ITEM 1. BUSINESS
Petrol Oil and Gas, Inc. was incorporated in the State of Nevada in March of 2000 as Euro Technology Outfitters. On August 19, 2002 we acquired approximately 289 oil and gas mineral leases from Petrol Energy, and concurrently changed our name to Petrol Oil and Gas, Inc. Our common stock trades on the over-the-counter securities market through the National Association of Securities Dealers Automated Quotation Bulletin Board System, under the trading symbol "POIG".
At December 31, 2007, the Company had long term debt (including the current portion of long term debt) of approximately $26.7 million. Approximately $15 million of this debt was utilized to develop the Coal Creek Project, which has contributed no significant revenue to the Company. As a result, the Company's cash position has seriously declined. On October 28, 2007, the Company was required to make a principal payment of approximately $1.1 million on a portion of its long term debt. The Company did not have adequate cash to make such principal payment and is currently in default under the terms of the note for this long term debt.
On April 9, 2008, the Company's debt was declared in default and accelerated by the lenders, LV Administrative Services, Inc. ("LV"), administrative and collateral agent for Laurus Master Fund, Ltd. ("Laurus"), Valens Offshore SPV I, Ltd. ("Valens Offshore"), Valens U.S. SPV I, LLC ("Valens US"), Calliope Capital Corporation ("Calliope") and Pallas Production Corp. ("Pallas", and together with, Laurus, Valens Offshore, Valens US and Calliope, the "Holders").
On April 30, 2008, the Company entered into a Foreclosure-Related Agreement (the "Foreclosure Agreement") with LV and the Holders. The aggregate amount due and owing to the Holders as of April 30, 2008 was approximately $35.7 million.
The outstanding obligations are secured by various mortgages and other fixed and mixed assets and real and personal property pursuant to security and other agreements covering assets or other rights to which the Company has rights (all such assets, rights and collateral, collectively, the "Collateral"), a portion of which are assets and rights referred to as the "Petrol-Neodesha Project," located in Neosho and Wilson Counties, Kansas, consisting of, among other Collateral, mortgages, and real, personal property and fixed and mixed assets used in connection with the Petrol-Neodesha Project (the "Neodesha Collateral").
The Agreement allows the Holders to foreclose on the Neodesha Collateral and governs the terms and conditions of the foreclosure. The Agreement provides that the Company will not contest the sale of the Neodesha Collateral, which will be conducted as a public foreclosure sale in accordance with Kansas law. The Company has agreed to reasonably assist LV and the Holders in the completion of the foreclosure sale. After the sale of the Neodesha Collateral becomes final, LV and the Holders will release Petrol of all remaining amounts owed or claims they may have, and the Holders will reassign to Petrol their overriding royalty interests in the mineral leases located at the Company 's Coal Creek Project.
As part of the Agreement, the Company will cancel all outstanding warrants for purchases of securities issued to Holders in connection with the Outstanding Obligations and replace them with warrants to purchase 1,000,000 shares of common stock at an initial exercise price of $0.20 per share.
The foreclosure by LV and the Holders described above will leave the Company with far fewer assets than it currently has. There can be no assurance that the Company will be able to continue operations and satisfy its obligations in the future.
Business of Issuer
We are an oil and gas exploration, development and production company. Our properties are located in the Cherokee and Forrest Basins along the Kansas and Missouri border. Our corporate strategy has been to build value through the development and acquisition of gas and oil assets that exhibit consistent, predictable, and long-lived production, with a focus on Coal Bed Methane ("CBM") reservoirs in the central U.S. In prior periods, we have described five separate projects of the Company. Two of those projects, the Pomona Project and the Missouri Project have been abandoned and the leases covering those projects have expired. We have segregated our current operations into three separate projects, which include:
Petrol-Neodesha Project
Our gas producing leases known as Petrol-Neodesha, in the Neosho and Wilson counties, account for approximately 10,000 of the Company's total of approximately 56,000 gross leased acres. However, this project produces substantially all of the Company's gas production. As discussed above, this project will be subject to foreclosure by our lenders pursuant to the Foreclosure Agreement.
The Petrol-Neodesha Project includes over 100 CBM production wells, 8 saltwater disposal wells ("SWD Wells") wells and a fully contained and integrated gas gathering pipeline and gas processing system. At this time, we have suspended our development plan for the Petrol-Neodesha Project and have discontinued lease acquisitions in the area due a shortage of funds. The Petrol-Neodesha properties have provided us with the bulk of our revenue stream and value in proven producing reserves and therefore represent the most valuable group of assets of the Company. However, if we do not resume development of these properties, we expect to see revenues decline as existing wells mature and experience production declines.
Coal Creek Project
The Coal Creek Project, centered in Coffey County, Kansas, includes leases covering about 46,000 gross acres. Leases for the Coal Creek Project covering approximately 46,000 gross acres have recently expired. The Company has invested approximately $15 million in the Coal Creek Project for the construction of a gathering system and the drilling and completion of over 50 CBM wells. Of these wells, only four wells are producing natural gas, and only one of these is producing CBM. Total production from these wells is minimal. Due to a number of technical issues with the wells and the geology, it is doubtful that significant production will ever be obtained from these properties. The Company does not currently plan to drill any additional CBM wells in the Coal Creek Project.
The Company doubts that the Coal Creek Project will at any time in the future contribute to the Company's revenues to any significant extent. The Company is currently evaluating whether there are exploration and development opportunities for oil or conventional natural gas from the leases acquired for the Coal Creek Project.
The Company is currently evaluating the cost of plugging and abandoning the wells drilled on the Coal Creek Project and the salvage value of the assets located on that project.
Oil Field Project
Petrol currently holds a 100% working interest in several oil producing properties in eastern Kansas that produced approximately 4,744 barrels of oil (bbl) during 2007 (3,819 bbl net to Petrol). The oil producing wells on these properties and in the surrounding areas are generally defined as stripper wells and usually produce under the influence of a water flood. Most of the leases that comprise this project were sold in September 2007.
Gas Purchase and Sale Agreement
To reduce our exposure to unfavorable changes in natural gas prices we utilize energy swaps in order to have a fixed-price contract. These contracts allow us to be able to predict with greater certainty the effective natural gas prices to be received for hedged production and benefit operating cash flows and earnings when market prices are less than the fixed prices provided under the contracts. However, we will not benefit from market prices that are higher than fixed prices in contracts for hedged production. If we are unable to provide the quantity that we have contracted for we will have to go to the open market to purchase the required amounts that we have contracted to provide.
In 2005, Petrol entered into contracts with Seminole Energy Services LLC to sell 60,000 mmbtu per month for the period of March 2005 to February 2006 at various fixed prices with the overall average price of $5.99. Additionally, Petrol had contracts with Virginia Power to sell certain of its gas production through March 2007 at various fixed prices with the overall average price of $8.13.
From April 2007 through March 2008 Petrol has agreed to sell approximately 30,500 mmbtu at an average sales price of $7.32. The remainder of Petrol's gas sales will be at current market price.
Governmental Regulations
Regulation of Oil and Natural Gas Production. Our oil and natural gas exploration, production and related operations, when developed, are subject to extensive rules and regulations promulgated by federal, state, tribal and local authorities and agencies. For example, some states in which we may operate require permits for drilling operations, drilling bonds and reports concerning operations and impose other requirements relating to the exploration and production of oil and natural gas. Such states may also have statutes or regulations addressing conservation matters, including provisions for the unitization or pooling of oil and natural gas properties, the establishment of maximum rates of production from wells, and the regulation of spacing, plugging and abandonment of such wells. Failure to comply with any such rules and regulations can result in substantial penalties. The regulatory burden on the oil and gas industry will most likely increase our cost of doing business and may affect our profitability. Although we believe we are currently in substantial compliance with all applicable laws and regulations, because such rules and regulations are frequently amended or reinterpreted, we are unable to predict the future cost or impact of complying with such laws. Significant expenditures may be required to comply with governmental laws and regulations and may have a material adverse effect on our financial condition and results of operations.
Federal Regulation of Natural Gas. The Federal Energy Regulatory Commission ("FERC") regulates interstate natural gas transportation rates and service conditions, which may affect the marketing of natural gas produced by us, as well as the revenues that may be received by us for sales of such production. Since the mid-1980's, FERC has issued a series of orders, culminating in Order Nos. 636, 636-A and 636-B ("Order 636"), that have significantly altered the marketing and transportation of natural gas. Order 636 mandated a fundamental restructuring of interstate pipeline sales and transportation service, including the unbundling by interstate pipelines of the sale, transportation, storage and other components of the city-gate sales services such pipelines previously performed. One of FERC's purposes in issuing the order was to increase competition within all phases of the natural gas industry. The United States Court of Appeals for the District of Columbia Circuit largely upheld Order 636 and the Supreme Court has declined to hear the appeal from that decision. Generally, Order 636 has eliminated or substantially reduced the interstate pipelines' traditional role as wholesalers of natural gas in favor of providing only storage and transportation service, and has substantially increased competition and volatility in natural gas markets.
The price we may receive from the sale of oil and natural gas liquids will be affected by the cost of transporting products to markets. Effective January 1, 1995, FERC implemented regulations establishing an indexing system for transportation rates for oil pipelines, which, generally, would index such rates to inflation, subject to certain conditions and limitations. We are not able to predict with certainty the effect, if any, of these regulations on our intended operations. However, the regulations may increase transportation costs or reduce well head prices for oil and natural gas liquids.
Environmental Matters
Our operations and properties subject to extensive and changing federal, state and local laws and regulations relating to environmental protection, including the generation, storage, handling, emission, transportation and discharge of materials into the environment, and relating to safety and health. The recent trend in environmental legislation and regulation generally is toward stricter standards, and this trend will likely continue. These laws and regulations may:
o require the acquisition of a permit or other authorization before construction or drilling commences and for certain other activities;
o limit or prohibit construction, drilling and other activities on certain lands lying within wilderness and other protected areas; and
o impose substantial liabilities for pollution resulting from our operations.
The permits required for our operations may be subject to revocation, modification and renewal by issuing authorities. Governmental authorities have the power to enforce their regulations, and violations are subject to fines or injunctions, or both. In the opinion of management, we are in substantial compliance with current applicable environmental laws and regulations, and have
no material commitments for capital expenditures to comply with existing environmental requirements. Nevertheless, changes in existing environmental laws and regulations or in interpretations thereof could have a significant impact on us, as well as the oil and natural gas industry in general.
The Comprehensive Environmental, Response, Compensation, and Liability Act ("CERCLA") and comparable state statutes impose strict, joint and several liability on owners and operators of sites and on persons who disposed of or arranged for the disposal of "hazardous substances" found at such sites. It is not uncommon for the neighboring land owners and other third parties to file claims for personal injury and property damage allegedly caused by the hazardous substances released into the environment. The Federal Resource Conservation and Recovery Act ("RCRA") and comparable state statutes govern the disposal of "solid waste" and "hazardous waste" and authorize the imposition of substantial fines and penalties for noncompliance. Although CERCLA currently excludes petroleum from its definition of "hazardous substance," state laws affecting our operations may impose clean-up liability relating to petroleum and petroleum related products. In addition, although RCRA classifies certain oil field wastes as "non-hazardous," such exploration and production wastes could be reclassified as hazardous wastes thereby making such wastes subject to more stringent handling and disposal requirements.
