As filed with the Securities and Exchange Commission on June 6, 2005
Reg. No. 333-_____
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U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM SB-2
REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933
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NATURAL GAS SYSTEMS, INC.
(Name of Small Business Issuer in its Charter)
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NEVADA 1382 80-0028196
(State of jurisdiction of (Primary Standard Industrial (I.R.S. Employer
incorporation or organization) Classification Code Number) Identification No.)
820 GESSNER
SUITE 1340
HOUSTON, TX 77024
(713) 935-0122
(Address and telephone number of principal executive offices
and principal place of business)
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NATURAL GAS SYSTEMS, INC.
820 GESSNER
SUITE 1340
HOUSTON, TX 77024
(713) 935-0122
(Name, address and telephone number of agent for service)
COPY TO:
LAWRENCE SCHNAPP, ESQ.
TROY & GOULD PROFESSIONAL CORPORATION
1801 CENTURY PARK EAST, SUITE 1600
LOS ANGELES, CALIFORNIA 90067
(310) 789-1255
Approximate date of proposed sale to the public: From time to time after the
date this registration statement becomes effective.
If this Form is filed to register additional securities for an offering pursuant
to Rule 462(b) under the Securities Act, please check the following box and list
the Securities Act registration statement number of the earlier effective
registration statement for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(c) under
the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]
If this Form is a post-effective amendment filed pursuant to Rule 462(d) under
the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [ ]
If delivery of the prospectus is expected to be made pursuant to Rule 434, check
the following box. [ ]
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CALCULATION OF REGISTRATION FEE
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Amount to be Proposed maximum Proposed maximum Amount of
Title of each class of securities registered offering price aggregate offering registration fee(1)
to be registered per share(1) price(1)
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Common stock, par value $0.001 6,864,345(2) $1.85 $12,699,039 $1,495
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(1) The price is estimated in accordance with Rule 457(c) under the Securities
Act of 1933, as amended, solely for the purpose of calculating the
registration fee and represents the average of the high and the low prices
of the our common stock on June 1, 2005, as reported on the OTC Bulletin
Board.
(2) Of these shares, 5,814,345 are currently outstanding shares to be offered
for resale by selling stockholders and 1,050,000 shares are currently
unissued shares to be offered for resale by selling stockholders following
issuance upon exercise of outstanding warrants. In addition to the shares
set forth in the table, the amount to be registered includes an
indeterminate number of shares issuable upon exercise of the warrants, as
such number may be adjusted as a result of stock splits, stock dividends
and similar transactions in accordance with Rule 416.
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The registrant hereby amends this registration statement on such date
or dates as may be necessary to delay its effective date until the registrant
shall file a further amendment which specifically states that this registration
statement shall thereafter become effective in accordance with Section 8(a) of
the Securities Act of 1933 or until the registration statement shall become
effective on such date as the Commission, acting pursuant to said Section 8(a),
may determine.
The information in this prospectus is not complete and may be changed. The
selling stockholders may not sell these securities until the registration
statement filed with the Securities and Exchange Commission is effective. This
prospectus is not an offer to sell these securities and it is not soliciting an
offer to buy these securities in any state where the offer or sale is not
permitted.
SUBJECT TO COMPLETION, DATED JUNE ___, 2005
PROSPECTUS
NATURAL GAS SYSTEMS, INC.
6,864,345 Shares of our common stock
This prospectus relates to the sale of up to 5,814,345 shares of our
currently outstanding shares of common stock that are owned by some of our
stockholders, and 1,050,000 shares of our common stock issuable upon the
exercise of outstanding common stock purchase warrants held by some of our
warrantholders. For a list of the selling stockholders, please see "Selling
Stockholders." We are not selling any shares of common stock in this offering
and therefore will not receive any proceeds from this offering. We will,
however, receive the exercise price of the warrants if and when those warrants
are exercised by the selling stockholders. None of the warrants has been
exercised as of the date of this prospectus. We will pay the expenses of
registering these shares.
Our common stock is traded in the over-the-counter market and is quoted on
the OTC Bulletin Board under the symbol NGSY. On June 1, 2005, the closing price
of our common stock was $1.85 per share.
The shares included in this prospectus may be offered and sold directly by
the selling stockholders in the open market at prevailing prices or in
individually negotiated transactions, through agents designated from time to
time or through underwriters or dealers. We will not control or determine the
price at which a selling stockholder decides to sell its shares. Brokers or
dealers effecting transactions in these shares should confirm that the shares
are registered under applicable state law or that an exemption from registration
is available.
YOU SHOULD UNDERSTAND THE RISKS ASSOCIATED WITH INVESTING IN OUR COMMON
STOCK. BEFORE MAKING AN INVESTMENT, READ THE "RISK FACTORS," WHICH BEGIN ON PAGE
3 OF THIS PROSPECTUS.
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES
COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR PASSED UPON THE
ADEQUACY OR ACCURACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
The date of this prospectus is ____________, 2005.
TABLE OF CONTENTS
Page
PROSPECTUS SUMMARY.............................................................1
RISK FACTORS...................................................................3
FORWARD-LOOKING STATEMENTS....................................................12
USE OF PROCEEDS...............................................................13
MARKET OF COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.......................13
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.......................................................14
BUSINESS......................................................................21
MANAGEMENT....................................................................27
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT................34
SELLING STOCKHOLDERS..........................................................35
PLAN OF DISTRIBUTION..........................................................40
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................................42
DESCRIPTION OF SECURITIES.....................................................43
EXPERTS.......................................................................45
LEGAL MATTERS.................................................................45
WHERE YOU CAN FIND MORE INFORMATION...........................................45
GLOSSARY OF TERMS.............................................................45
INDEX TO FINANCIAL STATEMENTS................................................F-1
YOU SHOULD RELY ONLY ON THE INFORMATION THAT IS CONTAINED IN THIS PROSPECTUS. WE
HAVE NOT AUTHORIZED ANYONE TO PROVIDE YOU WITH INFORMATION DIFFERENT FROM THAT
CONTAINED IN THIS PROSPECTUS. THIS PROSPECTUS MAY BE USED ONLY IN JURISDICTIONS
WHERE IT IS LEGAL TO SELL THESE SECURITIES. YOU SHOULD ASSUME THAT THE
INFORMATION CONTAINED IN THIS PROSPECTUS IS ACCURATE ONLY AS OF THE DATE OF THIS
PROSPECTUS, REGARDLESS OF THE TIME OF DELIVERY OF THIS PROSPECTUS OR ANY SALE OF
OUR COMMON STOCK. OUR BUSINESS, FINANCIAL CONDITION, RESULTS OF OPERATIONS AND
PROSPECTS MAY HAVE CHANGED SINCE THE DATE OF THIS PROSPECTUS. THIS PROSPECTUS IS
NOT AN OFFER TO SELL OR SOLICITATION OF AN OFFER TO BUY THESE SECURITIES IN ANY
CIRCUMSTANCES UNDER WHICH THE OFFER OR SOLICITATION IS UNLAWFUL.
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PROSPECTUS SUMMARY
This summary highlights information contained elsewhere in this
prospectus; it does not contain all of the information you should consider
before investing in our common stock. You should read the entire prospectus
before making an investment decision, including the information under the
headings "Risk Factors."
All information contained in this prospectus is adjusted to reflect a 40:1
reverse split of our common stock effected in May 2004.
Throughout this prospectus, the terms "we," "us," "our," "our company" and
"NGS" refer to Natural Gas Systems, Inc., a Nevada corporation formerly known as
Reality Interactive, Inc., and, unless the context indicates otherwise, also
includes our wholly-owned subsidiaries.
COMPANY OVERVIEW
Natural Gas Systems, Inc. was formed in late 2003 to acquire established
crude oil and natural gas resources and exploit them through the application of
conventional and specialized technology with the objective of increasing
production, ultimate recoveries, or both. We currently operate in four crude oil
and natural gas fields in the State of Louisiana. Our principal executive
offices are located at 820 Gessner, Suite 1340, Houston, Texas 77024. Our
telephone number is 713-935-0122 and we maintain a website at www.natgas.us.
Information contained on our website does not constitute part of this
prospectus.
In acquiring our crude oil and natural gas properties, we target
established, shallow oil and gas fields or resources, preferably with existing
road, pipeline and storage infrastructure, and reservoirs with low permeability
(referred to as "tight" reservoirs in which oil or gas flow is inhibited). Such
reservoirs typically have low decline rate production and limited drainage areas
per well. Our strategy is to develop incremental value by (i) bringing undrained
or partially drained areas of the reservoirs into production, and (ii)
accelerating existing production by engaging in:
o work-overs to clean sand, water and paraffin from wells,
o re-completions into other reservoirs,
o optimization of production facilities including installation of
compression facilities,
o development and exploitation drilling, and
o selective use of lateral drilling and hydraulic fracturing.
The NGS team is broadly experienced in oil and gas operations,
development, acquisitions and financing and follows a strategy of outsourcing
most of the property, corporate administrative and accounting functions.
CORPORATE HISTORY OF REVERSE MERGER
Reality Interactive, Inc. ("Reality"), a Nevada corporation that traded on
the OTC Bulletin Board under the symbol RLYI.OB, and the predecessor of Natural
Gas Systems, Inc., was incorporated on May 24, 1994 for the purpose of
developing technology-based knowledge solutions for the industrial marketplace.
On April 30, 1999, Reality ceased business operations, sold substantially all of
its assets and terminated all of its employees. Subsequent to ceasing
operations, Reality explored other potential business opportunities to acquire
or merge with another entity, while continuing to file reports with the SEC.
On May 26, 2004, Natural Gas Systems, Inc., a privately owned Delaware
corporation formed in September 2003 ("Old NGS"), was merged into a wholly owned
subsidiary of Reality. Reality was thereafter renamed Natural Gas Systems, Inc.
and adopted a June 30 fiscal year end. As part of the merger, the officers and
directors of Reality resigned, the officers and directors of Old NGS became the
officers and directors of our company and the crude oil and natural gas business
of Old NGS became that of our company.
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1
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THE OFFERING
We are registering 6,864,345 shares of our common stock in order to
enable the holders of those shares to freely re-sell those shares (on the open
market or otherwise) from time to time in the future through the use of this
prospectus. Of these shares, 5,814,345 shares are currently outstanding and were
issued in private transactions and 1,050,000 shares may be issued to selling
stockholders upon their exercise of outstanding warrants issued in private
transactions. Since the foregoing shares and warrants were issued in private,
unregistered transactions, none of the 6,864,345 shares can be freely
transferred at this time by the selling stockholders unless the shares are
included in a prospectus, such as this prospectus, or unless the shares are sold
in an exempt transaction such as a sale that complies with the terms and
conditions of Rule 144 under the Securities Act of 1933.
Common stock offered by the selling stockholders 6,864,345 shares, consisting of 5,814,345 outstanding
shares owned by selling stockholders and 1,050,000
shares issuable to selling stockholders upon exercise
of warrants.
Common stock currently outstanding 24,749,600 shares (1)
Common stock to be outstanding after the offering, 24,749,600 shares (1)
assuming no exercise of the warrants for the shares
covered by this prospectus
Common stock to be outstanding after the offering, 25,799,600 shares (1)
assuming the exercise of all warrants for the shares
covered by this prospectus
OTC Bulletin Board Trading Symbol NGSY
Risk Factors An investment in our common stock involves
significant risks. See "Risk Factors" beginning on
page 3.
(1) Does not include (i) up to 2,680,000 shares of our common stock available
for issuance under our 2004 Stock Plan, (ii) up to 1,200,000 shares of our
common stock issuable upon the exercise of options granted under over 2004 Stock
Plan, (iii) up to 510,000 shares of our common stock issuable upon the exercise
of options granted under our 2003 Stock Option Plan, or (iv) up to 2,028,467
shares of our common stock issuable upon exercise of outstanding warrants. This
prospectus covers the resale of 1,050,000 of the shares issuable upon exercise
of some of the foregoing warrants.
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2
RISK FACTORS
An investment in our common stock involves a high degree of risk. You
should carefully consider the risks described below and the other information
contained in this prospectus before deciding to invest in our company. If any of
the following risks actually occur, our business, financial condition or
operating results and the trading price or value of our securities could be
materially adversely affected.
RISKS RELATED TO OUR BUSINESS AND INDUSTRY
WE MAY BE UNABLE TO OBTAIN THE LARGE AMOUNT OF ADDITIONAL CAPITAL THAT WE NEED
TO OPERATE OUR BUSINESS.
Based on our current estimates of production and current oil and gas
prices, we currently have sufficient capital reserves to satisfy our immediate
short-term obligations and to fund our anticipated development activities
through the end of 2005, but we will require more capital or success in our
development activities or both to execute additional acquisitions, fund our
development plan beyond 2005, replace our existing depleting reserves or exploit
any technology projects we may develop from time to time. Additionally, we may
encounter unforeseen costs or lower commodity prices that could also require us
to seek additional capital. While we are exploring various capital raising
avenues, we cannot assure you that we will be able to obtain the capital needed
to acquire additional crude oil and natural gas fields. Further, we have been
operating at a loss and intend to increase our operating expenses and overhead
significantly as we expand our acquisitions and crude oil and natural gas
production and expand our field operations staff. The full and timely
development and implementation of our business plan and growth strategy beyond
2005 will require significant additional resources, and we may not be able to
obtain the funding necessary to implement our growth strategy on acceptable
terms or at all. An inability to obtain such resources would significantly
impair our ability to execute our growth plan or respond to competitive
pressures. Furthermore, our growth strategy may not produce material revenues
even if successfully funded.
We intend to explore a number of options to secure alternative sources of
capital, including the issuance of senior secured debt, volumetric production
payments, subordinated debt, or additional equity, including preferred equity
securities or other equity securities. We have not yet identified the sources
for the additional financing we require and we do not have commitments from any
third parties to provide this financing. We might not succeed, therefore, in
obtaining additional and acceptable financing when we need it or at all. Our
ability to obtain additional capital will also depend on market conditions,
national and global economics and other factors beyond our control. We cannot
assure you that we will be able to implement or capitalize on various financing
alternatives or otherwise obtain required working capital, the need for which is
substantial given our operating loss history. We refer you to "Management's
Discussion and Analysis of Financial Condition and Results of
Operations-Liquidity and Capital Resources."
OUR LIMITED OPERATING HISTORY MAKES IT DIFFICULT TO PREDICT FUTURE RESULTS AND
INCREASES THE RISK OF YOUR INVESTMENT.
We commenced operations in late 2003 and have a limited operating history.
Therefore, we face all the risks common to companies in their early stages of
development, including uncertainty of funding sources, high initial expenditure
levels and uncertain revenue streams, an unproven business model, and
difficulties in managing growth. Our prospects must be considered in light of
the risks, expenses, delays and difficulties frequently encountered in
establishing a new business. Any forward-looking statements in this prospectus
do not reflect any possible effect on us from the outcome of these types of
uncertainty. Since inception, we have incurred significant losses. We cannot
assure you that we will be successful. While members of our management have
previously carried out or been involved with acquisition and production
activities in the crude oil and natural gas industry while employed by other
companies, we cannot assure you that our intended acquisition targets and
development plans will lead to the successful development of crude oil and
natural gas production or additional revenue.
3
WE MAY BE UNABLE TO CONTINUE LICENSING FROM THIRD PARTIES THE TECHNOLOGIES THAT
WE USE IN OUR BUSINESS OPERATIONS.
As is customary in the crude oil and natural gas industry, we utilize a
variety of technologies in the crude oil and natural gas development and
drilling process. We do not have any patents or copyrights for the technology we
utilize. Instead, we license or purchase services from the holders of such
technology, or outsource the technology integral to our business from third
parties. Our commercial success will depend in part on these sources of
technology and assumes that such sources will not infringe on the propriety
rights of others. We cannot be certain whether any third-party patents will
require us to utilize or develop alternative technology or to alter our business
plan, obtain additional licenses, or cease activities that infringe on
third-parties' intellectual property rights. Our inability to acquire any
third-party licenses, or to integrate the related third-party products into our
business plan, could result in delays in development unless and until equivalent
products can be identified, licensed, and integrated. Existing or future
licenses may not continue to be available to us on commercially reasonable terms
or at all. Litigation, which could result in substantial cost to us, may be
necessary to enforce any patents licensed to us or to determine the scope and
validity of third-party obligations.
REGULATORY AND ACCOUNTING REQUIREMENTS MAY REQUIRE SUBSTANTIAL REDUCTIONS IN
PROVEN RESERVES (SEE GLOSSARY) AND LIMITATIONS OF HEDGING.
We review on a periodic basis the carrying value of our crude oil and
natural gas properties under the applicable rules of the various regulatory
agencies, including the SEC. Under these rules, the carrying value of proved
reserves of crude oil and natural gas properties may not exceed the present
value of estimated future net after-tax cash flows from proved reserves,
discounted at 10%. Application of this "ceiling" test generally requires pricing
future revenues at the unescalated prices in effect as of the end of our fiscal
year and requires a write down for accounting purposes if the ceiling is
exceeded, even if prices declined for only a short period of time. We may in the
future be required to write down the carrying value of our crude oil and natural
gas properties when crude oil and natural gas prices are depressed or unusually
volatile. Whether we will be required to take such a charge will depend on the
prices for crude oil and natural gas at the end of any fiscal period and the
effect of reserve additions or revisions and capital expenditures during such
period. If a write down is required, it would result in a charge to our earnings
but would not impact our cash flow from operating activities.
In order to reduce our exposure to short-term fluctuations in the price of
crude oil and natural gas and comply with the terms of our credit facility, we
have entered into commodity contracts. These arrangements apply to only a
portion of our production and provide only partial price protection against
declines in crude oil and natural gas prices. Our commodity contracts may expose
us to risk of financial loss in certain circumstances, including instances where
production is less than expected, our customers fail to purchase contracted
quantities of crude oil or natural gas or a sudden, unexpected event materially
impacts crude oil or natural gas prices. In addition, our commodity contracts
may limit the benefit to us of increases in the price of crude oil and natural
gas.
WE MAY BE UNABLE TO ACQUIRE AND DEVELOP THE ADDITIONAL OIL AND GAS RESERVES THAT
ARE REQUIRED IN ORDER TO SUSTAIN OUR BUSINESS OPERATIONS.
In general, the volumes of production from crude oil and natural gas
properties decline as reserves are depleted, with the rate of decline depending
on reservoir characteristics. Except to the extent we acquire properties
containing proved reserves or conduct successful development activities, or
both, our proved reserves will decline. Our future crude oil and natural gas
production is, therefore, highly dependent upon our level of success in finding
or acquiring additional reserves.
4
WE ARE SUBJECT TO SUBSTANTIAL OPERATING RISKS THAT MAY ADVERSELY AFFECT OUR
RESULTS OF OPERATIONS.
The crude oil and natural gas business involves numerous operating hazards
such as well blowouts, mechanical failures, explosions, uncontrollable flows of
crude oil, natural gas or well fluids, fires, formations with abnormal
pressures, hurricanes, flooding, pollution, releases of toxic gas and other
environmental hazards and risks. We could suffer substantial losses as a result
of any of these events. While we carry general liability, control of well, and
operator's extra expense coverage typical in our industry, we are not fully
insured against all risks incident to our business.
We may not always be the operator of some of our wells. As a result, our
operating risks for those wells and our ability to influence the operations for
these wells will be less subject to our control. Operators of these wells may
act in ways that are not in our best interests. If this occurs, the development
of, and production of crude oil and natural gas from, some wells may not occur
which would have an adverse effect on our results of operations.
THE LOSS OF KEY PERSONNEL COULD ADVERSELY AFFECT US.
We depend to a large extent on the services of certain key management
personnel, including our executive officers, the loss of any of whom could have
a material adverse effect on our operations. In particular, our future success
is dependent upon Robert S. Herlin, our President, for capital raising, sourcing
and evaluating and closing deals, and oversight of development and operations.
THE LOSS OF ANY OF OUR SKILLED TECHNICAL PERSONNEL COULD ADVERSELY AFFECT OUR
BUSINESS.
We depend to a large extent on the services of skilled technical personnel
to operate and maintain our crude oil and natural gas fields. We do not have the
resources to perform these services and therefor we outsource our requirements.
Additionally, as our production increases, so does our need for such services.
Generally, we do not have long-term agreements with our drilling and maintenance
service providers. Accordingly, there is a risk that any of our service
providers could discontinue servicing our crude oil and natural gas fields for
any reason. Although we believe that we could establish alternative sources for
most of our operational and maintenance needs, any delay in locating,
establishing relationships, and training our sources could result in production
shortages and maintenance problems, with a resulting loss of revenue to us. We
also rely on third-party carriers for the transportation and distribution of our
production, the loss of any of which could have a material adverse effect on our
operations.
BECAUSE OUR CURRENT GAS PRODUCING FIELD HAS ONLY ONE GAS PIPELINE OUTLET, OUR
BUSINESS WOULD BE ADVERSELY AFFECTED IF WE LOST ACCESS TO THAT OUTLET.
All of our natural gas sales are made via one gas pipeline connection. Our
ability to sell natural gas would be adversely affected if the operators of this
pipeline refused to or were unable to accept our gas. We have had infrequent
sales curtailment due to gas quality issues resulting from operational problems
with our gas treating facility that we believe have been rectified. Our only
alternative in such event would be to permit and construct a new pipeline
connection to a pipeline located several miles from the field and which could
require re-locating our gas treating facility.
WE MAY HAVE DIFFICULTY MANAGING FUTURE GROWTH AND THE RELATED DEMANDS ON OUR
RESOURCES AND MAY HAVE DIFFICULTY IN ACHIEVING FUTURE GROWTH.
We hope to experience rapid growth through acquisitions and development
activity. Any future growth may place a significant strain on our financial,
technical, operational and administrative resources. Our ability to grow will
depend upon a number of factors, including:
o our ability to identify and acquire new development or
acquisition prospects;
5
o our ability to develop existing properties;
o our ability to continue to retain and attract skilled
personnel;
o the results of our development program and acquisition
efforts;
o the success of our technology;
o hydrocarbon prices;
o our ability to successfully integrate new properties; and
o our access to capital.
We can not assure you that we will be able to successfully grow or manage
any such growth.
WE FACE STRONG COMPETITION FROM LARGER CRUDE OIL AND NATURAL GAS COMPANIES.
Our competitors include major integrated crude oil and natural gas
companies and numerous independent crude oil and natural gas companies,
individuals and drilling and income programs. Many of our competitors are large,
well-established companies with substantially larger operating staffs and
greater capital resources than we have. We may not be able to successfully
conduct our operations, evaluate and select suitable properties and consummate
transactions in this highly competitive environment. Specifically, these larger
competitors may be able to pay more for development projects and productive
crude oil and natural gas properties and may be able to define, evaluate, bid
for and purchase a greater number of properties and prospects than our financial
or human resources permit. In addition, such companies may be able to expend
greater resources on the existing and changing technologies that we believe are
and will be increasingly important to attaining success in our industry.
THE CRUDE OIL AND NATURAL GAS RESERVE DATA INCLUDED IN THIS PROSPECTUS ARE ONLY
ESTIMATES AND MAY PROVE TO BE INACCURATE.
There are numerous uncertainties inherent in estimating crude oil and
natural gas reserves and their estimated values. The reserves discussed in this
prospectus are only estimates that may prove to be inaccurate because of these
uncertainties. Reservoir engineering is a subjective and inexact process of
estimating underground accumulations of crude oil and natural gas that cannot be
measured in an exact manner. Estimates of economically recoverable crude oil and
natural gas reserves depend upon a number of variable factors, such as
historical production from the area compared with production from other
producing areas and assumptions concerning effects of regulations by
governmental agencies, future crude oil and natural gas prices, future operating
costs, severance and excise taxes, development costs and work-over and remedial
costs. Some or all of these assumptions may in fact vary considerably from
actual results. For these reasons, estimates of the economically recoverable
quantities of crude oil and natural gas attributable to any particular group of
properties, classifications of such reserves based on risk of recovery, and
estimates of the future net cash flows expected therefrom prepared by different
engineers or by the same engineers but at different times may vary
substantially. Accordingly, reserve estimates may be subject to downward or
upward adjustment. Actual production, revenue and expenditures with respect to
our reserves will likely vary from estimates, and such variances may be
material. The information regarding discounted future net cash flows included in
this prospectus should not be considered as the current market value of the
estimated crude oil and natural gas reserves attributable to our properties. As
required by the SEC, the estimated discounted future net cash flows from proved
reserves are based on prices and costs as of the date of the estimate, while
actual future prices and costs may be materially higher or lower. Actual future
net cash flows also will be affected by factors such as the amount and timing of
actual production, supply and demand for crude oil and natural gas, increases or
decreases in consumption, and changes in governmental regulations or taxation.
In addition, the 10% discount factor, which is required by the SEC to be used in
calculating discounted future net cash flows for reporting purposes, is not
necessarily the most appropriate discount factor based on interest rates in
effect from time to time and risks associated with us or the crude oil and
natural gas industry in general.
6
OUR CURRENT CREDIT FACILITY INCLUDES STRICT FINANCIAL COVENANTS THAT WE MAY BE
UNABLE TO SATISFY.
We recently entered into a credit facility with Prospect Energy
Corporation. This facility is secured by essentially all of our existing and
certain future assets including the common stock of our subsidiaries. While no
principal payments are required prior to maturity, we are required to meet
certain ongoing financial covenants. The primary covenants include maintaining a
minimum ratio of borrowing base to debt and a minimum ratio of EBITDA (earnings
before interest, income tax and other noncash charges such as depreciation,
depletion and amortization) to total interest. Our borrowing base is dependent
upon our proved reserves as determined by our outside engineers, to the
reasonable satisfaction of Prospect Energy, future operating costs and capital
expenditures and commodity prices. We cannot assure you that, in the future,
commodity prices will not decline, projected reserve increases will be obtained
or current proved reserves will be realized, any one of which could reduce our
borrowing base, which could in turn require us to reduce our outstanding
borrowings. Other covenants limit additional borrowings, sales of assets and the
distributions of cash or properties and prohibit the payment of dividends and
the incurrence of liens. The restrictions of the credit facility may have
adverse consequences on our operations and financial results, including our
ability to obtain financing for working capital, capital expenditures, our
development program, purchases of new technology or other purposes. We will be
required to use a substantial portion of our cash flow to make debt service
payments, which will reduce the funds that would otherwise be available for
operations and future business opportunities. A substantial decrease in our
operating cash flow or an increase in our expenses could make it difficult for
us to meet our debt service requirements, thus requiring us to modify operations
which could result in our becoming more vulnerable to downturns in our business
or the economy generally.
Our ability to obtain and service indebtedness will depend on our future
performance, including our ability to manage cash flow and working capital,
which are in turn subject to a variety of factors beyond our control. Our
business may not generate cash flow at or above anticipated levels or we may not
be able to borrow funds in amounts sufficient to enable us to service
indebtedness, make anticipated capital expenditures or finance our development
program. If we are unable to generate sufficient cash flow from operations or to
borrow sufficient funds in the future to service our debt, we may be required to
curtail portions of our development program, sell assets, reduce capital
expenditures, refinance all or a portion of our existing debt or obtain
additional financing. We may not be able to refinance our debt or obtain
additional financing, particularly in view of current industry conditions,
restrictions on our ability to incur debt under our existing debt or installment
purchase arrangements, and the fact that some or all of our assets are currently
pledged to secure obligations under our existing debt or installment purchase
arrangements.
WE CANNOT MARKET THE CRUDE OIL AND NATURAL GAS THAT WE PRODUCE WITHOUT THE
ASSISTANCE OF THIRD PARTIES.
