total pipeline operating expenses for the nine months ended September 30, 2014 were $202,836 compared to $147,537 for the nine months ended September 30, 2013.  The increase of $55,299 was primarily the result of increased production volumes, which required an additional compressor.

·  
Depletion and Depreciation Expense: Total depletion and depreciation for the nine months ended September 30, 2014 was $437,065, compared to $383,970 for the nine months ended September 30, 2013.  The increase in expense was primarily a consequence of increased gross production, which resulted from an increase in our share of production due to the completion of title work on the Haggard A well and the May 2014 buyout agreement of an investor’s working interest in the Haggard B well.

Other Income (Expenses):  Total other expenses for the nine months ended September 30, 2014 were $3,124,236, compared to $480,428 for the nine months ended September 30, 2013, resulting in an increase of $2,643,808.  The primary reason for the increase was a warrant modification expense of $2,642,266 incurred during the nine months ended September 30, 2014, whereas no such expense was incurred during the same period in 2013.  This expense was incurred in connection with a warrant modification offer to investors that closed on March 31, 2014.  Certain investors agreed to modify the terms of their warrants, whereby the expiration date was extended for three years in exchange for agreeing to increase the exercise price.   

Income Tax Expense:  No income tax expense was incurred during the nine months ended September 30, 2014, whereas we recognized a net income tax expense of $3,515 for state franchise taxes during the nine months ended September 30, 2013.  

Net Loss:  As a result of the above described revenue and expenses, we incurred a net loss of $8,092,932 for the nine months ended September 30, 2014, as compared to a net loss of $2,498,084 for the nine months ended September 30, 2013.


Liquidity and Capital Resources

We held $962,310 in cash at September 30, 2014, made up of a majority of our cash accounts. We held $2,467,761 in cash at December 31, 2013, made up of a majority of our cash accounts. However, at that date, several cash accounts had an overdraft that totaled $255,628, resulting in net cash of $2,212,133. The overall decrease in cash was due to cash used in operating activities, which exceeded funds received from sales of our common stock and cash used in investing activities, including purchases of oil and gas mineral leases.

Cash Flows

The following table summarizes our cash flows for the nine months ended September 30, 2014 and 2013:
 
   
2014
   
2013
 
Total cash provided by (used in):
           
Operating activities
 
$
(1,049,808)
   
$
1,164,422
 
Investing activities
   
(892,645
)
   
(1,719,412
)
Financing activities
   
437,002
     
279,682
 
Decrease in cash and cash equivalents
 
$
(1,505,451
)
 
$
(275,308
)
 
Cash provided by (used in) Operating Activities:  For the nine months ended September 30, 2014, cash used by operating activities was $1,049,808, compared to $1,164,422 provided by operating activities for the nine months ended September 30, 2013, resulting in a decrease in cash provided by operating activities of $2,214,230. 

The net loss of $8,092,932 for the nine months ended September 30, 2014 represented an increase of $5,594,848 from the net loss of $2,498,084 for the nine months ended September 30, 2013.

Non-cash expense items for the nine months ended September 30, 2014 totaled $6,656,647, an increase of $5,687,362 from $969,285 in non-cash expense items for the nine months ended September 30, 2013.  This increase is for the reasons set forth below.
 
Non-cash expense for stock-based compensation increased by $2,829,200, to $3,353,344 during the nine months ended September 30, 2014, from $524,144 incurred during the nine months ended September 30, 2013.  This compensation expense resulted from the issuance of stock options to selected employees, executives, and directors as incentive for continuing our development, as well as a modification of the expiration term on certain options.  In addition, there was a warrant modification expense of $2,642,266 for the extension of select warrant terms during the nine months ended September 30, 2014, whereas no such expense was incurred for the nine months ended September 30, 2013. We also incurred $198,250 in non-cash expense for stock issued to consultants for the nine months ended September 30, 2014, whereas such expense was only $35,500 in the nine months ended in September 30, 2013.  Depletion and depreciation expense increased $53,095 to $437,065 for the nine months ended September 30, 2014, compared to $383,970 for the nine months ended September 30, 2013, primarily as a consequence of increased production.
 
