Pegasi Energy Resources Corporation. - FORM 10-Q

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EX-31.01 - EX-31.01 - Pegasi Energy Resources Corporation.	ex31-01.htm
EX-31.02 - EX-31.02 - Pegasi Energy Resources Corporation.	ex31-02.htm
EX-32.01 - EX-32.01 - Pegasi Energy Resources Corporation.	ex32-01.htm
EXCEL - IDEA: XBRL DOCUMENT - Pegasi Energy Resources Corporation.	Financial_Report.xls

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2015

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 May 8, 2015.

Table of Contents

TABLE OF CONTENTS

		Page
PART I – FINANCIAL INFORMATION

Item 1.	Financial Statements	3
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	23
Item 4.	Controls and Procedures	23

PART II – OTHER INFORMATION

Item 1.	Legal Proceedings	25
Item 1A.	Risk Factors	25
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	25
Item 3.	Defaults Upon Senior Securities	25
Item 4.	Mine Safety Disclosures	25
Item 5.	Other Information	25
Item 6.	Exhibits	25

Signatures		26

Table of Contents

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PEGASI ENERGY RESOURCES CORPORATION

CONSOLIDATED BALANCE SHEETS

	March 31,			December 31,
	2015			2014
Assets	(Unaudited)
Current assets:
Cash and cash equivalents	$	1,402,440		$	373,506
Accounts receivable, trade		188,075			385,334
Accounts receivable, related parties		44,502			40,002
Joint interest billing receivable, related parties, net		32,458			58,727
Joint interest billing receivable, net		22,381			17,280
Other current assets		31,400			36,963
Total current assets		1,721,256			911,812

Property and equipment:
Equipment		67,435			67,435
Pipelines		981,340			981,933
Leasehold improvements		7,022			7,022
Vehicles		28,563			56,174
Office furniture		89,961			89,961
Total property and equipment		1,174,321			1,202,525
Less accumulated depreciation		(550,449	)		(557,160	)
Property and equipment, net		623,872			645,365

Crude oil and natural gas properties:
Costs subject to amortization		22,057,791			21,391,472
Costs not subject to amortization		11,774,866			12,337,167
Total crude oil and natural gas properties		33,832,657			33,728,639
Less accumulated amortization		(2,546,600	)		(2,468,546	)
Crude oil and natural gas properties, net		31,286,057			31,260,093

Other assets:
Restricted cash – drilling program		258,432			347,129
Deferred financing costs		81,251			10,000
Certificates of deposit		78,691			78,665
Easements		34,848			34,848
Total other assets		453,222			470,642

Total assets	$	34,084,407		$	33,287,912

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

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PEGASI ENERGY RESOURCES CORPORATION

CONSOLIDATED BALANCE SHEETS (continued)

	March 31,			December 31,
	2015			2014
	(Unaudited)
Liabilities and Stockholders' Equity
Current liabilities:
Cash overdraft	$	12,906		$	5,673
Accounts payable		788,485			999,554
Accounts payable, related parties		3,567,123			3,450,175
Revenue payable		370,679			460,618
Interest payable, related party		3,083,237			2,923,980
Liquidated damages payable		51,016			48,808
Other payables		27,020			40,780
Convertible note payables, net		740,361			-
Current portion of notes payable and capital leases		4,953			6,740
Notes payable, related party		8,160,646			8,160,646
Total current liabilities		16,806,426			16,096,974

Drilling prepayments		258,432			347,129
Notes payable and capital leases		2,019			2,493
Asset retirement obligations		903,510			891,092
Total liabilities		17,970,387			17,337,688

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 70,539,499 shares issued and outstanding, respectively		70,540			70,540
Additional paid-in capital		55,209,385			52,894,835
Accumulated deficit		(39,165,905	)		(37,015,151	)
Total stockholders' equity		16,114,020			15,950,224

Total liabilities and stockholders' equity	$	34,084,407		$	33,287,912

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

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PEGASI ENERGY RESOURCES CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

	Three Months
	Ended March 31,
	2015			2014
Revenues:
Crude oil and natural gas	$	156,589		$	484,781
Condensate and skim oil		4,608			9,189
Transportation and gathering		35,734			70,958
Total revenues		196,931			564,928

Operating expenses:
Lease operating expense		161,752			209,151
Pipeline operating expenses		65,517			57,662
Amortization and depreciation		98,955			132,212
General and administrative		660,731			3,857,168
Total operating expenses		986,955			4,256,193
Loss from operations		(790,024	)		(3,691,265	)

Other income (expense):
Interest income		26			26
Interest expense		(923,353	)		(158,680	)
Warrant modification expense		(439,550	)		(2,642,266	)
Other income (expense), net		2,147			(1,845	)
Total other expense, net		(1,360,730	)		(2,802,765	)

Loss from operations before income tax expense		(2,150,754	)		(6,494,030	)

Income tax expense		-			-

Net loss	$	(2,150,754	)	$	(6,494,030	)

Basic and diluted loss per share:
Basic and diluted loss per share	$	(0.03	)	$	(0.09	)

Weighted average shares outstanding – basic and diluted		70,539,499			68,751,130

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

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PEGASI ENERGY RESOURCES CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