The marketability of the crude oil and natural gas that we produce depends
upon the proximity of our reserves to, and the capacity of, facilities and
third-party services, including crude oil and natural gas gathering systems,
pipelines, trucking or terminal facilities, and processing facilities. The
unavailability or lack of capacity of such services and facilities could result
in the shut-in of producing wells or the delay or discontinuance of development
plans for properties. A shut-in or delay or discontinuance could adversely
affect our financial condition. In addition, federal and state regulation of
crude oil and natural gas production and transportation could affect our ability
to produce and market our crude oil and natural gas on a profitable basis.
7
CRUDE OIL AND NATURAL GAS DEVELOPMENT, RE-COMPLETION OF WELLS FROM ONE RESERVOIR
TO ANOTHER RESERVOIR, AND RESTORING WELLS TO PRODUCTION ARE SPECULATIVE
ACTIVITIES AND INVOLVE NUMEROUS RISKS AND SUBSTANTIAL AND UNCERTAIN COSTS.
Our growth will be materially dependent upon the success of our future
development program. Drilling for crude oil and natural gas and re-working
existing wells involve numerous risks, including the risk that no commercially
productive crude oil or natural gas reservoirs will be encountered. The cost of
drilling, completing and operating wells is substantial and uncertain, and
drilling operations may be curtailed, delayed or cancelled as a result of a
variety of factors beyond our control, including:
o unexpected drilling conditions;
o pressure or irregularities in formations;
o equipment failures or accidents;
o inability to obtain leases on economic terms;
o adverse weather conditions;
o compliance with governmental requirements; and
o shortages or delays in the availability of drilling rigs or
crews and the delivery of equipment.
Drilling or re-working is a highly speculative activity. Even when fully
utilized, modern well completion techniques such as hydraulic fracturing and
lateral drilling do not guarantee that we will find crude oil and/or natural gas
in our wells. Hydraulic fracturing involves pumping a fluid with particulates
into a formation at high pressure, thereby creating fractures in the rock and
leaving the particulates in the fractures to ensure that the fractures remain
open, thereby potentially increasing the ability of the reservoir to produce oil
or gas. Lateral drilling involves drilling horizontally out from an existing
vertical well bore, thereby potentially increasing the area and reach of the
well bore that is in contact with the reservoir. Our future drilling activities
may not be successful and, if unsuccessful, such failure would have an adverse
effect on our future results of operations and financial condition. We cannot
assure you that our overall drilling success rate or our drilling success rate
for activities within a particular geographic area will not decline. Although we
may discuss in this prospectus drilling prospects that we have identified or
budgeted for, we may ultimately not lease or drill these prospects within the
expected time frame, or at all. We may identify and develop prospects through a
number of methods, some of which do not include lateral drilling or hydraulic
fracturing. The drilling and results for these prospects may be particularly
uncertain. Our drilling schedule may vary from our capital budget. The final
determination with respect to the drilling of any scheduled or budgeted
prospects will be dependent on a number of factors, including, but not limited
to:
o the results of previous development efforts and the
acquisition, review and analysis of data;
o the availability of sufficient capital resources to us and the
other participants for the drilling of the prospects;
o the approval of the prospects by other participants after
additional data has been compiled;
o economic and industry conditions at the time of drilling,
including prevailing and anticipated prices for crude oil and
natural gas and the availability of drilling rigs and crews;
o our financial resources and results;
8
o the availability of leases and permits on reasonable terms for
the prospects; and
o the success of our drilling technology.
We cannot assure you that these projects can be successfully developed or
that the wells discussed will, if drilled, encounter reservoirs of commercially
productive crude oil or natural gas. There are numerous uncertainties in
estimating quantities of proved reserves, including many factors beyond our
control.
CRUDE OIL AND NATURAL GAS PRICES ARE HIGHLY VOLATILE IN GENERAL AND LOW PRICES
WILL NEGATIVELY AFFECT OUR FINANCIAL RESULTS.
Our revenues, profitability, cash flow, future growth and ability to
borrow funds or obtain additional capital, as well as the carrying value of our
properties, are substantially dependent upon prevailing prices of crude oil and
natural gas. Lower crude oil and natural gas prices also may reduce the amount
of crude oil and natural gas that we can produce economically. Historically, the
markets for crude oil and natural gas have been volatile, and such markets are
likely to continue to be volatile in the future. Prices for crude oil and
natural gas are subject to wide fluctuation in response to relatively minor
changes in the supply of and demand for crude oil and natural gas, market
uncertainty and a variety of additional factors that are beyond our control,
including:
o the level of consumer product demand;
o weather conditions;
o domestic and foreign governmental regulations;
o the price and availability of alternative fuels;
o political conditions;
o the foreign supply of crude oil and natural gas; and
o the price of foreign imports and overall economic conditions.
It is impossible to predict future crude oil and natural gas price
movements. Declines in crude oil and natural gas prices may materially adversely
affect our financial condition, liquidity, ability to finance planned capital
expenditures and results of operations.
GOVERNMENT REGULATION AND LIABILITY FOR ENVIRONMENTAL MATTERS MAY ADVERSELY
AFFECT OUR BUSINESS AND RESULTS OF OPERATIONS.
Crude oil and natural gas operations are subject to extensive federal,
state and local government regulations, which may be changed from time to time.
Matters subject to regulation include discharge permits for drilling operations,
drilling bonds, reports concerning operations, the spacing of wells, unitization
and pooling of properties and taxation. From time to time, regulatory agencies
have imposed price controls and limitations on production by restricting the
rate of flow of crude oil and natural gas wells below actual production capacity
in order to conserve supplies of crude oil and natural gas. There are federal,
state and local laws and regulations primarily relating to protection of human
health and the environment applicable to the development, production, handling,
storage, transportation and disposal of crude oil and natural gas, by-products
thereof and other substances and materials produced or used in connection with
crude oil and natural gas operations. In addition, we may be liable for
environmental damages caused by previous owners of property we purchase or
lease. As a result, we may incur substantial liabilities to third parties or
governmental entities. We are also subject to changing and extensive tax laws,
the effects of which cannot be predicted. The implementation of new, or the
modification of existing, laws or regulations could have a material adverse
effect on us.
9
RISKS RELATED TO OUR STOCK
OUR STOCK PRICE HAS BEEN AND MAY CONTINUE TO BE VERY VOLATILE.
Our common stock is thinly traded and the market price has been, and is
likely to continue to be, highly volatile. During the nine months prior to March
31, 2005 and following the merger of Old NGS (our predecessor) into a subsidiary
of our company, our stock price as traded on the OTC Bulletin Board has ranged
from $1.49 to $3.65. The variance in our stock price makes it extremely
difficult to forecast with any certainty the stock price at which you may be
able to buy or sell shares of our common stock. The market price for our common
stock could be subject to wide fluctuations as a result of factors that are out
of our control, such as:
o actual or anticipated variations in our results of operations;
o naked short selling of our common stock and stock price
manipulation;
o changes or fluctuations in the commodity prices of crude oil
and natural gas;
o general conditions and trends in the crude oil and natural gas
industry; and
o general economic, political and market conditions.
PRESENT MANAGEMENT AND DIRECTORS MAY CONTROL THE ELECTION OF OUR DIRECTORS AND
ALL OTHER MATTERS SUBMITTED TO OUR STOCKHOLDERS FOR APPROVAL.
Our executive officers and directors, in the aggregate, beneficially own
(or have the right to acquire within 60 days of the date of this prospectus)
approximately 38% of our outstanding common stock. Further, our Chairman of the
Board, Mr. Laird Q. Cagan, Managing Director of Cagan McAfee Capital Partners,
LLC ("CMCP") currently owns or controls, directly or indirectly, approximately
7.7 million shares (including shares issuable upon the exercise of warrants), or
approximately 31% of our outstanding common stock. Mr. Eric McAfee, also a
Managing Director of CMCP, currently owns or controls, directly or indirectly,
approximately 5.9 million shares (including shares issuable upon the exercise of
warrants), or approximately 24% of our outstanding common stock. Collectively,
these two managing directors of CMCP currently own or control, directly or
indirectly, approximately 13.6 million shares (including shares issuable upon
the exercise of warrants), or approximately 55% of our outstanding common stock.
As a result, these holders of our outstanding common stock are able to exercise
control over all matters submitted to our stockholders for approval (including
the election and removal of directors and any merger, consolidation or sale of
all or substantially all of our assets). This concentration of ownership may
have the effect of delaying, deferring or preventing a change in control of our
company, impede a merger, consolidation, takeover or other business combination
involving our company or discourage a potential acquirer from making a tender
offer or otherwise attempting to obtain control of our company, which in turn
could have an adverse effect on the market price of our common stock.
"PENNY STOCK" REGULATIONS MAY RESTRICT THE MARKETABILITY OF OUR COMMON STOCK.
The SEC's regulations generally define "penny stock" to be an OTC Bulletin
Board ("OTCBB") stock that has a market price of less than $5.00 per share. Our
common stock may be subject to rules that impose additional sales practice
requirements on broker-dealers who sell these securities to persons other than
established customers and accredited investors (generally those with assets in
excess of $1,000,000, or annual incomes exceeding $200,000 or $300,000 together
with their spouse). For transactions covered by these rules, the broker-dealer
must make a special suitability determination for the purchase of these
securities and have received the purchaser's prior written consent to the
transaction.
Additionally, for any transaction, other than exempt transactions,
involving a penny stock, the rules require the delivery, prior to the
transaction, of a risk disclosure document mandated by the SEC relating to the
penny stock market. The broker-dealer also must disclose the commissions payable
to both the broker-dealer and the registered representative, current quotations
for the securities and, if the broker-dealer is the sole market-maker, the
broker-dealer must disclose this fact and the broker-dealer's presumed control
over the market. Finally, monthly statements must be sent disclosing recent
price information for the penny stock held in the account and information on the
limited market in penny stocks. Consequently, the "penny stock" rules may
restrict the ability of broker-dealers to sell our common stock and may affect
the ability to sell our common stock in the secondary market.
10
THE MARKET FOR OUR COMMON STOCK IS LIMITED AND MAY NOT PROVIDE ADEQUATE
LIQUIDITY.
Our common stock is currently thinly traded on the OTC Bulletin Board, a
regulated quotation service that displays real-time quotes, last-sale prices,
and volume information in over-the-counter equity securities. As a result, an
investor may find it more difficult to dispose of, or obtain accurate quotations
as to the price of, our securities than if the securities were traded on the
Nasdaq Stock market, or another national exchange. There are a limited number of
active market makers of our common stock. In order to trade shares of our common
stock you must use one of these market makers unless you trade your shares in a
private transaction. In the nine months prior to March 31, 2005, the actual
trading volume in our common stock ranged from a low of no shares of common
stock traded to a high of over 64,500 shares of common stock traded, with only
46 days exceeding a trading volume of 10,000 shares. On most days, this trading
volume means there is limited liquidity in our shares of common stock. Selling
our shares is more difficult because smaller quantities of shares are bought and
sold and news media coverage about us is limited. These factors result in a
limited trading market for our common stock and therefore holders of our stock
may be unable to sell shares purchased should they desire to do so.
IF SECURITIES OR INDUSTRY ANALYSTS DO NOT PUBLISH RESEARCH REPORTS ABOUT OUR
BUSINESS OR IF THEY DOWNGRADE OUR STOCK, THE PRICE OF OUR COMMON STOCK COULD
DECLINE.
Small, relatively unknown companies can achieve visibility in the trading
market through research and reports that industry or securities analysts
publish. However, to our knowledge, no analysts cover our company. The lack of
published reports by independent securities analysts could limit the interest in
our common stock and negatively affect our stock price. We do not have any
control over the research and reports these analysts publish or whether they
will be published at all. If any analyst who does cover us downgrades our stock,
our stock price would likely decline. If any analyst ceases coverage of our
company or fails to regularly publish reports on us, we could lose visibility in
the financial markets, which in turn could cause our stock price to decline.
THE ISSUANCE OF ADDITIONAL COMMON AND PREFERRED STOCK WOULD DILUTE EXISTING
STOCKHOLDERS.
We are authorized to issue up to 100,000,000 shares of common stock. To
the extent of such authorization, our board of directors has the ability,
without seeking stockholder approval, to issue additional shares of common stock
in the future for such consideration as our board may consider sufficient. The
issuance of additional common stock in the future will reduce the proportionate
ownership and voting power of the common stock offered hereby. We are also
authorized to issue up to 5,000,000 shares of preferred stock, the rights and
preferences of which may be designated in series by our board of directors. Such
designation of new series of preferred stock may be made without stockholder
approval, and could create additional securities which would have dividend and
liquidation preferences over the common stock offered hereby. Preferred
stockholders could adversely affect the rights of holders of common stock by:
o exercising voting, redemption and conversion rights to the
detriment of the holders of common stock;
o receiving preferences over the holders of common stock
regarding or surplus funds in the event of our dissolution or
liquidation;
o delaying, deferring or preventing a change in control of our
company; and
11
o discouraging bids for our common stock.
SUBSTANTIAL SALES OF OUR COMMON STOCK COULD CAUSE OUR STOCK PRICE TO FALL.
As of May 20, 2005, we had outstanding 24,749,600 shares of common stock,
of which approximately 23,713,345 shares were "restricted securities" (as that
term is defined in Rule 144 promulgated under the Securities Act of 1933). Other
than the shares registered for resale by this prospectus, only approximately
1,036,255 shares are currently freely tradable shares without further
registration under the Securities Act. However, as a result of the registration
of the shares included in this prospectus, an additional 5,814,345 shares of our
currently outstanding common stock will be able to be freely sold on the market,
which number will increase to 6,864,345 shares if the warrants are exercised by
the selling stockholders and the underlying 1,050,000 shares that are included
in this prospectus are purchased. Because there currently are only 1,036,255
freely tradable shares, the release of 5,814,345 additional freely trading
shares included in this prospectus onto the market, or the perception that such
shares will or could come onto the market, could have an adverse affect on the
trading price of the stock.
In addition to the shares that are being registered for re-sale under this
prospectus, an additional 18,000,000 shares of restricted stock became eligible
for public resale under Rule 144 in late May 2005. Although Rule 144 restricts
the number of shares that any one holder can sell during any three-month period
under Rule 144, because more than one stockholder holds these restricted shares,
a significant number of shares can now be sold under Rule 144. We cannot predict
the effect, if any, that sales of the shares included in this prospectus or
subject to Rule 144 sales, or the availability of such shares for sale, will
have on the market prices prevailing from time to time. Nevertheless, the
possibility that substantial amounts of our common stock may be sold in the
public market may adversely affect prevailing market prices for our common stock
and could impair our ability to raise capital through the sale of our equity
securities.
WE DO NOT PLAN TO PAY ANY CASH DIVIDENDS ON OUR COMMON STOCK.
We have not paid any dividends on our common stock to date and do not
anticipate that we will be paying dividends in the foreseeable future. Any
payment of cash dividends on our common stock in the future will be dependent
upon the amount of funds legally available, our earnings, if any, our financial
condition, our anticipated capital requirements and other factors that our board
of directors may think are relevant. However, we currently intend for the
foreseeable future to follow a policy of retaining all of our earnings, if any,
to finance the development and expansion of our business and, therefore, do not
expect to pay any dividends on our common stock in the foreseeable future.
Additionally, we are currently restricted from paying dividends pursuant to the
terms of our credit agreement.
FORWARD-LOOKING STATEMENTS
This document contains forward-looking statements, which reflect the views
of our management with respect to future events and financial performance.
Certain of the statements contained in all parts of this document including, but
not limited to, those relating to our acquisition and development plans, the
effect of changes in strategy and business discipline, our project portfolio,
future general and administrative expenses on a per unit of production basis,
increases in wells operated, future growth, expansion and acquisitions, future
exploration, future seismic data (including timing and results), purchase of
technology licenses and their value and application, expansion of operations,
generation of additional prospects, review of outside generated prospects and
acquisitions, additional reserves and reserve increases, enhancement of
visualization and interpretation strengths, expansion and improvement of
capabilities, integration of new technology into operations, credit facilities,
attraction of new members to our exploration team, future compensation programs,
new focus on core areas, new prospects and drilling locations, future capital
expenditures (or funding thereof), sufficiency of future working capital,
borrowings and capital resources and liquidity, projected cash flows from
operations, expectation or timing of reaching payout, outcome, effects or timing
of any legal proceedings, drilling plans, including scheduled and budgeted
wells, the number, timing or results of any wells, the plans for timing,
interpretation and results of new or existing seismic surveys or seismic data,
future production or reserves, future acquisition of leases, lease options or
other land rights and any other statements regarding future operations,
financial results, opportunities, growth, business plans and strategy and other
statements that are not historical facts are forward looking.
12
These forward-looking statements reflect our current view of future events
and financial performance. When used in this document, the words "budgeted,"
"anticipate," "estimate," "expect," "may," "project," "believe," "intend,"
"plan," "potential" and similar expressions are intended to be among the
statements that identify forward looking statements. These forward-looking
statements speak only as of their dates and should not be unduly relied upon. We
undertake no obligation to update or review any forward-looking statement,
whether as a result of new information, future events, or otherwise. Such
statements involve risks and uncertainties, including, but not limited to, the
numerous risks and substantial and uncertain costs associated with drilling of
new wells, the volatility of crude oil and natural gas prices and the effects of
relatively low prices for our products, conducting successful exploration and
development in order to maintain reserves and revenue in the future, operating
risks of crude oil and natural gas operations, our dependence on key personnel,
our ability to utilize changing technology and the risk of technological
obsolescence, the significant capital requirements of our exploration and
development and technology development programs, governmental regulation and
liability for environmental matters, results of litigation, management of growth
and the related demands on our resources and the ability to achieve future
growth, competition from larger crude oil and natural gas companies, the
potential inaccuracy of estimates of crude oil and natural gas reserve data,
property acquisition risks, and other factors detailed in this document and our
other filings with the SEC. Should one or more of these risks or uncertainties
materialize, or should underlying assumptions prove incorrect, actual outcomes
will likely vary materially from those indicated. For a discussion of some of
the factors that may cause actual results to differ materially from those
suggested by the forward-looking statements, please read carefully the
information under "Risk Factors" beginning on page 3.
You may rely only on the information contained in this prospectus. We have
not authorized anyone to provide information different from that contained in
this prospectus. Neither the delivery of this prospectus nor the sale of common
stock means that information contained in this prospectus is correct after the
date of this prospectus. This prospectus is not an offer to sell or solicitation
of an offer to buy these securities in any circumstances under which the offer
or solicitation is unlawful.
USE OF PROCEEDS
We will not receive any proceeds from the sale of our common stock by the
selling stockholders pursuant to this prospectus. However, we will receive the
sale price of any common stock we sell to the selling stockholders upon exercise
by them of their warrants. If warrants to purchase all of the underlying
1,050,000 shares are exercised for cash, we would receive approximately $850,000
of total proceeds. We would expect to use these proceeds, if any, for general
working capital purposes. We have agreed to pay the expenses of registration of
these shares, including specified legal and accounting fees.
MARKET OF COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
Our common stock has been traded on the OTC Bulletin Board
over-the-counter market since August 9, 2004 under the symbol "NGSY." Prior to
the merger in which Natural Gas Systems, Inc. became our wholly owned subsidiary
on May 26, 2004, our common stock was listed on the OTC Bulletin Board
over-the-counter market under the symbol "RLYI." We recently submitted an
application to have our stock traded on the American Stock Exchange.
There was little trading in our common stock prior to the merger on May
26, 2004, and there has only been limited trading since then. Prior to the
merger, trading in our common stock was not necessarily based on our company's
operations or prospects, and trading since the merger also may not be fully
reflective of those factors. The following price information is reported as of
May 20, 2005 and represent prices between dealers, excluding retail mark-up or
commissions, reflects inter-dealer prices, without retail mark-up, mark-down or
commission and may not represent actual transactions:
13
QUARTER ENDING HIGH LOW
------------------------------- --------------------- ---------------
FISCAL 2004
September 30, 2003 $2.60 $1.20
December 31, 2003 $1.60 $0.64
March 31, 2004 $2.00 $0.75
June 30, 2004 $4.45 $0.91
FISCAL 2005
September 30, 2004 $3.65 $2.05
December 31, 2004 $2.29 $1.49
March 31, 2005 $2.20 $1.55
June 30, 2005 (through
May 20, 2005) $3.47 $1.80
HOLDERS
As of June 1, 2005, there were approximately 246 holders of record of our
common stock and 771 holders in street name, for a total of 1,017 stockholders.
DIVIDENDS
We have not paid any dividends on our common stock to date and do not
anticipate that we will be paying dividends in the foreseeable future. Any
payment of cash dividends on our common stock in the future will be dependent
upon the amount of funds legally available, our earnings, if any, our financial
condition, our anticipated capital requirements and other factors that our board
of directors may think are relevant. However, we currently intend for the
foreseeable future to follow a policy of retaining all of our earnings, if any,
to finance the development and expansion of our business and, therefore, do not
expect to pay any dividends on our common stock in the foreseeable future.
Additionally, we are currently restricted from paying dividends pursuant to the
terms of our credit agreement.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
We did not commence our oil and gas operations until October 2003.
Accordingly, our comparative results are limited.
During the nine months ended March 31, 2005, we generated revenues of
$1,016,828, as compared to $72,801 for the period from our inception (September
23, 2003) through March 31, 2004 (herein referred to as "the six months ended
March 31, 2004"). Of significance in the nine months ended March 31, 2005, we
began our first natural gas sales from our Delhi Field in July 2004, began
recognizing revenues from our first property acquisition in the Tullos Field
Area in September 2004 and began recognizing revenues from our second
acquisition in our Tullos Field Area during February 2005.
14
Although our revenues have continued to increase substantially each
quarter, our most disappointing result for the current fiscal quarter is that
revenues did not increase more dramatically, despite the fact that our most
recent acquisition in the Tullos Field Area generated revenues for two of the
latest three month period. Specifically, our operating results for the three
months ended March 31, 2005 were adversely impacted by the following events:
o What appears to be our most significant oil well to date, a
re-completion of the Delhi Ut. #87-2, did not begin production until
April 2005.
o Our second most significant oil well, the Delhi Ut. #197-2,
continued to experience reduced production and numerous
non-production days due to sand production.
o A major constraint on our revenues was caused by heavy rains that
prevented our crude oil purchaser from loading oil at many of our
tank batteries. Therefore, our oil sales during the quarter were
substantially less than our production, causing our crude oil
inventories to increase materially, thus reducing our recognized
revenues. In the Tullos Field Area, our ending inventories in
storage tanks were approximately 5,600 gross barrels of oil (which
is not recorded on our balance sheet), approximately 4,300 of which
are salable under ordinary operating conditions. Oil produced and
stored and not sold due to inaccessibility represents potential
future revenues to be recognized in subsequent periods.
o Extended rains also prevented most development work in all of our
fields as roads could not be built for new locations and existing
roads could not be maintained. The heavy rains also severely limited
ongoing maintenance and repair work in the Tullos area fields,
causing a loss in production from wells shut-in for repairs.
o The high industry demand for workover service rigs led to our not
having access to equipment during most of March 2005. As our wells
in the Tullos Field Area require a high level of maintenance and
repair, more active wells were not producing for a portion of those
months than is normal.
The following remedial actions have been or are planned to be taken:
o We are aggressively taking action to establish steady production for
the Delhi Ut. #87-2 re-completion, as we believe it has the
potential to substantially increase our production and results from
operations, beginning with the quarter ending June 30, 2005. Initial
test production from the well was approximately 90 barrels of oil
per day (90 BOD) and 30 thousand cubic feet of gas per day (30
MCFD). The well free-flowed at virgin pressure, indicating a lack of
previous depletion. Our completion activities caused a packer leak
that began constraining production, thus requiring us to shut-in the
well for remedial service at the end of April 2005. We anticipate
the well will be returned to production in the near future
o We are evaluating a switch to a progressive cavity pump for the
Delhi Ut. #197-2 that is more resistant to sand production.
o We are planning to sell our 4,300 gross barrels of excess inventory
at Tullos, thus improving our results from operations.
o We plan to start a program of improving the roads in the Tullos
Field Area and we are evaluating the movement of certain tank
batteries to locations more resistant to rain.
15
o We are considering the replacement of high maintenance beam pumps
with submersible pumps in the Tullos Field Area, potentially
reducing maintenance expense and production downtime.
o We have arranged for a local well service company to activate and
dedicate a service rig to our priority use in the Tullos Field Area.
Following is a summary of the progress we have made in both production and
revenue, net to our interest:
THREE MONTHS ENDED
-----------------------------------------------------------------
Net to NGS: Units 12-31-03 3-31-04 6-30-04 9-30-04 12-31-04 3-31-05
Oil & Gas Revenue $ $24,249 $48,572 $69,586 $231,167 $365,768 $419,893
Oil Volumes Sold BO 857 1,498 1,934 3,955 5,234 6,545
Gas Volumes Sold MCF - - 110 11,252 15,679 16,378
Barrels of Oil Equivalent Sold BOE 857 1,498 1,952 5,830 7,847 9,275
Oil Price $/BBL $28.29 $32.43 $ 35.64 $42.66 $47.94 $47.61
Gas Price $/MCF - - $5.90 $5.55 $7.32 $6.71
Operating cost BOE $92.54 $43.20 $43.17 $26.38 $24.14 $25.97
Depreciation, depletion and
amortization ("DD&A") BOE $16.29 $9.06 $14.33 $6.88 $6.88 $6.01
Highlights of our performance, as shown in the table above:
o Increasing revenues for each quarter since we began our operations
in September of 2003.
o Increasing volumes sold for each quarter since inception, with
average daily sales increasing from 9 BOEPD during the three months
ended December 31, 2003 to 103 BOEPD, net to our interest.
o Decreasing operating costs per BOE for all quarters since inception
(except for the most recent fiscal quarter, as a result of
constrained oil sales due to purchaser's inability to gain access to
storage tanks because of heavy rain).
o Decreasing DD&A, due to lower acquisition costs per BOE on recent
field purchases.
Average daily sales were 103 BOEPD for the three months ended March 31,
2005 compared to 16 BOEPD during the three months ended March 31, 2004.
General and administrative expenses increased for the nine months ended
March 31, 2005 to $1,706,871, from $509,783 for the six months ended March 31,
2004. Of the $1,706,871 incurred in the most recent nine month period, $620,589
was due to non-cash charges for stock compensation expense (mostly attributable
to the Tatum contract re-negotiation), versus $104,707 of similar non-cash
charges for the six months ended March 31, 2004. Also included in general and
administrative expenses for the nine month period ended March 31, 2005, are
significant costs of being a public company. Such costs include additional
audit, tax, legal, printing, stock transfer, annual proxy statement preparation,
public merger expenses and similar costs incurred by public companies. We were
not a public company during the six months ended March 31, 2004.
16
There were no changes in our internal control over financial reporting
that occurred during our last fiscal quarter that have materially affected, or
are reasonably likely to materially affect, our internal control over financial
reporting.
LIQUIDITY AND CAPITAL RESOURCES
As of March 31, 2005, we had $978,412 of unrestricted cash and positive
working capital of $832,243. In addition, we had $800,000 available for drawing
under a facility provided by Prospect Energy Corporation (the "Prospect
Facility" or "Facility"), which we allowed to expire on May 3, 2005 as described
in note 5 of our financial statements for the nine months ended March 21, 2005.