The Endangered Species Act ("ESA") seeks to ensure that activities do not jeopardize endangered or threatened animal, fish and plant species, nor destroy or modify the critical habitat of such species. Under ESA, exploration and production operations, as well as actions by federal agencies, may not significantly impair or jeopardize the species or its habitat. ESA provides for criminal penalties for willful violations of the Act. Other statutes that provide protection to animal and plant species and that may apply to our operations include, but are not necessarily limited to, the Fish and Wildlife Coordination Act, the Fishery Conservation and Management Act, the Migratory Bird Treaty Act and the National Historic Preservation Act. Although we believe that our operations will be in substantial compliance with such statutes, any change in these statutes or any reclassification of a species as endangered could subject us to significant expenses to modify our operations or could force us to discontinue certain operations altogether.
Competition
We compete with numerous other oil and gas exploration companies. Many of these competitors have substantially greater resources than we do. Should a larger and better financed company decide to directly compete with us, and be successful in its competitive efforts, our business could be adversely affected.
Personnel
We currently have eight full time employees and three part time employees as well as up to twelve contract personnel that support and operate our field operations. As drilling production activities increase, we intend to hire additional technical, operational and administrative personnel as appropriate. None of our employees are subject to any collective bargaining agreements.
Available Information. Our Internet website address is www.petroloilandgas.com. Information contained on our website is not part of this report on Form 10-K. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K filed with (or furnished to) the Securities and Exchange Commission (SEC) are available on our Internet website (in the "Investor Relations" section), free of charge, as soon as reasonably practicable after we file or furnish such material. Our governance documents are available in print to any stockholder that makes a written request to the Secretary of the Corporation at Corporate Woods, Building 51, 9393 West 110th Street, Suite 500, Overland Park, Kansas 66210.
ITEM 1A.
ITEM 1A. RISK FACTORS
Risks Associated with Laurus Funds Financing
We have substantial indebtedness to Laurus Master Fund, Ltd. which is secured by substantially all of our assets. We are in default on the secured notes issued to Laurus Funds, and Laurus Funds plans to foreclose on our Neodesha Project assets, which constitute most of the valuable assets of the Company.
On April 9, 2008, the Company's debt was declared in default and accelerated by the Company's lenders, LV and the Holders. On April 30, 2008, the Company entered into a Foreclosure Agreement with LV and the Holders. The aggregate amount due and owing to the Holders as of April 30, 2008 was approximately $35.7 million. The outstanding obligations are secured by various
mortgages and other fixed and mixed assets and real and personal property pursuant to security and other agreements covering assets or other rights to which Petrol has rights (all such assets, rights and collateral, collectively, the "Collateral"), a portion of which are assets and rights referred to as the "Petrol-Neodesha Project," located in Neosho and Wilson Counties, Kansas, consisting of, among other Collateral, mortgages, and real, personal property and fixed and mixed assets used in connection with the Petrol-Neodesha Project (the "Neodesha Collateral").
The Foreclosure Agreement allows the Holders to foreclose on the Neodesha Collateral and governs the terms and conditions of the foreclosure. The Agreement provides that Petrol will not contest the sale of the Neodesha Collateral, which will be conducted as a public foreclosure sale in accordance with Kansas law. Petrol has agreed to reasonably assist LV and the Holders in the completion of the foreclosure sale. After the sale of the Neodesha Collateral becomes final, LV and the Holders will release Petrol of all remaining amounts owed or claims they may have, and the Holders will reassign to Petrol their overriding royalty interests in the mineral leases located at Petrol's Coal Creek Project.
The foreclosure by LV and the Holders described above will leave the Company with far fewer assets than it currently has. There can be no assurance that the Company will continue operations and be able to satisfy its obligations in the future.
Risks Associated with Oil and Gas Operations
Because we face uncertainties in estimating proven recoverable natural gas reserves, you should not place undue reliance on such reserve information.
This Form 10-K contains estimates of natural gas reserves, and the future net cash flows attributable to those reserves, prepared by McCune Engineering, our independent petroleum and geological engineer. There are numerous uncertainties inherent in estimating quantities of proved reserves and cash flows from such reserves, including factors beyond our control and the control of McCune Engineering. Reserve engineering is a subjective process of estimating underground accumulations of natural gas and oil that cannot be measured in an exact manner. The accuracy of an estimate of quantities of reserves, or of cash flows attributable to these reserves, is a function of the available data; assumptions regarding future natural gas and oil prices; expenditures for future development and exploitation activities; and engineering and geological interpretation and judgment. Reserves and future cash flows may also be subject to material downward or upward revisions based upon production history, development and exploitation activities and natural gas and oil prices. Actual future production, revenue, taxes, development expenditures, operating expenses, quantities of recoverable reserves and value of cash flows from those reserves may vary significantly from the assumptions and estimates in this Form 10-K. Any significant variance from these assumptions to actual figures could greatly affect our estimates of reserves, the economically recoverable quantities of natural gas attributable to any particular group of properties, the classification of reserves based on risk of recovery, and estimates of the future net cash flows. In addition, reserve engineers may make different estimates of reserves and cash flows based on the same available data. The estimated quantities of proved reserves and the discounted present value of future net cash flows attributable to those reserves included in this Form 10-K were prepared by McCune Engineering in accordance with the rules of the SEC, and are not intended to represent the fair market value of such reserves.
The present value of future net cash flows from our proved reserves is not necessarily the same as the current market value of our estimated natural gas reserves. We base the estimated discounted future net cash flows from our proved reserves on prices and costs. However, actual future net cash flows from our natural gas and oil properties also will be affected by factors such as:
o geological conditions; o changes in governmental regulations and taxation; o assumptions governing future prices; o the amount and timing of actual production; o availability of funds; o future operating and development costs; and o capital costs of drilling new wells.
The timing of both our production and our incurrence of expenses in connection with the development and production of natural gas properties will affect the timing of actual future net cash flows from proved reserves, and thus their actual present value. In addition, the 10% discount factor we use when calculating discounted future net cash flows may not be the most appropriate discount factor based on interest rates in effect from time to time and risks associated with us or the natural gas and oil industry in general.
The SEC permits natural gas companies, in their filings with the SEC, to disclose only proved reserves that a company has demonstrated by actual production or conclusive formation tests to be economically and legally producible under existing economic and operating conditions. The SEC's guidelines strictly prohibit us from including "probable reserves" and "possible reserves" in filings with the SEC. We also caution you that the SEC views such "probable" and "possible" reserve estimates as inherently unreliable and these estimates may be seen as misleading to investors unless the reader is an expert in the natural gas industry. Unless you have such expertise, you should not place undo reliance on these estimates. Potential investors should also be aware that such "probable" and "possible" reserve estimates will not be contained in any "resale" or other registration statement filed by us that offers or sells shares on behalf of purchasers of our common stock and may have an impact on the valuation of the resale of the shares. We undertake no duty to update this information and does not intend to update the information.
Drilling wells is speculative, often involving significant costs that may be more than our estimates, and may not result in any addition to our production or reserves. Any material inaccuracies in drilling costs, estimates or underlying assumptions will materially affect our business.
Developing and exploring for natural gas and oil involves a high degree of operational and financial risk, which precludes definitive statements as to the time required and costs involved in reaching certain objectives. The budgeted costs of drilling, completing and operating wells are often exceeded and can increase significantly when drilling costs rise due to a tightening in the supply of various types of oilfield equipment and related services. Drilling may be unsuccessful for many reasons, including title problems, weather, cost overruns, equipment shortages and mechanical difficulties. Moreover, the successful drilling of a natural gas or oil well does not ensure a profit on investment. Exploratory wells bear a much greater risk of loss than development wells. A variety of factors, both geological and market-related, can cause a well to become uneconomical or only marginally economic. Our initial drilling and development sites, and any potential additional sites that may be developed, require significant additional exploration and development, regulatory approval and commitments of resources prior to commercial development. Any success that we may have with these wells or any future drilling operations will most likely not be indicative of our current or future drilling success rate, particularly, because we intend to emphasize on exploratory drilling. If our actual drilling and development costs are significantly more than our estimated costs, we may not be able to continue our business operations as proposed and would be forced to modify our plan of operation.
Development of our reserves, when established, may not occur as scheduled and the actual results may not be as anticipated. Drilling activity may result in downward adjustments in reserves or higher than anticipated costs. Our estimates will be based on various assumptions, including assumptions required by the Securities and Exchange Commission relating to natural gas and oil prices, drilling and operating expenses, capital expenditures, taxes and availability of funds. The process of estimating our natural gas and oil reserves is anticipated to be extremely complex, and will require significant decisions and assumptions in the evaluation of available geological, geophysical, engineering and economic data for each reservoir. Due to our inexperience in the oil and gas industry, our estimates may not be reliable enough to allow us to be successful in our intended business operations. Our actual production, revenues, taxes, development expenditures and operating expenses will likely vary from those anticipated. These variances may be material.
Gas and Oil prices are volatile. This volatility may occur in the future, causing negative change in cash flows which may result in our inability to cover our capital expenditures.
Our future revenues, profitability, future growth and the carrying value of our properties is anticipated to depend substantially on the prices we may realize for our natural gas and oil production. Our realized prices may also affect the amount of cash flow available for capital expenditures and our ability to borrow and raise additional capital.
Natural gas and oil prices are subject to wide fluctuations in response to relatively minor changes in or perceptions regarding supply and demand. Historically, the markets for natural gas and oil have been volatile, and they are likely to continue to be volatile in the future. For example, natural gas and oil prices declined significantly in late 1998 and 1999 and, for an extended
period of time, remained substantially below prices obtained in previous years. Among the factors that can cause this volatility are:
o worldwide or regional demand for energy, which is affected by economic conditions; o the domestic and foreign supply of natural gas and oil; o weather conditions; o domestic and foreign governmental regulations; o political conditions in natural gas and oil producing regions; o the ability of members of the Organization of Petroleum Exporting Countries to agree upon and maintain oil prices and production levels; and o the price and availability of other fuels.
It is impossible to predict natural gas and oil price movements with certainty. Lower natural gas and oil prices may not only decrease our future revenues on a per unit basis but also may reduce the amount of natural gas and oil that we can produce economically. A substantial or extended decline in natural gas and oil prices may materially and adversely affect our future business enough to force us to cease our business operations. In addition, our financial condition, results of operations, liquidity and ability to finance planned capital expenditures will also suffer in such a price decline. Further, natural gas and oil prices do not necessarily move together.
We may incur substantial write-downs of the carrying value of our gas and oil properties, which would adversely impact our earnings.
We periodically review the carrying value of our gas and oil properties under the full cost accounting rules of the Securities and Exchange Commission. Under these rules, capitalized costs of proved gas and oil properties may not exceed the present value of estimated future net revenues from proved reserves, discounted at an annual rate of 10%. Application of this "ceiling" test requires pricing future revenue at the un-escalated prices in effect as of the end of each fiscal quarter and requires a write-down for accounting purposes if the ceiling is exceeded, even if prices were depressed for only a short period of time. We may be required to write down the carrying value of our gas and oil properties when natural gas and oil prices are depressed or unusually volatile, which would result in a charge against our earnings. Once incurred, a write-down of the carrying value of our natural gas and oil properties is not reversible at a later date.
Currently the vast majority of our producing properties are located in the Cherokee Basin of southeastern Kansas, making us vulnerable to risks associated with having our production concentrated in one area.
The vast majority of our producing properties are geographically concentrated in the Cherokee Basin of southeastern Kansas. As a result of this concentration, we may be disproportionately exposed to the impact of delays or interruptions of production from these wells caused by significant governmental regulation, transportation capacity constraints, curtailment of production, natural disasters, adverse weather conditions or interruption of transportation of natural gas produced from the wells in this basin or other events which impact this area.
Competition in our industry is intense. We are very small and have an extremely limited operating history as compared to the vast majority of our competitors, and we may not be able to compete effectively.