	Three Months Ended March 31,
	2015			2014
Operating Activities
Net loss	$	(2,150,754	)	$	(6,494,030	)
Adjustments to reconcile net loss to net cash used in operating activities:
Amortization and depreciation		98,955			132,212
Accretion of discount on asset retirement obligations		12,418			8,968
Stock based compensation		-			3,091,270
Common stock issued for consulting services		-			72,000
Gain on sale of equipment		(4,100	)		-
Interest expense related to convertible note		763,535			-
Warrant modification expense		439,550			2,642,266
Changes in operating assets and liabilities:
Accounts receivable, trade		197,259			(63,675	)
Account receivable, related parties		(4,500	)		(4,500	)
Joint interest billing receivable, related parties, net		26,269			105,393
Joint interest billing receivable, net		(5,101	)		(112,963	)
Other current assets		5,563			(1,660	)
Accounts payable		(152,244	)		139,572
Accounts payable, related parties		116,948			135,302
Revenue payable		(89,939	)		115,244
Interest payable, related parties		159,257			158,079
Liquidated damages payable		2,208			1,850
Other payables		(13,760	)		2,127
Net cash used in operating activities		(598,436	)		(72,545	)

Investing Activities
Additions to certificates of deposit		(26	)		(26	)
Purchases of property and equipment		-			(8,373	)
Proceeds from sale of property and equipment		4,693			-
Purchase of oil and gas properties		(162,844	)		(485,557	)
Net cash used in investing activities		(158,177	)		(493,956	)

Financing Activities
Payments on notes payable and capital leases		(2,261	)		(2,110	)
Cash overdraft		7,233			(255,592	)
Proceeds from convertible notes		1,875,000			-
Deferred financing costs on convertible note		(94,425	)		-
Proceeds from sale of common stock, net of offering costs		-			694,900
Net cash provided by financing activities		1,785,547			437,198

Net increase (decrease) in cash and cash equivalents		1,028,934			(129,303	)
Cash and cash equivalents at beginning of period		373,506			2,467,761
Cash and cash equivalents at end of period	$	1,402,440		$	2,338,458

See Note 5 for supplemental cash flow and non-cash information.

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

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PEGASI ENERGY RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2015 AND 2014

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 focus is on the development of a repeatable, low-geological risk, high-potential project in the active East Texas oil and gas region. The Company’s business strategy is to identify and exploit resources in and adjacent to existing or indicated producing areas within the mature Rodessa oil field. The Company believes that it is uniquely familiar with the history and geology of the project area based on its collective experience in the region as well as through its development and ownership of a large proprietary database, which details the drilling history of the project area since 1980. In 2012, the Company drilled the Morse #1-H well targeting the Bossier formation and completed it using hydraulic fracture stimulation techniques. The Morse #1-H is the first such horizontal well completed in the Rodessa field and the Company believes that implementing the latest proven drilling and completion techniques to exploit its geological insight in the Cornerstone Project area will enable it to find significant crude oil and natural gas reserves.

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, 2014, and notes thereto, which are included in the Company’s annual report on Form 10-K filed with the SEC on April 3, 2015. 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 2014 annual consolidated financial statements, have been omitted.

b) Going Concern

The Company has incurred operating losses for over seven years and has negative cash flows from operations. It also has an accumulated deficit of $39,165,905 as of March 31, 2015. As a result, the Company’s continuation as a going concern is dependent on its ability to obtain additional financing until it can generate sufficient cash flows from operations to meet its debt and working capital obligations.

These financial statements have been prepared on a going concern basis, which implies the Company will continue to meet its obligations and continue its operations for the next fiscal year. The continuation of the Company as a going concern is dependent upon its ability to obtain necessary debt or equity financing to continue operations until it begins generating positive cash flow. There is no assurance that financing will be available to the Company when needed or, if available, or that it can be obtained on commercially reasonable terms. Considering its financial condition, the Company may be forced to issue debt or equity at less favorable terms than would otherwise be available.

Although the Company raised net proceeds of $1.78 million in the first quarter of 2015, if the Company is not able to obtain additional or alternative financing on a timely basis and is unable to generate sufficient revenues and cash flows, it will be unable to meet its capital requirements and will be unable to continue as a going concern. The financial statements do not include any adjustments to reflect that may be necessary if the Company is unable to continue as a going concern.

c) 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.

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PEGASI ENERGY RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2015 AND 2014

d) 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 March 31, 2015 and March 31, 2014, the Company recognized $-0- and $3,091,270, 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.

e) 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 months ended March 31, 2015 and 2014, the Company had potentially dilutive shares of 69,133,437 and 50,452,205, respectively, that were excluded from the earnings per share calculation because their impact would be anti-dilutive. For the three months ended March 31, 2015 and 2014, the diluted loss per share is the same as basic loss per share, as the effect of common stock equivalents is anti-dilutive.

f) 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.

g) Certificates of Deposit

Certificates of deposit have been posted as collateral supporting a reclamation bond guaranteeing remediation of our crude oil and natural gas properties in Texas. As of March 31, 2015 and December 31, 2014, the balance of the certificates of deposit totaled $78,691 and $78,665, respectively.

h) 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). Recently, the FASB voted to propose a one-year deferral of the effective date while at the same time permitting entities to adopt the standard on the original effective date if they choose. If the deferral is approved, the standard will be effective for interim and annual periods beginning after December 15, 2017. 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.