We incurred losses for the nine months ended March 31, 2005 of $1,682,775, of
which $620,589 were related to non-cash general and administrative charges
associated with compensatory stock expense (see note 6 to our financial
statements for the nine months ended March 31, 2005). Our working capital of
$832,243 at March 31, 2005 was positively impacted by the $4,000,000 we received
under the Prospect Facility, the proceeds of which were used to pay off most of
our short-term debt and to replenish our working capital. See note 5, Notes
Payable, to our financial statements for the nine months ended March 31, 2005.
During the nine months ended March 31, 2005, the Chairman of our Board of
Directors, Laird Q. Cagan, loaned us, through a series of advances, $920,000
pursuant to a secured promissory note bearing interest at 10% per annum (the
"Bridge Loan"), earmarked for our purchase of working interests in the Tullos
Urania Field in Louisiana, working capital and certain costs related to the
closing of the Prospect Facility. Pursuant to the terms of the Prospect
Facility, we were permitted to repay in full the Bridge Loan following
satisfaction of certain requirements, including the acquisition of oil and gas
price hedges for at least 50% of current net production for a two year period.
On February 15, 2005, we paid off the Bridge Loan in full, including accrued
interest thereon, in the amount of $953,589. As of February 22, 2005 we had
entered into commodity contracts representing in excess of 50% of our estimated
production from existing proved developed producing reserves covering a two year
period.
On February 3, 2005, we closed the Prospect Facility and drew down
$3,000,000, and on March 16, 2005 we drew down an additional $1,000,000 on the
total of $4,800,000 committed under the Facility. The draws were used to fund
the February 2005 acquisition of properties in Louisiana, costs of the
financing, funding of a debt service reserve fund, repayment of the Bridge Loan,
immediate re-development of our existing properties and for working capital
purposes. We allowed the remaining $800,000 commitment to expire on May 3, 2005.
After taking into account the effect of the completion of the February 2005
acquisition of properties (see note 2 to our financial statements for the nine
months ended March 31, 2005), the closing of the Prospect Facility and our
recent private placement of common stock described below, and before taking into
account the effect of any new projects or acquisitions, we believe that our
current liquidity and anticipated operating cash flows will be sufficient to
meet our near-term operating expense and capital expenditure needs, absent
unanticipated reductions of revenue or increases in expenses due to factors
including, but not limited to, drops in product prices, unanticipated shut
downs, bad weather and unforeseen expenses.
On May 6, 2005, we closed a private placement of 1,200,000 shares of our
common stock with a European institutional investor at a $2.50 price per share.
The gross proceeds to us from this offering were $3,000,000 before payment of a
$240,000 placement fee to Chadbourn Securities and Laird Q. Cagan, the Chairman
of our board of directors. We also issued Chadbourn Securities and Mr. Cagan
warrants to purchase up to a total of 96,000 shares of our common stock at a
price of $2.50 per share.
In accordance with our business objectives, we plan to continue expending
considerable time and effort to secure additional capital in order to acquire
additional oil and gas properties. We cannot assure you that we will be able to
secure such additional financing on terms satisfactory to us or at all, or that
we will be able to identify acquisitions that meet our strategic objectives.
17
During the nine months ended March 31, 2005, we raised gross proceeds of
$1,728,876 from the sale of our common stock and warrants to purchase our common
stock. Of the total, $579,868 was received from the sale of 394,200 shares of
our common stock and the issuance of 70,000 shares of our common stock upon the
exercise of options previously granted under our 2004 Stock Plan. The remaining
$1,149,008 was raised through the sale of warrants to Prospect Energy as
described under "Options and Warrants" in note 6 to our financial statements for
the nine months ended March 31, 2005.
During the nine months ended March 31, 2005, we increased our debt, net of
repayments, by $2,118,385, and replaced short-term debt with long-term debt and
equity under the Prospect Facility.
These debt and equity issuances have allowed us to:
o Better match our long-term asset base with a longer term debt
structure, while also relieving our liquidity issues. This is in
sharp contrast to our previous debt structure that was comprised
entirely of short-term debt.
o Close the acquisition of additional oil and gas properties in the
Tullos Urania, Colgrade and Crossroads field area where we already
own existing offset production acquired in September 2004 (together,
the "Tullos Field Area"), thus potentially increasing our cash flow
from operations through both increased production and synergies with
our existing properties.
o Initiate further development of our existing oil and gas properties
in accordance with our business plan to exploit known petroleum
resources.
o Continue to seek additional acquisition candidates in accordance
with our business plan.
For a summary of the terms of the Prospect Facility, the Prospect Loans
and the Prospect Warrants, see note 5, Notes Payable, and note 6, Common Stock,
Options and Warrants, to our financial statements for the nine months ended
March 31, 2005.
INCREASE IN OPERATING CASH FLOWS
We continue to work on increasing cash flow from operations through our
Delhi, Tullos Urania, Colgrade and Crossroads Fields, thereby spreading our
overhead, including significant expenses of being a public company, over a
larger revenue base. We also expect to continue evaluating additional
acquisition candidates that would increase our cash flows from operations.
SIGNIFICANT PROPERTIES, ESTIMATED PROVED CRUDE OIL AND NATURAL GAS RESERVES, AND
FUTURE NET REVENUES
We engaged W. D. Von Gonten & Associates ("Von Gonten") to perform
independent reviews of our proved developed reserves located in the Delhi Field
as of July 1, 2004, the Tullos Field assets purchased in September 2004 as of
July 1, 2004, and the Tullos Field assets purchased in February 2005 as of
January 1, 2005. Von Gonten also previously performed an independent review of
our proved developed reserves in the Delhi Field at January 1, 2004.
Estimates of reserve quantities and values must be viewed as being subject
to significant change as more data about the properties becomes available. All
of our existing wells are generally mature wells, some of which were originally
drilled as many as 79 years ago. As such, they contain older down-hole equipment
that is more subject to failure than new equipment. The failure of such
equipment or other subsurface failure can result in the complete loss of a well.
18
Utilizing the most recent engineering reports of Von Gonten, natural gas
and associated liquids represented 10% and crude oil represented 90% of total
proved reserves, denominated in equivalent barrels using a six MCF of natural
gas to one barrel of crude oil conversion ratio.
The following table sets forth information regarding our proved reserves
based on the assumptions set forth in note 10 to our consolidated financial
statements for the six months ended June 30, 2004, where additional reserve
information is provided. The average NYMEX prices used were adjusted for
transportation, market differentials and BTU content of natural gas produced.
Amounts do not include estimates of future Federal and State income taxes.
PROVED RESERVES
ESTIMATED FUTURE
----------------
GAS & ESTIMATED
CRUDE OIL NGL(1) $ PER FUTURE NET REVENUES
------ ----- ------ ------------
AS OF DATE (BBLS) (MCF) BBL MCF NET REVENUES DISCOUNTED AT 10%
---------- ------ ----- --- --- ------------ -----------------
July 1, 2004 238,904 508,800 $34.80 $6.506 $8,181,711 $6,320,754
July 1, 2004(2) 302,597 34.80 4,637,508 2,232,286
January 1, 2005(3) 275,664 41.20 5,457,703 2,891,390
-------------------------------------------------------------------------------------------------------------------
Total 817,165 508,800 18,276,922 11,444,430
-------------------------------------------------------------------------------------------------------------------
January 1, 2004 240,362 778,700 28.93 8.17 10,065,493 8,119,670
-------------------------------------------------------------------------------------------------------------------
(1) NGL reserves of 5,000 bbls are included in the above natural gas volumes,
at a 6:1 ratio.
(2) Reserves acquired post July 1, 2004, but effective as of July 1, 2004.
(3) Reserves acquired February 3, 2005.
Proved Developed reserves total 100% of Total Proved reserves, and Proved
Developed Producing reserves total 68% of Total Proved reserves.
PRODUCTION, AVERAGE SALES PRICES AND AVERAGE PRODUCTION COSTS
THREE MONTHS ENDED
-----------------------------------------------------------------------
NET TO NGS: UNITS 12/31/03 03/31/04 06/30/04 09/30/04 12/31/04 03/31/05
------------------------------- ----------- ----------- ----------- ---------- ----------- ----------- ------------
Oil Volumes Sold BO 857 1,498 1,934 3,955 5,234 6,545
Gas Volumes Sold MCF - - 110 11,252 15,679 16,378
Oil Price $/BBL $28.29 $32.43 $35.64 $42.66 $47.94 $47.61
Gas Price $/MCF - - $5.90 $5.55 $7.32 $6.71
Production Cost BOE $92.54 $43.20 $43.17 $26.38 $24.14 $25.97
19
PRODUCTIVE WELLS AND DEVELOPED ACREAGE
Developed acreage at February 28, 2005 totaled 14,155.36 net and gross
acres held by a unitization agreement or by production. Unitization occurs when
more than one owner of working interests in a given field and reservoir agree to
combine their interests into a single block, each owning a pro rata percentage
of the overall project. Unitization is used to simplify, or enable,
comprehensive and efficient development activity that is common to numerous
leases.
GROSS AND NET DEVELOPED ACREAGE
PROPERTY GROSS ACRES NET ACRES
-------- ----------- ---------
Delhi Field 13,636.55 13,636.55
Tullos Field - Sept 2004 Acq. 386.04 386.04
Tullos Field - Feb 2005 Acq. 132.77 132.77
Total 14,155.36 14,155.36
We own total working interests in 306 net and gross wells consisting of
253 crude oil wells, 3 natural gas wells, 18 water disposal wells and 32 shut-in
wells with uncertain future utility. Following is a table of productive wells
(defined as producing or capable of production) as of June 1, 2005:
Productive Gross and Net Wells
OIL GAS
------------------------- ---------------------
State Gross Net Gross Net
------------ ----------- --------- --------- ----------
Louisiana 253 253 3 3
----------- --------- --------- ----------
Total 253 253 3 3
----------- --------- --------- ----------
UNDEVELOPED ACREAGE
All working interest acreage owned by us is held by production or through
an active lease or through the Delhi unitization agreement described above.
DRILLING
During the fiscal year ended June 30, 2004 and for the period from July 1,
2004 to May 24, 2005, we drilled no new wells.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Accounting for Oil and Gas Property Costs. As more fully discussed in note
3 to our consolidated financial statements for the six months ended June 30,
2004, we (i) follow the full cost method of accounting for the costs of our oil
and gas properties, (ii) amortize such costs using the units of production
method, and (iii) apply a quarterly full cost ceiling test. Adverse changes in
conditions (primarily oil or gas price declines) could result in permanent
write-downs in the carrying value of our oil and gas properties as well as
non-cash charges to operations, but would not affect our cash flows.
20
Estimates of Proved Oil and Gas Reserves. An independent petroleum
engineer annually estimates 100% of our proved reserves. Reserve engineering is
a subjective process that is dependent upon the quality of available data and
the interpretation thereof. In addition, subsequent physical and economic
factors such as the results of drilling, testing, production and product prices
may justify revision of such estimates. Therefore, actual quantities, production
timing, and the value of reserves may differ substantially from estimates. A
reduction in proved reserves would result in an increase in depreciation,
depletion and amortization ("DD&A") expense.
Estimates of Asset Retirement Obligations. In accordance with SFAS No 143,
we make estimates of future costs and the timing thereof in connection with
recording our future obligations to plug and abandon wells. Estimated
abandonment dates will be revised in the future based on changes to related
economic lives, which vary with product prices and production costs. Estimated
plugging costs may also be adjusted to reflect changing industry experience.
Increases in operating costs and decreases in product prices would increase the
estimated amount of the obligation and increase DD&A expense. Cash flows would
not be affected until costs to plug and abandon were actually incurred.
BUSINESS
COMPANY OVERVIEW
Natural Gas Systems, Inc. was formed as a Delaware corporation in late
2003 to acquire established crude oil and natural gas properties and exploit
them through the application of conventional and specialized technology, with
the objective of increasing the production of crude oil and natural gas and
revenue from these properties. We currently operate our properties in the State
of Louisiana, with three full time employees and a small number of independent
contractors and service providers operating from our headquarters in Houston,
Texas.
Our principal executive offices are located at 820 Gessner, Suite 1340,
Houston, TX 77024 and our telephone number at that address is (713) 935-0122. We
maintain a website at www.natgas.us. Information contained on our website does
not constitute part of this prospectus. Our stock is quoted on the OTC Bulletin
Board under the symbol of NGSY.OB.
CORPORATE HISTORY
Reality Interactive, Inc. ("Reality"), a Nevada corporation, was
incorporated on May 24, 1994 for the purpose of developing technology-based
knowledge solutions for the industrial marketplace. On April 30, 1999, this
company ceased business operations, sold substantially all of its assets and
terminated all of its employees. Subsequent to ceasing operations, Reality
explored potential business opportunities to acquire or merge with an entity
with existing operations, while continuing to file reports with the SEC.
On May 26, 2004, Natural Gas Systems, Inc., a privately owned Delaware
corporation formed in September 2003 ("Old NGS"), was merged into a wholly owned
subsidiary of Reality and Reality acquired all the outstanding shares of Old NGS
in exchange for 21,750,001 shares of our common stock and warrants and options
to purchase approximately 903,932 shares of our common stock upon cancellation
of outstanding warrants and options to purchase shares of Old NGS. Reality
thereafter changed its name to Natural Gas Systems, Inc. and adopted a June 30
fiscal year end. As part of the merger, the officers and directors of Reality
resigned and the officers and directors of Old NGS became the officers and
directors of Natural Gas Systems, Inc., and we moved our offices to Houston,
Texas. Immediately prior to the merger, Reality did not conduct any operations
and had minimal assets and liabilities.
21
BUSINESS ACTIVITIES
We formed NGS to acquire crude oil and natural gas resources and to
develop these resources through the application of capital and technology. We
focus particularly on majority working interests in established oil and gas
resources in fields with low decline rate production from shallower reservoirs,
particularly those reservoirs with low permeability or high geological
complexity. We believe this strategy provides us with the following advantages:
o By focusing on established resources, we believe we are likely to
incur less exposure to the risk of whether or not resources are
present. We also expect a lower level of capital expenditures
necessary for infrastructure, such as roads, water handling
facilities and pipelines.
o By acquiring low decline rate producing wells that can be expected
to produce for many years, we expect to reduce the risk from
short-term crude oil and natural gas price volatility.
o By focusing on shallower reservoirs, we hope to reduce technical and
operational risks associated with higher pressures and temperatures
that are associated with deeper reservoirs, as well as the higher
overall cost of repair, maintenance and drilling associated with
deeper wells.
o By seeking majority working interests, we maintain control of
operations and development.
o By focusing on low permeability or highly complex reservoirs we may
be able to apply certain technologies that could increase recovery
or aid in the identification of development opportunities.
Old NGS purchased its first property in September 2003 through the
acquisition of a 100% working interest and an approximate 80% average net
revenue interest, in property and wells located in northeastern Louisiana which
we refer to as the "Delhi Field." Please see "--Properties." This acquisition
included the purchase of six producing wells, one salt water disposal well and
37 shut-in wells with aggregate average production of approximately 18 barrels
of crude oil per day ("BOPD") and no natural gas sales. The Delhi Field
encompasses approximately 13,636 acres. We own all working interest rights from
the surface to the top of the Massive Anhydride Formation, which lies below the
Tuscaloosa formation in which our currently producing wells are completed and
that are targeted in our development plan, less and except the Mengel Reservoir,
which is being produced by another operator in a small number of wells.
In September 2004, we completed the acquisition of a 100% working interest
and an approximate 78% average net revenue interest, in producing crude oil
wells, equipment and improvements located in the Tullos Urania, Colgrade and
Crossroads Fields in LaSalle and Winn Parishes, Louisiana, which we refer to
collectively as the "Tullos Field." The purchased assets included approximately
124 oil wells, nine water disposal wells, and all associated infrastructure,
including water disposal facilities, crude oil and water tanks, flow lines and
pumping units. The purchase included 15 wells without leases, for which we are
attempting to secure new leases.
In early February 2005, we completed the acquisition of a 100% working
interest and an approximate 80% average net revenue interest in similar
properties in the Tullos Field. The purchased assets included approximately 121
oil wells, 8 salt water disposal wells and associated infrastructure and
equipment.
MARKETS AND CUSTOMERS
Marketing of crude oil and natural gas production is influenced by many
factors that are beyond our control, the exact effect of which is difficult to
predict. These factors include changes in supply and demand, market prices,
government regulation and actions of major foreign producers.
22
Over the past 20 years, crude oil price fluctuations have been extremely
volatile, with crude oil prices varying from $8.50, to in excess of $50 per
barrel. Worldwide factors such as geopolitical, macroeconomic, supply and
demand, refining capacity, petrochemical production and derivatives trading,
among others, influence prices for crude oil. Local factors also influence
prices for crude oil and include regulation and transportation issues unique to
certain producing regions.
Over the past 20 years, domestic natural gas prices have also been
volatile, ranging from $1 to $9 per MCF. The spot market for natural gas,
changes in supply and demand, derivatives trading, pipeline availability, BTU
content of the natural gas and weather patterns, among others, cause natural gas
prices to be subject to significant fluctuations. Due to the practical
difficulties in transporting natural gas, price influences tend to be more
localized for natural gas than for crude oil.
In the U.S. market where we operate, crude oil and gas liquids are readily
transportable and marketable. We sell all of our crude oil production from our
Delhi and Tullos Fields to Plains Marketing, a crude oil purchaser, at
competitive spot field prices. A portion of our crude oil production,
approximately 2100 barrels per month, is subject to a twelve month fixed price
contract with Plains Marketing that began March 1, 2005 and was extended through
May 31, 2006. Please see "--Commodity Contracts." We believe that other crude
oil purchasers are readily available.
We currently sell our natural gas liquids to Dufour Petroleum, L.P., a
subsidiary of Enbridge, at a market- competitive price. We receive an index
price based upon the components of the liquids less a charge of $0.175 per
gallon for transportation and fractionation.
All of our current crude oil and natural gas production is located in
northern Louisiana. There is only one natural gas pipeline sales point readily
available in this area, which reduces our leverage in negotiating a more
favorable transportation charge and sales price. The current natural gas sales
line is also a delivery line to customers, downstream of the pipeline's
processing and treating facilities, thus making the pipeline very sensitive to
the quality of natural gas sold into our point of interconnection.
We presently sell a portion of our natural gas under a short-term contract
with Texla Energy Management, Inc., a natural gas marketer/aggregator, at either
the daily cash price or at the monthly index, as elected by us prior to each
month. The balance, a fixed volume of 100 MMBTU per day, is sold at a fixed
price of $6.21 per MMBTU over a fifteen month period beginning March 1, 2005
(see "Commodity Contracts"). We believe that other natural gas marketers are
readily available. Title to the natural gas passes to the purchaser at the
metered interconnection to the transportation pipeline, where the Index price is
reduced by certain pipeline charges. Natural gas sold from the Delhi Field that
is not subject to the commodity contract referred to above is priced on either a
monthly average index price or a daily cash price as established at the Henry
Hub market, less a $0.21 per MMBTU deduction for the market differential between
Henry Hub and our sales point. All gas sold from the Delhi Field also is charged
$0.0854 per MCF by Gulf South, the pipeline into which we deliver our gas, for
transportation. These costs, along with the costs for natural gas processing and
transportation prior to delivery to the sales point, are deducted from the
natural gas sales receipts before calculation and distribution of royalties.
In late 2003, we entered into an agreement with Verdisys, Inc. to provide
us with lateral drilling services based on our projected needs, subject only to
adequate advance notice, at a fixed price not to exceed the lowest price offered
to any other customer for similar services. Although we may find the Verdisys
technology useful, our business plan does not rely on it. To date, we have used
the Verdisys technology in only two wells, the results of which were
inconclusive.
Since purchase of the Delhi Field and the Tullos Field, we have expended
an estimated approximately $735,000 on development activities.
23
COMMODITY CONTRACTS
In February 2005, we entered into three commodity contracts. The first,
with Plains Marketing L.P., includes the purchase of 70 barrels of crude oil per
day for a 12 month period, including the months of March 2005 through February
2006. The fixed sale price is based upon the NYMEX WTI (West Texas Intermediate)
crude oil price and requires monthly settlements wherein Plains Marketing
delivers a fixed price of $48.35 per barrel to us before adjustment for the
basis differential between NYMEX price and the contract price. This hedge was
extended for the months of March 2006 through May 2006 at a fixed price of
$52.55 per barrel of oil or 70 barrels of oil per day.
The second contract is between us and Wells Fargo Bank, N.A. We purchased
a series of price floors, set at a NYMEX WTI price of $38.00 per barrel of crude
oil based upon the arithmetic average of the daily settlement price for the
first nearby month of NYMEX WTI futures, for 2000 barrels of crude oil per month
for March 2006 through February 2007. The cost of the hedge was $3.00 per barrel
of oil. It is our intent to, each month, buy back the front month of crude oil
floor, purchase a back month, and extend our fixed price contract with Plains
Marketing by one month. Plains Marketing L.P. is our crude oil purchaser and
picks up our production in the field using their trucks.
Our third contract is with Texla Energy Management, Inc., a natural gas
marketer currently purchasing our natural gas production at the Delhi Field.
This contract provides for us to sell 3 MMMBTU of natural gas each month at a
fixed price of $6.21 per MMBTU, before deduction of the $0.0854 per MCF
gathering charge by Gulf South, the owner of the natural gas pipeline into which
we deliver our natural gas from Delhi Field. This fixed price includes the basis
differential from NYMEX to our sales point on the Gulf South pipeline.
As required under our credit agreement with Prospect Energy, these
contracts are placed in amounts aggregating more than 50% of the production
volumes that our outside petroleum engineers have estimated to occur from our
existing proved developed producing reserves over the next two years. Our credit
agreement also requires us to extend such coverage on a rolling two-year basis
through the five year term of the loan.
COMPETITION
Our competitors include major integrated crude oil and natural gas
companies and numerous independent crude oil and natural gas companies,
individuals and drilling and income programs. Many of our competitors are large,
well-established companies with substantially larger operating staffs and
greater capital resources than us. Competitors are national, regional or local
in scope and compete on the basis of financial resources, technical prowess or
local knowledge. The principal competitive factors in our industry are the
ability to efficiently conduct operations, achieve technological advantages and
identify and acquire suitable properties.
GOVERNMENT REGULATION
Crude oil and natural gas drilling and production operations are regulated
by various Federal, state and local agencies. These agencies issue binding rules
and regulations that carry penalties, often substantial, for failure to comply.
These regulations and rules require monthly, semiannual and annual reports on
production amounts and water disposal amounts, and govern most aspects of
operations, drilling and abandonment, as well as crude oil spills. We anticipate
the aggregate burden of Federal, state and local regulation will continue to
increase, including in the area of rapidly changing environmental laws and
regulations. We also believe that our present operations substantially comply
with applicable regulations. To date, such regulations have not had a material
effect on our operations, or the costs thereof. We do not believe that capital
expenditures related to environmental control facilities or other regulatory
matters will be material in the near term. We cannot predict what subsequent
legislation or regulations may be enacted or what affect it will have on our
operations or business.
24
EMPLOYEES
We currently operate our properties in the State of Louisiana with a small
number of independent contractors and service providers administered by four
full time employees located in our Houston office. Our development operations in
Louisiana are carried out by independent contractors through our wholly owned
subsidiaries, Arkla Petroleum, LLC and Four Star Development Corporation. We
plan to add a senior operations executive to our staff in the near term. Our
employees are not represented by a labor organization or covered by a collective
bargaining agreement. We have not experienced work stoppages, and we believe
that our relationship with our employees is good.
PROPERTIES
DELHI FIELD
In late September 2003, Old NGS purchased a 100% working interest and an
80% net revenue interest in 43 wells in Richland, Franklin and Madison Parishes,
Louisiana, which we refer to as the Delhi Field, by paying $995,000 in cash,
issuing non-interest bearing notes for $1,500,000 and assuming a plugging and
abandonment reclamation liability in the amount of approximately $302,000, in
exchange for the conveyance of all the underlying, unitized leasehold interests.
The notes were collateralized by a first mortgage on the leasehold interests and
were fully repaid by the end of 2004.
The Delhi Field was discovered in the mid-1940's and extensively developed
over the subsequent decades through the drilling and completion of approximately
450 wells. According to W. D. Von Gonten & Associates engineers, the third party
reservoir engineering firm that audits our reserves, the Delhi Field has
produced more than 200 million barrels of crude oil and substantial amounts of
natural gas to date. Much of the natural gas production was processed to remove
natural gas liquids and re-injected for pressure maintenance. Beginning in the
late 1950's, the field was unitized to conduct a pressure maintenance water
flood project. Unitization is the process of combining multiple leases into a
single ownership entity in order to simplify operations and equitably distribute
royalties when common operations are conducted over multiple leases. Drilling
operations resulted in primarily 40-acre spacing across the unit's 13,636 acres.
A few wells were drilled below the targeted Tuscaloosa formation.
At the time of acquisition in 2003, production in the Delhi Field averaged
approximately 18 BOPD with no natural gas being sold due to a lack of natural
gas processing and transportation facilities. The best producing well, the
161-36, was immediately lost during a periodic sand wash work-over when water
from a lower reservoir broke through along the casing exterior and into the
producing reservoir. Following the acquisition, we initiated a development
program for the Delhi Field based on re-completion of wells to other reservoirs
and restoring nonproducing wells to producing status. We further refurbished a
gas injection line to serve as our gas gathering line.
In March of 2004, we installed a leased natural gas treating and
compression facility under a one-year operating lease that automatically extends
on a month-to-month basis. The facility, located just north of the Delhi Field
on land provided to us by another oil and gas operator, was necessary to begin
sales of natural gas, which began in July of 2004, thus expanding our revenue
base as contemplated by our original plan for the Delhi Field.
By early April 2005, the gross productive rate of the field was
approximately 110 BOPD and 375 MCFD of natural gas and 5 BLPD. Current natural
gas sales have been about 75-100 MCFD less as a portion of the produced natural
gas is utilized as compressor, dehydrator and pump engine fuel on site and a
portion is converted into natural gas liquids. Several of our currently shut-in
wells are scheduled to be restored to production through workovers to repair
mechanical problems or through re-completions into new reservoirs. In addition,
we have scheduled the first five development wells to be drilled that target
remaining oil and gas reserves.
25
TULLOS FIELD AREA
On September 3, 2004, through a wholly owned subsidiary, we completed the
acquisition of a 100% working interest and approximately 78% average net revenue
interest in producing and shut-in crude oil wells, water disposal wells,
equipment and improvements located in the Tullos Urania, Colgrade and Crossroads
Fields in LaSalle and Winn Parish, Louisiana, collectively referred to as the
Tullos Field. The purchased assets included 124 completed wells, nine water
disposal wells, and all associated infrastructure, including water disposal
facilities, crude oil and water tanks, flow lines and pumping units. In addition
we acquired 15 crude oil wells that required new leases. Of the purchased wells,
81 were producing and 43 were shut-in due to repair and maintenance
requirements. Our current production rate is approximately 65 barrels of crude
oil per day plus a small amount of associated natural gas that is not sufficient
in volume to warrant collection for sales. The purchase price for the
acquisition was $725,000, before adjustment for post-effective date production
and expenses.
In early February 2005, we closed the purchase of a 100% working interest
and approximately 80% average net revenue interest in additional properties in
the same Tullos Urania and Colgrade Fields. The purchased assets included 65
producing crude oil wells, 56 shut-in crude oil wells, eight salt water disposal
wells and associated infrastructure and equipment with estimated gross
production of approximately 70 barrels of crude oil per day. The purchase price
for the acquisition was $798,907, after post-closing adjustments.