We intend to compete with major and independent natural gas and oil companies for property acquisitions. We will also compete for the equipment and labor required to operate and to develop natural gas and oil properties. The majority of our anticipated competitors have substantially greater financial and other resources than we do. In addition, larger competitors may be able to absorb the burden of any changes in federal, state and local laws and regulations more easily than we can, which would adversely affect our competitive position. These competitors may be able to pay more for natural gas and oil properties and may be able to define, evaluate, bid for and acquire a greater number of properties than we can. Our ability to acquire additional properties and develop new and existing properties in the future will depend on our ability to conduct operations, to evaluate and select suitable properties and to consummate transactions in this highly competitive environment. In addition, some of our competitors have been operating in our core areas for a much longer time than we have and have demonstrated the ability to operate through industry cycles.
The natural gas and oil business involves numerous uncertainties and operating risks that can prevent us from realizing profits and can cause substantial losses.
Our development, exploitation and exploration activities may be unsuccessful for many reasons, including weather, cost overruns, equipment shortages and mechanical difficulties. Moreover, the successful drilling of a natural gas and oil well does not ensure a profit on investment. A variety of factors, both geological and market-related, can cause a well to become uneconomical or only marginally economical. In addition to their cost, unsuccessful wells can hurt our efforts to replace reserves.
The natural gas and oil business involves a variety of operating risks, including:
o fires; o explosions; o blow-outs and surface cratering; o uncontrollable flows of oil, natural gas, and formation water; o natural disasters, such as hurricanes and other adverse weather conditions; o pipe, cement, or pipeline failures; o casing collapses; o embedded oil field drilling and service tools; o abnormally pressured formations; and o environmental hazards, such as natural gas leaks, oil spills, pipeline ruptures and discharges of toxic gases.
If we experience any of these problems, it could affect well bores, gathering systems and processing facilities, which could adversely affect our ability to conduct operations. We could also incur substantial losses as a result of:
o injury or loss of life; o severe damage to and destruction of property, natural resources and equipment; o pollution and other environmental damage; o clean-up responsibilities; o regulatory investigation and penalties; o suspension of our operations; and o repairs to resume operations.
Because we intend to use third-party drilling contractors to drill our wells, we may not realize the full benefit of worker compensation laws in dealing with their employees. Our insurance does not protect us against all operational risks. We do not carry business interruption insurance at levels that would provide enough funds for us to continue operating without access to other funds. For some risks, we may not obtain insurance if we believe the cost of available insurance is excessive relative to the risks presented. In addition, pollution and environmental risks generally are not fully insurable. If a significant accident or other event occurs and is not fully covered by insurance, it could impact our operations enough to force us to cease our operations.
The high cost of drilling rigs, equipment, supplies, personnel and other services could adversely affect our ability to execute on a timely basis our development, exploitation and exploration plans within our budget.
Shortages or an increase in cost of drilling rigs, equipment, supplies or personnel could delay or interrupt our operations, which could impact our financial condition and results of operations. Drilling activity in the geographic areas in which we conduct drilling activities may increase, which would lead to increases in associated costs, including those related to drilling rigs, equipment, supplies and personnel and the services and products of other vendors to the industry. Increased drilling activity in these areas may also decrease the availability of rigs. We do not have any contracts with providers of drilling rigs and we cannot assure you that drilling rigs will be readily available when we need them. Drilling and other costs may increase further and necessary equipment and services may not be available to us at economical prices.
Our lease ownership may be diluted due to financing strategies we may employ in the future due to our lack of capital or due to our focus on producing leases.
To accelerate our development efforts we plan to take on working interest partners that will contribute to the costs of drilling and completion and then share in revenues derived from production. In addition, we may in the
future, due to a lack of capital or other strategic reasons, establish joint venture partnerships or farm out all or part of our development efforts. These economic strategies may have a dilutive effect on our lease ownership and will more than likely reduce our operating revenues.
In addition, our lease ownership is subject to forfeiture in the event we are unwilling or unable to continue making lease payments. Our leases vary in price per acre and on the term period of the lease. Each lease requires payment to maintain an active lease. In the event we are unable or unwilling to make our lease payments or renew expiring leases, then we will forfeit our rights to such leases. Such forfeiture would prevent us from pursuing development activity on the leased property and could have a substantial impact on our gross leased acreage.
We are subject to complex laws and regulations, including environmental regulations, which can adversely affect the cost, manner or feasibility of doing business.
Development, production and sale of natural gas and oil in the United States are subject to extensive laws and regulations, including environmental laws and regulations. We may be required to make large expenditures to comply with environmental and other governmental regulations. Matters subject to regulation include:
o location and density of wells; o the handling of drilling fluids and obtaining discharge permits for drilling operations; o accounting for and payment of royalties on production from state, federal and Indian lands; o bonds for ownership, development and production of natural gas and oil properties; o transportation of natural gas and oil by pipelines; o operation of wells and reports concerning operations; and o taxation.
Under these laws and regulations, we could be liable for personal injuries, property damage, oil spills, discharge of hazardous materials, remediation and clean-up costs and other environmental damages. Failure to comply with these laws and regulations also may result in the suspension or termination of our operations and subject us to administrative, civil and criminal penalties. Moreover, these laws and regulations could change in ways that substantially increase our costs. Accordingly, any of these liabilities, penalties, suspensions, terminations or regulatory changes could materially adversely affect our financial condition and results of operations enough to possibly force us to cease our business operations.
Our oil and gas operations may expose us to environmental liabilities.
Any leakage of crude oil and/or gas from the subsurface portions of our wells, our gathering system or our storage facilities could cause degradation of fresh groundwater resources, as well as surface damage, potentially resulting in suspension of operation of the wells, fines and penalties from governmental agencies, expenditures for remediation of the affected resource, and liabilities to third parties for property damages and personal injuries. In addition, any sale of residual crude oil collected as part of the drilling and recovery process could impose liability on us if the entity to which the oil was transferred fails to manage the material in accordance with applicable environmental health and safety laws.
Risks Associated with Our Business
Our auditor's report reflects the fact that without realization of additional capital, it would be unlikely for us to continue as a going concern.
As a result of our deficiency in working capital at December 31, 2007, the anticipated foreclosure by our secured lenders and other factors, our auditors have included an explanatory paragraph in their audit report regarding substantial doubt about our ability to continue as a going concern. The financial statements do not include any adjustments as a result of this uncertainty. The going concern qualification may adversely impact our ability to raise the capital necessary for the expansion and continuation of operations.
Our internal controls may be inadequate, which could cause our financial reporting to be unreliable and lead to misinformation being disseminated to the public.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. As defined in Exchange Act Rule 13a-15(f), internal control over financial reporting is a process designed by,
or under the supervision of, the principal executive and principal financial officer and effected by the board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that: (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of Petrol; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of Petrol are being made only in accordance with authorizations of management and directors of Petrol, and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of Petrol's assets that could have a material effect on the financial statements.
Effective internal controls are necessary for us to provide reliable financial reports, prevent fraud and operate successfully as a public company. We cannot be certain that our efforts to maintain internal controls will be successful, that we will be able to maintain adequate controls over our financial processes and reporting in the future or that we will be able to comply with our obligations under Section 404 of the Sarbanes-Oxley Act of 2002. Further, we have a limited number of personnel that are required to perform various roles and duties as well as be responsible for monitoring and ensuring compliance with our internal control procedures. As a result, our internal controls may be inadequate or ineffective, which could cause our financial reporting to be unreliable and lead to misinformation being disseminated to the public. Any failure to develop or maintain effective internal controls or difficulties encountered in implementing or improving our internal controls could harm operating results or cause us to fail to meet our reporting obligations. Ineffective internal controls also could cause our stockholders and potential investors to lose confidence in our reported financial information, which would likely have a negative effect on the trading price of our common stock. In addition, investors relying upon this misinformation may make an uninformed investment decision.
We may need additional capital in the future to finance our planned growth, which we may not be able to raise or it may only be available on terms unfavorable to us or our stockholders, which may result in our inability to fund our working capital requirements and harm our operational results.
We have had substantial capital expenditure and working capital needs associated with the development of our Coal Creek Project. We believe that current cash on hand and the other sources of liquidity are only sufficient enough to fund our operations through fiscal 2007. After that time we will need to rely on cash flow operations or raise additional cash to fund our operations, to fund our anticipated reserve replacement needs and implement our growth strategy, or to respond to competitive pressures and/or perceived opportunities, such as investment, acquisition, exploration and development activities.
If low natural gas and oil prices, operating difficulties or other factors, many of which are beyond our control, cause our revenues or cash flows from operations to decrease, we may be limited in our ability to spend the capital necessary to complete our development, production exploitation and exploration programs. If our resources or cash flows do not satisfy our operational needs, we will require additional financing, in addition to anticipated cash generated from our operations, to fund our planned growth. Additional financing might not be available on terms favorable to us, or at all. If adequate funds were not available or were not available on acceptable terms, our ability to fund our operations, take advantage of unanticipated opportunities, develop or enhance our business or otherwise respond to competitive pressures would be significantly limited. In such a capital restricted situation, we may curtail our acquisition, drilling, development, and exploration activities or be forced to sell some of our assets on an untimely or unfavorable basis.
If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders would be reduced, and these newly issued securities might have rights, preferences or privileges senior to those of existing stockholders.
Shortages of natural gas and oil field service personnel and equipment could adversely affect our business.
The demand for qualified and experienced field personnel to drill wells and conduct field operations, geologists, geophysicists, engineers and other professionals in the oil and natural gas industry can fluctuate significantly, often in correlation with oil and natural gas prices, causing periodic shortages. Due to recent high natural gas and oil prices, we have experienced shortages of drilling rigs and other equipment, as demand for rigs and equipment has increased along with the number of wells being drilled. Higher natural gas and oil prices generally stimulate increased demand and result in increased prices for drilling rigs, crews and associated supplies, oilfield equipment and
services and personnel in our exploration and production operations. These types of shortages or price increases could significantly decrease our profit margin, cash flow and operating results or restrict or delay our ability to drill those wells and conduct those operations that we currently have planned and budgeted.
Risk Factors Relating to Our Common Stock - -----------------------------------------
If we fail to remain current on our reporting requirements, we could be removed from the OTC Bulletin Board which would limit the ability of broker-dealers to sell our securities and the ability of stockholders to sell their securities in the secondary market.
Companies trading on the OTC Bulletin Board, such as us, must be reporting issuers under Section 12 of the Securities Exchange Act of 1934, as amended, and must be current in their reports under Section 13, in order to maintain price quotation privileges on the OTC Bulletin Board. More specifically, NASD has enacted Rule 6530, which determines eligibility of issuers quoted on the OTC Bulletin Board by requiring an issuer to be current in its filings with the Commission. Pursuant to Rule 6530(e), if we file our reports late with the Commission three times in a two-year period or our securities are removed from the OTC Bulletin Board for failure to timely file twice in a two-year period then we will be ineligible for quotation on the OTC Bulletin Board. As a result, the market liquidity for our securities could be severely adversely affected by limiting the ability of broker-dealers to sell our securities and the ability of stockholders to sell their securities in the secondary market.
Because our common stock is deemed a low-priced "Penny" stock, an investment in our common stock should be considered high risk and subject to marketability restrictions.
Since our common stock is a penny stock, as defined in Rule 3a51-1 under the Securities Exchange Act, it will be more difficult for investors to liquidate their investment even if and when a market develops for the common stock. Until the trading price of the common stock rises above $5.00 per share, if ever, trading in the common stock is subject to the penny stock rules of the Securities Exchange Act specified in rules 15g-1 through 15g-10. Those rules require broker-dealers, before effecting transactions in any penny stock, to:
o Deliver to the customer, and obtain a written receipt for, a disclosure document; o Disclose certain price information about the stock; o Disclose the amount of compensation received by the broker-dealer or any associated person of the broker-dealer; o Send monthly statements to customers with market and price information about the penny stock; and o In some circumstances, approve the purchaser's account under certain standards and deliver written statements to the customer with information specified in the rules.