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PEGASI ENERGY RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2015 AND 2014

In April 2015, the FASB issued Accounting Standards Update No. 2015-03, Interest – Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs (“ASU 2015-03”). ASU 2015-03 seeks, in part, “to identify, evaluate, and improve areas of GAAP for which cost and complexity can be reduced, while maintaining or improving the usefulness of the information provided to users of the financial statements”. ASU No. 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discount, however, the recognition and measurement guidance for debt issuance costs are not affected. This standard is effective for fiscal years beginning after December 15, 2015 for public business entities, and interim periods within those fiscal years. Management is currently evaluating the impact of the pending adoption of ASU 2015-03 on the Company’s consolidated financial statements

3. SENIOR SECURED CONVERTIBLE NOTES

In January 2015, the Company entered into securities purchase agreements (the “Securities Purchase Agreement”) with certain accredited investors (“Investors”) whereby the Company issued and sold to the Investors 12% Senior Secured Convertible Notes (“Notes”) in the aggregate amount of $875,000 and warrants (“Warrants”) to purchase up 2,430,555 shares of the Company’s common stock.

To secure the Company’s obligations under the Notes, the Company granted the Investors a security interest in certain assets of Pegasi Energy Resources Corporation, as Texas corporation and one of the Company’s subsidiaries (“Pegasi Texas”) pursuant to a Deed of Trust, Mortgage, Security Agreement, Financing Statement and Assignment of Production, as amended (the “Security Agreement”). In addition, pursuant to a guarantee (the “Guarantee”), Pegasi Texas agreed to guarantee the punctual payment, as and when due and payable, of all amounts owed by the Company in respect of the Securities Purchase Agreement, the Notes and the other transaction documents executed in connection with the Securities Purchase Agreement. As well, the Company granted the Investors certain registration rights pursuant to a registration rights agreement, pursuant to which the Company is obligated to file a registration statement registering for resale the common stock issuable upon conversion of the Notes and exercise of the Warrants no later than May 9, 2015 (the “Registration Rights Agreement”). The obligation to file a registration statement was met on May 7, 2015.

On March 27, 2015, the Company entered into an omnibus amendment agreement (the “Amendment”) with the Investors pursuant to which, among other things:

·	The Company and the Investors amended the Securities Purchase Agreement to extend the Additional Investment Period until March 31, 2015, to increase the Warrant ratio from 33% to 100% and allowed for up to $1 million of Additional Securities to be sold;

The Company and the Investors amended the Notes to increase the minimum conversion price from $0.05 to $0.09, to require payments (including prepayments) to principal and interest to be on a pro rata basis, to provide for additional consideration to the Investors upon the Company’s failure to timely process conversion requests, and to increase the maximum beneficial ownership limitation from 9.99% to 19.99%;

·	The Company and the Investors amended the Warrants to provide for cashless exercise at any time, to increase the maximum beneficial ownership limitation from 9.99% to 19.99%, and to provide for additional consideration to the Investors upon the Company’s failure to timely process exercise notices;

·	The Company and the Investors amended the Registration Rights Agreement to clarify the liquidated damages due upon a default by the Company; and

·	The Company issued all the Investors additional Warrants (the “Consideration Warrants”) to purchase 4,861,116 shares of common stock, so that the Warrants, together with the Consideration Warrants, equaled the new Warrant ratio of 100%.

On March 27, 2015, the Company entered into a securities purchase agreement with an accredited investor, pursuant to which the Company issued and sold to the investor a $1,000,000 Note and Warrants to purchase 8,333,334 shares of common stock (the “Subsequent Investment”). In connection therewith, the Guarantee was amended and restated to include the Subsequent Investment and the Company covenanted to file an amendment to the Security Agreement to include the Subsequent Investment. To date, in connection with the offering, the Company sold Notes in the aggregate principal amount of $1,875,000 and Warrants (including Consideration Warrants) to purchase 15,625,005 shares of common stock, resulting in net proceeds of approximately $1.78 million.

The Notes are due upon written demand of Investors holding a majority in interest of outstanding Notes, provided, however, that such demand cannot be made prior to January 9, 2016 and will bear interest at the rate of 12% per annum.

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PEGASI ENERGY RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2015 AND 2014

The Notes are convertible, in whole or in part, into shares of the Company’s common stock at the option of the investor, at the lower of (i) $0.12 or (ii) the higher of (x) $0.09 or (y) the volume weighted average price of our common stock for the 10 trading days immediately preceding the date of conversion, subject to adjustment upon certain events, as set forth in the Note. The discount attributable to the fair value of the beneficial conversion feature was $740,361, which represents the residual value remaining after determining the fair value of the Warrants. Because the Notes are convertible any time at the option of the Investor, the discount for the beneficial conversion feature has been recognized in full as interest expense and recorded as general and administrative expense in the consolidated statements of operations.

The Company has the right, at any time after the date that the Registration Statement is declared effective, to redeem some or all of the outstanding Notes, upon 30 days prior written notice. If the Notes are redeemed prior to the first anniversary of issuance, the redemption price shall equal 110% of the amount of principal and interest being redeemed.

The Warrants are exercisable, at the option of the investor, for seven (7) years after issuance, in whole or in part, at an exercise price equal to the lower of (i) $0.132 or (ii) the higher of (x) $0.06 or (y) 110% of the volume weighted average price of the Company’s common stock for the 10 trading days immediately preceding the date of exercise, subject to adjustment upon certain events, as set forth in the Warrant. The discount attributable to the fair value of the Warrants is $1,134,639 and was calculated using a Black-Scholes option pricing model. The discount will be amortized through January 9, 2016, which is the date that the Notes are first due upon written demand of the Investors. The amortization expense will be recorded as interest expense in the consolidated statements of operations beginning in the quarter ending June 30, 2015.