To date, our development work has been focused on reducing producing well
downtime due to mechanical problems. In April of 2005, we began a program to
return wells to active production that had been shut-in for extended periods of
time. Other near term projects include gathering natural gas from the producing
wells to power electric generators that will power our electric pumps in the
area. We also plan to increase the overall and localized capacity for produced
water disposal.
We maintain insurance on our properties and operations for risks and in
amounts customary in the industry. Such insurance includes general liability,
excess liability, control of well, operators extra expense and casualty
coverage. Not all losses are insured, and we retain certain risks of loss
through deductibles, limits and self-retentions. We do not carry lost profits
coverage.
We occupy a leased headquarters containing 2,259 square feet in a modern
high-rise office building located in the West Memorial area of Houston, Texas.
In April 2004, we extended our lease for three years with an option for early
termination after 18 months, and the right to use furniture and fixtures without
cost.
For more complete information regarding current year activities, including
crude oil and natural gas production, refer to "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
LEGAL PROCEEDINGS
We are not a party to any material legal proceedings.
26
MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
The following table sets forth the name, age, background and position held
by each of our executive officers and directors as of May 20, 2005. Directors
are elected for a period of one year and thereafter serve until the next annual
meeting at which their successors are duly elected by the stockholders.
YEAR FIRST
ELECTED
NAME AGE PRINCIPAL OCCUPATION DIRECTOR
---- --- -------------------- --------
Laird Q. Cagan 47 Mr. Cagan has served as our Chairman of the Board and Secretary since 2004
May 2004. Mr. Cagan is a co-founder, and, since 2001, has been
Managing Director, of Cagan McAfee Capital Partners, LLC, a
technology-focused private equity firm in Cupertino, California. He
also serves as President of Cagan Capital, LLC, a merchant bank he
formed in 1990. From 1999 to 2001, he served as Chairman and Chief
Executive Officer of BarterNet Corporation, a worldwide Internet B2B
exchange. Mr. Cagan attended M.I.T. and received a BS and an MS
degree in engineering, and an MBA from Stanford University. He is a
member of the Young Presidents Organization. Please also see
"Certain Relationships and Related Transactions."
Robert S. Herlin 50 Mr. Herlin has been President, Chief Executive Officer and a Director 2004
of our company since May 2004. Prior to the merger of Natural Gas
Systems, Inc. ("Old NGS") into our company, Mr. Herlin served as
President, Chief Executive Officer and Director of Old NGS. He is
responsible for all of our operations, development of our business
model, identifying acquisitions of applicable crude oil and natural
gas properties, developing our operating team and creating,
establishing and maintaining industry partnerships. Mr. Herlin has
more than 21 years of experience in energy transactions, operations
and finance with small independents, larger independents and major
integrated crude oil companies. Since 2003, Mr. Herlin has also
served as a Partner with Tatum CFO, a financial advisory firm that
provides executive officers on a part-time or full-time basis to
clients. From 2001 to 2003, Mr. Herlin served as Senior Vice
President and Chief Financial Officer of Intercontinental Towers
Corporation, an international wireless infrastructure company. From
1997 to 2001, he was employed at Benz Energy, Inc., a crude oil and
natural gas company, most recently as President, CEO and CFO. Mr.
Herlin also serves on the board of directors of Boots and Coots
Group, a crude oil field services company. Mr. Herlin graduated with
honors from Rice University with B.S. and M.E. degrees in chemical
engineering and has an MBA from Harvard University.
John Pimentel 38 Mr. Pimentel has served as a director of our company since May 2004. 2004
Since 2002, Mr. Pimentel has been a principal of Cagan McAfee Capital
Partners, where he is responsible for business development,
investment structuring, and portfolio company management. From 1998
to 2002, he worked with Bain & Company in that firm's Private Equity
Group, and the general consulting practice. From 1993-1996, Mr.
Pimentel served as Deputy Secretary for Transportation for the State
of California. Mr. Pimentel has served as a director of World Waste
Technologies, Inc., a waste technology company, and Pacific Ethanol,
Inc. since early 2004. Mr. Pimentel has an MBA degree from the
Harvard Business School, and a BA degree from UC Berkeley
27
YEAR FIRST
ELECTED
NAME AGE PRINCIPAL OCCUPATION DIRECTOR
---- --- -------------------- --------
Gene Stoever (1)(2) 65 Mr. Stoever has served as a director of our company since May 2004. 2004
In 1993, Mr. Stoever retired from KPMG Peat Marwick after 32 years of
service, including 24 years as a partner. Since 1999, he has acted as
an independent consultant for various companies. From 1999 to 2004,
he served as a trustee of the Sterling Diagnostic Imaging and SDI
Liquidating Trust. He also serves as a Director of Exopack, LLC, a
flexible packaging company and Propex Fabricx, Inc., a producer of
primary and secondary carpet backing and manufacturer of
polypropylene synthetic fabrics. Mr. Stoever earned his B.B.A.
degree in accounting with honors from the University of Texas at
Austin, is a Certified Public Accountant in the State of Texas and a
member of the American Institute of CPAs and the Texas Society of
Certified Public Accountants. Mr. Stoever serves as Chairman of our
Audit Committee.
E.J. DiPaolo (1)(2) 51 Mr. DiPaolo has served as a director of our company since May 2004. 2004
Mr. DiPaolo has served as an Energy Advisor to Growth Capital
Partners, L.P., an investment banking company, since 2003. From 2002
to the present, Mr. DiPaolo has served as an independent energy
producer. From 1976 to 2002, Mr. DiPaolo was with Halliburton
Company, most recently as Group Senior Vice President of Global
Business Development, where he was responsible for the management of
overall customer relationships with the companies within
Halliburton's upstream businesses, including Halliburton Energy
Services, Brown and Root Energy Services, and Landmark Graphics and
Wellstream. Previously, Mr. DiPaolo was the North American Regional
Vice President and Far East Regional Vice President for Halliburton,
accountable for the overall operation of Halliburton Energy Services
in those regions. Mr. DiPaolo also serves on the Board of Directors
of Boots and Coots Group, a crude oil field services company, and
Edgen Corporation, a pipe distribution company. He received his
undergraduate degree in agricultural engineering from West Virginia
University in 1976 where he currently serves on the Advisory Board of
the College of Engineering. Mr. DiPaolo serves as Chairman of our
Compensation Committee.
Sterling H. McDonald 56 Mr. McDonald joined Old NGS as Chief Financial Officer in 2003 and N/A
has served as our Chief Financial Officer since the merger of Old NGS
into our company in May 2004. Since joining us, Mr. McDonald has
also been responsible for our administrative functions. From 1999 to
2003, Mr. McDonald acted as an independent consultant and interim
Chief Financial Officer to various companies. From 1997 to 1999, he
served as Chief Financial Officer for PetroAmerican Services, a
subsidiary of an integrated NYSE-traded crude oil and natural gas
company. Previously, he served as Chief Financial Officer of
PetroStar Energy, an exploration and production company, and
Treasurer of Reading and Bates Corporation, a NYSE-traded
international offshore drilling services, exploration and production
company. Mr. McDonald holds an MBA, with highest academic
achievement, from the University of Tulsa.
28
(1) Member of our Audit Committee.
(2) Member of our Compensation Committee.
AUDIT COMMITTEE AND COMPENSATION COMMITTEE
In May 2004, our board of directors established an Audit Committee. Our
board has instructed the Audit Committee to meet periodically with our
management and independent accountants to, among other things, review the
results of the annual audit and quarterly reviews and discuss our financial
statements, recommend to our board the independent accountants to be retained,
and receive and consider the accountants' comments as to controls, adequacy of
staff and management performance and procedures in connection with audit and
financial controls. The Audit Committee is also authorized to review related
party transactions for potential conflicts of interest. The Audit Committee is
composed of Mr. Gene Stoever, Chairman, and Mr. E.J. DiPaolo. Each of these
individuals is a non-employee director. Mr. Stoever has been designated as an
"audit committee financial expert" as defined under Item 401(e)(2) of Regulation
SB of the Securities Act of 1933. Messrs. Stoever and DiPaolo are each
considered "independent" directors as that term is used in Item 7(d)(3)(iv) of
Schedule 14A under the Securities Act.
In addition, our board of directors has established a Compensation
Committee, currently comprised of Mr. DiPaolo, as Chairman, and Mr. Stoever. The
Compensation Committee administers our 2004 Stock Option Plan and negotiates and
approves employment agreements with our executive officers.
EXECUTIVE COMPENSATION
The following table sets forth the compensation for services in all
capacities to our company for the fiscal year ended June 30, 2004, for our Chief
Executive Officer (the "Named Executive"). No other executive officer earned
total annual salary and bonus in excess of $100,000:
29
SUMMARY COMPENSATION TABLE
ANNUAL COMPENSATION
-------------------
NAME AND FISCAL SECURITIES UNDERLYING
PRINCIPAL POSITION YEAR SALARY OPTIONS AND WARRANTS
---------------------------------------- --------- ------------------------- --------------------------
Robert S. Herlin 2004 $141,187 250,000 (1)
President and Chief Executive Officer
--------------
(1) These options were issued at an exercise price of $0.001. In 2005, Mr.
Herlin was awarded an option to acquire up to an additional 50,000 shares at an
exercise price of $1.80 per share and a warrant to acquire up to 287,500 shares
of common stock at an exercise price of $1.80 per share.
OPTION GRANTS AND EXERCISES IN LAST FISCAL YEAR
The following table sets forth certain information with respect to stock
options granted under our 2004 Stock Plan to the Named Executive during the
fiscal year ended June 30, 2004, stock option exercises during that year, and
the value of unexercised stock options at that year's end.
INDIVIDUAL GRANTS
-----------------------------------------------------------------------------------
NAME NUMBER OF SHARES % OF TOTAL EXERCISE EXPIRATION DATE
OF OUR COMMON OPTIONS GRANTED
STOCK UNDERLYING TO EMPLOYEES IN
OPTIONS GRANTED (1) FISCAL YEAR PRICE ($/SH)
-------------------------- -------------------- ------------------- --------------- -----------------
Robert S. Herlin 250,000 50% $0.001 9/23/2013 (1)
--------------
(1) The options were granted for a term of 10 years, subject to earlier
termination in certain events related to termination of employment.
There were no option exercises during the fiscal year ended June 30, 2004.
EMPLOYMENT AGREEMENTS; CHANGE IN CONTROL AGREEMENTS
Executive Employment Agreement: Robert S. Herlin
On September 23, 2003, Natural Gas Systems, Inc., a Delaware corporation
("Old NGS"), a subsidiary of Natural Gas Systems, Inc., a Nevada corporation
(the "Company"), entered into an Executive Employment Contract (the "Original
Herlin Employment Contract") with Robert S. Herlin for Mr. Herlin to serve as
President and Chief Executive Officer. Pursuant to the Original Herlin
Employment Contract, Mr. Herlin was granted a stock option to purchase 250,000
shares of Old NGS common stock with an exercise price equal to $0.001 vesting
over four years, that were to be cancelled when the Company granted warrants to
Tatum CFO Partners, LLP, a provider of contract CFO's and other executive level
executives ("Tatum"), in connection with Mr. Herlin's status as a partner of
Tatum and certain other services to be provided by Tatum. In addition, under the
Original Herlin Employment Contract Mr. Herlin received an annual salary of
$180,000, an annual discretionary bonus of up to $180,000, a six month severance
package, and purchased 1,000,000 shares of common stock of Old NGS, with Old NGS
having a repurchase right under a reverse vesting arrangement over 27 months
(the "Stock Purchase Agreement"). The Original Herlin Employment Contract and
Stock Purchase Agreement were assumed by us when our subsidiary merged with Old
NGS in May 2004. In addition, the stock options were exchanged in the merger for
stock options exercisable for shares of our common stock.
30
On April 4, 2005, we entered into an Executive Employment Contract (the
"New Herlin Employment Contract") with Mr. Herlin. The New Herlin Employment
Contract supersedes the Original Herlin Employment Contract. Pursuant to the New
Herlin Employment Contract, Mr. Herlin will continue to serve as our President
and Chief Executive Officer. He will receive an annual salary of $180,000, which
will increase to $210,000 at the end of one year, and a one year severance
package. Mr. Herlin is also eligible to receive an annual discretionary bonus
equal to 100% of his annual salary. As a bonus for fiscal 2004, Mr. Herlin will
retain the 250,000 stock options granted to him under the Original Employment
Agreement. We also entered into a new agreement with Tatum, which supercedes the
original agreement with Tatum and provides for us to grant Tatum a warrant to
purchase 262,500 shares our common stock, exercisable at $0.001 exercisable for
five years. We refer you to "Amended and Restated Agreement with Tatum
Partners."
On April 4, 2005, Mr. Herlin was granted a stock option to purchase
500,000 shares of our common stock, with an exercise price equal to $1.80 that
vests over four years, as well as an additional grant of a warrant to purchase
287,500 shares of our common stock, with an exercise price equal to $1.80 that
vests over four years.
Amended and Restated Agreement with Tatum Partners.
In September 2003, Old NGS entered into a Resources Agreement with Tatum
CFO Partners, LLP (the "Original Tatum Contract"). The Original Tatum Contract
provided for Tatum to make available to Old NGS the services of its partner,
Robert S. Herlin, and provide access to various Tatum resources in exchange for
sharing of Mr. Herlin's compensation from Old NGS. The Original Tatum Contract
was assumed by us when our subsidiary merged with Old NGS in May 2004.
On April 4, 2005, we executed an Amended and Restated Resources Agreement
(the "Amended and Restated Tatum Contract") with Tatum. Pursuant to the Amended
and Restated Tatum Contract, Tatum will receive $12,000 per year for access to
its services. In addition, we granted Tatum a warrant to purchase 262,500 shares
of our common stock, exercisable at $0.001 per share and exercisable for a
period of five years.
Executive Employment Agreement: Sterling H. McDonald
On November 10, 2003, Old NGS entered into an Executive Employment
Contract with Sterling H. McDonald for Mr. McDonald to serve as Chief Financial
Officer (the "Original McDonald Employment Contract"). The Original McDonald
Employment Contract provided for a grant of a stock option to purchase 250,000
shares of common stock of Old NGS, with an exercise price of $0.25 that vests
over 48 months. In addition, under the Original McDonald Employment Contract Mr.
McDonald received an annual salary of $120,000, an annual discretionary bonus,
and a maximum six month severance package. The Original McDonald Employment
Contract was assumed by us when our subsidiary merged with Old NGS in May 2004.
In addition, the stock options were exchanged in the merger for stock options
exercisable for shares of our common stock.
On April 4, 2005, we entered into an Executive Employment Contract (the
"New McDonald Employment Contract") with Mr. McDonald. The New McDonald
Employment Contract supersedes the Original McDonald Employment Contract, with
the exception that Mr. McDonald retained the stock options under the terms
previously granted. Pursuant to the New McDonald Employment Contract, Mr.
McDonald will continue to serve as our Chief Financial Officer. In addition, Mr.
McDonald will receive an annual salary of $150,000. Mr. McDonald is also
eligible to receive an annual discretionary bonus equal to 75% of his annual
salary, and a six month severance package which may be increased to one year
under conditions related to a change of control. In addition, on April 4, 2005,
Mr. McDonald was granted a stock option to purchase 350,000 shares of our common
stock at an exercise price of $1.80 vesting over four years.
31
COMPENSATION OF BOARD OF DIRECTORS
On October 22, 2004, our board approved the grant of options to purchase
up to 100,000 shares of common stock with an exercise price of $1.27 per share,
to each of our two independent board members, Messrs. Gene Stoever and Jed
DiPaolo. The options vest annually over a two-year period beginning May 26,
2004, the date of the directors' election to our board. The independent
directors are paid $3,000 per fiscal quarter for attending board meetings. Mr.
Stoever is also paid $13,000 per year for his services as Chairman of the Audit
Committee, and Mr. DiPaolo is paid $13,000 per year for his services as Chairman
of the Compensation Committee. We also reimburse our non-employee directors for
any direct expenses they incur in their capacity as directors.
Laird Q. Cagan, chairman of our board, also earns compensation from our
company through his relationship with our financial advisor, Cagan McAfee
Capital Partners, LLC ("CMCP") and placement agent (Chadbourn Securities, Inc.).
In addition, we reimburse CMCP for the costs of legal services performed by
staff members of CMCP under the direction of our general counsel. Mr. Cagan is
also reimbursed by us for documented travel expenses he incurs from time to time
directly on our behalf. Please see "Certain Relationships and Related
Transactions."
Mr. Pimentel, who also serves on our board, is a principal of CMCP but
does not receive compensation from CMCP in connection with CMCP's services to
us.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
On August 2, 2004, our stockholders approved the adoption of our 2004
Stock Plan, under which 4,000,000 shares are authorized for issuance. The
purpose of the 2004 Stock Plan is to grant stock options to purchase our common
stock to our employees and key consultants. On October 22, 2004, our board of
directors authorized the issuance of an option to acquire up to 100,000 shares
of our common stock to each of our two independent directors, Mr. E. J. DiPaolo
and Mr. Gene Stoever, at an exercise price of $1.27 per share. On April 4, 2005,
our board authorized the issuance of options to acquire a total of up to
1,000,000 shares of our common stock and the issuance of warrants to purchase up
to 287,500 shares of our common stock, all at an exercise price of $1.80 per
share, to our employees and general counsel. On May 5, 2005, we granted Liviakis
Financial Communications, Inc. ("Liviakis"), our investor relations firm,
120,000 restricted shares of common stock, at a purchase price of $0.001 per
share, subject to monthly vesting over one year. Further, in connection with the
Merger, we assumed the obligations of 600,000 stock options under our newly
acquired subsidiary's 2003 Stock Option Plan. No further shares will be issued
under the 2003 Stock Option Plan.
STOCK PLAN
We adopted an equity incentive plan, the 2004 Stock Plan, pursuant to
which we are authorized to grant options, restricted stock and stock
appreciation rights to purchase up to 4,000,000 shares of our common stock to
our employees, officers, directors, consultants and other agents and advisors.
Our wholly owned subsidiary, Natural Gas Systems, Inc., a Delaware corporation
("Old NGS"), also adopted a Stock Option Plan in 2003. The 2003 Stock Option
Plan was adopted prior to the consummation of the merger with Old NGS so as to
enable us to issue in connection with the merger options to purchase our common
stock in exchange for all of the stock options that were outstanding under Old
NGS's option plan. Awards under the plan may consist of stock options (both non-
qualified options and options intended to qualify as "Incentive Stock Options"
under Section 422 of the Internal Revenue Code of 1986, as amended), restricted
stock awards and stock appreciation rights.
32
The 2004 Stock Plan is administered by our board of directors or a
committee of our board, which determines the persons to whom awards will be
granted, the type of award to be granted, the number of awards to be granted and
the specific terms of each grant, including the vesting thereof, subject to the
provisions of the plan.
The 2004 Stock Plan provides that the exercise price of each incentive
stock option may not be less than the fair market value of our common stock on
the date of grant (or 110% of the fair market value in the case of a grantee
holding more than 10% of our outstanding common stock). Non-qualified stock
options may be granted under the plan at an exercise price established by the
administrator at the time of grant. The maximum number of options that may be
granted in any fiscal year to any participant is 500,000.
The plan also permits the committee to grant freestanding stock
appreciation rights or in tandem with option awards. The grant price of a stock
appreciation right may not be less than the fair market value of a share on the
date of grant of the stock appreciation right. No stock appreciation right may
be exercisable later than the tenth anniversary of its grant. Upon the exercise
of a stock appreciation right, a participant is entitled to receive common stock
at a fair market value equal to the benefit to be received by the exercise.
The plan also provides us with the ability to grant or sell shares of
common stock that are subject to certain transferability, forfeiture, repurchase
or other restrictions. The type of restriction, the number of shares of
restricted stock granted and other such provisions are determined by the
committee.
Unless otherwise determined by the committee, awards granted under the
2004 Stock Plan are not transferable other than by will or by the laws of
descent and distribution.
The committee may alter, amend or terminate the plan in any respect at any
time, but no alteration, amendment or termination can adversely affect in any
material way any award previously granted under the plan, without the written
consent of the participant holding such award.
We currently have outstanding options under our 2003 Stock Option Plan to
purchase 510,000 shares of our common stock at a weighted- average exercise
price of approximately $0.12 per share. We currently have outstanding options
under our 2004 Stock Plan to purchase 1,200,000 shares of our common stock at a
weighted- average exercise price of approximately $1.71 per share.
INDEMNIFICATION
Our articles of incorporation provide that no officer or director shall be
personally liable to our corporation or our stockholders for monetary damages
except as provided pursuant to Nevada law. Our bylaws and articles of
incorporation also provide that we shall indemnify and hold harmless each person
who serves at any time as a director, officer, employee or agent of our company
from and against any and all claims, judgments and liabilities to which such
person shall become subject by reason of the fact that he is or was a director,
officer, employee or agent of our company, and shall reimburse such person for
all legal and other expenses reasonably incurred by him or her in connection
with any such claim or liability. We also have the power to defend such person
from all suits or claims in accord with Nevada law. The rights accruing to any
person under our bylaws and articles of incorporation do not exclude any other
right to which any such person may lawfully be entitled, and we may indemnify or
reimburse such person in any proper case, even though not specifically provided
for by our bylaws or articles of incorporation.
Insofar as indemnification for liabilities arising under the Securities
Act may be permitted to directors, officers and controlling persons of our
company pursuant to the foregoing provisions, or otherwise, we have been advised
that in the opinion of the Securities and Exchange Commission such
indemnification is against public policy as expressed in the Securities Act and
is, therefore, unenforceable.
33
SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT
Based solely upon information made available to us, the following table
sets forth information with respect to the beneficial ownership of our common
stock as of May 20, 2005 by (1) each person who is known by us to beneficially
own more than five percent of our common stock; (2) each director; (3) the Named
Executive; and (4) all executive officers and directors as a group. Shares of
common stock that are subject to outstanding options and warrants that are
presently exercisable or exercisable within 60 days of May 20, 2005 are deemed
to be outstanding for purposes of computing the percentage ownership of the
holder of the options and warrants, but not for any other person. Except as
otherwise indicated, the holders listed below have sole voting and investment
power with respect to all shares of common stock beneficially owned by them,
subject to community property laws where applicable.
NAME AND ADDRESS OF AMOUNT AND NATURE OF
BENEFICIAL OWNER BENEFICIAL OWNERSHIP PERCENT OF CLASS(1)
-------------------------------------------------- ------------------------------------- ----------------------
Robert Herlin(2)(3) 1,158,594 4.65%
Laird Q. Cagan(4)(5) 7,704,643 30.83
John Pimentel(4) 450,000 1.82
E.J. DiPaolo(2)(6) 50,000 *
Gene Stoever(2)(6) 50,000 *
Eric A. McAfee, P2 Capital LLC , Park Capital 5,907,500 23.79
III, and McAfee Capital LLC(4)(7)
All executive officers and directors as a group 9,528,862 37.57
(six persons)(3)(5)(6)(7)
-------------
* Less than 1%
(1) Based on 24,749,600 shares outstanding on May 20, 2005.
(2) Address: c/o Natural Gas Systems, Inc., 820 Gessner, Suite 1340, Houston,
Texas 77024.
(3) Includes (i) 1,000,000 shares directly held by Mr. Herlin of which 100,000
shares are subject to a repurchase agreement in favor of our company
expiring September 22, 2005; (ii) up to 140,625 shares of our common stock
issuable upon exercise of options currently exercisable (or exercisable
within 60 days of the date of this prospectus); and (iii) up to 17,969
shares of our common stock issuable upon exercise of warrants currently
exercisable (or exercisable within 60 days of the date of this
prospectus). Does not include (i) up to 609,375 shares of our common stock
issuable upon the exercise of options and (ii) up to 232,031 shares of our
common stock issuable upon the exercise of warrants, in each case not
exercisable within 60 days of the date of this prospectus.
(4) Address: c/o Cagan McAfee, 10600 N. De Anza Blvd., Suite 250, Cupertino,
California 95014.
(5) Includes (i) 6,464,000 shares directly held by Mr. Cagan; (ii) 1,000,000
shares held in trust by Mr. Cagan's two daughters; (iii) currently
exercisable warrants to acquire 158,143 shares of common stock held by Mr.
Cagan issued in connection with services rendered through Chadbourn
Securities as our placement agent; and (iv) currently exercisable warrants
to purchase 82,500 shares owned by Cagan McAfee Capital Partners, LLC
("CMCP"), out of a total of warrants to purchase 165,000 shares owned by
CMCP, an entity in which Mr. Cagan owns a 50% interest and shares voting
and dispositive power.
(6) Includes 50,000 shares of our common stock issuable upon exercise of
options currently exercisable (or exercisable within 60 days of the date
of this prospectus), but excludes up to 50,000 shares of our common stock
issuable upon exercise of options not exercisable within 60 days of the
date of this prospect.
34
(7) Includes (i) 1,000,000 shares directly held by Mr. McAfee, (ii) 2,000,000
shares held by P2 Capital LLC, an entity owned 50% by Marguerite McAfee
(Mr. McAfee's spouse) and 25% by each of Mr. and Mrs. McAfee's minor
children (over which shares Mrs. McAfee holds sole dispositive and voting
power), (iii) 2,700,000 shares held by McAfee Capital, LLC, an entity
owned 50% by each of Mr. and Mrs. McAfee (over which shares Mr. and Mrs.
McAfee share voting and dispositive power); (iv) 125,000 shares owned by
Berg McAfee Companies, LLC (out of total of 250,000 shares owned by Berg
McAfee Companies, LLC), an entity in which Mr. McAfee owns a 50% interest
and shares voting and dispositive power; and (v) currently exercisable
warrants to purchase 82,500 shares owned by Cagan McAfee Capital Partners,
LLC ("CMCP"), out of a total of warrants to purchase 165,000 shares owned
by CMCP, an entity in which Mr. McAfee owns a 50% interest and shares
voting and dispositive power. Mr. McAfee disclaims beneficial ownership
over all of the shares held by P2 Capital LLC and 50% of the shares held
by Berg McAfee. McAfee Capital LLC disclaims beneficial ownership over all
of the shares held by P2 Capital LLC.
SELLING STOCKHOLDERS
We are registering our shares of common stock in order to permit the
selling stockholders to offer the shares for resale from time to time. Except
for the ownership of our common stock issued pursuant to a Securities Purchase
Agreement between us and Rubicon Master Fund, or as otherwise set forth below,
none of the selling stockholders have had any material relationship with us
within the past three years.
The table below lists the selling stockholders and other information
regarding the beneficial ownership of our shares of common stock by each of the
selling stockholders. The second column lists the number of shares of our common
stock beneficially owned by each selling stockholder as of May 20, 2005.
In accordance with the terms of registration rights agreements with
certain of the selling stockholders, this prospectus generally covers the resale
of 100% of the securities as of the trading day immediately preceding the date
the registration statement is initially filed with the SEC. The selling
stockholders may sell all, some or none of their shares in this offering. See
"Plan of Distribution."