Operating assets increased by $43,747 in the nine months ended September 30, 2014, compared to a decrease of $1,431,215 for the nine months ended September 30, 2013, resulting in a change of $1,474,962. Approximately $1,208,424 of this change is a result of a decrease of $39,993 in joint interest billing receivables from related parties in the nine months ended September 30, 2014, compared to a decrease of $1,248,417 in the nine months ended September 30, 2013.  Joint interest billings receivable decreased $32,011 in the nine months ended September 30, 2014, compared to a decrease of $224,344 for the nine months ended September 30, 2013, resulting in a change of approximately $192,333.  The decrease in both the related party receivables and joint interest billings receivable was due to payments received from working interest owners during the nine months ended September 30, 2013. Trade account receivables increased by $113,104 in the nine months ended September 30, 2014, whereas they only increased $55,272 in the nine months ended September 30, 2013, resulting in a change from period to period of $57,832. The increase during the nine months ended September 30, 2014 was due to our higher working interest from the completion of title work and the buyout agreement previously mentioned.  The remaining changes in operating assets of approximately $16,373 consisted of changes in other assets.

Operating liabilities increased by $430,224 during the nine months ended September 30, 2014, compared to an increase of $1,262,006 for the nine months ended September 30, 2013, resulting in a change in cash flow of $831,782. Accounts payable decreased $84,470 for the nine months ended September 30, 2014, resulting in a change in cash flow of $207,622 from the $123,152 increase in the nine months ended September 30, 2013. Accounts payable to related parties increased by $395,749 during the nine months ended September 30, 2014, compared to an increase of $345,057 for the same period in 2013, resulting in a change in cash flow of $50,692.  Revenue payable decreased $341,552 for the nine months ended September 30, 2014, compared to an increase of $281,521 during the nine months ended September 30, 2013, resulting in a change in cash flow of $623,073.  Revenue payable decreased following the completion of title opinion and the distribution to royalty owners of revenue previously held in a suspense account. The remaining changes in other operating liabilities resulted in a decrease in cash flow by approximately $51,779 in the nine months ended September 30, 2014, compared to the nine months ended September 30, 2013.
 

Cash used in Investing Activities:  For the nine months ended September 30, 2014, cash used in investing activities was $892,645, compared to $1,719,412 for the nine months ended September 30, 2013, resulting in a change in cash flow of $826,767. We spent $852,797 on purchases of mineral leases and additional drilling and completion costs during the nine months ended September 30, 2014, compared to $1,707,435 spent in the nine months ended September 30, 2013 on the completion of the Haggard A and the Morse #1-H wells, as well as the purchase of mineral leases, resulting in a change in cash flow of $854,638. We spent $39,769 on property and equipment during the nine months ended September 30, 2014, compared to $11,893 for the nine months ended September 30, 2013, resulting in a change in cash flow of $27,876.  

Cash provided by Financing Activities:  For the nine months ended September 30, 2014, cash provided by financing activities totaled $437,002, compared to $279,682 for the nine months ended September 30, 2013, resulting in an increase in cash flow of $157,320. During the nine months ended September 30, 2014, we received $694,900 in net proceeds from the sale of units of common stock and warrants, compared to $245,000 received in the nine months ended September 30, 2013, resulting in a change in cash flow of $449,900. We reduced our cash overdraft by $255,628 in the nine months ended September 30, 2014, whereas we increased it by $35,915 during the nine months ended September 30, 2013, resulting in a change in cash flow of $291,543.

Sources of Liquidity

Production revenue has not been sufficient to finance our operating expenses; therefore, we have had to raise capital in recent years to fund our activities. Planned lease acquisitions and exploration, development, production and marketing activities, as well as administrative requirements (such as salaries, insurance expenses, general overhead expenses, legal compliance costs and accounting expenses) will require a substantial amount of additional capital and cash flow.

We expect that additional funds raised from future financing activities will be needed to finance our operations for the next twelve months.  The extent of our drilling program in 2015 is dependent on our ability to raise additional capital.  There are no guarantees that we will be able to raise additional funds on terms acceptable to us, if at all.  We will also consider farm-out agreements, whereby we would lease parts of our properties to other operators for drilling purposes and we would receive payment based on the production.  