4. 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.

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 March 31, 2015:

	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	$	-	$	-	$	903,510	$	903,510

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PEGASI ENERGY RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2015 AND 2014

The following table sets forth our estimate of fair value of our financial instruments that are liabilities as of December 31, 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	$	-	$	-	$	891,092	$	891,092

The following table sets forth a summary of changes in fair value of our asset retirement obligation during the three months ended March 31, 2015 and 2014:

	2015		2014
Beginning Balance - January 1,	$	891,092	$	674,092
Accretion expense		12,418		8,968
Liabilities settled		-		(8,261	)
Revisions to estimates		-		36,142
Balance at March 31,	$	903,510	$	710,941

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 debt approximates market value due to the use of market interest rates.

5. SUPPLEMENTAL CASH FLOW AND NON-CASH INFORMATION

The following non-cash transactions were recorded during the quarter ended March 31:

	2015		2014

Oil and gas assets financed through account payables	$	76,301	$	323,207

Asset retirement obligation settled	$	-	$	27,881

Discount on convertible debt related to the fair value of warrants issued	$	1,134,639	$	-

The following is supplemental cash flow information for the quarter ended March 31:

	2015		2014
Cash paid during the period for interest	$	561	$	601
Cash paid during the period for taxes	$	-	$	-

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PEGASI ENERGY RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2015 AND 2014

6. 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.

Stock Options Forfeited

During the three months ended March 31, 2015, there were forfeited stock options for 516,093 shares of common stock due to termination of employment and/or death of optionee of various option holders according to the terms of their respective stock option agreements.

There were no options granted and vested during the three months ended March 31, 2015.

A summary of option activity during the three months ended March 31, 2015 is as follows:

	Options			Weighted Average Exercise Price
Outstanding at December 31, 2014		16,750,000		$	0.66
Options granted		-			-
Options forfeited		(516,093	)		0.49
Outstanding at March 31, 2015		16,233,907		$	0.67

A summary of stock options outstanding as of March 31, 2015 is as follows:

Exercise Price		Options Outstanding		Remaining Contractual Lives (Years)		Options Exercisable
$	0.65		900,000		1.76		900,000
$	0.42		806,190		1.76		806,190
$	0.50		283,306		1.76		283,306
$	0.55		363,636		1.76		363,636
$	0.50		616,600		3.77		616,600
$	0.79		7,000,000		3.77		7,000,000
$	0.55		3,000,000		3.77		3,000,000
$	0.50		264,175		3.77		264,175
$	0.66		3,000,000		3.77		3,000,000
			16,233,907				16,233,907

Based on the Company's stock price of $0.19 at March 31, 2015, the options outstanding had an intrinsic value of $0. Based on the Company’s stock price of $0.80 at March 31, 2014, the options outstanding had an intrinsic value of $2,211,579.

Total options exercisable at March 31, 2015 amounted to 16,233,907 shares and had a weighted average exercise price of $0.67. 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.

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PEGASI ENERGY RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2015 AND 2014

7. WARRANTS OUTSTANDING

Warrants Modified

In connection with the Senior Secured Convertible Notes issued on March 27, 2015, as described in footnote 3 above, the Company entered into the Amendment with the Investors, to amend the Securities Purchase Agreement to increase the Warrant ratio from 33% to 100%.

The Company issued all the Investors additional Warrants (the “Consideration Warrants”) to purchase 4,861,116 shares of common stock, so that the Warrants, together with the Consideration Warrants, equaled the new warrant ratio of 100%. The consideration warrants were issued as of March 27, 2015 and have a seven year term. There was no change in the exercise price formula from the original agreement or in the term of the warrants. However, in accordance with the Amendment as described in Footnote 3, the warrants are now exercisable on a cashless basis at all times.

The modification resulted in warrant modification expense of $439,550, which was recorded in the quarter ended March 31, 2015. 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. The following table details the significant assumptions used to compute the fair market value of the warrant modifications:

	Before				After
Risk free rates	1.679 %	to	1.683	%	1.679 %	to	1.730	%
Dividend yield	0 %				0 %
Expected volatility	100.85 %	to	100.94	%	100.85 %	to	102.90	%
Remaining term (years)	6.795 years	to	6.808 years		6.795 years	to	7.000 years

	Warrants			Shares Issuable Under Warrants			Weighted Average Exercise Price
Outstanding at December 31, 2014		16,459,619			19,679,649		$	0.80
Warrants cancelled under modification		(2,430,555	)		(2,430,555	)		0.13
Warrants issued under modification		9,722,226			9,722,226			0.13
Warrants issued		8,333,334			8,333,334			0.13
Warrants exercised		-			-			-
Outstanding at March 31, 2015		32,084,624			35,304,654		$	0.49

The outstanding warrants at March 31, 2015 had an intrinsic value of $1,046,875. All of the 32,084,624 warrants outstanding at March 31, 2015 are exercisable and expire at various dates between September 2015 and March 2022.