-------------------------------------------------------------------------------------------------------------------------
BENEFICIAL OWNERSHIP BENEFICIAL OWNERSHIP
BEFORE OFFERING AFTER OFFERING (1)
-------------------------------------------------------------------------------------------------------------------------
NUMBER OF
NUMBER OF SHARES BEING NUMBER OF
NAME SHARES PERCENT OFFERED SHARES PERCENT
-------------------------------------------------------------------------------------------------------------------------
Rubicon Master Fund(2) 1,200,000 4.84% 1,200,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Prospect Energy Corporation (3) 1,000,000 3.88 1,000,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Linden Growth Partners, L.P. 500,000 2.02 500,000 -0-
-------------------------------------------------------------------------------------------------------------------------
Bradley Rotter 299,477 1.21 299,477 -0- -
-------------------------------------------------------------------------------------------------------------------------
Berg McAfee Companies, LLC (4) 250,000 1.01 250,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Sunrise Foundation Trust 249,667 1.01 249,667 -0- -
-------------------------------------------------------------------------------------------------------------------------
Prima Capital Group, Inc. (5) 210,000 * 210,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Sobrato 1979 Revocable Trust 200,001 * 200,001 -0- -
-------------------------------------------------------------------------------------------------------------------------
Michael Brown Trust dated 6/30/2000 200,000 * 200,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
MLPF&S Custodian FBO Michael L. Peterson, IRRA 200,000 * 200,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Thomas R. Grimm TTEE 200,000 * 200,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
35
-------------------------------------------------------------------------------------------------------------------------
BENEFICIAL OWNERSHIP BENEFICIAL OWNERSHIP
BEFORE OFFERING AFTER OFFERING (1)
-------------------------------------------------------------------------------------------------------------------------
NUMBER OF
NUMBER OF SHARES BEING NUMBER OF
NAME SHARES PERCENT OFFERED SHARES PERCENT
-------------------------------------------------------------------------------------------------------------------------
Tom Lenner 200,000 * 200,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
George Andros 100,000 * 100,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Matthew R. Iwasaka 100,000 * 100,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Pepper Snyder 100,000 * 100,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Barry Fay 75,000 * 75,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Karen P. Christensen 57,500 * 57,500 -0- -
-------------------------------------------------------------------------------------------------------------------------
Bill Kemp 55,000 * 55,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Barsema Community Property Trust 50,000 * 50,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Douglas J. Hansen Revocable Trust-dated Feb. 22, 2000 50,000 * 50,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Ellis Group 50,000 * 50,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
James F. George 50,000 * 50,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Joseph B. Childrey 50,000 * 50,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Richard From (6) 50,000 * 50,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Select Partnership 50,000 * 50,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Sycamore Capital Partners (7) 45,000 * 45,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Stephen George 42,500 * 42,500 -0- -
-------------------------------------------------------------------------------------------------------------------------
Elizabeth A. Reed 40,000 * 40,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Blair Capital, Inc. 35,000 * 35,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Louis S. Lyras 35,000 * 35,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Alex & Lisa Jachno 30,000 * 30,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
George Myers 30,000 * 30,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
R.V. Edwards, Jr. 30,000 * 30,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Albert T. & Janice T. Kogura 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Andrew Hoffman 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
David J. Scoffone 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Elizabeth Rose 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
James and Patricia Iwasaka 2000 Living Trust 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
James E. George 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Jim Wolfenberger 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Kranenburg Fund, LP 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Larry J. & Kathie L. Magdaleno 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Marcus Abundis 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Navid Eskandari 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Nigel Gallimore 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Peter Rettman 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Venkata S K Kollipara Cust Priya Kollipara UTMA OH 25,000 * 25,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Tony Lao 21,800 * 21,800 -0- -
-------------------------------------------------------------------------------------------------------------------------
Jeffrey Schlossberg 20,400 * 20,400 -0- -
-------------------------------------------------------------------------------------------------------------------------
36
-------------------------------------------------------------------------------------------------------------------------
BENEFICIAL OWNERSHIP BENEFICIAL OWNERSHIP
BEFORE OFFERING AFTER OFFERING (1)
-------------------------------------------------------------------------------------------------------------------------
NUMBER OF
NUMBER OF SHARES BEING NUMBER OF
NAME SHARES PERCENT OFFERED SHARES PERCENT
-------------------------------------------------------------------------------------------------------------------------
Bellano Family Trust 20,000 * 20,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Colum McDermott 20,000 * 20,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Ellias & Tina Argyropoulos 20,000 * 20,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Gary B. Laughlin 20,000 * 20,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
John G. Fallon 20,000 * 20,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Lakshmana Madala 20,000 * 20,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
McDonald Investments Inc., c/FBO Michael A. 20,000 * 20,000 -0- -
Frangopoulos IRA Rollo A/C 85413874 dtd 02/05/99
-------------------------------------------------------------------------------------------------------------------------
Ruben Rey & Marie A. Rey 20,000 * 20,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Steven Chang 20,000 * 20,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Venkata Kollipara 20,000 * 20,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Venkata S.K. Kollipara 20,000 * 20,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Venkata S K Kollipara Cust Puneet Kollipara UTMA OH 15,000 * 15,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Vincent J. Cicillini 15,000 * 15,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Judy Hui 13,000 * 13,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Wing Chun Liu 11,500 * 11,500 -0- -
-------------------------------------------------------------------------------------------------------------------------
George Myers 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Armen Arzoomanian 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Barbara Sherman 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Byron Sudduth 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Daniel J. Yates 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
David A. Desilva 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Dr. Sayed M. Yossef 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Edward W Muransky Revocable Trust 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Elizabeth G. Reinhold, sole trustee of Revocable * -0- -
Living Trust 10,000 10,000
-------------------------------------------------------------------------------------------------------------------------
Henry H. Mauz, Jr. 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Henry Mauz 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Howard Kaplan 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
James Todd Burkdoll 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Joseph W. Brown 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Joseph Zito 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Kennon Harlen White 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Kevin Henning 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Lakshmana R. Madala MD Defined Benefits Plan 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Mark V. Taylor 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Michael Kemp 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Rex V. Jobe 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
37
-------------------------------------------------------------------------------------------------------------------------
BENEFICIAL OWNERSHIP BENEFICIAL OWNERSHIP
BEFORE OFFERING AFTER OFFERING (1)
-------------------------------------------------------------------------------------------------------------------------
NUMBER OF
NUMBER OF SHARES BEING NUMBER OF
NAME SHARES PERCENT OFFERED SHARES PERCENT
-------------------------------------------------------------------------------------------------------------------------
Steve Elefter 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Steven A. McIntee 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Talbert Sakamoto 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Vandeweghe Living Trust 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Yannis Kaplanis 10,000 * 10,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Michael L. Bowman 7,500 * 7,500 -0- -
-------------------------------------------------------------------------------------------------------------------------
Richard Garia 6,700 * 6,700 -0- -
-------------------------------------------------------------------------------------------------------------------------
Jim Phillips (8) 6,000 * 6,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Bhargava Ravi 5,000 * 5,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Donna Velazquez 5,000 * 5,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
G. Alfred Roensch Trust (9) 5,000 * 5,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Gregg Wm Mullery 5,000 * 5,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
James & Bernice Campbell 5,000 * 5,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
John J. Burke 5,000 * 5,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Lori Bosi 5,000 * 5,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Mace Matiosian 5,000 * 5,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Martin Hagenson 5,000 * 5,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Robert Bellano (10) 5,000 * 5,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Santuccio Ricciardi 5,000 * 5,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Steven Berglund 5,000 * 5,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Tom Beck 5,000 * 5,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Cynthia Hiatt 3,800 * 3,800 -0- -
-------------------------------------------------------------------------------------------------------------------------
Alex & Agafio L. Jachno 3,000 * 3,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Barbara M. LaCosse 3,000 * 3,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Leif Johansson 3,000 * 3,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Steven Saint Germain 3,000 * 3,000 -0- -
-------------------------------------------------------------------------------------------------------------------------
Charles Ta 2,500 * 2,500 -0- -
-------------------------------------------------------------------------------------------------------------------------
-----------------
* Less than 1%
(1) The "Beneficial Ownership After Offering" table assumes that all shares
being offered under this prospectus will be resold by the selling
stockholders after this offering, including all convertible securities.
(2) Pursuant to investment agreements, each of Rubicon Fund Management Ltd., a
company organized under the laws of the Cayman Islands, which we refer to
in this prospectus as Rubicon Fund Management Ltd, and Rubicon Fund
Management LLP, a limited liability partnership organized under the laws
of the United Kingdom, which we refer to in this prospectus as Rubicon
Fund Management LLP, Mr. Paul Anthony Brewer, Mr. Jeffrey Eugene
Brummette, Mr. William Francis Callanan, Mr. Vilas Gadkari, Mr. Robert
Michael Greenshields and Mr. Horace Joseph Leitch III share all investment
and voting power with respect to the securities held by Rubicon Master
Fund. Mr. Brewer, Mr. Brummette, Mr. Callanan, Mr. Gadkari, Mr.
Greenshields and Mr. Leitch control both Rubicon Fund Management Ltd and
Rubicon Fund Management LLP. Each of Rubicon Fund Management Ltd, Rubicon
Fund Management LLP, Mr. Brewer, Mr. Brummette, Mr. Callanan, Mr. Gadkari,
Mr. Greenshields and Mr. Leitch disclaim beneficial ownership of these
securities.
38
(3) Represents shares of common stock issuable upon exercise of warrants
issued in connection with the Prospect Facility. These five year warrants
give Prospect the right to purchase up to 600,000 shares of our common
stock at an exercise price of $0.75 per share, and to purchase up to an
additional 400,000 shares of our common stock at an exercise price of
$0.75 per share ("revocable warrants"); provided that the revocable
warrants are subject to cancellation by us prior to their exercise if we
meet certain operating cash flow targets.
(4) Mr. McAfee is a founder and major stockholder of our company (see
"Security Ownership of Certain Beneficial Owners and Management"). Mr.
McAfee has represented to us that he is a 50% owner of Berg McAfee
Companies, LLC, which owns approximately 30% of the shares of Verdisys,
Inc. a company for which Mr. McAfee previously served as Vice Chairman of
the Board. We paid $130,000 to Verdisys during calendar year 2003 for
horizontal drilling services, and $25,960 to Verdisys during 2004. In
2004, Mr. McAfee resigned from the Board of Directors of Verdisys, but
continues to hold shares in both Verdisys and our company. Mr. McAfee is
also a Managing Director of CMCP, which has acted as a financial
consultant to our company. During fiscal 2003, we paid CMCP $32,500 as
monthly retainers. During the six months ended June 30, 2004, we paid CMCP
$30,000 as monthly retainers and recorded an additional $150,000 for
accrued but unpaid retainers. During the nine months ended March 31, 2005,
we paid CMCP $15,000 as monthly retainers and recorded an additional
$120,000 for accrued but unpaid retainers. In May 2005 we paid CMCP
$180,000 for accrued but unpaid monthly retainers. In May 2004 we issued
CMCP seven-year warrants to purchase up to 165,000 shares of our common
stock as additional compensation for arranging the merger of Old NGS into
our company. These warrants have an exercise price of $1.00 per share.
(5) Includes 10,000 shares of our common stock purchased by Demetri
Argyropoulos, who has a controlling interest in Prima Capital Group
("Prima") from Laird Q. Cagan at a nominal price in connection with
consulting services performed for Mr. Cagan, and 50,000 shares purchased
from us by Prima in a capital raising transaction. Prima was also a
founder of our company (acquiring 150,000 shares at a nominal price) and
has acted periodically as a consultant in connection with acquiring such
shares.
(6) Represents shares sold to Richard From by CMCP at a nominal price in
connection with consulting services performed for CMCP. We agreed to
register these shares in consideration for various consulting services
performed by Mr. From for us.
(7) Represents warrants to purchase 45,000 shares issued to Sycamore Capital
Partners in connection with consulting services performed for us.
(8) Represents 6,000 shares purchased by Jim Phillips from Laird Q. Cagan at a
nominal price in connection with consulting services performed for Mr.
Cagan.
(9) Represents 5,000 shares sold to G. Alfred Roensch Trust by CMCP at a
nominal price in connection with consulting services performed for CMCP.
We agreed to register these shares in consideration for various consulting
services performed by Mr. Roensch for us.
(10) Represents warrants to purchase 5,000 shares issued to Robert Bellano in
connection with consulting services performed for us.
39
RELATIONSHIPS WITH SELLING STOCKHOLDERS
All stockholders, other than as disclosed in the footnotes above, are
investors who acquired their securities from us in one or more private
placements of common stock and who have had no position, office, or other
material relationship (other than as purchasers of securities) with us or any of
our affiliates within the past three years.
The information in the above table is as of the date of this prospectus.
Information concerning the selling stockholders may change from time to time and
any such changed information will be described in supplements to this prospectus
if and when necessary.
PLAN OF DISTRIBUTION
We are registering shares of our common stock to permit the resale of
these shares of our common stock by the holders of such shares of our common
stock from time to time after the date of this prospectus. We will not receive
any of the proceeds from the sale by the selling stockholders of the shares of
our common stock. We will bear all fees and expenses incident to our obligation
to register the shares of our common stock.
The selling stockholders may sell all or a portion of the shares of our
common stock owned by them and offered hereby from time to time directly or
through one or more underwriters, broker-dealers or agents. If the shares of our
common stock are sold through underwriters or broker-dealers, the selling
stockholders will be responsible for underwriting discounts or commissions or
agent's commissions. The shares of our common stock may be sold in one or more
transactions at fixed prices, at prevailing market prices at the time of the
sale, at varying prices determined at the time of sale, or at negotiated prices.
These sales may be effected in transactions, which may involve crosses or block
transactions,
o on any national securities exchange or quotation service on
which the securities may be listed or quoted at the time of
sale;
o in the over-the-counter market;
o in transactions otherwise than on these exchanges or systems
or in the over-the-counter market;
o through the writing of options, whether such options are
listed on an options exchange or otherwise;
o ordinary brokerage transactions and transactions in which the
broker-dealer solicits purchasers;
o block trades in which the broker-dealer will attempt to sell
the shares as agent but may position and resell a portion of
the block as principal to facilitate the transaction;
o purchases by a broker-dealer as principal and resale by the
broker-dealer for its account;
o an exchange distribution in accordance with the rules of the
applicable exchange;
o privately negotiated transactions;
o short sales;
o sales pursuant to Rule 144;
40
o broker-dealers may agree with the selling stockholders to sell
a specified number of such shares at a stipulated price per
share;
o a combination of any such methods of sale; and
o any other method permitted pursuant to applicable law.
If the selling stockholders effect such transactions by selling shares of
our common stock to or through underwriters, broker-dealers or agents, such
underwriters, broker-dealers or agents may receive commissions in the form of
discounts, concessions or commissions from the selling stockholders or
commissions from purchasers of the shares of our common stock for whom they may
act as agent or to whom they may sell as principal (which discounts, concessions
or commissions as to particular underwriters, broker-dealers or agents may be in
excess of those customary in the types of transactions involved). In connection
with sales of the shares of our common stock or otherwise, the selling
stockholders may enter into hedging transactions with broker-dealers or others,
which may in turn engage in short sales of the shares of our common stock in the
course of hedging in positions they assume. The selling stockholders may also
sell shares of our common stock short and deliver shares of our common stock
covered by this prospectus to close out short positions and to return borrowed
shares in connection with such short sales. The selling stockholders may also
loan or pledge shares of our common stock to broker-dealers or others that in
turn may sell such shares.
The selling stockholders may pledge or grant a security interest in some
or all of the shares of our common stock owned by them and, if they default in
the performance of their secured obligations, the pledgees or secured parties
may offer and sell the shares of our common stock from time to time pursuant to
this prospectus or any amendment to this prospectus under Rule 424(b)(3) or
other applicable provision of the Securities Act of 1933, amending, if
necessary, the list of selling stockholders to include the pledgee, transferee
or other successors in interest as selling stockholders under this prospectus.
The selling stockholders also may transfer and donate the shares of our common
stock in other circumstances in which case the transferees, donees, pledgees or
other successors in interest will be the selling beneficial owners for purposes
of this prospectus, including, without limitation, with respect to shares being
sold by Rubicon Master Fund, in accordance with Section 2(f) of the Securities
Purchase Agreement.
The selling stockholders and any broker-dealer participating in the
distribution of the shares of our common stock may be deemed to be
"underwriters" within the meaning of the Securities Act, and any commission
paid, or any discounts or concessions allowed to, any such broker-dealer may be
deemed to be underwriting commissions or discounts under the Securities Act. At
the time a particular offering of the shares of our common stock is made, a
prospectus supplement, if required, will be distributed which will set forth the
aggregate amount of shares of our common stock being offered and the terms of
the offering, including the name or names of any broker-dealers or agents, any
discounts, commissions and other terms constituting compensation from the
selling stockholders and any discounts, commissions or concessions allowed or
reallowed or paid to broker-dealers.
Under the securities laws of some states, the shares of our common stock
may be sold in such states only through registered or licensed brokers or
dealers. In addition, in some states the shares of our common stock may not be
sold unless such shares have been registered or qualified for sale in such state
or an exemption from registration or qualification is available and is complied
with.
We cannot assure you that any selling stockholder will sell any or all of
the shares of our common stock registered pursuant to the shelf registration
statement, of which this prospectus forms a part.
The selling stockholders and any other person participating in such
distribution will be subject to applicable provisions of the Securities Exchange
Act of 1934, as amended, and the rules and regulations thereunder, including,
without limitation, Regulation M of the Exchange Act, which may limit the timing
of purchases and sales of any of the shares of our common stock by the selling
stockholders and any other participating person. Regulation M may also restrict
the ability of any person engaged in the distribution of the shares of our
common stock to engage in market-making activities with respect to the shares of
our common stock. All of the foregoing may affect the marketability of the
shares of our common stock and the ability of any person or entity to engage in
market-making activities with respect to the shares of our common stock.
41
We will pay all expenses of the registration of the shares of our common
stock pursuant to various registration rights agreements, including, without
limitation, SEC filing fees and expenses of compliance with state securities or
"blue sky" laws; provided, however, that a selling stockholder will pay all
underwriting discounts and selling commissions, if any. We will indemnify the
selling stockholders against liabilities, including some liabilities under the
Securities Act, in accordance with the registration rights agreements, or the
selling stockholders will be entitled to contribution. We may be indemnified by
the selling stockholders against civil liabilities, including liabilities under
the Securities Act, that may arise from any written information furnished to us
by the selling stockholders specifically for use in this prospectus, in
accordance with the applicable registration rights agreements, or we may be
entitled to contribution.
Once sold under the shelf registration statement, of which this prospectus
forms a part, the shares of our common stock will be freely tradable in the
hands of persons other than our affiliates.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Laird Q. Cagan, Chairman of our board of directors, is a Managing Director
of Cagan McAfee Capital Partners, LLC ("CMCP"), with a 50% controlling interest.
CMCP performs financial advisory services to us pursuant to a written agreement
and is entitled to the payment of a monthly retainer of $15,000. During fiscal
2003, we expensed and paid CMCP $32,500 as monthly retainers. During the six
months ended June 30, 2004, we expensed and paid CMCP $30,000 as monthly
retainers and expensed an additional $60,000 for accrued but unpaid retainers.
During the nine months ended March 31, 2005, we expensed and paid CMCP $15,000
as monthly retainers and expensed an additional $120,000 for accrued but unpaid
retainers. In May 2005 we paid CMCP $180,000 for previously expensed but unpaid
monthly retainers. In May 2004 we issued CMCP and their assigns seven-year
warrants to purchase up to 240,000 shares of our common stock as additional
compensation for arranging the merger of Old NGS into our company, in addition
to a cash fee of $300,000. These warrants have an exercise price of $1.00 per
share.
Mr. Cagan is a registered representative of Chadbourn Securities, Inc.
("Chadbourn"), our placement agent in private equity and debt financings. We pay
Mr. Cagan and Chadbourn a cash fee and warrant fee that is negotiated for each
investor round. Since the inception of Old NGS on September 23, 20 through June
1, 2005, we paid $337,840 to Chadbourn and Mr. Cagan for commissions from sales
of our common stock and also during this period, we issued seven-year warrants
to Mr. Cagan and Chadbourn (and their assigns) to purchase a total of 188,467
shares in connection with capital raising services, at an exercise price equal
to the offering price paid by the investors in each round.
In connection with the founding of Old NGS, 18,000,000 shares of Old NGS's
common stock were directly and indirectly purchased by various parties as
founder's shares, including, 1,000,000 shares by Robert S. Herlin offered as an
incentive for Mr. Herlin to serve as our president and chief executive officer;
1,000,000 shares by Liviakis Financial Communications, Inc., our investor
relations firm; 7,500,000 shares by Mr. Cagan, the Chairman of our board of
directors and a Managing Director of CMCP; 5,700,000 shares by Eric M. McAfee, a
Managing Director of CMCP; and 450,000 shares by John Pimentel, a member of our
board of directors and a principal of CMCP. Later in May 2005, we renewed our
investor relations contract with Liviakis Financial Communications, Inc., and
issued them 120,000 shares of the Company's common stock at a purchase price of
$0.001 per share, vesting over one year, and a monthly fee of $5,000.
42
Mr. McAfee, a Managing Director of CMCP, previously served as Vice
Chairman of the Board of Verdisys, Inc., the provider of a limited amount of
horizontal drilling services to us in 2003. In 2004, Mr. McAfee resigned from
the Board of Directors of Verdisys, but continues to hold shares in both
Verdisys and our company. Mr. McAfee has represented to us that he is also a 50%
owner of Berg McAfee Companies, LLC, which owns approximately 30% of the shares
of Verdisys. We paid $130,000 to Verdisys during calendar year 2003 for
horizontal drilling services, but did not utilize the services of Verdisys in
the years 2004 or 2005 to date.
During 2004, we borrowed $920,000 under a short-term secured promissory
note (the "Bridge Loan") held by Mr. Cagan, our Chairman and a major
stockholder, secured by a pledge of all of our assets. The loans were earmarked
as partial bridge financing for our purchase of the Tullos Urania Field
properties for $725,000, prior to post closing adjustments, on September 2,
2004, working capital and certain costs related to the closing of the loan with
Prospect Energy Corporation. On February 15, 2005, we paid off the Bridge Loan
to Mr. Cagan, totaling $953,589, including accrued interest at 10% per annum as
specified in the Bridge Loan, from a portion of the proceeds of the loan with
Prospect Energy Corporation.
During 2004 Mr. Herlin advanced us $3,000 for working capital under a
demand note bearing interest at 8% per annum, which was repaid in April 2005.
DESCRIPTION OF SECURITIES
We are presently authorized to issue 100,000,000 shares of $.001 par value
common stock and 5,000,000 shares of $0.001 par value preferred stock. As of May
20, 2005, we had 24,749,600 shares of common stock issued and outstanding and no
preferred stock issued and outstanding.
COMMON STOCK
The holders of our common stock are entitled to equal dividends and
distributions per share with respect to our common stock when, as and if
declared by our board of directors from funds legally available therefor. No
holder of any shares of our common stock has a preemptive right to subscribe for
any of our securities, nor are any of our common shares subject to redemption or
convertible into other securities. Upon liquidation, dissolution or winding-up
of our company, and after payment of creditors and preferred stockholders, if
any, our remaining assets will be divided pro rata on a share-for-share basis
among the holders of our shares of common stock. All shares of our common stock
now outstanding are fully paid, validly issued and non-assessable. Each share of
our common stock is entitled to one vote with respect to the election of any
director or any other matter upon which stockholders are required or permitted
to vote.
PREFERRED STOCK
Under our articles of incorporation, our board of directors has the power,
without further action by the holders of our common stock, to designate the
relative rights and preferences of our preferred stock, and to issue our
preferred stock in one or more series as designated by our board of directors.
The designation of rights and preferences could include preferences as to
liquidation, redemption and conversion rights, voting rights, dividends or other
preferences, any of which may be dilutive of the interest of the holders of our
common stock or our preferred stock of any other series. The issuance of
preferred stock may have the effect of delaying or preventing a change in
control of our company without further stockholder action and may adversely
affect the rights and powers, including voting rights, of the holders of our
common stock.
REGISTRATION RIGHTS
Under the terms of the private placements that we completed in 2003, 2004
and January 2005, we are required under certain conditions to register certain
shares of our common stock and certain shares of our common stock that may be
issued in the future upon exercise of the warrants that were acquired by the
investors in those offerings.
43
We are required to use our reasonable best efforts to maintain the
effectiveness of the registration statement of which this prospectus is a part
until the first anniversary of its effectiveness or until all of the registered
shares have been sold, whichever comes first, except that we will be permitted
to suspend the use of the registration statement during certain periods under
certain circumstances. We will bear all registration expenses, other than
underwriting discounts and commissions.
In connection with various consulting services, we also agreed to register
the 71,000 shares of our common stock held by Demetri Argyropoulos, Richard
From, G. Alfred Roensch Trust and Jim Phillips. This prospectus includes the
shares that we are obligated to register under the foregoing registration rights
agreements.
SHARES ELIGIBLE FOR FUTURE SALE
As of Mary 20, 2005, we had 24,749,600 shares of common stock outstanding.
That number does not include (i) the 1,720,000 shares that are reserved for
issuance under outstanding options that may be issued if and when the options
are exercised, or (ii) the 2,028,467 shares and that may be issued upon the
exercise of warrants, of which 1,050,000 are included in this prospectus.
Freely Tradable Shares After This Offering. As of May 20, 2005, only
1,036,255 of our 24,749,600 outstanding shares were free trading shares.
However, upon the sale of the 5,814,345 currently outstanding shares covered by
this prospectus, and the exercise and sale of the 1,050,000 warrant shares
included in this prospectus, all of these 6,864,345 shares will also be freely
tradable without restriction or limitation under the Securities Act. As a
result, after the completion of this offering, assuming the exercise of warrants
to purchase 1,050,000 shares of our common stock, there will be a total of
7,900,600 shares of our common stock that will be tradable without restriction
under the Securities Act. Other than these 7,900,600 shares, the remaining
17,899,000 shares are "restricted securities" as that term is defined in Rule
144 promulgated under the Securities Act.
Rule 144. In general, under Rule 144 as currently in effect, a person (or
persons whose shares are aggregated) who has beneficially owned restricted
securities for at least one year, including persons who may be deemed our
"affiliates," as that term is defined under the Securities Act, would be
entitled to sell within any three-month period a number of shares that does not
exceed the greater of 1% of the then outstanding shares (approximately 247,496
shares if the outstanding warrants and options are not exercised, or
approximately 257,996 shares if all warrant shares included in the prospectus
are exercised) or the average weekly trading volume of shares during the four
calendar weeks preceding such sale. Sales under Rule 144 are subject to certain
manner of sale provisions, notice requirements and the availability of current
public information about the company. A person who has not been our affiliate at
any time during the three months preceding a sale, and who has beneficially
owned his shares for at least two years, would be entitled under Rule 144(k) to
sell such shares without regard to any manner of sale or volume limitations
under Rule 144.
Of the 23,713,345 "restricted shares" currently outstanding, 22,199,145
shares are currently eligible for public resale under Rule 144. The sale, or
availability for sale, of substantial amounts of our common stock could, in the
future, adversely affect the market price of our common stock and could impair
our ability to raise additional capital through the sale of our equity
securities or debt financing. The future availability of Rule 144 to our holders
of restricted securities would be conditioned on, among other factors, the
availability of certain public information concerning our company.
Form S-8 Registration of Options. We intend to file a registration
statement on Form S-8 covering the shares of our common stock that have been
issued or reserved for issuance under our stock option plan, which would permit
the resale of such shares in the public marketplace.
44
TRANSFER AGENT
Our transfer agent currently is Continental Stock Transfer, 17 Battery
Park, New York, NY 10004.
EXPERTS
The financial statements for the six month period ended June 30, 2004 and
the period from September 23, 2003 (inception) to December 31, 2003 included in
this prospectus have been audited by Hein & Associates, LLP to the extent and
for the periods indicated in their report thereon. Such financial statements
have been included in this prospectus and registration statement in reliance
upon the report of Hein & Associates, LLP and upon the authority of such firm as
experts in auditing and accounting.