Consequently, the penny stock rules may restrict the ability or willingness of broker-dealers to sell the common stock and may affect the ability of holders to sell their common stock in the secondary market and the price at which such holders can sell any such securities. These additional procedures could also limit our ability to raise additional capital in the future.
NASD sales practice requirements may also limit a stockholder's ability to buy and sell our stock.
In addition to the "penny stock" rules described above, the National Association of Securities Dealers (NASD) has adopted rules that require that in recommending an investment to a customer, a broker-dealer must have reasonable grounds for believing that the investment is suitable for that customer. Prior to recommending speculative low priced securities to their non-institutional customers, broker-dealers must make reasonable efforts to obtain information about the customer's financial status, tax status, investment objectives and other information. Under interpretations of these rules, the NASD believes that there is a high probability that speculative low priced securities will not be suitable for at least some customers. The NASD requirements make it more difficult for broker-dealers to recommend that their customers buy our common stock, which may limit your ability to buy and sell our stock and have an adverse effect on the market for our shares.
We could be subject to class action litigation due to stock price volatility, which, if occurs, could result in substantial costs or large judgments against us.
The market for our common stock may experience extreme price and volume fluctuations, which may be unrelated or disproportionate to our operating performance or prospects. In the past, securities class action litigation has often been brought against companies following periods of volatility in the market prices of their securities. We may be the target of similar litigation in the future. Securities litigation could result in substantial costs and divert our management's attention and resources, which could have a negative effect on our business, operating results and financial condition.
Our common stock is an unsecured equity interest.
As an equity interest, our common stock will not be secured by any of our assets. Therefore, in the event of our liquidation, the holders of the common stock will receive a distribution only after all of our secured and unsecured creditors have been paid in full. There can be no assurance that we will have sufficient assets after paying our secured and unsecured creditors to make any distribution to the holders of the common stock.
Our Articles of Incorporation authorize our Board of Directors to issue up to 10,000,000 shares of preferred stock, which could adversely affect the voting power of our common stock holders.
Our Board of Directors is authorized, without further approval of our stockholders, to fix the dividend rights and terms, conversion rights, voting rights, redemption rights and terms, liquidation preferences, and any other rights, preferences, privileges and restrictions applicable to our preferred stock. The issuance of such stock could adversely affect the voting power of the holders of Common Stock and, under certain circumstances, make it more difficult for a third party to gain control of Petrol, discourage bids for the common stock at a premium, or otherwise adversely affect the market price of the common stock.
Provisions in Nevada law could delay or prevent a change in control, even if that change would be beneficial to our stockholders. Certain provisions of Nevada law may delay, discourage, prevent or render more difficult an attempt to obtain control of Petrol, whether through a tender offer, business combination, proxy contest or otherwise. The provisions of Nevada law are designed to discourage coercive takeover practices and inadequate takeover bids. These provisions are also designed to encourage persons seeking to acquire control of Petrol to first negotiate with our board of directors.
The Nevada Revised Statutes (the "NRS") contain two provisions, described below as "Combination Provisions" and the "Control Share Act," that may make more difficult the accomplishment of unsolicited or hostile attempts to acquire control of Petrol through certain types of transactions.
Restrictions on Certain Combinations Between Nevada Resident Corporations and Interested Stockholders. The NRS includes the Combination Provisions prohibiting certain "combinations" (generally defined to include certain mergers, disposition of assets transactions, and share issuance or transfer transactions) between a resident domestic corporation and an "interested stockholder" (generally defined to be the beneficial owner of 10% or more of the voting power of the outstanding shares of the corporation), except those combinations which are approved by the board of directors before the interested stockholder first obtained a 10% interest in the corporation's stock. There are additional exceptions to the prohibition, which apply to combinations if they occur more than three years after the interested stockholder's date of acquiring shares. The Combination Provisions apply unless the corporation elects against their application in its original articles of incorporation or an amendment thereto. Our articles of incorporation do not currently contain a provision rendering the Combination Provisions inapplicable.
Nevada Control Share Act. Nevada's Control Share Act imposes procedural hurdles on and curtails greenmail practices of corporate raiders. The Control Share Act temporarily disenfranchises the voting power of "control shares" of a person or group ("Acquiring Person") purchasing a "controlling interest" in an "issuing corporation" (as defined in the NRS) not opting out of the Control Share Act. In this regard, the Control Share Act will apply to an "issuing corporation", unless the articles of incorporation or bylaws in effect on the tenth day following the acquisition of a controlling interest provide that it is inapplicable. Our articles of incorporation and bylaws do not currently contain a provision rendering the Control Share Act inapplicable.
Under the Control Share Act, an "issuing corporation" is a corporation organized in Nevada which has 200 or more stockholders of record, at least 100 of whom have addresses in that state appearing on the company's stock ledger, and which does business in Nevada directly or through an affiliated company. Our
status at the time of the occurrence of a transaction governed by the Control Share Act (assuming that our articles of incorporation or bylaws have not theretofore been amended to include an opting out provision) would determine whether the Control Share Act is applicable. We currently conduct business in Nevada through an executive office located in Las Vegas, Nevada.
The Control Share Act requires an Acquiring Person to take certain procedural steps before he or it can obtain the full voting power of the control shares. "Control shares" are the shares of a corporation (1) acquired or offered to be acquired which will enable the Acquiring Person to own a "controlling interest," and (2) acquired within 90 days immediately preceding that date. A "controlling interest" is defined as the ownership of shares which would enable the Acquiring Person to exercise certain graduated amounts (beginning with one-fifth) of all voting power of the corporation in the election of directors. The Acquiring Person may not vote any control shares without first obtaining approval from the stockholders not characterized as "interested stockholders" (as defined below).
To obtain voting rights in control shares, the Acquiring Person must file a statement at the principal office of the issuer ("Offeror's Statement") setting forth certain information about the acquisition or intended acquisition of stock. The Offeror's Statement may also request a special meeting of stockholders to determine the voting rights to be accorded to the Acquiring Person. A special stockholders' meeting must then be held at the Acquiring Person's expense within 30 to 50 days after the Offeror's Statement is filed. If a special meeting is not requested by the Acquiring Person, the matter will be addressed at the next regular or special meeting of stockholders.
At the special or annual meeting at which the issue of voting rights of control shares will be addressed, "interested stockholders" may not vote on the question of granting voting rights to control the corporation or its parent unless the articles of incorporation of the issuing corporation provide otherwise. Our articles of incorporation and bylaws do not currently contain a provision allowing for such voting power.
If full voting power is granted to the Acquiring Person by the disinterested stockholders, and the Acquiring Person has acquired control shares with a majority or more of the voting power, then (unless otherwise provided in the articles of incorporation or bylaws in effect on the tenth day following the acquisition of a controlling interest) all stockholders of record, other than the Acquiring Person, who have not voted in favor of authorizing voting rights for the control shares, must be sent a notice advising them of the fact and of their right to receive "fair value" for their shares. Our articles of incorporation and bylaws do not provide otherwise. By the date set in the dissenter's notice, which may not be less than 30 nor more than 60 days after the dissenter's notice is delivered, any such stockholder may demand to receive from the corporation the "fair value" for all or part of his shares. "Fair value" is defined in the Control Share Act as "not less than the highest price per share paid by the Acquiring Person in an acquisition."
The Control Share Act permits a corporation to redeem the control shares in the following two instances, if so provided in the articles of incorporation or bylaws of the corporation in effect on the tenth day following the acquisition of a controlling interest: (1) if the Acquiring Person fails to deliver the Offeror's Statement to the corporation within 10 days after the Acquiring Person's acquisition of the control shares; or (2) an Offeror's Statement is delivered, but the control shares are not accorded full voting rights by the stockholders. Our articles of incorporation and bylaws do not address this matter.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
Production
The following table shows the results of operations from our oil and gas producing activities during the years presented in the financial statements. Results of operations from these activities have been determined using historical revenues, production costs, depreciation, depletion and amortization of the capitalized costs subject to amortization. General and administrative expenses and interest expense have been excluded from this determination.
Direct Costs
Direct costs are the costs associated with operating producing wells, and transporting the oil and natural gas to the market for sale. Direct cost for the fiscal year ended December 31, 2007 was $2,605,257, a decrease of $303,436, or 10.4%, from $2,908,693 for the fiscal year ended December 31, 2006. The decrease over the prior period is directly attributable to our reduction in costs related to work-overs, repairs and modification to the Neodesha wells and pipeline system that we had previously experienced during the same period in the previous year. We do not anticipate maintenance and work-over costs to that extent in the future and our current direct operating costs are more indicative of our overall production costs.
Pipeline Costs
Pipeline costs for the fiscal year ended December 31, 2007 were $856,814, a decrease of $53,925, or 6%, from $910,739 for the fiscal year ended December 31, 2006. The decrease in pipeline costs was primarily the result of changes to our compression system, resulting in reduced compressor rentals.
General and Administrative Expenses
General and administrative expenses for the fiscal year ended December 31, 2007 were $1,814,211, a decrease of $850,262 or 31.9%, from $2,644,473 for the fiscal year ended December 31, 2006. The decrease was primarily the result of the elimination of compensation and benefits for our former Chief Executive Officer and rationalization of expenditures.
Professional and Consulting Fees
Professional and consulting fees for the fiscal year ended December 31, 2007 was $766,683, a decrease of $1,190,494, or 60.8% from $1,957,177 for the fiscal year ended December 31, 2006. The decrease in professional and consulting fees was a result of an overall reduction in the use of consultants and levels of accounting and legal services as well as general cost cutting.
Impairment of Oil & Gas Properties and Pipelines
During 2007, we have impaired our oil and gas properties and pipeline assets by $15,564,184 based on our reserve study of the present value of future cash flows discounted by 10% and the determination that the pipeline assets had fair market value of zero because these facilities will not be used and are not saleable.
Depreciation, Depletion, and Amortization Expense
Depreciation, depletion, and amortization expense for the fiscal year ended December 31, 2007 was $2,338,490, a decrease of $472,695, or 16.8%, from $2,811,185 for the fiscal year ended December 31, 2006.
Net Operating (Loss)
The net operating loss for the fiscal year ended December 31, 2007 was $18,456,966, versus a net operating loss of $4,719,469 for the fiscal year ended December 31, 2006, a change in net reduction of $13,737,497 or 291.1%.
Other Income (Expense)
Interest expense
Interest expense for the fiscal year ended December 31, 2007 was $4,478,425, an increase of $1,402,686, or 45.6%, from $3,075,739 for the fiscal year ended December 31, 2006. The increase in interest expense is the result of the increased amount of debt financing received from Laurus Funds.
Net Loss
Our net loss for the fiscal year ended December 31, 2007 was $22,935,390, an increased loss of $15,140,182, or 194.2%, from a net loss of $7,795,208 for the fiscal year ended December 31, 2006.
Direct Costs
Direct costs are the costs associated with operating producing wells, and transporting the oil and natural gas to the market for sale. Direct cost for the fiscal year ended December 31, 2006 was $2,908,693, a decrease of $175,801, or 6%, from $3,084,494 for the fiscal year ended December 31, 2005. The decrease over the prior period is directly attributable to our reduction in costs related to work-overs, repairs and modification to the Neodesha wells and pipeline system that we had previously experienced during the same period in the previous year. We do not anticipate maintenance and work-over costs to that extent in the future and our current direct operating costs are more indicative of our overall production costs.