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PEGASI ENERGY RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2015 AND 2014

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 natural 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 March 31, 2015 and December 31, 2014 and for the three months ended March 31, 2015 and 2014:

	Three Months Ended March 31,
	2015			2014
Business segment revenue:
Crude oil and natural gas	$	156,589		$	484,781
Condensate and skim oil		4,608			9,189
Transportation and gathering		35,734			70,958
Total revenues	$	196,931		$	564,928

Business segment profit (loss):
Crude oil and natural gas	$	(84,084	)	$	163,179
Condensate and skim oil		4,608			9,189
Transportation and gathering		(60,662	)		(13,768	)
General corporate		(649,886	)		(3,849,865	)
Loss from operations	$	(790,024	)	$	(3,691,265	)

Amortization and depreciation:
Crude oil and natural gas	$	78,921		$	112,451
Transportation and gathering		17,570			16,787
General corporate		2,464			2,974
Total amortization and depreciation	$	98,955		$	132,212

	Three Months Ended March 31,
	2015		2014
Capital expenditures:
Crude oil and natural gas	$	104,018	$	291,372
Transportation and gathering		-		4,052
General corporate		-		4,321
Total capital expenditures	$	104,018	$	299,745

	March 31,		December 31,
	2015		2014
Business segment assets:
Crude oil and natural gas	$	32,891,327	$	31,791,516
Transportation and gathering		661,241		697,075
General corporate		531,839		799,321
Total assets	$	34,084,407	$	33,287,912

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PEGASI ENERGY RESOURCES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2015 AND 2014

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 March 31, 2015, management reevaluated the status of the registration statement and determined an accrual of $51,016 was sufficient to cover any potential payments for liquidated damages and the related accrued interest. The damages are reflected as liquidated damages payable of $51,016 and $48,808 in the accompanying consolidated balance sheets as of March 31, 2015 and December 31, 2014, respectively. The difference of $2,208 was recorded as expense in the Other Income (Expense) section of the consolidated statements of operations.

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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. The Rodessa oil field has to date produced over 400 million barrels of crude oil and 2.3 trillion cubic feet of natural gas from over 2,000 producing wells. 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. We believe that implementing the latest proven drilling and completion techniques to exploit our geological insight in this mature oil field will enable us to develop significant crude oil and natural gas resources that were not amenable to development with the technology available to earlier developers.

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 May 1, 2015, our leasehold position is approximately 23,460 gross acres and 6,695 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.

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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 natural gas and condensate bearing Travis Peak, the crude oil and natural gas bearing upper Cotton Valley sands, the crude oil bearing Bossier sands and the crude oil bearing Cotton Valley Limestone. Approximately 62% of our net leased acreage is currently undeveloped (approximately 4,183 undeveloped net acres of a total of 6,695 net acres as of May 1, 2015).

Horizontal Wells Targeting the Bossier/Cotton Valley Limestone. Our priority is to drill horizontal wells targeting the Bossier/Cotton Valley Limestone. The low permeability crude 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 five‐stage 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 subsequently decreased and we recorded an average production rate of 13 Bbl/day of crude oil during March 2015. The decrease in the production rate has been irregular and we have observed several instances of unexpected, sustained surges in production, typically resulting in a doubling of production volume 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 believe that the successful production of crude oil from the Morse #1-H, which has produced a cumulative total of approximately 43,250 Bbls of crude oil through May 1, 2015, supports our development strategy for the Bossier/Cotton Valley Limestone. We have gained a substantial amount of knowledge and experience 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 or more frack stages to improve the well economics. We estimate that the drilling and completion costs of such wells will be approximately $7 million. We are not currently capitalized to drill a program of such wells and are actively engaged in seeking the necessary finance 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 natural gas and condensate. In August 2014, we concluded a participation agreement with Pacific World Energy (“PWE”) for the drilling of up to 10 wells on our leased acreage in Marion County. On October 1, 2014, we spudded the first vertical well of this program, the Huntington #4. Drilling reached a final depth of 9,300 feet, production casing of 4 ½” was set and cemented at 9,300 feet 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. In light of the precipitous decline in energy prices, PWE postponed completion of the well in the first quarter. Having now analyzed the drilling results and with energy prices recovering, we have renewed discussion of the completion procedure for this well with PWE.

Consolidated Results of Operations

Three Months Ended March 31, 2015 Compared to Three Months Ended March 31, 2014

Summarized Consolidated Results of Operations


	2015			2014			(Decrease)
Total revenues	$	196,931		$	564,928		$	(367,997	)
Total operating expenses		986,955			4,256,193			(3,269,238	)
Loss from operations		(790,024	)		(3,691,265	)		(2,901,241	)
Total other expenses, net		(1,360,730	)		(2,802,765	)		(1,442,035	)
Net loss	$	(2,150,754	)	$	(6,494,030	)	$	(4,343,276	)

Revenues: Total revenues for the quarter ended March 31, 2015 were $196,931, compared to $564,928 for the quarter ended March 31, 2014. The decrease of $367,997 in total revenues for the quarter ended March 31, 2015 as compared to the quarter ended March 31, 2014 was primarily driven by falling energy prices and declining production volumes resulting in a decrease of $179,368 in crude oil revenue and a decrease of $148,824 in natural gas revenue, compounded by a $35,224 decrease in transportation and gathering revenue.