LEGAL MATTERS
Troy & Gould Professional Corporation, Los Angeles, California, has
rendered an opinion with respect to the validity of the shares of our common
stock covered by this prospectus.
WHERE YOU CAN FIND MORE INFORMATION
We are subject to the information and periodic reporting requirements of
the Exchange Act, and, in accordance with that act, file periodic reports, proxy
statements and other information with the SEC. The periodic reports, proxy
statements and other information filed by us are available for inspection and
copying at prescribed rates at the SEC's Public Reference Room at 450 Fifth
Street, N.W., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for
further information about the operation of the SEC's Public Reference Room. The
SEC also maintains an Internet site that contains all reports, proxy statements
and other information that we file electronically with the SEC. The address of
that website is http://www.sec.gov.
We have filed with the SEC a registration statement on Form SB-2 under the
Securities Act for the common stock offered under this prospectus. The
registration statement, including the exhibits to the registration statement,
contains additional information about us and the common stock offered by this
prospectus. The rules and regulations of the SEC allow us to omit from this
prospectus certain information that is included in the registration statement.
For further information about us and our common stock, you should review the
registration statement and the exhibits filed with the registration statement.
GLOSSARY OF TERMS
GLOSSARY OF SELECTED PETROLEUM TERMS
The following abbreviations and definitions are terms commonly used in the
crude oil and natural gas industry and throughout this prospectus:
"BBL" A standard measure of volume for crude oil and liquid petroleum
products. One barrel equals 42 U.S. gallons.
"BCF" Billion cubic feet of natural gas at standard conditions (see MCF).
"BOE" Barrels of crude oil equivalent. Calculated by converting 6 MCF of
natural gas to 1 BBL of crude oil.
"BTU" or "British Thermal Unit" The standard unit of measure of energy
equal to the amount of heat required to raise the temperature of one pound of
water 1 degree Fahrenheit. One BBL of crude is typically 5.8 MMBTU, and one
standard MCF is typically 1 MMBTU. 1 MMBTU is one million BTU, and 1 MMMBTU is
one billion BTU.
45
"FIELD" An area consisting of one or more reservoirs all grouped on or
related to the same geologic feature.
"GROSS WELL" The total number of wells participated in, regardless of the
amount of working interest owned. (See net wells).
"MBOE" One thousand barrels of crude oil equivalent.
"MCF" One thousand cubic feet of natural gas at standard conditions, being
approximately sea level pressure and 60 degrees Fahrenheit temperature. Standard
pressure in the state of Louisiana is deemed to be 15.025 psi by regulation but
varies in other states. 1 MMCF is one million cubic feet of natural gas.
"NET WELLS" The aggregate fractional working interests owned, e.g., a 20%
working interest in each of 5 gross wells equals one net well. (See Gross Well).
"NGL" Natural gas liquids, being the combination of ethane, propane,
butane and natural gasolines that can be removed from natural gas through
processing, typically through refrigeration plants that utilize low
temperatures, or through J-T plants that utilize compression, temperature
reduction and expansion to a lower pressure.
"NYMEX" New York Mercantile Exchange.
"PERMEABILITY" The measure of ease with which petroleum can move through a
reservoir.
"POROSITY" The relative volume of the pore space compared to the total
bulk volume of the reservoir.
"PROVED RESERVES" The estimated quantities of crude oil, natural gas, and
natural gas liquids which geological and engineering data demonstrate with
reasonable certainty to be recoverable in future years from known reservoirs
under existing economic and operating conditions, i.e. prices and costs as of
the date the estimate is made. Prices include consideration of changes in
existing prices provided only by contractual arrangements, but not on
escalations based upon future conditions. A complete definition of reserves can
be found in Regulation S-X, Subsection 4-10 (a). Proved Developed Producing
reserves are proved reserves that are currently producing.
"ROYALTY OR ROYALTY INTEREST" The mineral owner's share of crude oil or
natural gas production (typically 1/8, 1/6 or 1/4), free of costs, but subject
to severance taxes unless the lessor is a government. In certain circumstances,
the royalty owner bears a proportionate share of the costs of making the natural
gas saleable, such as processing, compression and gathering.
"PSI" Pounds per square inch, a measure of pressure. "SHUT-IN WELL" A well
that is not on production, but has not been plugged and abandoned. Wells may be
shut-in in anticipation of future utility as a producing well, plugging and
abandonment or other use.
"STANDARDIZED MEASURE" An estimate of future net reserves from a property,
is calculated in the same exact same fashion as a PV-10 value, except that the
projected revenue stream is adjusted to account for the estimated amount of
federal income tax that must be paid.
"WORKING INTEREST" The interest in the crude oil and natural gas in place
which is burdened with the cost of development and operation of the property.
Also referred to as the operating interest.
"WORK-OVER" A remedial operation on a completed well to restore, maintain
or improve the well's production.
46
INDEX TO FINANCIAL STATEMENTS
NATURAL GAS SYSTEMS, INC.
INDEPENDENT AUDITORS REPORT F-2
AUDITED FINANCIAL STATEMENTS: F-3
BALANCE SHEETS F-3
STATEMENTS OF OPERATIONS F-4
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) F-5
STATEMENTS OF CASH FLOW F-6
NOTES TO AUDITED FINANCIAL STATEMENTS F-7
INDEPENDENT AUDITORS REPORT F-19
STATEMENT OF REVENUES AND DIRECT OPERATING EXPENSES OF THE DELHI FIELD
ACQUIRED ON SEPTEMBER 23, 2003 F-20
UNAUDITED FINANCIAL STATEMENTS: F-23
BALANCE SHEETS F-24
STATEMENTS OF OPERATIONS F-25
STATEMENTS OF CASH FLOW F-26
NOTES TO UNAUDITED FINANCIAL STATEMENTS F-27
F-1
INDEPENDENT AUDITORS' REPORT
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Natural Gas Systems, Inc.
Houston, Texas
We have audited the accompanying consolidated balance sheets of Natural
Gas Systems, Inc. as of June 30, 2004 and December 31, 2003 and the related
consolidated statements of operations, stockholders' equity, and cash flows for
the six month period ended June 30, 2004 and the period from September 23, 2003
(inception) to December 31, 2003. These consolidated financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these consolidated 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. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes 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 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Natural Gas
Systems, Inc. and subsidiaries as of June 30, 2004 and December 31, 2003, and
the results of their operations and their cash flows for each of the periods
then ended, in conformity with accounting principles generally accepted in the
United States of America.
HEIN & ASSOCIATES LLP
Houston, Texas
September 28, 2004
F-2
NATURAL GAS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
JUNE 30, DECEMBER 31,
2004 2003
ASSETS
Current Assets
Cash and short-term investments $ 367,831 $ 830,312
Receivables 24,387 56,837
Inventories 115,859 109,216
Prepaid expenses 69,067 25,930
Retainers and deposits 5,000 210,000
------------ ------------
Total current assets 582,144 1,232,295
Oil and gas properties being amortized (full cost method) 3,075,438 2,971,468
Oil and gas properties not being amortized 105,225 --
Less: accumulated amortization (55,509) (13,960)
------------ ------------
Net oil and gas properties 3,125,154 2,957,508
Furniture, fixtures and equipment, at cost 3,091 3,091
Less: accumulated depreciation (1,159) (386)
------------ ------------
Net furniture, fixtures and equipment 1,932 2,705
Other assets (cash balances earmarked for bonding requirements) 301,835 301,835
------------ ------------
Total Assets $ 4,011,065 $ 4,494,343
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable $ 139,188 $ 114,188
Accrued liabilities 50,073 41,118
Notes payable 776,235 1,437,073
Production taxes payable -- 665
------------ ------------
Total current liabilities 965,496 1,593,044
Deferred plugging and abandonment liabilities 311,442 305,004
Stockholders' equity:
Common stock, par value $0.001 per share; 100,000,000 shares authorized, 22,945 21,772
22,945,406 and 21,772,362 shares issued and outstanding as of June 30, 2004
and December 31, 2003, respectively
Additional paid-in capital 4,453,905 3,398,178
Deferred stock based compensation (378,136) (486,750)
Accumulated deficit (1,364,587) (336,905)
------------ ------------
Total stockholders' equity 2,734,127 2,596,295
------------ ------------
Total liabilities and stockholders' equity $ 4,011,065 $ 4,494,343
============ ============
See accompanying notes to consolidated financial statements.
F-3
NATURAL GAS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE
PERIOD FROM
SIX MONTHS SEPTEMBER 23, 2003
ENDED (INCEPTION) TO
JUNE 30, 2004 DECEMBER 31, 2003
Revenues:
Oil sales $ 117,509 $ 24,229
Gas sales 649 --
Total revenues 118,158 24,229
Expenses:
Operating costs 134,420 76,303
Production taxes 14,581 3,002
Depletion 41,549 13,960
Reverse-merger fees and expenses 370,000 --
General and administrative 542,761 239,093
Total expenses 1,103,311 332,358
Loss from operations (985,153) (308,129)
Other revenues and expenses:
Interest income 4,093 1,148
Interest expense (46,622) (29,924)
Total other revenues and expenses (42,529) (28,776)
Net loss $ (1,027,682) $ (336,905)
Income (loss) per common share:
Basic and diluted $ (0.05) $ (0.02)
Weighted average number of common shares, basic and diluted 22,057,614 20,091,720
See accompanying notes to consolidated financial statements.
F-4
NATURAL GAS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE PERIOD FROM SEPTEMBER 23, 2003 (INCEPTION) TO JUNE 30, 2004
ADDITIONAL TOTAL
PAID-IN ACCUMULATED STOCKHOLDERS'
SHARES DOLLARS CAPITAL DEFERRED DEFICIT EQUITY
Balances, September 23, 2003 -- $ -- $ -- $ -- $ --
Sales of common stock 21,772,362 21,772 2,861,028 -- -- 2,882,800
Stock-based compensation -- -- 537,150 (486,750) -- 50,400
Net loss -- -- -- -- (336,905) (336,905)
Balances, December 31, 2003 21,772,362 21,772 3,398,178 (486,750) (336,905) 2,596,295
Sales of common stock 923,377 923 825,977 -- -- 826,900
before merger
Sales of common stock after 249,667 250 229,750 -- -- 230,000
merger
Deferred -- -- -- 108,614 -- 108,614
compensation
Net loss -- -- -- -- (1,027,682) (1,027,682)
Balances, June 30, 2004 22,945,406 $ 22,945 $ 4,453,905 $ (378,136) $ (1,364,587) $ 2,734,127
See accompanying notes to consolidated financial statements.
F-5
NATURAL GAS SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE PERIOD FROM
SIX MONTHS SEPTEMBER 23, 2003
ENDED (INCEPTION) TO
JUNE 30, 2004 DECEMBER 31, 2003
Operating activities:
Net loss $ (1,027,682) $ (336,905)
Adjustments to reconcile net loss to net cash provided (used) by operating
activities:
Depletion 41,549 13,960
Depreciation 773 386
Stock-based compensation expense 108,614 50,400
Accretion of debt discount -- 29,924
Changes in assets and liabilities:
Accretion of deferred plugging
and abandonment
Liability 6,438 3,169
Accounts receivable 32,450 (28,762)
Inventories (6,643) (109,216)
Accounts payable 24,999 114,188
Other current liabilities 8,289 41,783
Prepaid expenses (43,137) (25,930)
Retainers and deposits 205,000 (210,000)
Net cash used by operating (649,350) (457,003)
activities
Investing activities:
Capital expenditures for oil and gas properties (209,194) (1,290,560)
Capital expenditures for furniture, fixtures, and equipment -- (3,090)
Cash restricted for Delhi bonding requirements -- (301,835)
Net cash used in investing (209,194) (1,595,485)
activities
Financing activities:
Payments on notes payable (710,327) --
Proceeds from notes payable 49,490 --
Proceeds from issuance of common stock 1,056,900 2,882,800
Net cash provided by 396,063 2,882,800
financing activities
Net (decrease) increase in cash (462,481) 830,312
Cash and cash equivalents, beginning of period 830,312 --
Cash and cash equivalents, end of period $ 367,831 $ 830,312
Supplemental Cash Flow Information:
Interest paid $ 46,622 --
Taxes paid -- --
Non-cash transactions:
Seller note issued to acquire properties, net of discount -- $ 1,407,049
Assumption of plugging and abandonment liability -- $ 301,835
See accompanying notes to consolidated financial statements.
F-6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2004
NATURAL GAS SYSTEMS, INC. AND SUBSIDIARIES
1. COMPANY'S BUSINESS
Reality Interactive, Inc. ("REALITY"), a Nevada corporation that traded on the
OTC Bulletin Board under the symbol RLYI.OB, and the predecessor of Natural Gas
Systems, Inc., was incorporated on May 24, 1994 for the purpose of developing
technology-based knowledge solutions for the industrial marketplace. On April
30, 1999, Reality ceased business operations, sold substantially all of its
assets and terminated all of its employees. Subsequent to ceasing operations,
Reality explored other potential business opportunities to acquire or merge with
another entity, while continuing to file reports with the SEC. During the most
recent two years, Reality represented that it had not conducted any operations
and had minimal assets and liabilities.
On May 26, 2004, Natural Gas Systems, Inc., a privately owned Delaware
corporation formed in September of 2003 ("OLD NGS"), was merged into a wholly
owned subsidiary of Reality and Reality changed its name to Natural Gas Systems,
Inc. On the effective date of the merger, Laird Q. Cagan was elected as Chairman
of the Board of Directors of Reality and Robert S. Herlin and Sterling H.
McDonald, the CEO and CFO of Old NGS, were elected CEO and CFO of Reality,
respectively. The corporation was renamed Natural Gas Systems, Inc. (the
"COMPANY" or "NGS") and adopted a June 30 fiscal year end.
Headquartered in Houston, Texas, Natural Gas Systems, Inc. is a development
stage petroleum company engaged primarily in the acquisition, exploitation and
development of properties for the production of crude oil and natural gas from
underground reservoirs. NGS acquires established oil and gas properties and
exploits them through the application of conventional and specialized technology
to increase production, ultimate recoveries, or both. At June 30, 2004, NGS
conducted operations through its 100% working interest in the Delhi Field in
Louisiana.
All regulatory filings and other historical information including stock prices
prior to May 26, 2004 apply to Reality, the predecessor of the Company. NGS
trades on the OTC Bulletin Board under the symbol NGSY.OB. All stock information
is adjusted to reflect Reality's 40:1 reverse stock split effected prior to the
merger with NGS.
2. SIGNIFICANT RISKS AND UNCERTAINTIES
Preparation of the Company's financial statements requires management to make
estimates and assumptions that affect the reported amounts of assets,
liabilities and contingencies as of the balance sheet date, and the reported
amount of revenues and expenses during the reporting period. On an ongoing
basis, management reviews its estimates, including those related to litigation,
environmental liabilities, income taxes, abandonment costs and the determination
of proved reserves. Changes in circumstances may result in revised estimates and
actual results may differ from those estimates.
The Company's business makes it vulnerable to changes in crude oil and natural
gas prices. Such prices have been volatile in the past and can be expected to be
volatile in the future. This volatility can dramatically affect cash flows and
proved reserves, since price declines reduce the estimated quantity of proved
reserves and increase annual amortization expense (which is based on proved
reserves). Other risks related to proved reserves, revenues, and cash flows
include the Company's current reliance on the concentration of a few wells. The
reserve report dated July 1, 2004, identified six wells that make up
approximately 60% of the Company's future net cash flows, discounted at 10% per
annum. At July 31, 2004, approximately 85% of the Company's production was
derived from three wells.
F-7
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation --The consolidated financial statements include the
Company and its subsidiaries. All material intercompany accounts and
transactions have been eliminated.
Oil and Gas Properties and Furniture, Fixtures and Equipment --The Company
follows the full cost method of accounting for its investments in oil and
natural gas properties. All costs incurred in the acquisition, exploration and
development of oil and natural gas properties, including unproductive wells, are
capitalized. Included in capitalized costs are general and administrative costs
that are directly related to acquisition, exploration and development
activities. Proceeds from the sale of oil and natural gas properties are
credited to the full cost pool, unless the sale involves a significant quantity
of reserves, in which case a gain or loss is recognized. Under the rules of the
Securities and Exchange Commission ("SEC") for the full cost method of
accounting, the net carrying value of oil and natural gas properties, reduced by
the asset retirement obligation, is limited to the sum of the present value (10%
discount rate) of the estimated future net cash flows from proved reserves,
based on the current prices, plus the lower of cost or estimated fair market
value of unproved properties adjusted for related income tax effects.
Capitalized costs of proved oil and natural gas properties are depleted on a
unit of production method using proved oil and natural gas reserves. Costs
depleted include net capitalized costs subject to depletion and estimated future
dismantlement, restoration and abandonment costs.
Equipment, which includes computer equipment, hardware and software and
furniture and fixtures, is recorded at cost and is generally depreciated on a
straight-line basis over the estimated useful lives of the assets, which range
from two to seven years.
Repairs and maintenance are charged to expense as incurred.
Statement of Cash Flows --For purposes of the statements of cash flows, cash
equivalents include highly liquid financial instruments with maturities of three
months or less as of the date of purchase.
Concentrations of Credit Risk --All of the Company's trade receivables are due
from one purchaser. Accounts receivable are not collateralized.
Revenue Recognition --The Company recognizes oil and natural gas revenue from
its interests in producing wells as oil and natural gas is sold.
Accounting for Reverse Merger --The Company accounts for its reverse-merger in
accordance with Staff Accounting Bulletin ("SAB") Topic 2A. Generally, the staff
of the Division of Corporate Finance considers reverse-mergers into public
shells to be capital transactions in substance, rather than business
combinations. That is, the transaction is equivalent to the issuance of stock by
the private company for the net monetary assets of the shell corporation,
accompanied by a recapitalization.
Under this treatment, post reverse-acquisition comparative historical financial
statements are those of the "legal acquiree" ( i.e. , the "accounting
acquirer"), with appropriate disclosure concerning the change in the capital
structure effected at the acquisition date. In the Company's case, the
historical financial statements are those of the oil and gas operations of Old
NGS, except that the Consolidated Statement of Changes in Stockholder's Equity
reflect the activity of Old NGS prior to the merger. All share and per share
amounts have been adjusted to reflect the conversion ratio of shares exchanged
between Reality and Old NGS.
Also, in accordance with SAB Topic 2A, transaction costs incurred for the
reverse-merger, such as legal fees, investment banking fees and the like, may be
charged directly to equity only to the extent of the cash received, while all
costs in excess of cash received should be charged to expense. Accordingly,
since no cash was received, $370,000 in transaction fees were expensed in the
Company's accompanying financial statements.
F-8
Stock Options --As permitted by SFAS No. 123, "Accounting for Stock Based
Compensation," the Company follows the accounting requirements for stock options
and stock-based awards contained in Accounting Principles Board Opinion No. 25,
"Accounting for stock Issued to Employees," and related Interpretations and
consensus of the Emerging Issues Task Force in terms of measuring compensation
expense.
SFAS 123, "Accounting for Stock-Based Compensation," as amended by SFAS 148,
"Accounting for Stock-Based Compensation--Transition and Disclosure,"
established accounting and disclosure requirements using a fair value-based
method of accounting for stock-based employee compensation plans. The Company
accounts for stock-based compensation using the intrinsic value method
prescribed in Accounting Principles Board Opinion 25, "Accounting for Stock
Issued to Employees" ("APB 25").
Fair Value of Financial Instruments --Our financial instruments consist of cash
and cash equivalents, accounts receivable, accounts payable and seller notes.
The carrying amounts of cash and cash equivalents, accounts receivable and
accounts payable approximate fair value due to the highly liquid nature of these
short-term instruments. The fair values of the seller notes approximates their
carrying amounts as of June 30, 2004, based upon interest rates currently
available to us for borrowings with similar terms.
New Accounting Pronouncements --During December 2003, the FASB issued
Interpretation No. 46R, "Consolidation of Variable Interest Entities" ("FIN
46"), which requires the consolidation of certain entities that are determined
to be variable interest entities ("VIE's"). An entity is considered to be a VIE
when either (i) the entity lacks sufficient equity to carry on its principal
operations, (ii) the equity owners of the entity cannot make decisions about the
entity's activities or (iii) the entity's equity neither absorbs losses or
benefits from gains. NGS owns no interest in variable interest entities, and
therefore this new interpretation has not affected the Company's consolidated
financial statements.
4. ACQUISITIONS
In September 2003, Old NGS completed the acquisition of a 100% working interest
in the Delhi Field. The acquisition closed on September 25, 2003, whereby Old
NGS paid $995,000 in cash, issued a purchase money mortgage for $1,500,000 (See
Note 7, Notes Payable, for a description of the mortgage) and assumed a plugging
and abandonment reclamation liability in the amount of approximately $302,000
(see Note 5, Asset Retirement Obligations), in exchange for the conveyance of
all the underlying leasehold interests. In addition to the mortgage, the
property is burdened by an aggregate 20% royalty interest.
On May 26, 2004, Reality Interactive, Inc., a publicly traded Nevada corporation
("Reality"), executed an Agreement and Plan of Merger with Natural Gas Systems,
Inc., a private Delaware corporation ("Old NGS"), whereby the shareholders of
Old NGS received 21,749,478 shares of common stock of Reality, in exchange for
all of the 21,749,748 shares of Old NGS common stock then outstanding. The
operations and management of Old NGS became our own, and Reality's name was
changed to Natural Gas Systems, Inc., a Nevada corporation (the "Company" or
"NGS"). Immediately prior to the closing of the merger, Reality had virtually no
operations, assets or liabilities.
5. ASSET RETIREMENT OBLIGATIONS
When an oil or gas property ceases economic production, the Company dismantles
and removes all surface equipment, plugs the wells and restores the property's
surface in accordance with various regulations and agreements before abandoning
the property. The state of Louisiana requires operators of oil and gas
properties to secure plugging, abandonment and reclamation liabilities with
financial collateral in favor of the state. In the case of the Delhi Field, the
previous owner had established a Site Specific Trust Fund (SSTA Account) that is
considered a fully funded liability by the state of Louisiana. Pursuant to the
Company's agreement to purchase the Delhi Field in September of 2003, NGS agreed
to replace the seller's collateral on the SSTA Account within 120 days of
closing. During the six months ended June 30, 2004, NGS replaced the seller's
collateral by posting a letter of credit in the face amount of $301,835, fully
collateralized by a certificate of deposit issued on Wells Fargo Bank. These
restricted cash equivalents are carried as "Other Assets" in the Company's
balance sheet.
F-9
In accordance with FAS 143, the Company has recorded an estimated asset
retirement obligation ("ARO") for its Delhi Field of approximately $302,000, of
which $274,000 relates to the Company's wells and $28,000 relates to wells
operated by the Company for a third party. Accordingly, the Company has recorded
an asset retirement obligation in the amount of $302,000, with an offsetting
$274,000 charge to the full cost pool and a $28,000 receivable due from the 3rd
party at December 31, 2003. The receivable was collected during the six months
ended June 30, 2004.
Also in accordance with FAS 143, the Company provides accretion expense on all
ARO liabilities. For the Delhi Field, NGS uses the 10-year constant maturity
Treasury yield of 4.27% available at September 30, 2003, which equates to 1.05%
per quarter.
The following table describes the change in the Company's asset retirement
obligations for the period from September 23, 2003 (inception) to June 30, 2004:
Asset retirement obligation at September 23, 2003 $301,835
Accretion expense for 2003 3,169
Asset retirement obligation at December 31, 2003 305,004
Accretion expense for 2004 6,438
Asset retirement obligation at June 30, 2004 $311,442
6. OIL AND GAS PROPERTIES
Depletion expense for the period from September 23, 2003 (inception) to December
31, 2003 and for the six months ended June 30, 2004 totaled $13,960 and $41,549,
respectively.
During 2003, no costs were excluded from amortization. For the six months ended
June 30, 2004, $105,225 of costs were not being amortized, pending the closing
or abandonment of property acquisitions under active consideration.
7. NOTES PAYABLE
In September 2003, the Company issued $1,500,000 of notes payable in connection
with its acquisition of the Delhi Field. The notes were collateralized by a
first mortgage on the Company's Delhi field and are payable to the sellers in
twelve equal monthly installments beginning on January 30, 2004. Although the
notes bear no interest, the Company has imputed interest at 8% per annum, thus
resulting in an initial recorded principal amount of $1,407,049. At December 31,
2003, the balance of the notes payable was $1,436,973, including $29,924 of
imputed interest. At June 30, 2004, the principal balance outstanding was
$732,807.
In May 2004, the Company borrowed $49,490 to finance 70% of its Director and
Officer's liability insurance premiums. The note requires eight level
mortgage-amortizing payments in the amount of $5,350 per month, including 7%
interest per annum, with the first payment due on June 25, 2004. At June 30,
2004, the principal outstanding balance of the note was $43,429.
8. COMMON STOCK AND STOCK OPTIONS
At December 31, 2003, Reality had issued and outstanding 256,598 shares of its
$0.001 par value common stock. From January 1, 2004, up to, but not including,
the merger closing on May 26, 2004, Reality issued 689,663 of its $0.001 par
value common shares, net of cancellations and redemptions. At the closing of the
merger on May 26, 2004, Reality issued 21,749,478 of its $0.001 par value common
shares in exchange for all of the 21,749,478 issued and outstanding $0.001 par
value common shares of Old NGS.
F-10
During 2003, Old NGS issued 18,000,000 common shares as founder's capital at
$0.001 per share, and sold 2,864,600 of its $0.001 par value common shares at
$1.00 per share through a private equity offering to accredited investors. Prior
to the merger closing in 2004, Old NGS sold an additional 884,878 of its $0.001
par value common shares to accredited investors for $886,900 gross proceeds,
less $60,000 in commissions equal to 8% of the gross cash proceeds and the
issuance of 7 year term warrants equal to 8% of the shares issued, for the
account of Chadbourn Securities, Inc. and Laird Q. Cagan, an affiliate of the
Company as described in Footnote 9 on Related Party Transactions.
Since the merger closing through June 30, 2004, the Company sold 249,667 shares
of its $0.001 par value common shares for gross proceeds of $250,000, less
$30,000 in commissions and the same warrant structure described above for the
account of Chadbourn Securities, Inc. and Laird Q. Cagan.
At June 30, 2004, the Company had 22,945,406 issued and outstanding shares of
common stock.
See Note 11, Subsequent Events, for information on additional sales of common
stock since June 30, 2004.
Options
Old NGS adopted a stock option plan in 2003 (the "2003 Plan"). The purpose of
the 2003 Plan was to offer selected individuals an opportunity to acquire a
proprietary interest in the success of Old NGS, or to increase such interest, by
purchasing shares of the Old NGS' common stock. The 2003 Plan provided both for
the direct award or sale of shares and for the grant of options to purchase
shares in an aggregate amount not to exceed 4,000,000 shares. Options granted
under the Plan included nonstatutory options as well as incentive stock options
intended to qualify under Section 422 of the Code. Options granted under the
2003 Plan were assumed by Reality Interactive, Inc., predecessor to the Company.
No further shares will be granted under the 2003 Stock Option Plan.
At June 30, 2004, options totaling 600,000 shares of the Company's stock had
were outstanding, having been granted in 2003 by Old NGS and assumed in 2004 by
the Company, subject to various vesting requirements. Options to purchase
250,000, 250,000 and 100,000 shares were granted to Messrs. Herlin, McDonald and
Lee (counsel to the Company), respectively. Mr. Herlin's options are committed
for subsequent cancellation and re-issuance as warrants to Tatum Partners, in
consideration of its services agreement with the Company. These options were
accounted for under APB 25, with respect to Messrs. Herlin and McDonald, and
under FASB 123 with respect to Messrs. Lee, and gave rise to $537,150 of Company
expense to be recognized over the respective vesting periods of the options.