Pipeline Costs
Pipeline costs for the fiscal year ended December 31, 2006 were $910,739, an increase of $679,795, or 294%, from $230,944 for the fiscal year ended December 31, 2005. The increase in pipeline costs in the current period was partially the result of the addition of our Coal Creek Pipeline as well as additional maintenance costs required in order to maintain in a fully operational status.
General and Administrative Expenses
General and administrative expenses for the fiscal year ended December 31, 2006 were $1,649,028, an increase of $32,694 or 2%, from $1,616,334 for the fiscal year ended December 31, 2005. The minimal increase in general and administrative expenses is attributable to additional office and administrative costs associated with increased field operations.
Professional and Consulting Fees
Professional and consulting fees for the fiscal year ended December 31, 2006 was $1,957,177, a decrease of $620,793, or 24% from $2,577,970 for the fiscal year ended December 31, 2005. The decrease in professional and consulting fees in the current period was a result of decreased investor relations and accounting fees to our prior CFO.
Salaries and Wages
Salaries and wages for the fiscal year ended December 31, 2006 was $262,436, a decrease of $1,613, or 0.02% from $264,049. As expected, we did not intend to increase staffing levels during our project development stage. Our project managers and support staff for the development of our Coal Creek project were placed during 2005.
Salaries and Wages - Officer
Salaries and wages - Officer, for the fiscal year ended December 31, 2006 was $753,009 compared to $234,636 in 2005. The increase in the amount of $518,373 or 221% is primarily due to the amortization of options granted pursuant to his employment agreement of October 2005. In addition, a bonus in the amount of $100,000 was granted by the Board of Directors for the efforts of our CEO in connection with our financing agreements.
Depreciation, Depletion, and Amortization Expense
Depreciation, depletion, and amortization expense for the fiscal year ended December 31, 2006 was $2,811,185, an increase of $1,418,843, or 102%, from $1,392,342 for the fiscal year ended December 31, 2005. The increase in depreciation, depletion and amortization expense was a result of increased depletion on each unit of production due to our increase in capital expenditures and a decline in reserves.
Net Operating (Loss)
The net operating loss for the fiscal year ended December 31, 2006 was $4,719,469, versus a net operating loss of $4,155,963 for the fiscal year ended December 31, 2005, a change in net loss of $563,506 or 14%. The increase in net operating loss is attributable to our increase in depletion which was offset slightly by our decrease in professional fees.
requirements. We issued a three-year Secured Term Note in the aggregate principal amount of $10,000,000 and a five-year warrant to purchase 1,000,000 shares of our common stock at $2.00 per share. The note bears an interest rate equivalent to the "prime rate" published by the Wall Street Journal from time to time plus 3.25%, subject to a floor of 10% and a ceiling of 14% per annum. In addition, Laurus, in their sole discretion, may purchase additional notes from us in an aggregate principal amount of up to $40,000,000 pursuant to substantially similar terms of the initial note dated October 31, 2005.
On March 31, 2006, we entered into agreements with Laurus to draw down an additional $5,000,000 under the credit facility provided by Laurus in October 2005. Under the terms of the Laurus agreements we issued a Secured Term Note in the aggregate principal amount of $5,000,000 and a five-year warrant to purchase 200,000 shares of our common stock at $1.80 per share. On June 20, 2006, Laurus transferred the 200,000 warrants to Pallas. The Note has a three-year term and bears an interest rate equivalent to the "prime rate" published by the Wall Street Journal from time to time plus 3.25%, subject to a floor of 10% and a ceiling of 14% per annum. Concurrently with the agreements listed above, we amended and restated our previous $10,000,000 Secured Term Note dated October 31, 2005 with Laurus.
On April 7, 2006, the funds were released from Escrow. Net proceeds to Petrol from the financing, after payment of fees and expenses to Laurus and its affiliates, were $4,806,688. The proceeds are being utilized by Petrol for drilling activities on our Coal Creek Project.
On May 31, 2006, we entered into agreements with Laurus to draw down an additional $10,000,000 under the credit facility provided by Laurus in October 2005. Under the terms of the Laurus agreements we issued a Secured Term Note in the aggregate principal amount of $10,000,000 and a five-year warrant to purchase 400,000 shares of our common stock at $1.65 per share. The Note has a three-year term and bears an interest rate equivalent to the "prime rate" published by the Wall Street Journal from time to time plus 3.25%, subject to a floor of 10% and a ceiling of 14% per annum. Concurrently with the execution of the new Laurus Funds agreements, Petrol amended and restated its previous $10,000,000 Secured Term Note dated October 31, 2005 and the $5,000,000 Secured Term Note dated March 31, 2006 with Laurus Funds.
On June 2, 2006, the funds were released from Escrow. Net proceeds to Petrol from the financing, after payment of fees and expenses to Laurus Funds and its affiliates, were $9,629,679. The proceeds will be utilized by Petrol for drilling activities on Petrol's Coal Creek Project.
At December 31, 2007, the Company had long term debt (including the current portion of long term debt) of approximately $26.7 million. Approximately $15 million of this debt was utilized to develop the Coal Creek Project, which has contributed no significant revenue to the Company. As a result, the Company's cash position has seriously declined. On October 28, 2007, the Company was required to make a principal payment of approximately $1.1 million on a portion of its long term debt. The Company did not have adequate cash to make such principal payment and is currently in default under the terms of the note for this long term debt.
On April 9, 2008, the Company's debt was declared in default and accelerated by Laurus.
On April 30, 2008, the Company entered into a Foreclosure-Related Agreement (the "Foreclosure Agreement") with Laurus. The aggregate amount due and owing to Laurus as of April 30, 2008 was approximately $35.7 million.
The outstanding obligations are secured by various mortgages and other fixed and mixed assets and real and personal property pursuant to security and other agreements covering assets or other rights to which the Company has rights (all such assets, rights and collateral, collectively, the "Collateral"), a portion of which are assets and rights referred to as the "Petrol-Neodesha Project," located in Neosho and Wilson Counties, Kansas, consisting of, among other Collateral, mortgages, and real, personal property and fixed and mixed assets used in connection with the Petrol-Neodesha Project (the "Neodesha Collateral").
The Agreement allows Laurus to foreclose on the Neodesha Collateral and governs the terms and conditions of the foreclosure. The Agreement provides that the Company will not contest the sale of the Neodesha Collateral, which will be conducted as a public foreclosure sale in accordance with Kansas law. The Company has agreed to reasonably assist Laurus in the completion of the foreclosure sale. After the sale of the Neodesha Collateral becomes final, Laurus will release Petrol of all remaining amounts owed or claims they may have, and Laurus will reassign to Petrol their overriding royalty interests in the mineral leases located at the Company 's Coal Creek Project.
As part of the Agreement, the Company will cancel all outstanding warrants for purchases of securities issued to Laurus in connection with the Outstanding Obligations and replace them with warrants to purchase 1,000,000 shares of common stock at an initial exercise price of $0.20 per share.
The foreclosure by Laurus described above will leave the Company with far fewer assets than it currently has. There can be no assurance that the Company will be able to continue operations and satisfy its obligations in the future.
Cash Flows. Since inception, we have financed cash flow requirements through debt financing, the issuance of common stock and revenues generated from the sale of oil and gas. As we expand operational activities, we may experience net negative cash flows from operations, pending receipt of sales or development fees, and may be required to obtain additional financing to fund operations through common stock offerings and debt borrowings to the extent necessary to provide working capital.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results or operations, liquidity, capital expenditures or capital resources that is material to investors.
Derivatives
To reduce our exposure to unfavorable changes in natural gas prices we have entered into an agreement to utilize energy swaps in order to have a fixed-price contract. This contract allows us to be able to predict with greater certainty the effective natural gas prices to be received for hedged production and benefit operating cash flows and earnings when market prices are less than the fixed prices provided under the contracts. However, we will not benefit from market prices that are higher than the fixed prices in our contracts for hedged production. If we are unable to provide the quantity that we have contracted for we will have to go to the open market to purchase the required amounts that we have contracted to provide.
The following table summarizes our fixed price contracts as of December 31, 2007: Year Ending December 31, ------------------ ------------------ Gas Contract volume 90,000 Weighted-average price $7.23
Oil Contract volume -- Weighted-average price --
Fair value asset (liability) 77,800
On October 9, 2006, we entered into a "Fixed Price Contract" to sell 1,000.0 DTH per day of our natural gas productions at a fixed price of $7.32 per DTH. The contract period begins April 1, 2007 and expires on March 31, 2008.
Critical Accounting Policies and Estimates
Our accounting estimates include bad debts on our receivables, amount of depletion of our oil and gas properties subject to amortization, the asset retirement obligation and the value of the options and warrants that we issue. Our trade receivables have been fully collectible since inception and we only have sales to a small base of customers. We believe that all of our receivables are collectible. The depletion of our oil and gas properties is based in part on the evaluation of our reserves and an estimate of our reserves. We obtain an evaluation of the proved reserves from a professional engineering company and on
a quarterly basis we review the estimates and determine if any adjustments are needed. If the actual reserves are less than the estimated reserves we would not fully deplete our costs. The asset retirement obligation relates to the plug and abandonment costs when our wells are no longer useful. We determine the value of the liability by obtaining quotes for this service and estimate the increase we will face in the future. We then discount the future value based on an intrinsic interest rate that is appropriate for Petrol. If costs rise more than what we have expected there could be additional charges in the future however we monitor the costs of the abandoned wells and we will adjust this liability if necessary. The value we assign to the options and warrants that we issue is based on the fair market value as calculated by the Black-Scholes pricing model. To perform a calculation of the value of our options and warrants we determine the volatility of our stock. We believe our estimate of volatility is reasonable and we review the assumptions used to determine this whenever we have an equity instrument that needs a fair market value. Although the offset to the valuation is in paid in capital were we to have an incorrect material volatility assumption our expenses could be understated or overstated. The preparation of our financial statements requires us to make assumptions and estimates that affect the reported amounts of assets, liabilities, revenues and expenses as well as the disclosure of contingent assets and liabilities. We base our assumptions and estimates on historical experience and other sources that we believe to be reasonable at the time. Actual results may vary from our estimates due to changes in circumstances, weather, politics, global economics, mechanical problems, general business conditions and other factors.
Effects of Inflation and Pricing
The oil and natural gas industry is very cyclical and the demand for goods and services of oil field companies, suppliers and others associated with the industry puts extreme pressure on the economic stability and pricing structure within the industry. Material changes in prices impact revenue stream, estimates of future reserves, borrowing base calculations of bank loans and value of properties in purchase and sale transactions. Material changes in prices can impact the value of oil and natural gas companies and their ability to raise capital, borrow money and retain personnel. We anticipate the increased business costs will continue while the commodity prices for oil and natural gas, and the demand for services related to production and exploration, both remain high (from a historical context) in the near term.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Commodity Price Risk
Our major market risk exposure is in the pricing applicable to our oil and gas production. Realized pricing is primarily driven by the prevailing worldwide price for crude oil and spot prices applicable to natural gas production. Historically, prices received for oil and gas production have been volatile and unpredictable and price volatility is expected to continue.
Monthly oil price realizations ranged from a low of approximately $40.73 per barrel to a high of approximately $64.00 per barrel during 2005 and as high as $56.00 per barrel during the year ended December 31, 2006. Gas price realizations ranged from a monthly low of approximately $4.24 per Mcf to a monthly high of approximately $9.37 per Mcf during the same period.
Since new well development is an ongoing program, management expects revenue to grow in the foreseeable future. In order to reduce natural gas price volatility, we have entered into hedging transactions.