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Crude oil revenue for the quarter ended March 31, 2015 was $65,863, compared to $245,231 for the quarter ended March 31, 2014. The $179,368 decrease represented a 73% decline in crude oil revenue, which was driven by a 42% decrease in crude oil volume and a 54% decline in the realized crude oil sales price from $95.37 per barrel for the quarter ended March 31, 2014 to $44.27 per barrel for the quarter ended March 31, 2015. The primary reasons for the decline in crude oil volume between the quarters ended March 31, 2014 and 2015 were:

·	The production rate of the Morse #1-H well declined from 2014 to 2015, resulting in a net decrease of $75,539 in crude oil revenue; and

·	The Haggard A and Huntington 1 wells had minimal production during the quarter ended March 31, 2015 due to work-overs being performed, but those wells generated $54,005 in crude oil revenue during the quarter ended March 31, 2014.

Natural gas revenue for the quarter ended March 31, 2015 was $90,726, compared to $239,550 for the quarter ended March 31, 2014. This decrease of $148,824 was due to a 44% decrease in the realized natural gas price and a 32% decrease in natural gas volume. We received a realized sales price of $4.90 per MCF for the quarter ended March 31, 2014 compared to $2.73 per MCF for the quarter ended March 31, 2015. The production rates of the Haggard A and Huntington 1 wells declined for the comparative quarters due to work-overs during the quarter ended March 31, 2015, resulting in decreases in natural gas revenue of $132,497 and $29,060, respectively. These decreases were somewhat offset by small increases in the production rates of other wells.

Expenses: Total operating expenses for the quarter ended March 31, 2015 were $986,955, compared to $4,256,193 for the quarter ended March 31, 2014. This change was primarily a result of decreases in general and administrative expenses, together with small decreases in lease operating expenses and amortization and depreciation expenses.

General and Administrative Expense: There was a $3,196,437 decrease in general and administrative expense to $660,731 for the quarter ended March 31, 2015, from $3,857,168 for the quarter ended March 31, 2014, primarily due to a decrease of $3,091,270 in stock-based compensation. There was an issuance of stock-based compensation in the quarter ended March 31, 2014, but no stock-based compensation in the quarter ended March 31, 2015. The compensation resulted from the issuance of stock options to selected employees, executives, and directors as well as a modification of certain outstanding options granted under our stock option plans to extend the expiration date.

In addition, investor relations consulting fees of $112,000 were incurred for the quarter ended March 31, 2014, whereas no such expense was recorded for the same period in 2015. These decreases were offset by an increase of $52,944 in investor funding expenses during the quarter ended March 31, 2015, which were incurred in connection with the convertible note financing. There was no such expense recorded for the same period in 2014.

Lease Operating Expense: Total lease operating expense for the quarter ended March 31, 2014 was $209,151, compared to $161,752 for the quarter ended March 31, 2015. The decrease of $47,399 in lease operating expense is primarily the result of the decline in sales prices and volume of production. Marketing charges and production taxes are dependent on production volumes and energy prices, as well as some of the other lease operating expenses. Two of our strongest producing wells in the first quarter of 2014, the Morse #1-H and the Haggard A, whose production significantly decreased in the first quarter of 2015, had an aggregate decrease in lease operating expenses of $28,858 from the comparative quarter in 2014. In addition, the Fee #675 well had $19,014 in lease operating expenses for workover costs in the quarter ended March 31, 2014, whereas its costs for comparable quarter in 2015 were only $8,462, resulting in a decrease of $10,552.

·	Amortization and Depreciation Expense: Total amortization and depreciation for the quarter ended March 31, 2015 was $98,955, compared to $132,212 for the quarter ended March 31, 2014. The decrease of $33,257 was largely a consequence of the reduced rate of production.

Other Income (Expenses): Total other expenses for the quarter ended March 31, 2014 was $2,802,765, compared to $1,360,730 for the quarter ended March 31, 2015, representing a decrease of $1,442,035. The primary reason for the decrease was warrant modification expense of $2,642,266 incurred in the first quarter of 2014, whereas the warrant modification expense was $439,550 in the first quarter of 2015, resulting in a decrease of $2,202,716. During the first quarter of 2014, a warrant modification offer to investors of warrants issued in 2011 through 2013 was closed on March 31, 2014. This warrant modification extended the expiration terms of their warrants by three years in exchange for an increase in the exercise price of the warrants. The warrant modification offer in the first quarter of 2015 was only to investors that acquired warrants in January 2015, and the warrant modification resulted in the issuance of additional warrants in exchange for modifying certain terms of the transaction documents relating to the January 2015 financing. This decrease was offset by an increase in interest expense of $740,361 in the quarter ended March 31, 2015, resulting from the immediate expensing of the discount for the beneficial conversion feature associated with the convertible debt financing. There was no such corresponding interest expense in the quarter ended March 31, 2014.

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Net Loss: As a result of the above described revenues and expenses, we incurred a net loss of $2,150,754 for the quarter ended March 31, 2015, as compared to a net loss of $6,494,030 for the quarter ended March 31, 2014.

Liquidity and Capital Resources

We held $1,402,440 in cash at March 31, 2015, and net cash of $1,389,534 after an overdraft of $12,906 was deducted. By comparison, we held $373,506 in cash at December 31, 2014, which when netted against an overdraft of $5,673, gave us net cash of $367,833. The increase in cash was a consequence of obtaining new financing during the quarter ended March 31, 2015.

Going Concern Consideration

In their report dated April 3, 2015, our independent registered public accounting firm stated that our financial statements for the year ended December 31, 2014 were prepared assuming that we would continue as a going concern. Our ability to continue as a going concern is an issue raised due to incurring operating losses for several years and having negative cash flows from operations. In addition, we have an accumulated deficit of $39,165,905 as of March 31, 2015 and require additional financing to fund future operations. Our financial statements contain additional note disclosures describing the circumstances that led to this disclosure.