On August 3, 2004, the Company adopted its 2004 Stock Option Plan (the "2004
Plan"). The purpose of the 2004 Plan is to offer selected individuals an
opportunity to acquire a proprietary interest in the success of the Company, or
to increase such interest, by purchasing shares of the Company's common stock.
The 2004 Plan provides both for the direct award or sale of shares and for the
grant of options to purchase shares in an aggregate amount not to exceed
4,000,000 shares. Options granted under the 2004 Plan may include nonstatutory
options as well as incentive stock options intended to qualify under Section 422
of the Code.
No options were issued during the six months ended June 30, 2004. However,
200,000 options have been authorized, but not issued, to two members of the
Board of Directors of the Company.
A reconciliation of reported loss as if the Company used the fair value method
of accounting for stock-based compensation has not been provided as the fair
value of options computed under FASB 123 was essentially the same as the amount
determined in accordance with APB 25.
Fair value was estimated at the date of grant using the Black-Scholes options
pricing model with the following weighted average assumptions: risk-free
interest rate of approximately 2.5%; dividend yield of 0%; volatility factor of
1.31; and a weighted-average expected life of three years. These assumptions
resulted in a weighted average grant date fair value of $.99. For purposes of
the pro forma disclosures, the estimated fair value is amortized to expense over
the awards' vesting period.
F-11
The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a single measure of the
fair value of its employee stock options. At June 30, 2004, 3,400,000 shares
were available for grant under the plans. A summary of options transactions for
the period from September 23, 2003 (inception) to June 30, 2004 follows:
NUMBER WEIGHTED
OF SHARES AVERAGE
EXERCISE PRICE
Outstanding at September 23, 2003 $ --
Granted 600,000 0.10
Exercised -- --
Canceled -- --
Outstanding at December 2003 600,000 $ 0.10
Granted -- --
Exercised -- --
Canceled -- --
Outstanding at June 30, 2004 600,000 $ 0.10
Shares exercisable at June 30, 2004 153,122 $ 0.05
OPTIONS OUTSTANDING
WEIGHTED
RANGE OF OUTSTANDING AT AVERAGE EXERCISABLE
EXERCISABLE PRICES JUNE 30, 2004 EXERCISE PRICE JUNE 30, 2004
.001 350,000 .001 121,872
.25 250,000 .25 31,250
The weighted average remaining contractual life of options outstanding at June
30, 2004, was approximately 38 months. The weighted average grants date fair
value of the options granted in 2003 was $.89 per share. The options vest as
follows: 2004 - 150,000; 2005 - 150,000; 2006 - 150,000; and 2007 - 150,000.
Warrants
At June 30, 2004, outstanding warrants to purchase the Company's $0.001 par
value common shares were as follows:
WARRANTS OUTSTANDING
EXERCISABLE
RANGE OF OUTSTANDING AT JUNE 30, 2004
HOLDER EXERCISABLE PRICES JUNE 30, 2004 THRU 2011
------------------- ------------------ ------------------
Fairmont Analytics $1.00 25,000 25,000
Michael Peterson $1.00 50,000 50,000
Cagan McAfee Capital Partners, LLC $1.00 165,000 165,000
Chadborn Securities, Inc. $1.00 3,147 3,147
Demetri Argyropoulos $1.00 1,000 1,000
Kathy Cole $1.00 5,000 5,000
Patricia Prass $1.00 2,000 2,000
Barbara Hall $1.00 2,000 2,000
Laird Q. Cagan $1.00 66,784 66,784
Total 319,932 319,932
F-12
The warrants above were issued for services rendered for the merger and the sale
of the Company's common shares. Laird Q. Cagan and Cagan McAfee Capital Partners
("CMCP") are affiliates of the Company. We issued 240,000 of these warrants to
CMCP in connection with arranging the merger. We issued 79,932 to Laird Q. Cagan
and Chadbourn Securities, Inc., in connection with capital raising services.
9. RELATED PARTY TRANSACTIONS
Laird Cagan, Chairman of the Board of the Company, is a Managing Director of
Cagan McAfee Capital Partners, LLC ("CMCP"). CMCP performs financial advisory
services to the Company pursuant to a written agreement and is paid a monthly
retainer of $15,000. In addition, Mr. Cagan is a registered representative of
Chadbourn Securities, Inc. ("Chadbourn"), the Company's placement agent in
private equity financings. Pursuant to the Agreement between the Company, Mr.
Cagan, and Chadbourn, the Company pays a cash fee equal to 8% of gross equity
proceeds and warrants equal to 8% of the shares purchased. During 2003, the
Company expensed and paid CMCP $32,500 for monthly retainers.
In connection with the founding of the Company, 18,000,000 shares of NGS common
stock were directly and indirectly purchased by various parties as founder's
shares, including, 1,000,000 shares by Robert S. Herlin as an incentive to
perform as the Company's President and CEO; 1,000,000 shares by Liviakis
Financial Communications, Inc., the Company's investor relations firm; 7,500,000
shares by Laird Q. Cagan, the Company's Chairman and Managing Director of CMCP;
and 5,700,000 by Eric M. McAfee, Managing Director of CMCP, and 450,000 by John
Pimentel, a member of the Company's Board of Directors.
During the six months ended June 30, 2004 the Company has expensed $90,000 in
monthly retainers, $60,000 of which remains unpaid at June 30, 2004, and charged
$80,000 to stockholder's equity as a reduction of the proceeds from common stock
sales in the amount of $1,000,000. The $80,000 paid to Chadbourn Securities and
Laird Q. Cagan was for commissions from the sale of the common stock. Also
during the six months ended June 30. 2004 NGS issued warrants to purchase
319,932 shares of our common stock to CMCP, Chadbourn Securities and Laird Q.
Cagan in connection with arranging the merger, (240,000 warrants) and placement
of 999,145 common shares (79,932 warrants). These warrants have a $1.00 exercise
price and a seven year term.
Eric McAfee, also a Managing Director of Cagan McAfee Capital Partners, has
served as Vice Chairman of the Board of Verdisys, Inc., the provider of certain
horizontal drilling services to the Company. Subsequently in 2004, Mr. McAfee
resigned from the Board of Directors of Verdisys, but continues to hold shares
in both companies. Mr. McAfee has represented to the Company that he is also a
50% owner of Berg McAfee Companies, LLC, which owns approximately 30% of
Verdisys, Inc. NGS paid $130,000 to Verdisys during 2003 and $25,960 during 2004
for horizontal drilling services.
Subsequent to June 30, 2004, Laird Cagan, Chairman of the Board of the Company,
loaned the Company $475,000 as partial bridge financing for the acquisition of
the Tullos Urania Field. See Footnote 11, Subsequent Events, for a further
explanation.
F-13
10. SUPPLEMENTAL OIL AND GAS DISCLOSURES (UNAUDITED)
COSTS INCURRED IN OIL AND GAS PRODUCING ACTIVITIES
FOR THE PERIOD FROM
SIX MONTHS SEPTEMBER 23, 2003
ENDED (INCEPTION) TO
JUNE 30, 2004 DECEMBER 31, 2003
Property acquisition costs:
Proved $ 6,855 $ 2,363,716
P&A liability assumed -- 273,760
Unproved 105,225 --
Exploration costs -- --
Development costs 97,114 333,992
Total Property Acquisition Costs $ 209,194 $ 2,971,468
RESULTS OF OPERATIONS FOR OIL AND GAS PRODUCING ACTIVITIES
FOR THE PERIOD FROM
SIX MONTHS SEPTEMBER 23, 2003
ENDED (INCEPTION) TO
JUNE 30, 2004 DECEMBER 31, 2003
Oil and gas sales $ 118,158 $ 24,229
Production costs (134,420) (76,303)
Production taxes (14,581) (3,002)
Depletion (41,549) (13,960)
Results of operations for oil and gas
producing activities (excluding corporate $ (72,392) $ (69,036)
overhead and financing costs)
PROVED DEVELOPED AND UNDEVELOPED RESERVES
PREPARED BY W.D. VON GONTEN & CO. PETROLEUM ENGINEERS
The following table sets forth the net proved reserves of the Company as of July
1, 2004, and the changes therein for the period from September 23, 2003
(inception) to July 1, 2004. The reserve information was reviewed by W.D. Von
Gonten & Co., independent petroleum engineers. All of the Company's oil and gas
producing activities are located in the United States.
OIL GAS
(BBLS) (MCF)
September 23, 2003 -- --
Purchases of minerals in place 241,219 778,700
Extensions and discoveries -- --
Production (857) --
Sales of minerals in place -- --
December 31, 2003 240,362 778,700
Purchases of minerals in place
Extensions, discoveries and revisions 2,352 (270,021)
Production (3,810) (123)
Sales of minerals in place -- --
July 1, 2004 238,904 508,556*
Proved developed reserves:
December 31, 2003 240,400 778,700
July 1, 2004 238,900 508,556*
* Includes 5,000 BBL of NGL's converted at 6 BBLs / MCF
F-14
STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS
AT DECEMBER 31, 2003 AND JUNE 30, 2004
The information that follows has been developed pursuant to SFAS No. 69 and
utilizes reserve and production data prepared or reviewed by independent
petroleum consultants. Reserve estimates are inherently imprecise and estimates
of new discoveries are less precise than those of producing oil and natural gas
properties. Accordingly, these estimates are expected to change as future
information becomes available.
The estimated discounted future net cash flows from estimated proved reserves
are based on prices and costs as of the date of the estimate unless such prices
or costs are contractually determined at such date. Actual future prices and
costs may be materially higher or lower. Actual future net revenues also will be
affected by factors such as actual production, supply and demand for oil and
natural gas, curtailments or increases in consumption by natural gas purchasers,
changes in governmental regulations or taxation and the impact of inflation on
costs. Future income tax expense has been reduced for the effect of available
net operating loss carryforwards.
FOR THE PERIOD FROM
SIX MONTHS SEPTEMBER 23, 2003
ENDED (INCEPTION) TO
JUNE 30, 2004 DECEMBER 31, 2003
Future cash inflows $ 11,549,850 $ 13,318,169
Future production costs (2,978,139) (2,895,677)
Future development costs (450,000) (357,000)
Future income taxes (1,465,000) (2,412,000)
Future Net Cash Flows 6,656,711 7,653,492
10% annual discount (1,476,100) (1,479,544)
Standardized Measure $ 5,180,611 $ 6,173,948
CHANGES IN STANDARDIZED MEASURE
The following table sets forth the changes in standardized measure of discounted
future net cash flows for the period from September 23, 2003 (inception) to
December 31, 2003 and for the six months ended June 30, 2004:
FOR THE PERIOD FROM
SIX MONTHS SEPTEMBER 23, 2003
ENDED (INCEPTION) TO
JUNE 30, 2004 DECEMBER 31, 2003
Standardized Measure, beginning $ 6,173,948 $ --
Net change in income taxes 737,006 (1,945,721)
Oil and gas sales, net of costs 30,843 51,065
Purchase of minerals in place -- 8,068,605
Changes in prices and costs 82,230 --
Change in developments costs (84,042) --
Accretion of discount 308,697 --
Revisions of estimates (2,131,318) --
Other 64,246 --
Standardized Measure, ending $ 5,180,611 $ 6,173,948
11. SUBSEQUENT EVENTS
Subsequent to June 30, 2004, the Company received $475,000 under a short-term
secured promissory note (the "Note") held by Laird Q. Cagan, the Company's
Chairman and major stockholder, for the purpose of bridge financing part of the
purchase price of the Tullos Urania Field. Under the terms of the Note, all net
revenue derived from the Company's Tullos Urania Field, less operating expenses
and development costs, must be applied toward repayment of the Note. The Note
bears interest at 10% per annum, is secured by a pledge of all of the Company's
assets and is due in full by February 10, 2005. Since the origination of the
loan, the Company and Mr. Cagan agreed to amend the repayment terms of the loan
by delaying the repayment until the earlier of (a) July 1, 2005, or (b) the date
on which the cumulative gross equity funding after August 14, 2004 reaches $1
million. Also amended are the terms of the Note which delays the mandatory
prepayment until all net revenue derived from the Company's Tullos Urania Field,
less operating expenses and capital costs accruing after February 5, 2005 and
50% of the net proceeds of any related third party financings of any kind
conducted by the Company after the date of this Note.
F-15
From July 1, 2004 through September 24, 2004, NGS raised gross proceeds from the
sale of common stock in the amount of $544,734.
On September 2, 2004, NGS purchased its second property comprising a 100%
working interest in approximately 81 producing oil wells, 8 salt water disposal
wells and 54 shut-in wells located in La Salle and Winn Parishes, Louisiana.
Fourteen of the shut-in wells will require a new lease prior to restoration of
production. The purchase included leases covering 386.04 gross and net acres,
and fee ownership of 2.33 acres around certain of the wells. NGS intends to
initiate a program of restoring the shut-in wells to production, increasing
overall production per well by addition of incremental water disposal capacity
and utilizing gas production to replace purchased power for pumps. NGS will file
at a later date a Form 8-K to further describe the purchased assets.
12. INCOME TAXES
The tax effect of significant temporary differences representing deferred tax
assets and liabilities at December 31, 2003 and June 30, 2004 are as follows:
JUNE 30, 2004 DECEMBER 31, 2003
Oil and gas properties $ (69,389) $ (113,558)
Net operating loss carryforwards 366,425 228,043
Valuation Allowance (297,036) (114,485)
Net deferred tax asset $ -- $ --
The increase in the valuation allowance during fiscal 2003 and 2004 of $114,485
and $182,551; respectively, is the result of additional net tax losses incurred
during the year.
As of June 30, 2004, the Company has net operating loss carryforwards of
approximately $1,078,000 that will expire in 2023 and 2024. Future utilization
of the net operating loss carryforwards and other tax attributes may be limited
by changes in the ownership of the Company in May 2004 under section 382 of the
Internal Revenue Code.
The following is a reconciliation of the Company's expected income tax expense
(benefit) based on statutory rates to the actual expense (benefit):
FOR THE PERIOD FROM
SIX MONTHS SEPTEMBER 23, 2003
ENDED (INCEPTION) TO
JUNE 30, 2004 DECEMBER 31, 2003
Income taxes (benefit) at US statutory rate $ (349,412) $ (114,548)
Non-deductible amortization and expenses 165,141 62
Deferred tax asset valuation allowance adjustment 182,551 114,485
Net operating losses -- --
Other $ 1.720 1
$ -- $ --
F-16
13. LIQUIDITY
As of June 30, 2004, we had $367,831 of unrestricted cash and negative working
capital of $383,352. We incurred losses for the six months period ended June 30,
2004 and three months period ended December 31, 2003 of $1,027,682 and $336,905,
respectively. Our negative working capital of $383,352 was adversely impacted by
$732,806 of short-term mortgage notes we owe on the Delhi Field, payable in
approximately equal monthly installments through December 30, 2004 (the "Delhi
Notes" See Note 7 to the financial statements for a further description).
Although our cash flow from operations currently approximates our recurring
overhead, our cash flow has been, and continues to be, insufficient to cover the
Delhi Note payments. Although we are current in our payments on the Delhi Notes,
we have relied on additional funding sources to meet these payments since the
beginning of 2004. At September 24, 2004, we owed four remaining monthly
payments of $125,000 each on the Delhi Notes. At that date, we had cash balances
of approximately $256,000 and approximately $176,000 of accounts payable due
(excluding deferred fees due CMCP).
Our negative working capital and cash position, as well as our ongoing operating
losses, raise concerns about our ability to meet future obligations and fund
future operations. Accordingly, management has and continues to expend
considerable time and effort to deal with this issue as discussed below.
Subsequent to June 30, 2004, we have been working to improve our liquidity using
three strategies:
1. ADDITIONAL SALES OF COMMON STOCK: From June 30 through September 24,
2004 we received $544,734 of additional gross cash proceeds from the
private sale of our common stock, before commissions. We plan to
raise funds through additional sales of equity securities in private
transactions. Because there can be no assurance that we will be able
to do so, we are pursuing borrowing arrangements as discussed below.
2. BORROWING: On August 11, 2004, we borrowed $475,000 under a
short-term secured promissory note (the "Bridge") held by Laird Q.
Cagan, the Company's Chairman and major stockholder, secured by a
pledge of all of our assets. The loan was earmarked as partial
bridge financing for our purchase of the Tullos Urania Field
properties for $732,000 on September 3, 2004. The Bridge loan with
Mr. Cagan has been amended to delay the repayment until the earlier
of (a) July 1, 2005, or (b) the date on which the cumulative gross
equity funding after August 14, 2004 reaches $1 million. Terms of
the mandatory prepayment have also been amended as more fully
described in the original documents filed or incorporated by
reference herein. Mr. Cagan is a founding Managing Partner of Cagan
McAfee Capital Partners, the financial advisor to the Company that
is arranging private equity fundings. If additional funds are not
raised, we may not have sufficient funds to repay the Bridge loan or
complete our capital expenditure program as currently contemplated.
Since the beginning of 2004, we also began developing relations with
at least three commercial banks and several private equity sources
that specialize in making loans or investing in oil and gas
producers. We believe that our Delhi and Tullos properties could
provide sufficient collateral to repay the remaining Delhi Notes in
full, as well as providing us with additional development capital
aimed at increasing our production from our existing wells according
to our original plan. In the event that the collateral is not
sufficient to also repay the Bridge loan above, we would likely be
required to negotiate those terms further.
3. INCREASED PRODUCTION: We continue to work on increasing cash flow
from operations through our Delhi Field and additional acquisition
candidates, thereby spreading our overhead, including significant
expenses of being a public company, over a larger revenue base. On
September 3, 2004, we closed the purchase of producing properties in
the Tullos Urania Field, located close to our Delhi Field operations
in Northern Louisiana. We believe that net cash flow from operations
at our Tullos property currently exceeds $30,000 per month. We also
believe that opportunities exist to increase Tullos production with
relatively small amounts of additional capital expenditures.
F-17
We are pursuing additional acquisition candidates meeting our
targeted requirements.
14. LEASES
The Company is obligated for operating lease payments related to the Company's
headquarters in Houston, Texas, and a gas processing plant servicing the
Company's Delhi Field. Minimum lease payments are:
Fiscal 2005: $ 101,772
Fiscal 2006: 12,516
Total $ 114,288
Lease expense was $44,770 for the six months ended June 30, 2004 and $8,541 for
the three months ended December 31, 2003.
15. EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted earnings
(loss) per share:
FOR THE PERIOD FROM
SIX MONTHS SEPTEMBER 23, 2003
ENDED (INCEPTION) TO
JUNE 30, 2004 DECEMBER 31, 2003
Numerator:
Net loss applicable to common stockholders $ (1,027,682) $ (336,905)
Plus income impact of assumed conversions:
Preferred stock dividends N/A N/A
Interest on convertible subordinated notes N/A N/A
Net loss applicable to common stockholders plus assumed Conversions (1,027,682) (336,905)
Denominator:
22,057,614 20,091,720
Affect of potentially dilutive common shares:
Warrants N/A N/A
Employee and director stock options N/A N/A
Convertible preferred stock N/A N/A
Convertible subordinated notes N/A N/A
Redeemable preferred stock N/A N/A
Denominator for dilutive earnings per share--weighted-average shares
Outstanding and assumed conversions 22,057,614 20,091,720
Loss per common share:
Basic and diluted $ (0.05) $ (0.02)
F-18
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors
Natural Gas Systems, Inc.
We have audited the accompanying statements of revenues and direct operating
expenses of the Delhi Field acquired on September 23, 2003, for the period from
January 1, 2003 to September 23, 2003 and for the nine-month period ended
December 31, 2002. The statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on the statements based
on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
statements are free from material misstatement. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the statements. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the overall
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.
In our opinion, the statements referred to above present fairly, in all material
respects, the direct operating revenues and direct operating expenses of the
Delhi Field acquired on September 23, 2003, in conformity with accounting
principles generally accepted in the United States of America.
Hein & Associates LLP
Houston, Texas
July 30, 2004
--------------------------------------------------------------------------------
F-19
NATURAL GAS SYSTEMS, INC.
STATEMENT OF REVENUES AND DIRECT OPERATING EXPENSES OF THE DELHI FIELD
ACQUIRED ON SEPTEMBER 23, 2003
FOR THE
PERIOD FROM FOR THE
JANUARY 1, NINE-MONTH
2003 TO PERIOD ENDED
SEPTEMBER 23, DECEMBER 31,
2003 2002
------------- -------------
OIL AND GAS SALES $ 148,506 $ 64,491
DIRECT OPERATING EXPENSES 141,854 55,202
------------- -------------
NET REVENUE $ 6,652 $ 9,289
============= =============
--------------------------------------------------------------------------------
NATURAL GAS SYSTEMS, INC.
NOTES TO STATEMENT OF REVENUES AND DIRECT OPERATING EXPENSES
1. BASIS OF PREPARATION
The accompanying historical summaries of revenues and direct operating
expenses relate to the operations of the Delhi Field oil and gas properties
acquired by Natural Gas Systems, Inc. (the "Company") on September 23, 2003 from
Delta Exploration and Development Co. and Camark Production Co. The properties
were acquired for $1,000,000 in cash and an interest-free note payable in the
amount of $1,495,000.
Revenues are recorded when the Company's share of oil or natural gas and
related liquids are sold. Direct operating expenses are recorded when the
related liability is incurred. Direct operating expenses include lease operating
expenses, ad valorem taxes and production taxes. Depreciation and amortization
of oil and gas properties, general and administrative expenses and income taxes
have been excluded from operating expenses in the accompanying historical
summaries because the amounts would not be comparable to those resulting from
proposed future operations.
The historical summaries presented herein were prepared for the purpose of
complying with the financial statement requirements of a business acquisition to
be filed on Form 8-K as promulgated by Regulation S-B Item 3-10 of the
Securities Exchange Act of 1934.
2. SUPPLEMENTAL INFORMATION ON OIL AND GAS RESERVES (UNAUDITED)
Proved oil and gas reserves consist of those estimated quantities of crude
oil, natural gas, and natural gas liquids that geological and engineering data
demonstrate with reasonable certainty to be recoverable in future years from
known reservoirs under existing economic and operating conditions.
The following estimates of proved reserves have been made by independent
engineers, based on the 80% net revenue interest purchased by the Company. The
estimated net interest in proved reserves are based upon subjective engineering
judgments and may be affected by the limitations inherent in such estimation.
The process of estimating reserves is subject to continual revision as
additional information becomes available as a result of drilling, testing,
reservoir studies and production history. There can be no assurance that such
estimates will not be materially revised in subsequent periods.
The changes in proved reserves of the Delhi Field properties acquired on
September 23, 2003 for the period from January 1, 2003 to September 23, 2003 and
for the nine months ended December 31, 2002 are set forth below.
F-20
NATURAL GAS
OIL (THOUSAND
(BARRELS) CUBIC FEET)
------- -------
Reserves at April 1, 2002 248,074 778,700
Production (2,461) --
Revisions, extensions and discoveries -- --
------- -------
Reserves at January 1, 2003 245,613 778,700
Production (4,394) --
Revisions, extensions and discoveries -- --
------- -------
Reserves at September 23, 2003 241,219 778,700
======= =======
The standardized measure of discounted estimated future net cash flows
related to proved oil and gas reserves as of September 23, 2003 and December 31,
2002 is as follows:
SEPTEMBER 23, DECEMBER 31,
2003 2002
------------ ------------
Future cash inflows $ 11,097,902 $ 11,437,004
Future production costs (2,892,314) (3,054,627)
Future development costs (357,000) (357,000)
Future income taxes (1,658,000) (1,718,000)
------------ ------------
Future net cash flows 6,190,588 6,307,377
10% annual discount (1,290,548) (1,669,865)
------------ ------------
Standardized measure of discounted future net cash flows $ 4,900,040 $ 4,637,512
============ ============
The primary changes in the standardized measure of discounted estimated
future net cash flows for the period from January 1, 2003 to September 23, 2003
and for the nine-month period ended December 31, 2002, were as follows:
2003 2002
----------- -----------
Beginning of period $ 4,637,512 $ 3,254,254
Sales of oil and gas produced, net of production costs (6,652) (9,289)
Effect of change in prices (267,891) 1,846,310
Accretion of discount 463,751 325,425
Net change in income taxes 47,492 (609,524)
Revision of estimates and other 25,828 (169,664)
----------- -----------
End of period $ 4,900,040 $ 4,637,512
=========== ===========
Estimated future cash inflows are computed by applying year-end prices of
oil and gas to year-end quantities of proved reserves. Estimated future
development and production costs are determined by estimating the expenditures
to be incurred in developing and producing the proved oil and gas reserves at
the end of the year, based on period-end costs and assuming continuation of
existing economic conditions. Estimated future income tax expense is calculated
by applying year-end statutory tax rates to estimated future pre-tax net cash
flows related to proved oil and gas reserves, less Natural Gas Systems' tax
basis of the properties involved as if the purchase had occurred at April 1,
2002.
F-21
The assumptions used to compute the standardized measure are those
prescribed by the Financial Accounting Standards Board and as such, do not
necessarily reflect the Company's expectations of actual revenues to be derived
from those reserves nor their present worth. The limitations inherent in the
reserve quantity estimation process are equally applicable to the standardized
measure computations since these estimates are the basis for the valuation
process.
On September 23, 2003, Natural Gas Systems, Inc. (the "Company") acquired
interests in the Delhi Field for considering of $2,495,000. Unaudited pro forma
financial statements have not been prepared to demonstrate the effect on the
Company's financial position and results of operations as if the properties had
been acquired on December 31, 2002 (with respect to the pro forma balance sheet)
and at January 1, 2003 and April 1, 2002 (with respect to the pro forma
statements of income) because the Company did not exist prior to September 23,
2003.
F-22
UNAUDITED
FINANCIAL
STATEMENTS
NATURAL GAS SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
MARCH 31, 2005 JUNE 30, 2004
-------------- -------------
(unaudited)
ASSETS
Current Assets:
Cash $ 978,412 $ 367,831
Accounts receivable 176,388 24,387
Inventories 250,050 115,859
Prepaid expenses 55,872 69,067
Retainers and deposits 34,530 5,000
----------- -----------
Total current assets 1,495,252 582,144
Oil & Gas properties - full cost 4,922,029 3,075,438
Oil & Gas properties - not amortized 95,510 105,225
Less: accumulated depletion (212,330) (55,509)
----------- -----------
Net oil and gas properties 4,805,209 3,125,154
Furniture, fixtures, and equipment, at cost 8,128 3,091
Less: accumulated depreciation (2,461) (1,159)
----------- -----------
Net furniture, fixtures, and equipment 5,667 1,932
Other Assets:
Restricted deposits 602,246 301,835
Other assets 304,103 0
----------- -----------
Net other assets 906,349 301,835
----------- -----------
Total assets 7,212,477 4,011,065
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable 499,206 139,188
Accrued liabilities 98,192 50,073
Notes payable 16,774 776,235
Production taxes payable 48,837 0
----------- -----------
Total current liabilities 663,009 965,496
Long term Liabilities:
Notes payable 2,877,846 0
Deferred plugging and abandonment liabilities 321,374 311,442
----------- -----------
Total liabilities 3,862,229 1,276,938
F-23
Stockholders' Equity:
Common Stock, par value $0.001 per share; 23,409 22,945
100,000,000 shares authorized, 23,409,600 and 22,945,400
shares issued and outstanding as of March 31, 2005
and June 30, 2004, respectively
Subscription receivable 30 0
Additional paid-in capital 6,684,358 4,453,905
Deferred stock based compensation (310,187) (378,136)
Retained earnings (deficit) (3,047,362) (1,364,587)
----------- -----------
Total stockholders' equity 3,350,248 2,734,127
----------- -----------
Total liabilities and stockholders' equity $ 7,212,477 $ 4,011,065
=========== ===========
See accompanying notes to condensed consolidated financial statements.