Normal hedging arrangements have the effect of locking in for specified periods the prices we would receive for the volumes and commodity to which the hedge relates. Consequently, while hedges are designed to decrease exposure to price decreases, they also have the effect of limiting the benefit of price increases.
Interest Rate Risk
Our long term debt with Laurus Funds has a floating interest rate of prime plus 3% to 3.25%, with a floor of 7.5% to 14%. Therefore, interest rate changes will impact future results of operations and cash flows.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Index to Financial Statements and Financial Statement Schedules appearing on page of this Form 10-K.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Petrol has had no disagreements with its independent auditors on accounting or financial disclosures.
Item 9T. Controls and Procedures
We carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of December 31, 2007. This evaluation was carried out under the supervision and with the participation of our sole executive officer, Chief Executive Officer, Loren Moll and with the assistance of our company accountant. Based upon that evaluation, they concluded that, as of December 31, 2007, our disclosure controls and procedures have not been identified and we have not yet tested their effectiveness. Because of this lack of identification and testing, we cannot assure the effectiveness of the controls and procedures. There have been no significant changes in our internal controls over financial reporting during the year ended December 31, 2007 that have materially affected or are reasonably likely to materially affect such controls.
Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.
The Company has established disclosure controls and procedures to ensure that information disclosed in this MD&A and the related financial statements was properly recorded, processed, summarized and reported to the Company`s Board of Directors. A control system, no matter how well conceived or operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.
There has been no change in the Company's disclosure controls during 2007 that has materially affected or is likely to materially affect its control over financial reporting.
Management's Report on Internal Control over Financial Reporting - ----------------------------------------------------------------
The CEO of the Company acknowledges that he is responsible for designing internal controls over financial reporting or causing them to be designed under their supervision in order to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with Rule 240.13a-15(f) or Rule 240.15d-15(f). This report shall not be deemed to be filed for purposes of Section 18 of the Exchange Act or otherwise subject to the liabilities of that section.
Management and the Board of Directors work to mitigate the risk of a material misstatement in financial reporting, however, there can be no assurance that this risk can be reduced to less than a remote likelihood of a material misstatement.
Management has not yet identified the critical disclosure controls and procedures associated with the Company's internal control over financial reporting for the fiscal year ending December 31, 2007 and has not yet tested the effectiveness of these disclosure controls and procedures and, therefore, cannot yet deem these controls to be effective. Therefore, the Company has determined that a material weakness exists related to the lack of identification and testing of disclosure controls and procedures associated with the Company's internal control over financial reporting for the fiscal year ending December 31, 2007. This material weakness could materially affect the Company's control over financial reporting.
Limitations on the Effectiveness of Internal Controls - -----------------------------------------------------
Our management does not expect that our disclosure controls and procedures or our internal control over financial reporting will necessarily prevent all fraud and material error.
Weaver & Martin LLC, the Company's independent registered public accounting firm, was not required to and has not issued a report concerning the effectiveness of the Company's internal control over financial reporting as of December 31, 2007.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
Election of Directors and Officers. - -----------------------------------
Directors are elected to serve until the next annual meeting of stockholders and until their successors have been elected and qualified. Officers are appointed to serve until the meeting of the Board of Directors following the next annual meeting of stockholders and until their successors have been elected and qualified.
Involvement in Certain Legal Proceedings
No Executive Officer or Director of the Corporation has been the subject of any Order, Judgment, or Decree of any Court of competent jurisdiction, or any regulatory agency permanently or temporarily enjoining, barring suspending or otherwise limiting him/her from acting as an investment advisor, underwriter, broker or dealer in the securities industry, or as an affiliated person, director or employee of an investment company, bank, savings and loan association, or insurance company or from engaging in or continuing any conduct or practice in connection with any such activity or in connection with the purchase or sale of any securities.
No Executive Officer or Director of the Corporation has been convicted in any criminal proceeding (excluding traffic violations) or is the subject of a criminal proceeding which is currently pending.
Change in Control Arrangements
Pursuant to our financing agreements with Laurus Master Fund, Ltd., the occurrence of a change of control in the controlling ownership of Petrol would be a default under the agreements. A change in control (as defined below) shall occur with respect to Petrol, unless Laurus shall have expressly consented to such change of control in writing. A "Change of Control" shall mean any event or circumstance as a result of which (i) any "Person" or "Group" (as such terms are defined in Sections 13(d) and 14(d) of the Exchange Act), other than Laurus, is or becomes the "beneficial owner" (as defined in Rules 13(d)-3 and 13(d)-5 under the Exchange Act), directly or indirectly, of 35% or more on a fully diluted basis of the outstanding voting equity interest of Petrol, (ii) the Board of Directors of Petrol shall cease to consist of a majority of Petrol's board of directors at the time of the execution of the Laurus Agreements (Paul Branagan, Loren Moll and Suzanne Herring were the only board members at the time of the execution of the Laurus Agreements subject to this provision), as amended or ratified, or (iii) Petrol or any of its Subsidiaries merges or consolidates with, or sells all or substantially all of its assets to, any other person or entity.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), requires our executive officers and directors, and persons who beneficially own more than ten percent of our common stock, to file initial reports of ownership and reports of changes in ownership with the SEC. Executive officers, directors and greater than ten percent beneficial owners are required by SEC regulations to furnish us with copies of all Section 16(a) forms they file. Based upon a review of the copies of such forms furnished to us and written representations from our executive officers and directors, we believe that as of the date of this filing they were all current in there filings.
Code of Business Conduct and Ethics
On November 18, 2005, we adopted a Code of Business Conduct and Ethics that applies to our Directors, officers and employees. A copy of the Code of Business Conduct and Ethics is attached as Appendix A to the proxy filed with the SEC on November 22, 2005 and is also available on our website at www.petroloilandgas.com.
Corporate Governance
The Company currently has only two directors, one of which, Loren Moll, is acting as President and CEO of the Company on an interim basis. Due to the limited size of the Board, it is not now operating the various committees that were established at an earlier time.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Overview of Compensation Program
The Board of Director's (the "Board") has responsibility for establishing, implementing and continually monitoring adherence with Petrol's compensation philosophy. The Board ensures that the total compensation paid to the Executives is fair, reasonable and competitive. We do not currently have a Compensation Committee. At this time, the Company has only one executive
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
On June 30, 2006, we expensed a subscription receivable in the amount of $75,000 for one of our shareholders in exchange for public relation services rendered.
During the year ended December 31, 2007 and 2006, we paid fees to Caldwell & Moll, LLC totaling $163,715 and $100,091, respectively for legal services provided in connection with current litigation. An Officer of the Company is a member of the service provider. As of December 31, 2006 the balance owed to Caldwell & Moll was $20,384.
During the year ended December 31, 2007 and 2006, we paid fees to Accuity Financial Services, Inc. totaling $47,100 and $82,500, respectively for services provided in connection with preparation of our quarterly financial statements. A Director (resigned in 2007) of the Company is an officer of the service provider. As of December 31, 2006 the balance owed to Accuity Financial Services, Inc. was $18,000
Director Independence
The Board of Directors has analyzed the independence of each director and has concluded that Robert Kite is considered an independent Director in accordance with the director independence standards of the American Stock Exchange, and has determined that he does not have a material relationship with Petrol which would impair his independence from management or otherwise compromise his ability to act as an independent director.
Review, approval or ratification of transactions with related persons
Transactions between related persons (including directors and executive officers of Petrol and their immediate family members) and Petrol or their affiliates are subject to approval by the board of directors. Petrol has no written policy setting forth the procedures for the review and approval of related party transactions. Officers and directors will be regularly reminded of their obligation to seek board approval of any related party transaction or potential conflict of interest. The board will consider all factors that it deems relevant, including the nature of the related party's interest in the transaction, whether the terms are no less favorable than could be obtained in arms-length dealings with unrelated third parties, and the materiality of the transaction to Petrol.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
(1) AUDIT FEES The aggregate fees billed for professional services rendered by Weaver & Martin, LLC, for the audit of our annual financial statements and review of the financial statements included in our Form 10-QSB or services that are normally provided by the accountant in connection with statutory and regulatory filings or engagements for fiscal years 2007, 2006 and 2005 were $ 108,605, $120,737 and $105,702, respectively.
(2) AUDIT-RELATED FEES
None. (3) TAX FEES
The aggregate fees to be billed by Weaver & Martin LLC for professional services to be rendered for tax fees for fiscal years 2007, 2006 and 2005 were $ 15,860, $13,650 and $10,250, respectively.
(4) ALL OTHER FEES The aggregate fees for professional services for audit related services relating to the Registration Statement on Form SB-2 for fiscal years 2007, 2006 and 2005 were $0, $33,725 and $30,750 respectively. There were no other fees to be billed by Weaver & Martin LLC for the fiscal years 2007, 2006 and 2005 other than the fees described herein and above.
(5) AUDIT COMMITTEE POLICIES AND PROCEDURES We do not have an audit committee. (6) If greater than 50 percent, disclose the percentage of hours expended on the principal accountant's engagement to audit the registrant's financial statements for the most recent fiscal year that were attributed to work performed by persons other than the principal accountant's full-time, permanent employees.
Not applicable.
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PETROL OIL AND GAS, INC.
Dated: May 15, 2008 By: /s/ Loren Moll ------------------------------- Loren Moll, President
In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date - --------- ----- ----
/s/ Loren Moll President, May 15, 2008 - ------------------- CEO, Director, Loren Moll Principal Accounting Officer
/s/ Robert Kite Director May 15, 2008 - ------------------- Robert Kite
Petrol Oil and Gas, Inc. Index To Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets, December 31, 2007 and 2006
Consolidated Statement of Operations for the Years Ended December 31, 2007 and 2006
Consolidated Statement of Stockholders' Equity for the Years Ended December 31, 2007 and 2006
Consolidated Statement of Cash Flows for the Years Ended December 31, 2007 and 2006
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders Petrol Oil & Gas, Inc.
We have audited the accompanying consolidated balance sheet of Petrol Oil & Gas, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of operations, changes in shareholders' equity and cash flows for each of the two years in the period December 31, 2007. These financial statements are the responsibility of Petrol Oil & Gas, Inc.'s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Petrol Oil & Gas, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States.
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company has suffered recurring losses and had negative cash flows from operations that raise substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters are also described in the Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ Weaver & Martin LLC - ----------------------------- Weaver & Martin LLC
Kansas City, Missouri May 15, 2008
PETROL OIL AND GAS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Significant Accounting Policies
Nature of Business We are engaged in the exploration, development, production and marketing of oil and natural gas. Our primary objective is the development of Coalbed Methane (CBM) gas production projects. CBM was identified early on as an area in the oil and gas industry that was gaining recognition as a viable source of natural gas and was experiencing above average growth. We have focused our efforts to eastern Kansas and western Missouri where leases were acquired that appeared geologically suitable for CBM exploration.
Principles of Consolidation Our consolidated financial statements include the accounts of our wholly owned subsidiaries, Neodesha Pipeline, LLC and Coal Creek Pipeline, LLC after elimination of intercompany transactions.
Use of Estimates The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Trade Accounts Receivable Trade accounts receivable are recorded at the invoiced amount and do not bear interest. We regularly review collectibility and establish or adjust an allowance for uncollectible accounts as necessary using the specific identification method. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. There were no reserves for uncollectible amounts in the periods presented.
Stock-Based Compensation We record stock-based compensation in accordance with SFAS No. 123R "Share Based Payments", using the fair value method. All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on Emerging Issues Task Force Issue No. 96-18, "Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services" using the fair value of the consideration received or the fair value of the equity.