Our operations have not been sufficient to generate cash flow to fund operations and we have financed our activities using equity and debt financings and drilling participations. Our cash flow from operations is sensitive to the prices paid for our crude oil and natural gas as well as to the quantities of crude oil and natural gas we sell. Our ability to continue as a going concern is subject to our ability to obtain necessary funding from outside sources, including obtaining additional funding from the sale of our securities or obtaining loans from various financial institutions, where possible. Our continued net operating losses increase the difficulty in meeting such goals and there can be no assurances that such methods will prove successful. While we continually look for additional financing sources, in the current economic environment the procurement of outside funding is difficult and there can be no assurance that such financing will be available on terms acceptable to us, if at all.

Cash Flows

The following table summarizes our cash flows for the three months ended March 31, 2015 and 2014:

	2015			2014
Total cash provided by (used in):
Operating activities	$	(598,436	)	$	(72,545	)
Investing activities		(158,177	)		(493,956	)
Financing activities		1,785,547			437,198
Increase (decrease) in cash and cash equivalents	$	1,028,934		$	(129,303	)

Cash Used in Operating Activities: For the quarter ended March 31, 2015, cash used by operating activities was $598,436, compared to $72,545 used by operating activities for the quarter ended March 31, 2014, resulting in an increase in cash used by operations of $525,891.

The net loss of $2,150,754 for the quarter ended March 31, 2015 was a decrease of $4,343,276 from the net loss of $6,494,030 for the quarter ended March 31, 2014. Non-cash income and expense decreased by $4,636,358, to $1,310,358 for the quarter ended March 31, 2015, from $5,946,716 for the quarter ended March 31, 2014.

Non-cash expense incurred for stock-based compensation decreased to $0 for the quarter ended March 31, 2015, from $3,091,270 for the quarter ended March 31, 2014. The compensation resulted from the issuance of stock options to selected employees, executives, and directors as well as a modification of certain outstanding options granted under our stock option plans to extend the expiration date. There was a warrant modification expense of $2,642,266 for the extension of select warrant terms during the quarter ended March 31, 2014, compared to a warrant modification expense of $439,550 during the quarter ended March 31, 2015. The Company incurred $72,000 in non-cash expense for stock issued to consultants for the quarter ended March 31, 2014, whereas no such expense was incurred in the first quarter of 2015. Amortization and depreciation expense decreased by $33,257, from $132,212 for the quarter ended March 31, 2014, to $98,955 for the quarter ended March 31, 2015, primarily as a consequence of lower production volumes. Interest expense related to convertible note financing of $763,535 was incurred for the quarter ended March 31, 2015 and was due to the immediate expensing of the discount for the beneficial conversion feature and amortization of the deferred financing costs. There was no such interest expense or amortization for the quarter ended March 31, 2014.

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In the quarter ended March 31, 2015, operating assets decreased by $219,490, compared to an increase of $77,405 for the quarter ended March 31, 2014, resulting in an improvement in cash flow of $296,895. Related party receivables decreased $26,269 in the quarter ended March 31, 2015, compared to a decrease of $105,393 for the quarter ended March 31, 2014, resulting in a decrease of $79,124 in cash flows. Joint interest billings receivable increased $5,101 in the quarter ended March 31, 2015, compared to an increase of $112,963 in the quarter ended March 31, 2014, increasing the quarter on quarter cash flow by approximately $107,862. Trade accounts receivable decreased by $197,259 in 2015, whereas it increased by $63,675 in 2014, improving the cash flow comparison by $260,934. The remaining changes in operating assets consisted of changes in accounts receivable, related parties and other assets, which decreased by approximately $1,063 in the first quarter 2015, compared to an increase of $6,160 in the corresponding period in 2014.

Operating liabilities increased by $22,470 for the quarter ended March 31, 2015, compared to an increase of $552,174 for the quarter ended March 31, 2014, resulting in a deterioration in cash flow of $529,704. Revenue payable decreased $89,939 for the quarter ended March 31, 2015, compared to a $115,244 increase during the quarter ended March 31, 2014. Accounts payable decreased by $152,244 for the quarter ended March 31, 2015, compared to an increase of $139,572 during the quarter ended March 31, 2014. The remaining changes in other operating liabilities resulted in an increase in liabilities of $264,653 in the first quarter of 2015, compared to an increase of $297,358 in the first quarter of 2014. These consisted of increases in interest payable, related parties of $159,257, accounts payable, related parties of $116,948, and liquidated damages payable of $2,208, offset by decreases in other payables of $13,760, resulting in a decline in cash flow of $32,705.

Cash Used in Investing Activities: For the quarter ended March 31, 2015, cash used in investing activities was $158,177, compared to $493,956 for the quarter ended March 31, 2014, representing a decrease of $335,779. We spent $162,844 during the quarter ended March 31, 2015 on purchases of mineral leases, compared to $485,557 spent during the quarter ended March 31, 2014, resulting in a decrease of $322,713. In addition, there were no purchases of property and equipment during the quarter ended March 31, 2015, while there was $8,373 spent on the purchases of property and equipment during the quarter ended March 31, 2014.