We are actively pursuing sources of additional capital through various financing transactions or arrangements, including farm-outs, joint venturing of projects, debt financing, equity financing and other means.

Off Balance Sheet Arrangements

We do not have any off balance sheet arrangements that are reasonably likely to have a current or future effect on our consolidated financial condition, revenue, results of operations, liquidity, or capital expenditures.

Critical Accounting Policies
 
Our critical accounting policies, including the assumptions and judgments underlying them, are disclosed in the notes to consolidated financial statements which accompany the consolidated financial statements.  The notes to consolidated financial statements, which would substantially duplicate the disclosures required in our 2013 annual consolidated financial statements, have been omitted. These policies have been consistently applied in all material respects and address such matters as revenue recognition and depreciation methods.  The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the recorded amounts of revenue and expenses during the reporting period.  Actual results could differ from these estimates. 
 
Accounts Receivable

We perform ongoing credit evaluations of our customers’ financial condition and extend credit to virtually all of our customers.  Collateral is generally not required, nor is interest charged on past due balances.  Credit losses to date have not been significant and have been within management’s expectations.  In the event of complete non-performance by our customers, our maximum exposure is the outstanding accounts receivable balance at the date of non-performance.
 
 
Property and Equipment

Property and equipment are stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets, which range from five to thirty-nine years.  Expenditures for major renewals and betterments that extend the useful lives are capitalized.  Expenditures for normal maintenance and repairs are expensed as incurred.  Upon the sale or abandonment, the cost of the equipment and related accumulated depreciation are removed from the accounts and any gains or losses thereon are recognized in the operating results of the respective period.

Oil and Gas Properties

We use the full-cost method of accounting for our oil and gas producing activities, which are all located in Texas.  Accordingly, all costs associated with the acquisition, exploration, and development of oil and gas reserves, including directly-related overhead costs, are capitalized.

All capitalized costs of oil and gas properties, including the estimated future costs to develop proved reserves, are amortized on the units-of-production method using estimates of proved reserves.  Investments in unproved properties and major development projects are not amortized until proved reserves associated with the projects can be determined or until impairment occurs.  If the results of an assessment indicate that the properties are impaired, the amount of the impairment will be added to the capitalized costs to be amortized.
 
In addition, the capitalized costs are subject to a “ceiling test,” which limits such costs to the aggregate of the “estimated present value,” discounted at a ten percent interest rate, of future net revenue from proved reserves, based on current economic and operating conditions, plus the lower of cost or fair market value of unproved properties and less the income tax effects related to the properties. 
 
Sales of proved and unproved properties are accounted for as adjustments of capitalized costs with no gain or loss recognized, unless such adjustments would significantly alter the relationship between capitalized costs and proved reserves of oil and gas, in which case the gain or loss is recognized in the operating results of the respective period.
  
Fair Value of our Debt and Equity Instruments

Many of our various debt and equity transactions require us to determine the fair value of a debt or equity instrument in order to properly record the transaction in our consolidated financial statements.  Fair value is generally determined by applying widely acceptable valuation models, (e.g. the Black Scholes model) using the trading price of the underlying instrument or by comparison to instruments with comparable maturities and terms.
 
Revenue Recognition

We utilize the accrual method of accounting for crude oil and natural gas revenue, whereby revenue is recognized based on our net revenue interest in the wells.  Crude oil inventories are immaterial and are not recorded.

Gas imbalances are accounted for using the entitlement method.  Under this method, revenue is recognized only to the extent of our proportionate share of the gas sold.  However, we have no history of significant gas imbalances.

Income Taxes

Deferred income taxes are determined using the “liability method” in accordance with FASB ASC Topic No. 740, Income Taxes.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.
 
Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which such temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the operating results of the period that includes the enactment date.  In addition, a valuation allowance is established to reduce any deferred tax asset for which it is determined that it is more likely than not that some portion of the deferred tax asset will not be realized.

Recently Issued Accounting Pronouncements

In May 2014, the FASB issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which supersedes nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-09 is to recognize revenue when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing GAAP.
 