Income Taxes We account for income taxes under SFAS 109, Accounting for Income Taxes. The asset and liability approach requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities. The provision for income taxes differ from the amounts currently payable because of temporary differences in the recognition of certain income and expense items for financial reporting and tax reporting purposes.
Deferred income taxes may arise from temporary differences resulting from income and expense items reported for financial accounting and tax purposes in different periods. Deferred taxes are classified as current or non-current, depending on the classification of assets and liabilities to which they relate. Deferred taxes arising from temporary differences that are not related to an asset or liability are classified as current or non-current depending on the periods in which the temporary differences are expected to reverse.
We adopted FASB Interpretation NO. 48, Accounting for Uncertainty in Income Taxes, as of January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the companies' financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. As a result, the Company applies a more-likely-than-not recognition threshold for all tax uncertainties. FIN 48 only allows the recognition of those tax benefits that have a greater than fifty percent likelihood of being sustained upon examination by the taxing authorities. As a result of implementing FIN 48, we reviewed our tax positions and determined there were no outstanding, or retroactive tax positions with less than a fifty percent likelihood of being sustained upon examination, therefore the implementation of this standard has not had a material affect on the financial statements.
We classify tax-related penalties and net interest as income tax expense. As of December 31, 2007 and 2006, no income tax expense has been incurred.
Fair value of financial instruments The carrying amounts of our financial instruments, including cash and cash equivalents, accounts receivable, accounts payable, accrued expenses and notes payable approximate their fair values based on their short-term nature. Fair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of December 31, 2007 and 2006. The respective carrying value of certain on-balance-sheet financial instruments approximated their fair values.
Earnings per common share SFAS No. 128, Earnings Per Share. This standard requires dual presentation of basic and diluted earnings per share on the face of the income statement for all entities with complex capital structures and requires a reconciliation of the numerator and denominator of the diluted loss per share computation.
Potentially issuable shares of common stock pursuant to outstanding stock options and warrants are excluded from the diluted computation, as their effect would be anti-dilutive.
Cash and cash equivalents We consider all highly liquid investment instruments purchased with original maturities of three months or less to be cash equivalents for purposes of the consolidated statements of cash flows and other statements. We maintain cash on deposit in non-interest bearing accounts, which, at times, exceed federally insured limits. We have not experienced any losses on such accounts and believe we are not exposed to any significant credit risk on cash and equivalents.
Revenue recognition and imbalances Oil and gas revenues are recognized when production is sold to a purchaser at a fixed or determinable price, when delivery has occurred and title has transferred, and if collectibility of the revenue is probable. Cash received relating to future revenues is deferred and recognized when all revenue recognition criteria are met.
We use the sales method of accounting for gas production imbalances. The volumes of gas sold may differ from the volumes to which we are entitled based on our interests in the properties. These differences create imbalances that are recognized as a liability only when the properties' estimated remaining reserves net to us will not be sufficient to enable the underproduced owner to recoup its entitled share through production. No receivables are recorded for those wells where we have taken less than our share of production. Gas imbalances are reflected as adjustments to estimates of proved gas reserves and future cash flows in the unaudited supplemental oil and gas disclosures. There was no imbalance at December 31, 2007 and 2006.
Debt issue costs Debt issuance costs incurred are capitalized and subsequently amortized over the term of the related debt on an interest method of accretion over the estimated life of the debt.
Property and Equipment Property and equipment are recorded at cost. Depreciation is on a straight-line method using the estimated lives of the assets (5-30 years). Expenditures for maintenance and repairs are charged to expense.
Oil and gas properties We follow the full cost method of accounting for oil and gas properties. Accordingly, all costs associated with acquisition, exploration, and development are capitalized.
All capitalized costs included in the estimated future costs to develop proved reserves, are amortized on the unit-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 is added to the capitalized costs to be amortized. Abandonment's of oil and gas properties are charged to the full cost pool and amortized.
Under the full cost method, the net book value of oil and gas properties are subject to a "ceiling". The ceiling is the estimated after-tax future net revenue from proved oil and gas properties, discounted at 10% per annum plus the lower of cost or fair market value of unproved properties. In calculating future net revenues, prices and costs in effect at the time of the calculation are held constant indefinitely, except for changes that are fixed and determinable by existing contracts. The excess, if any, of the net book value above the ceiling is written off as an expense.
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 as income.
Long-lived assets Impairment of long-lived assets is recorded when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying value. The carrying value of the assets is then reduced to their estimated fair value, which is usually measured based on an estimate of future discounted cash flows.
Asset retirement obligations We are required to recognize an estimated liability for the plugging and abandonment of our oil and gas wells and associated pipelines and equipment. The liability and the associated increase in the related long-lived asset are recorded in the period in which our asset retirement obligation ("ARO") is incurred. The liability is accreted to its present value each period and the capitalized cost is depreciated over the useful life of the related asset.
The estimated liability is based on historical experience in plugging and abandoning wells, estimated remaining lives of those wells based on reserves estimates and federal and state regulatory requirements. The liability is discounted using an assumed credit-adjusted risk-free rate.
Revisions to the liability could occur due to changes in estimates of plugging and abandonment costs, changes in the risk-free rate or remaining lives of the wells, or if federal or state regulators enact new plugging and abandonment requirements.
Concentration of credit risk We substantially sell all oil and gas production to two customers. In 2007 and 2006 the two largest customers accounted for 92% and 6% and 75% and 12%, of sales, respectively.
Accounting for Derivative Instruments and Hedging Activities We seek to reduce our exposure to unfavorable changes in natural gas prices by utilizing effectively fixed price contracts. The derivative instruments are recognized as assets or liabilities in the statement of financial position, measured at fair value. Accounting for changes in the fair value of the derivative depends on the intended use of the derivative and the resulting designation. For derivatives that are designated as cash flow hedges changes in fair value are recognized in other comprehensive income until the hedged item is recognized in earnings. Hedge effectiveness is measured at least quarterly based on the relative changes in fair value between the derivative contract and the hedged item over time. Any change in fair value resulting from ineffectiveness is recognized immediately in earnings.
Although our fixed price contracts may not qualify for special hedge accounting treatment from time to time under specific guidelines of SFAS 133, we refer to these contracts as hedges inasmuch as this was the intent when such contracts were executed, the characterization is consistent with the actual economic performance of the contracts, and we expect the contracts to continue to mitigate our commodity price risk in the future. The accounting for the contracts is consistent with the requirements of SFAS 133.
We have established the fair value of all derivative instruments using estimates determined by using established index prices and bases adjustments. The values reported in the financial statements change as these estimates are revised to reflect actual results, changes in market conditions or other factors.
Recent issued accounting Standards In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS No. 159"). SFAS No. 159 allows us to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The adoption of SFAS 159 is not expected to have a material impact on our financial position, results of operation or cash flows.
In December 2007, the FASB issued SFAS No. 160, "Non-controlling Interests in Consolidated Financial Statements". This statement amends ARB 51 to establish accounting and reporting standards for the non-controlling (minority) interest in a subsidiary and for the de-consolidation of a subsidiary. It clarifies that a non-controlling interest in a subsidiary is equity in the consolidated financial
statements. SFAS No. 160 is effective for fiscal years and interim periods beginning after December 15, 2008. Management is currently evaluating the effect of this pronouncement on our financial position, results of operation or cash flows.
In December 2007, the FASB issued SFAS No. 141 (Revised), "Business Combinations". SFAS 141 (Revised) establishes principals and requirements for how an acquirer of a business recognizes and measures in its financial statements, the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree. This statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The guidance will become effective for the fiscal year beginning after December 15, 2008. Management is currently evaluating the effect of this pronouncement on our financial position, results of operation or cash flows.
Reclassifications Certain reclassifications have been made to prior periods to conform to current presentation.
2. Going concern
Our financial statements are prepared using generally accepted accounting principles applicable to a going concern, which contemplates the realization of assets and liquidation of liabilities in the normal course of business. Our ability to continue as a going concern is dependent upon us obtaining additional sources of capital or borrowings until the time when we are able to attain future profitable operations. The accompanying financial statements do not include any adjustments that might be necessary should the company be unable to continue as a going concern.
3. Stockholders' Equity
Common stock - ------------
Stock Transactions ------------------
----
During fiscal 2006, Laurus Master Fund Ltd. Converted $913,530 of principal and $203,300 of accrued interest under the convertible term note. Pursuant to the conversion rate of $1.50 they were issued 744,553 shares of common stock.
On February 16, 2006, we issued 40,334 shares of our common stock in exchange for working interest in producing wells valued at $60,500.
On March 31, 2006, we expensed $75,000 subscription receivable in exchange for services rendered in connection with investor relation services.
On May 9, 2006, we issued 368,861 shares of our common stock for the purchase of working interests in producing wells valued at $615,997.
During the year ended December 31, 2006 we issued 95,317 shares of our common stock for various services received. We recorded an expense in the amount of $118,000, the fair value of the underlying shares. We recorded as expense $47,600 and $70,400 in the years ended December 31, 2007 and 2006, respectively.
At December 31, 2006, we authorized the issuance of 6,329 shares of our common stock and recorded an expense in the amount of $15,000, the fair value of services rendered. As of December 31, 2006. These shares were unissued at December 31. 2006.
----
During the year ended December 31, 2007, 6,329 shares that were owed but unissued at the end of December 31, 2006 were issued.
Options and warrants -------------------- All values of options and warrants were determined based on the Black-Scholes pricing model.
The weighted average of the assumptions used to value options and warrants in 2006 were: Interest rate-6.44%, Days to expiration-1,460, Stock price $1.60, Strike price-$1.74, Volatility-49%, Yield-0%.
There were no options or warrants issued in the year ended December 31, 2007.
Options -------
---- On January 1, 2006, we entered into a one-year agreement with R. J. Falkner whereby we granted Mr. Falkner 110,000 options at a strike price of $1.76 exercisable for a period of thirty-six months. The value of the option was $104,004. . We recognized $26,004 and $78,00 as consulting expense in fiscal 2007 and 2006 respectively.
On June 30, 2006, we extended the term of options previously issued to a consultant and recorded an expense in the amount of $30,910.
On September 15, we granted CSC Group 25,000 options at a strike price of $1.75 exercisable for a period of twenty-four months. The value of the option was $10,338 and was recorded as consulting expense.
---- As of December 31, 2006, there was $1,461,747 of unamortized costs of options issued for compensation relating to the options issued to Mr. Branagan in 2005. $127,128 of that amount was amortized into compensation expense in fiscal 2007. During 2007, Mr. Branagan's employment with the Company ended. At that time the options were cancelled and the remaining $1,334,619 unamortized cost of the options was offset to Paid in Capital.
Warrants --------
---- On February 22, 2006, we issued 100,000 shares of our common stock for the exercise of warrants in exchange for cash totaling $150,000.
On April 1, 2006 we granted Laurus Master Fund 200,000 warrants at a strike price of $1.80 per share for a five-year period in connection with the new note. The value of the warrants was $265,015. The value will be accreted to interest expense over the estimated term of the loan.
On April 28, 2006, we issued 105,000 shares of our common stock for the exercise of warrants in exchange for cash totaling $91,875.
On May 31, 2006 we granted Laurus Master Fund 400,000 warrants at a strike price of $1.65 per share for a five-year period in connection with the new note. The value of the warrants was $396,763. The value will be accreted to interest expense over the estimated term of the loan.
----
In fiscal 2007 the remaining unamortized balance of warrants that were issued to Laurus Master Fund in connection with the loans was expensed as the loan was in default. The amount expensed was $1,106,546.