Cash Provided by Financing Activities: For the quarter ended March 31, 2015, cash provided by financing activities totaled $1,785,547, compared to $437,198 for the quarter ended March 31, 2014, resulting in an increase of $1,348,349. In the first quarter of 2015, we received $1,780,575 in net proceeds from the sale of convertible notes, whereas no such financing occurred in first quarter of 2014. In the quarter ended March 31, 2015, no proceeds were received from the sale of common stock and warrants, whereas in the quarter ended March 31, 2014, we received $694,900 in net proceeds from the sale of units of common stock and warrants. The remaining change in cash provided by financing activities for the quarter ended March 31, 2014 was primarily a result of a change in the cash overdraft. There was an increase of $7,233 in our cash overdrafts for the quarter ended March 31, 2015, whereas in the quarter ended March 31, 2014, there was a $255,592 decrease in our cash overdrafts, resulting in an increase of $262,825 in cash flow.

Sources of Liquidity

Production revenues have 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 required 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 and our participation partners providing funding as required. 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.

First Quarter 2015 Financing

In January 2015, we entered into securities purchase agreements (the “Securities Purchase Agreement”) with certain accredited investors (“Investors”) whereby we issued and sold to the Investors 12% Senior Secured Convertible Notes (“Notes”) in the aggregate amount of $875,000 and warrants (“Warrants”) to purchase up to 2,430,555 shares of our common stock.

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On March 27, 2015, we entered into an omnibus amendment agreement (the “Amendment”) with the Investors pursuant to which, among other things:

·	We and the Investors amended the Securities Purchase Agreement to extend the Additional Investment Period until March 31, 2015, to increase the Warrant ratio from 33% to 100% and allowed for up to $1 million of Additional Securities to be sold;

We and the Investors amended the Notes to increase the minimum conversion price from $0.05 to $0.09, to require payments (including prepayments) to principal and interest to be on a pro rata basis, to provide for additional consideration to the Investors upon our failure to timely process conversion requests, and to increase the maximum beneficial ownership limitation from 9.99% to 19.99%;

·	We and the Investors amended the Warrants to provide for cashless exercise at any time, to increase the maximum beneficial ownership limitation from 9.99% to 19.99%, and to provide for additional consideration to the Investors upon our failure to timely process exercise notices;

·	We and the Investors amended the Registration Rights Agreement to clarify the liquidated damages due upon a default by us; and

·	We issued all the Investors additional Warrants (the “Consideration Warrants”) to purchase 4,861,116 shares of common stock, so that the Warrants, together with the Consideration Warrants, equaled the new Warrant ratio of 100%.

On March 27, 2015, we entered into a securities purchase agreement with an accredited investor, pursuant to which we issued and sold to the investor a $1,000,000 Note and Warrants to purchase 8,333,334 shares of common stock (the “Subsequent Investment”). In connection therewith, the Guarantee was amended and restated to include the Subsequent Investment and we covenanted to file an amendment to the Security Agreement to include the Subsequent Investment. In connection with the financing, we sold Notes in the aggregate principal amount of $1,875,000 and Warrants (including Consideration Warrants) to purchase 15,625,005 shares of common stock, resulting in net proceeds of approximately $1.78 million.

The Notes are convertible, in whole or in part, into shares of our common stock at the option of the investor, at the lower of (i) $0.12 or (ii) the higher of (x) $0.09 or (y) the volume weighted average price of our common stock for the 10 trading days immediately preceding the date of conversion, subject to adjustment upon certain events, as set forth in the Note.

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 2014 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.

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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.

Crude Oil and Natural Gas Properties

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

All capitalized costs of crude oil and natural 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 crude oil and natural 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.

Natural 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 natural gas sold. However, we have no history of significant natural 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.

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Recently Issued Accounting Pronouncements

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). Recently, the FASB voted to propose a one-year deferral of the effective date while at the same time permitting entities to adopt the standard on the original effective date if they choose. If the deferral is approved, the standard will be effective for interim and annual periods beginning after December 15, 2017. 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.

In April 2015, the FASB issued Accounting Standards Update No. 2015-03, Interest – Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs (“ASU 2015-03”). ASU 2015-03 seeks, in part, “to identify, evaluate, and improve areas of GAAP for which cost and complexity can be reduced, while maintaining or improving the usefulness of the information provided to users of the financial statements”. ASU No. 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discount, however, the recognition and measurement guidance for debt issuance costs are not affected. This standard is effective for fiscal years beginning after December 15, 2015 for public business entities, and interim periods within those fiscal years. We are currently evaluating the impact of the pending adoption of ASU 2015-03 on our consolidated financial statements.

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 March 31, 2015, 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:

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.

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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 March 31, 2015 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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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

During the quarter ended March 31, 2015, we sold Notes in the aggregate principal amount of $1,875,000 and Warrants (including Consideration Warrants) to purchase 15,625,005 shares of common stock, resulting in net proceeds of approximately $1.78 million. The securities described above were offered and sold in reliance on Section 4(a)(2) of the Securities Act of 1933 or Rule 506 of Regulation D promulgated thereunder.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. MINE SAFETY DISCLOSURES

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

31.01

Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.02

Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.01

Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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

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SIGNATURES

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: May 15, 2015	By: /s/ MICHAEL NEUFELD
	Michael Neufeld
	Chief Executive Officer

Date: May 15, 2015	By: /s/ JONATHAN WALDRON
	Jonathan Waldron
	Chief Financial Officer

Pegasi Energy Resources Corporation. - FORM 10-Q - May 15, 2015

Attached files

Pegasi Energy Resources Corporation. Reports