The standard is effective for annual periods beginning after December 15, 2016, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). We are currently evaluating the impact of adoption of ASU 2014-09 on our consolidated financial statements and have not yet determined the method we will adopt by which to implement the standard.  We are studying the new standard and starting to evaluate and determine the impact the new standard will have on the timing of revenue recognition under our customer agreements. We cannot, however, provide any estimate of the impact of adopting the new standard at this time.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Not required under Regulation S-K for “smaller reporting companies.”

ITEM 4.  CONTROLS AND PROCEDURES.

(a) Evaluation of disclosure controls and procedures.

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934 as of the end of the period covered by this Quarterly Report on Form 10-Q. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.

Based on our evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as a result of the material weakness described below, as of September 30, 2014, our disclosure controls and procedures are not designed at a reasonable assurance level and are ineffective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.  The material weakness, which relates to internal control over financial reporting, that was identified is: 

 
a)  
Due to our small size, we do not have a proper segregation of duties in certain areas of our financial reporting process.  The areas where we have a lack of segregation of duties include cash receipts and disbursements, approval of purchases and approval of accounts payable invoices for payment. This control deficiency, which is pervasive in nature, results in a reasonable possibility that material misstatements of the consolidated financial statements will not be prevented or detected on a timely basis.

We are committed to improving our financial organization.  When funds are available, we will take the following action to enhance our internal controls: Hiring additional knowledgeable personnel with technical accounting expertise to further support our current accounting personnel, which management estimates will cost approximately $100,000 per annum.  As our operations are relatively small and we continue to have net cash losses each quarter, we do not anticipate being able to hire additional internal personnel until such time as our operations are profitable on a cash basis or until our operations are large enough to justify the hiring of additional accounting personnel.  We currently engage an outside accounting firm to assist us in the preparation of our consolidated financial statements and anticipate doing so until we have a sufficient number of internal accounting personnel to achieve compliance. As necessary, we will engage consultants in the future in order to ensure proper accounting for our consolidated financial statements.

Due to the fact that our internal accounting staff consists solely of a Chief Financial Officer, additional personnel will also ensure the proper segregation of duties and provide more checks and balances within the department. Additional personnel will also provide the cross training needed to support us if personnel turn over issues within the department occur. We believe this will greatly decrease any control and procedure issues we may encounter in the future.

(b) Changes in internal control over financial reporting.

There were no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 
PART II – OTHER INFORMATION
 
ITEM 1. LEGAL PROCEEDINGS.

From time to time, we may become involved in various lawsuits and legal proceedings which arise in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business. We are currently not aware of any such legal proceedings or claims that we believe will have, individually or in the aggregate, a material adverse effect on our business, consolidated financial condition, or operating results.

ITEM 1A. RISK FACTORS.

Not required under Regulation S-K for “smaller reporting companies.”

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

On July 1, 2014, we issued 50,000 shares of common stock to a consultant for services rendered. The shares were issued pursuant an exemption under Section 4(a)(2) of the securities Act of 1933, as amended.

On July 28, 2014, we issued 7,970 shares of common stock to an investor holding 2011 Warrants who exercised 7,970 warrants for proceeds of $4,782.  The shares were issued pursuant an exemption under Section 4(a)(2) of the securities Act of 1933, as amended.


None.

ITEM 4. MINE SAFETY DISCLOSURES.

None.

ITEM 5. OTHER INFORMATION.

None.

ITEM 6.  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.




101 INS
XBRL Instance Document

101 SCH
XBRL Taxonomy Extension Schema Document
 
101 CAL
XBRL Taxonomy Calculation Linkbase Document
 
101 LAB
XBRL Taxonomy Labels Linkbase Document
 
101 PRE
XBRL Taxonomy Presentation Linkbase Document

101 DEF
XBRL Taxonomy Extension Definition Linkbase Document



In accordance with the requirements of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


 
PEGASI ENERGY RESOURCES CORPORATION
 
     
Date: November 13, 2014
By: /s/ MICHAEL NEUFELD
 
 
Michael Neufeld
 
 
Chief Executive Officer
 
     
Date: November 13, 2014
By: /s/ JONATHAN WALDRON
 
 
Jonathan Waldron
 
 
Chief Financial Officer
 



 
 
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