Convertible note ---------------- On October 2004 we issued an $8,000,000 secured convertible term note ("Note") to Laurus Master Fund, Ltd. ("Laurus"). The Note is convertible into shares of our common stock at an initial conversion price of $1.50 per share. The convertible note has a term of three years and accrues interest at the prime rate plus 3% per year The Note is secured by substantially all our assets. This note is in default at December 31, 2007.
Secured term notes ------------------ In October 2005 we borrowed $10,000,000 from Laurus on a secured term note. The interest on the note is prime plus 3.25%. Principal payments are based on an amount that approximated 80% of net revenues as defined in the note agreement. This principally consists of net revenue on new producing wells. The loan will mature on October 31, 2008. The loan is in default as of December 31, 2007.
On March 31, 2006, we borrowed $5,000,000 from Laurus under the credit facility provided in October 2005. Under the terms of the agreement the Company issued a Secured Term Note (the "Note") in the aggregate principal amount of $5 million. The Note has a three-year term and bears an interest rate equivalent to the "prime rate" published by the Wall Street Journal from time to time plus 3.25%, subject to a floor of 10% and a ceiling of 14% per annum. Concurrently with the agreements listed above, the Company amended and restated its previous $10 million Secured Term Note dated October 31, 2005 with Laurus Funds. The loan will mature on March 31, 2009 but is in default as of December 31, 2007.
On May 31, 2006, we borrowed $10,000,000 from Laurus under the credit facility provided in October 2005. Under the terms of the agreement the Company issued a Secured Term Note (the "Note") in the aggregate principal amount of $5 million. The Note has a three-year term and bears an interest rate equivalent to the "prime rate" published by the Wall Street Journal from time to time plus 3.25%, subject to a floor of 10% and a ceiling of 14% per annum. Concurrently with the agreements listed above, the Company amended and restated its previous $10 million Secured Term Note dated October 31, 2005 with Laurus Funds. The loan will mature on May 31, 2009 but is in default as of December 31, 2007.
The master security agreement establishes substantially all of our assets as collateral for the convertible note as well as for this note.
Other notes payable ------------------- We acquired a truck on September 10, 2003 and financed the purchase with a five-year loan from GMAC bearing an interest rate of 8.74%. As of December 31, 2007, the outstanding loan balance is $4,891.
We have $35,583 outstanding on two loans with Cornerstone bank as of December 1, 2007. One loan bears interest of 7% and matured on March 13, 2008. The other loan bears interest of 8% and matured on February 25, 2008.
Loan fees We have incurred loan fees in connection with our financing activities as follows:
--------------------- Financing Fees =====================
Balance, January 1, 2006 $ 816,329 Add for 2006 Notes 563,634 2006 amortization (717,452) ---------------------
Balance, December 31, 2006 $ 662,511 =====================
Balance, January 1, 2007 $ 662,511 2007 amortization (662,511) --------------------- Balance, December 31, 2007 $ -- =====================
Capitalized Interest -------------------- We capitalize interest cost incurred on funds used in the development of our oil and gas properties. Capitalized interest is recorded as part of our capitalized oil and gas properties and is depleted over the estimated useful life of the assets. Interest cost capitalized for the years ended December 31, 2007 and 2006 was $-and $808,714, respectively.
6. Income Taxes
Deferred income taxes are determined based on the tax effect of items subject to differences in book and taxable income. We had no income tax provision for the years ended December 31, 2006, 2005 and 2004. There are approximately $22,500,000 of net operating loss carry-forwards, which expire in 2018-2021. The net deferred tax is as follows as of December 31,:
2007 2006 ------------ ------------ Non-current deferred tax asset (liabilities): Net operating loss carry-forward $10,641,000 $ 7,650,000 Impaired assets & Goodwill 1,279,000 -- Oil & gas properties (6,690,000) (5,226,000) Valuation allowance (5,230,000) (2,424,000) ------------ ------------ Total deferred tax, net $ -- $ -- ============ ============
A reconciliation of the provision for income taxes to the statutory federal rate for continuing operations is as follows as of December 31,:
---------- ---------- 2007 2006 ---------- ---------- Statutory tax rate 34.0% 34.0% Non-deductible expense (2.4) 7.8 Oil & gas properties (14.8) (21.4) Change in valuation allowance (16.8) (20.4) ---------- ---------- Effective tax rate 0.0% 0.0% ========== ==========
7. Related Party Transactions
On June 30, 2006, we expensed a subscription receivable in the amount of $75,000 for one of our shareholders in exchange for public relation services rendered.
During the year ended December 31, 2007 and 2006, we paid fees to Caldwell & Moll, LLC totaling $163,715 and $100,091, respectively for legal services provided in connection with current litigation. An Officer of the Company is a member of the service provider. As of December 31, 2006 the balance owed to Caldwell & Moll was $20,384.
During the year ended December 31, 2007 and 2006, we paid fees to Accuity Financial Services, Inc. totaling $47,100 and $82,500, respectively for services provided in connection with preparation of our quarterly financial statements. A Director (resigned in 2007) of the Company is an officer of the service provider. As of December 31, 2006 the balance owed to Accuity Financial Services, Inc. was $18,000.
8. Derivatives
Description of contracts. ------------------------- We utilize energy swaps to reduce exposure to unfavorable changes in natural gas prices through fixed-price contracts. These contracts allow us to predict with greater certainty the effective natural gas prices received for hedged production. These contracts also benefit operating cash flows and earnings when market prices are less than the fixed prices provided under the contracts. However, we will not benefit from market prices that are higher than fixed prices in contracts for hedged production. If we are unable to provide the quantity that we have contracted for we will have to go to the open market to purchase the required amounts that we have contracted to provide. For the year ended December 31, 2007 and 2006 fixed price contracts hedged approximately 88% and 84%, respectively, of our oil & gas production.
The following table summarizes our fixed price contracts as of December 31, 2007: Year Ending December 31, ------------------- ------------------- Gas Contract volume 90,000 Weighted-average price $7.23
Oil Contract -- volume Weighted-average price --
Fair value asset $ 77,800
Accounting. All fixed price contracts have been executed in connection with our natural gas hedging program. The differential between the fixed price and the floating price for each contract settlement period multiplied by the associated contract volume is the contract profit or loss. All of our contracts are considered to be cash flow hedges and there were no realized gains or losses in the years ending December 31, 2007 and 2006. The change in the fair value is shown as an adjustment to other comprehensive income with a corresponding balance sheet asset or liability recorded.
Credit risk. The counter parties to our fixed-price contracts are the customers buying our product. Should the counter party default on a contract there can be no assurance that we will be able to enter into a new contract with a third party on terms comparable to the original contract. We have not experienced non-performance. Cancellation or termination of a fixed-price contract would subject a greater portion of our gas and oil production to market prices, which in a low price environment, could have an adverse effect on our operating results.
Market risk. Market risk has been significantly hedged through fixed-price contracts.
9. Asset Retirement Obligations
Our asset retirement obligations relate to the abandonment of oil and gas wells. The amounts recognized were based on numerous estimates and assumptions, including future retirement costs, inflation rates and credit adjusted risk-free interest rates. The following shows the changes in asset retirement obligations for the financial statements presented.
Years Ended December 31, 2007 2006 --------- --------- Asset retirement obligation, beginning of year $ 907,797 $ 749,618 Liabilities incurred during the year -- 84,600 Liabilities settled during the year (455,386) -- Accretion of expense 58,589 71,779 --------- --------- Asset retirement obligations, end of year $ 511,000 $ 907,797 ========= =========
10. Impairment of Oil & Gas Properties
We perform a full-cost ceiling test each quarter. The test establishes a limit (ceiling), on a country-by-country basis, on the book value of oil and gas properties. The capitalized costs of proved oil and gas properties, net of accumulated DD&A and the related deferred income taxes, may not exceed this "ceiling". The ceiling limitation is the estimated after-tax future net cash flows from proved oil and gas reserves, excluding future cash outflows associated with settling asset retirement obligations accrued on the balance sheet. The estimate of after-tax future net cash flows is calculated using a discount rate of 10 percent per annum and prices in effect at the end of the period held flat for the life of production, except where future oil and gas sales are covered by physical contract terms or by derivative instruments that qualify, and are accounted for, as cash flow hedges. If capitalized costs exceed this limit, the excess is charged to expense. The ceiling test resulted in an impairment of $15,564,184 in the year ended December 31, 2007. This impairment was for costs assigned to the full cost method subject to amortization, which included the cost of the wells, gathering systems and leasehold costs.
11.Subsequent Events
In January, 2008 we entered into a fixed price contract covering approximately 45,000 DTH per month at a weighted average price of $7.10 for a one-year period beginning April 1, 2008.
On April 30, 2008, Petrol Oil and Gas, Inc., Neodesha Pipeline, Inc. and Coal Creek Pipeline, Inc. (collectively, "Petrol") entered into a Foreclosure-Related Agreement (the "Agreement") with LV Administrative Services, Inc. ("LV"), administrative and collateral agent for Laurus Master Fund, Ltd. ("Laurus"), Valens Offshore SPV I, Ltd. ("Valens Offshore"), Valens U.S. SPV I, LLC ("Valens US"), Calliope Capital Corporation ("Calliope") and Pallas Production Corp. ("Pallas", and together with, Laurus, Valens Offshore, Valens US and Calliope, the "Holders").
Petrol is in default of certain obligations to its Holders under its Secured Convertible Term Note, dated October 28, 2004, in the principle amount of $8,000,000; its Secured Term Note, dated October 31, 2005, in the principle amount of $10,000,000; its Secured Term Note, dated March 31, 2006, in the principle amount of $5,000,000; and its Secured Term Note, dated May 26, 2006, in the principle amount of $10,000,000 (collectively, the "Notes," and all other obligations of Petrol together with the Notes,
the "Outstanding Obligations"), and has received from LV and the Holders a default and acceleration notice with respect to the Outstanding Obligations. The aggregate amount due and owing to the Holders as of April 30, 2008 is approximately $35.7 million.
The Outstanding Obligations are secured by various mortgages and other fixed and mixed assets and real and personal property pursuant to security and other agreements covering assets or other rights to which Petrol has rights (all such assets, rights and collateral, collectively, the "Collateral"), a portion of which are assets and rights referred to as the "Petrol-Neodesha Project," located in Neosho and Wilson Counties, Kansas, consisting of, among other Collateral, mortgages, and real, personal property and fixed and mixed assets used in connection with the Petrol-Neodesha Project (the "Neodesha Collateral").
The Agreement allows the Holders to foreclose on the Neodesha Collateral and governs the terms and conditions of the foreclosure. The Agreement provides that Petrol will not contest the sale of the Neodesha Collateral, which will be conducted as a public foreclosure sale in accordance with Kansas law. Petrol has agreed to reasonably assist LV and the Holders in the completion of the foreclosure sale. After the sale of the Neodesha Collateral becomes final, LV and the Holders will release Petrol of all remaining amounts owed or claims they may have, and the Holders will reassign to Petrol their overriding royalty interests in the mineral leases located at Petrol's Coal Creek Project.
As part of the Agreement, Petrol will cancel all outstanding warrants for purchases of securities issued to Holders in connection with the Outstanding Obligations and replace them with warrants to purchase 1,000,000 shares of common stock at an initial exercise price of $0.20 per share.
12. Supplemental Oil and Gas Reserve Information (Unaudited)
Net Capitalized costs related to oil & gas producing activities
Years Ended December 31, ------------ ------------ 2007 2006 ------------ ------------
Proved $ 12,710,443 $ 24,576,664 Unproved 313,829 1,210,174 ------------ ------------ 13,024,272 25,783,838 Accumulated depreciation and depletion (4,104,601) (2,717,301) ------------ ------------ Net capitalized costs $ 8,919,671 $ 23,066,537 ============ ============