F-24
NATURAL GAS SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
NINE MONTHS FOR THE PERIOD FROM
ENDED MARCH 31, SEPTEMBER 23, 2003
2005 (INCEPTION) TO
MARCH 31, 2004
------------ ------------
(unaudited) (unaudited)
Revenues:
Oil sales $ 723,625 $ 72,801
Gas sales $ 293,203 $ --
------------ ------------
Total revenues $ 1,016,828 $ 72,801
Expenses:
Operating costs $ 555,418 $ 134,929
Production taxes $ 44,773 $ 9,027
Depletion $ 158,123 $ 27,537
General and administrative $ 1,706,871 $ 509,783
------------ ------------
$ 2,465,185 $ 681,276
Loss from operations $ (1,448,357) $ (608,475)
Other income and expense:
Interest income $ 8,226 $ 3,413
Interest expense $ (201,698) $ (56,350)
Unrealized loss on financial instruments $ (40,946) $ --
------------ ------------
Total other income and expense $ (234,418) $ (52,937)
------------ ------------
Net Loss $ (1,682,775) $ (661,412)
============ ============
Loss per common share, basic and diluted $ (0.07) $ (0.03)
Weighted average number of common shares,
basic and diluted 23,299,719 20,948,744
See accompanying notes to condensed consolidated financial statements.
F-25
NATURAL GAS SYSTEMS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED FOR THE PERIOD
MARCH 31, 2005 FROM SEPTEMBER 23,
2003 (INCEPTION)
TO MARCH 31, 2004
----------- -----------
(unaudited) (unaudited)
Operating activities:
Net loss $(1,682,775) $ (661,412)
Adjustments to reconcile net loss to net cash used by operating
activities:
Stock-based compensation 620,589 104,707
Depletion 156,821 27,537
Depreciation 1,302 773
Accretion of asset retirement obligation 9,932 0
Changes in assets and liabilities:
Accounts receivable (152,001) (73,625)
Retainers and deposits (29,530) (342,473)
Inventories (134,191) (119,908)
Accounts payable 360,018 109,397
Production taxes payable 48,837 0
Prepaid expenses 13,195 (11,413)
Accrued expenses 48,119 0
----------- -----------
Net cash used by operating activities (739,684) (966,417)
Investing activities:
Capital expenditures for oil and gas properties (1,836,876) (3,331,553)
Capital expenditures for furniture, fixtures and equipment (5,037) (3,092)
Other assets (344,811) 308,206
----------- -----------
Net cash used in investing activities (2,186,724) (3,026,439)
Financing activities:
Deferred financing fees (259,703) 0
Proceeds from notes payable 3,855,721 1,088,499
Payments on notes payable (1,737,336) 0
Proceeds from issuance of common stock 1,678,307 3,018,200
----------- -----------
Net cash generated by financing activities 3,536,989 4,106,699
Net increase in cash 610,581 113,843
Cash and cash equivalents, beginning of period 367,831 0
Cash and cash equivalents, end of period 978,412 113,843
Supplemental Cash Flow Information:
Interest paid $ 168,475 $ --
Non-cash transactions:
Seller note issued to acquire properties, net of discount $ -- $ 1,407,049
Assumption of plugging and abandonment liability $ -- $ 301,835
See accompanying notes to condensed consolidated financial statements.
F-26
NATURAL GAS SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)
NATURAL GAS SYSTEMS, INC. AND SUBSIDIARIES
1. NATURE OF BUSINESS, ORGANIZATION AND BASIS OF PREPARATION AND PRESENTATION
Headquartered in Houston, Texas, Natural Gas Systems, Inc. (the "Company",
"NGS", "we" or "us") is a petroleum company incorporated under the laws of the
State of Nevada, engaged primarily in the acquisition, exploitation and
development of properties for the production of crude oil and natural gas from
underground reservoirs. The Company acquires established oil and gas properties
and exploits them through the application of conventional and specialized
technology to increase production, ultimate recoveries, or both. At March 31,
2005, NGS conducted operations through its 100% working interests in the Delhi,
Tullos Urania, Crossroads and Colgrade Fields located in Louisiana.
The condensed consolidated financial statements for the nine month period ended
March 31, 2005 have been prepared by the Company, without audit, pursuant to the
rules and regulations of the Securities and Exchange Commission. Certain
information and footnotes normally prepared in accordance with accounting
principles generally accepted in the United States of America have been omitted
or condensed. However, in management's opinion, all adjustments, consisting of
normal recurring accruals, necessary to present fairly the financial position
and results of operations of the Company have been made.
The condensed consolidated financial statements provided herein should be read
in conjunction with the financial statements and their accompanying notes
included in the Company's Form 10-KSB filed for the period ended June 30, 2004
and Forms 10-QSB filed for the fiscal quarters ended September 30, 2004 and
December 31, 2004.
2. ACQUISITIONS
On February 3, 2005, we completed the purchase of a 100% working interest in
certain leases with approximately 65 producing oil wells, 9 salt water disposal
wells and 56 shut-in wells located in the Tullos Urania and Colgrade Fields in
La Salle and Winn Parishes, Louisiana. Four of the 56 shut-in wells will require
a new lease prior to restoration of production. The purchase price was $798,907
after post-closing adjustments to reflect an effective date of December 1, 2004,
paid in cash. The acquisition was accounted for under the purchase method of
accounting. No goodwill arose from the purchase. Revenue and expense from the
property is recognized beginning February 1, 2005.
We believe that the foregoing acquisition is consistent with our strategic
business plan to acquire established oil and gas properties in order to exploit
them through the application of conventional and specialized technology to
increase production, ultimate recoveries, or both. At the purchase date, the
field's production capacity was estimated to average approximately 70 barrels of
oil per day. Following the closing, we initiated a program of restoring shut-in
wells to production, increasing overall production per well by the addition of
incremental water disposal capacity and utilizing gas production to replace
purchased power for pumps.
In September 2004, we purchased approximately 140 wells in the same fields from
another operator. Those leases and wells directly offset (i.e. are
geographically and geologically adjacent to) the wells purchased in February
2005, and NGS anticipates that the combination of operations will result in a
more efficient and effective overall operation. Each of these property
acquisitions, together and individually, are referred to as the "Tullos Field
Area."
F-27
As is common with the purchase of producing oil and gas properties, we assumed
an asset retirement obligation in connection with the acquisition of the fields
described above. In accordance with FAS 143, management is making an assessment
as to the amount of liability to be recorded in the Company's financial
statements as a result of our assumption of these obligations.
3. LOSS PER SHARE
The following table sets forth the computation of basic and diluted loss per
share:
For the period
Nine months from September 23,
ended March 31, 2003 (inception)
2005 to March 31, 2004
------------ ----------------
Numerator:
Net loss applicable to common stockholders $ (1,682,775) $ (661,412)
Plus income impact of assumed conversions:
Preferred stock dividends N/A N/A
Interest on convertible subordinated notes N/A N/A
------------ ----------------
Net loss applicable to common stockholders
plus assumed conversions $ (1,682,775) $ (661,412)
============ ================
Denominator:
Affect of potentially dilutive common shares:
Warrants N/A N/A
Employee and director stock options N/A N/A
Convertible preferred stock N/A N/A
Convertible subordinated notes N/A N/A
Redeemable preferred stock N/A N/A
Denominator for dilutive earnings per share - weighted
average shares
Outstanding and assumed conversions 23,299,719 20,948,744
Loss per common share:
basic and diluted $ (0.07) $ (0.03)
============ ================
4. LIQUIDITY
As of March 31, 2005, we had $978,412 of unrestricted cash and positive working
capital of $832,243, excluding $800,000 available for drawing under a facility
provided by Prospect Energy Corporation (the "Prospect Facility" or "Facility"),
which we have allowed to expire on May 3, 2005 as described in Note 5 below. We
incurred losses for the nine months ended March 31, 2005 of $1,682,775, of which
$620,589 were related to non-cash general and administrative charges associated
with compensatory stock expense (See Note 6). Our positive working capital of
$832,243 at March 31, 2005 was positively impacted by the $4,000,000 we received
under the Prospect Facility, the proceeds of which were used to pay off most of
our short-term debt and to replenish our working capital. See Note 5, Notes
Payable.
F-28
During the nine months ended March 31, 2005, the Chairman of our Board of
Directors, Laird Q. Cagan, loaned us, through a series of advances, $920,000
pursuant to a secured promissory note bearing interest at 10% per annum (the
"Bridge Loan"), earmarked for our purchase of working interests in the Tullos
Urania Field in Louisiana, working capital and certain costs related to the
closing of the Prospect Facility. Pursuant to the terms of the Prospect
Facility, we were permitted to repay in full the Bridge Loan following
satisfaction of certain requirements, including the acquisition of oil and gas
price hedges for at least 50% of current net production for a two year period.
On February 15, 2005, we paid off the Bridge Loan in full, including accrued
interest thereon, in the amount of $953,589. As of February 22, 2005 we had
entered into contracts to hedge in excess of 50% of our estimated production
from existing proved developed producing reserves covering a two year period.
On February 3, 2005, we closed the Prospect Facility and drew down $3,000,000,
and on March 16, 2005 we drew down an additional $1,000,000 on the total of
$4,800,000 committed under the Facility. The draws were used to fund the
February 2005 acquisition of properties in Louisiana, costs of the financing,
funding of a debt service reserve fund, repayment of the Bridge Loan, immediate
re-development of our existing properties and for working capital purposes. We
allowed the remaining $800,000 commitment to expire on May 3, 2005. After taking
into account the effect of the completion of the February 2005 acquisition of
properties (see Note 2), the closing of the Prospect Facility and our recent
private placement of common stock described below, and before taking into
account the effect of any new projects or acquisitions, we believe that our
current liquidity and anticipated operating cash flows will be sufficient to
meet our near-term operating expense and capital expenditure needs, absent
unanticipated reductions of revenue or increases in expenses due to factors
including, but not limited to, drops in product prices, unanticipated shut
downs, bad weather and unforeseen expenses.
Subsequent to the end of the quarter, on May 6, 2005, we closed a private
placement of 1,200,000 shares of common stock with a European institutional
investor at a $2.50 price per share. Our gross proceeds were $3,000,000 before
payment of a $240,000 placement fee to Chadbourn Securities and Laird Q. Cagan,
the Chairman of our Board of Directors, and our obligation to issue them
warrants to purchase up to 96,000 shares of our common stock at a price of $2.50
per share.
In accordance with our business objectives, we plan to continue expending
considerable time and effort to secure additional capital in order to acquire
additional oil and gas properties. There can be no assurance that we will be
able to secure such additional financing on terms satisfactory to us or at all,
or that we will be able to identify acquisitions that meet our strategic
objectives.
5. NOTES PAYABLE
The following table sets forth the Company's notes payable balances as of the
dates indicated:
MARCH 31, JUNE 30,
BORROWING 2005 2004
--------- ---------- ----------
Delhi Mortgage Note $ -- $ 732,807
AICCO Insurance Premium Loan -- 43,428
Cananwill Insurance Premium Loan 16,774 --
Prospect Energy 5-Year Note 2,877,846 --
Bridge Loan by our Chairman of the Board -- --
Herlin Loan -- --
TOTAL OUTSTANDING $2,894,620 $ 776,235
DELHI MORTGAGE NOTES: In September 2003, we issued $1,500,000 of notes payable
in connection with our acquisition of the Delhi Field. The notes were
collateralized by a first mortgage on our Delhi Field and were payable to the
sellers in twelve equal monthly installments beginning on January 30, 2004.
Although the notes bear no interest, the Company imputed interest at 8% per
annum, thus resulting in an initial recorded principal amount of $1,407,049. At
March 31, 2005, there were no outstanding amounts owed under the Delhi Mortgage
Notes.
F-29
AICCO LOAN: In May 2004, we borrowed $49,490 to finance 70% of our Director and
Officer's liability insurance premiums. The loan required eight level
mortgage-amortizing payments in the amount of $6,350 per month, including 7%
interest per annum. At March 31, 2005, there were no outstanding amounts owed
under the AICCO Loan.
CANANWILL LOAN: In October 2004, we borrowed $33,186 to finance 80% of our
General Liability, Casualty and Well Control insurance premiums. The loan
requires ten level payments in the amount of $3,399 per month, including 5.25%
interest per annum. At March 31, 2005, $16,774 was owed under the Cananwill
Insurance Premium Loan.
BRIDGE LOAN: As described in Note 4, during the nine months ended March 31,
2005, we borrowed a total of $920,000 from Laird Q. Cagan, the Company's
Chairman and a major stockholder, secured by a pledge of all of our assets. On
February 15, 2005, we repaid the Bridge Loan in full.
HERLIN LOAN: During the nine months ended March 31, 2005, Mr. Herlin advanced us
$3,000 for working capital, with interest payable at 10% per annum. At March 31,
2005, Mr. Herlin's loan was included in accounts payable, which was paid in
April, 2005.
PROSPECT FACILITY: As described in Note 4, on February 3, 2005 we closed the
"Prospect Facility" (or "Facility"). Advances under the Prospect Facility can
aggregate up to $4,800,000 if funded on or prior to May 3, 2005. To date, we
have drawn $4,000,000 under the Facility in order to pay fees and expenses
related to the financing, to fund the debt service reserve account, to fund the
purchase of additional oil producing properties in the Tullos Urania and
Colgrade Fields in Louisiana, to pay off the Bridge Loan to Mr. Cagan, to fund
working capital and to fund the immediate re-development of our existing
properties. We have allowed the remaining $800,000 commitment to expire as of
May 4, 2005. At March 31, 2005, we owed $2,877,846 on the Prospect Facility,
including the accreted discount through such date. At maturity or, exclusive of
any prepayment penalty, on early prepayment, the total amount owed under the
Facility will be $4,000,000 due to accretion of the original issue discount.
Under the terms of the Prospect Facility, each advance requires us to issue two
securities, a debt security and an equity security (in the form of irrevocable
and revocable warrants) as follows:
(i) The debt securities issued under the Facility (the "Prospect Loan(s)") were
secured by all of our assets, bear an initial interest rate of 14% per annum
payable in arrears on the "face" (the par or matured amount of the loan), mature
on February 2, 2010 and do not require principal payments until the end of the
term. For each draw under the Facility, we recorded a loan with an imputed
discount equivalent to the value of the Prospect Warrants described below.
Through March 31, 2005, we had drawn $4,000,000 under the Facility, crediting
$2,850,992 (net of the discount described below) to the Prospect Loan. The fair
value of the Prospect Warrants of $1,149,008 was recorded as a discount on the
Prospect Loans with a corresponding credit to additional paid-in capital for the
Prospect Warrants. The discount will be accreted as additional loan interest
expense using the interest rate method over the five-year life of the loan,
yielding an annual effective interest rate of 27.26% and 24.87% for the first
and second Prospect Loans, respectively.
(ii) The equity securities issued under the Facility consisted of irrevocable
and revocable warrants (the "Prospect Warrants"). An irrevocable warrant to
purchase one share of our common stock was issued to Prospect for each $6.666667
drawn under the Facility, and a revocable warrant to purchase one share of our
common stock was issued for each $10 drawn under the Facility. Through March 31,
2005 we had issued to Prospect Energy irrevocable warrants to acquire up to
600,000 shares of common stock exercisable over a five-year term at a price of
$0.75 per common share, and revocable warrants to acquire up to 400,000 shares
of common stock on the same terms, except that the revocable warrants will be
automatically canceled if we attain certain financial targets by the end of
February 2006, and such revocable warrants cannot be exercised prior to such
date. As described under the Prospect Loan above, the Prospect Warrants have
been credited to additional paid-in capital in the amount of $1,149,008. The
holder of the shares of common stock underlying the Prospect Warrants are
subject to a registration rights agreement, briefly described in Note 6, "Common
Stock, Options and Warrants".
F-30
Among other restrictions and subject to certain exceptions, the Prospect
Facility restricts us from creating liens, entering into certain types of
mergers or consolidations, incurring additional indebtedness, changing the
character of our business, or engaging in certain types of transactions. The
Loan Agreement also requires us to maintain specified financial ratios
(including a 1.5:1 ratio of borrowing base to debt and, commencing with the
quarter ended September 30, 2005, a 2.0:1 ratio of operating cash flow to
interest). In order to satisfy certain of these ratios, we will need to
significantly increase our operating cash flow, of which there can be no
assurance.
6. COMMON STOCK, OPTIONS AND WARRANTS
COMMON STOCK
During the nine months ended March 31, 2005, we raised gross proceeds of
$1,728,876 from the sale of our common stock and warrants to purchase our common
stock. Of the total, $579,868 was received from the sale of 394,200 shares of
our common stock and 70,000 shares were issued upon the exercise of options
previously granted under the stock option plan. The remaining $1,149,008 was
allocated to the sale of the Prospect Warrants as described under "Options and
Warrants" in this footnote. In connection with these issuances, we incurred
placement fees to Chadbourn Securities and Laird Q. Cagan, our Chairman, in the
aggregate amount of $17,840 and were obligated to issue them warrants to
purchase up to a total of 12,536 shares of our common stock at an exercise price
of $1.50 per share. We also paid $32,659 to unrelated third parties as finder's
fees.
On May 6, 2005, we raised gross proceeds of $3,000,000 from the sale of common
stock from one institutional investor in a private placement. A placement fee of
$240,000 was paid to Chadbourn Securities and Laird Q. Cagan, and the Company is
obligated to issue them warrants to purchase 96,000 shares of common stock at a
price of $2.50 per share.
OPTIONS AND WARRANTS
During the nine months ended March 31, 2005, we issued options to purchase
200,000 shares of our common stock, issued warrants to purchase 1,429,836 shares
of our common stock (including the warrants described under "Common Stock" in
this footnote), cancelled warrants to purchase 16,000 shares of our common stock
and honored the exercise of warrants to purchase 104,800 shares of our common
stock, as described below:
With respect to the 200,000 options, on October 22, 2004 we recorded the grant
of options to purchase up to an aggregate total of 200,000 shares of common
stock with an exercise price of $1.00 per share, to our two independent board
members, in error. In fact, the options were issued at an exercise price of
$1.27 per share, which was 85% of the market price at the time of the grant, the
minimum threshold allowed under the Stock Plan of 2004 (the "Plan"). In the
current fiscal quarter, an adjustment was made to accurately reflect the terms
of the grant.
As part of the $4,000,000 we have drawn under the Prospect Facility described in
Note 5, we have issued to Prospect Energy irrevocable warrants to acquire up to
600,000 shares of common stock exercisable over a five-year term at a price of
$0.75 per common share, and revocable warrants to acquire up to 400,000 shares
of common stock on the same terms, except that the revocable warrants will be
automatically canceled if we attain certain financial targets by the end of
February 2006. We also issued 5-year warrants to a third-party finder to acquire
up to 50,000 shares of our common stock at $2.00 per share.
F-31
The shares of common stock issuable upon exercise of the Prospect Warrants are
subject to a registration rights agreement, pursuant to which we have granted
the holder certain piggyback registration rights.
As of January 1, 2005, we issued fully vested warrants to Tatum Partners to
purchase up to 262,500 shares of our common stock at $.001 per share in exchange
for a re-negotiated contract for Tatum's services. Under the terms of our
original contract dated September 18, 2003, Tatum Partners agreed to provide the
services of Robert Herlin as our CEO and provide access to Tatum's network of
resources in exchange for a fee of $3,000 per month, a ten-year option to
purchase up to 250,000 shares of our common stock at an exercise price of $.001
per share and 25% of any bonus or stock compensation awarded to Mr. Herlin
during his service with us. As previously reported in our public filings, an
option for 250,000 shares had been awarded in the name of Mr. Herlin in
September of 2003 that was earmarked for transfer or reissuance to Tatum. Under
the re-negotiated Tatum agreement, our monthly fee has been reduced to $1,000
per month, a new warrant to purchase 262,500 shares of our common stock was
issued to Tatum, Tatum forfeited any interest in the original option to purchase
up to 250,000 shares and Tatum agreed that they hold no rights to earn any
additional amounts arising from Mr. Herlin's compensation, other than the
reduced fee of $1,000 per month for one year. During the quarter ending March
31, 2005, we charged $432,976 to expense, representing the fair value of the
warrants issued to Tatum. Tatum's warrants do not contain registration rights.
Also during the nine months ended March 31, 2005, we issued warrants to purchase
up to 104,800 shares of our common stock at a nominal exercise price to
investors who purchased our common stock in a private placement, warrants to
purchase up to 50,000 shares at $2.00 per share to a third party finder in
connection with the Prospect Facility, and warrants to purchase up to 12,536
shares at an exercise price of $1.50 per share to Chadbourn Securities for
placement services related to sales of our common stock during the period.
During the nine months ended March 31, 2005, warrants to purchase 16,000 shares
of our common stock were cancelled and warrants to purchase 104,800 shares were
exercised.
We account for our employee stock option plan under the recognition and
measurement principles of Accounting Principles Board Opinion No. 25, Accounting
for Stock Issued to Employees and related interpretations. The following table
illustrates the effect on net income and earnings per share for the nine months
ended March 31, 2005, as if the Company had applied the fair value recognition
provisions of SFAS No. 123, Accounting for Stock-Based Compensation, as amended
by SFAS 148, Accounting for Stock-Based Compensation Transition and Disclosure,
issued in December 2002.
Nine Months
ended March
31, 2005
-------------
Pro forma impact of Fair Value Method (SFAS 148):
Net loss attributable to common stockholders, as reported $ (1,682,775)
Plus employee compensation expense determined under Intrinsic Value Method
Less employee compensation expense determined under Fair Value $ 11,000
Method $ (51,046)
-------------
Pro forma net loss attributable to common stockholders $ (1,722,821)
Loss per share (basic & diluted):
As reported $ (0.07)
Pro Forma $ (0.07)
Weighted average Black-Schoales fair value assumptions:
Risk free interest rate 4.93%
Expected life 3 years
Expected volatility 103.6%
Expected dividend yield 0.0%
F-32
7. COMMODITY HEDGING
Pursuant to the terms of the Prospect Facility we closed on February 3, 2005, we
entered into financial instruments covering approximately 50% of our expected
oil and gas production from proved developed producing properties over the next
two years. We used reserve report data prepared by W. D. Von Gonten & Co., our
independent petroleum engineering firm, to estimate our future production for
hedging purposes. As we may elect under FAS 133, Accounting for Derivative
Instruments and Hedging Activities, we have designated our physical delivery
contracts as normal delivery sale contracts. For the puts we recently purchased,
we have not fulfilled the documentation requirements of FAS 133. As a result,
the unrealized losses from our put contracts are expensed in our statement of
operations. At March 31, 2005, we had the following financial instruments in
place:
(i) 2,100 Bbls of oil to be delivered monthly from March 2005 through February
2006 to Plains Oil Marketing LLC, at $48.35 per barrel, plus or minus changes in
basis between: (a) the arithmetic daily average of the prompt month "Light Sweet
Crude Oil" contract reported by the New York Mercantile Exchange, and (b)
Louisiana field posted price. This is accounted for as a normal delivery sales
contract.
(ii) 100 MCFD of natural gas at a fixed price of $6.21, delivered through our
Delhi Field sales tap into Gulf South's pipeline, for the account of Texla for
deliveries from March 2005 to May 2006. This is accounted for as a normal
delivery sales contract.
(iii) Purchase of a non-physical put contract (or price floor) at $38 per barrel
for 2,000 Bbls of crude oil production from March 2006 through February 2007.
This is accounted for as a "mark-to-market" derivative investment. Of the
$72,000 premium we paid for the put option, we charged $40,946 to expense for
the difference between the purchase price paid and the market value of the put
at March 31, 2005.
Subsequent to the end of the quarter ended March 31, 2005, we extended the price
swap described in (i) above for an additional three months for the volume of
2,100 barrels of oil per month at a fixed price of $52.55 per barrel of oil.
8. RELATED PARTY TRANSACTIONS
Laird Q. Cagan, Chairman of our Board, is a Managing Director and co-owner of
Cagan McAfee Capital Partners, LLC ("CMCP"). CMCP performs financial advisory
services to us pursuant to a written agreement, earning a monthly retainer of
$15,000. At March 31, 2005, CMCP's fees for March 2004 through January, 2005,
totaling $180,000, were accrued, but unpaid. Mr. Cagan is a registered
representative of Chadbourn Securities, Inc. ("Chadbourn"), our placement agent
in private equity financings. Mr. Cagan and Chadbourn Securities earned $17,840
for the placement of 394,200 shares of our common stock during the nine months
ended March 31, 2005.
During the nine month period ended March 31, 2005, we charged $17,840 to
stockholder's equity as a reduction of the proceeds from common stock sales
placed by Chadbourn Securities and Mr. Cagan, and were issued warrants to
purchase up to a total of 12,536 shares of our common stock to Chadbourn
Securities and Mr. Cagan in connection with the placement of our common shares.
These warrants have a $1.50 exercise price and a seven-year term.
John Pimentel, a member of our Board of Directors, is a principal at CMCP.
Eric McAfee, also a Managing Director of CMCP and a significant shareholder of
ours, has served as Vice Chairman of the Board of Verdisys, Inc., the provider
of certain horizontal drilling services to us. During 2004, Mr. McAfee resigned
from the Board of Directors of Verdisys, but continues to hold shares in both
companies. Mr. McAfee has represented to us that he is also a 50% owner of Berg
McAfee Companies, LLC, which owns approximately 30% of the outstanding shares of
Verdisys, Inc. NGS paid $130,000 to Verdisys during fiscal 2003 and $25,960
during fiscal 2004 for horizontal drilling services.
F-33
During the nine months ended March 31, 2005, Mr. Cagan loaned us $920,000 under
the Bridge Loan. We paid off the loan in the amount of $953,589, including
accrued interest, on February 15, 2005. See Note 5, Notes Payable, for a further
explanation.
F-34
PART II - INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 24. INDEMNIFICATION OF DIRECTORS AND OFFICERS
Our Articles of Incorporation provide that no officer or director shall be
personally liable to our corporation or our stockholders for monetary damages
except as provided pursuant to Nevada law. Our bylaws and Articles of
Incorporation also provide that we shall indemnify and hold harmless each person
who serves at any time as a director, officer, employee or agent of our company
from and against any and all claims, judgments and liabilities to which such
person shall become subject by reason of the fact that he is or was a director,
officer, employee or agent of our company, and shall reimburse such person for
all legal and other expenses reasonably incurred by him or her in connection
with any such claim or liability. We also have the power to defend such person
from all suits or claims in accord with Nevada law. The rights accruing to any
person under our bylaws and Articles of Incorporation do not exclude any other
right to which any such person may lawfully be entitled, and we may indemnify or
reimburse such person in any proper case, even though not specifically provided
for by our bylaws or Articles of Incorporation.
Insofar as indemnification for liabilities arising under the Securities
Act may be permitted to directors, officers and controlling persons of our
company pursuant to the foregoing provisions, or otherwise, we have been advised
that in the opinion of the Securities and Exchange Commission such
indemnification is against public policy as expressed in the Securities Act and
is, therefore, unenforceable.
ITEM 25. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION
We estimate that expenses in connection with the distribution described in
this registration statement (other than brokerage commissions, discounts or
other expenses relating to the sale of the shares by the selling stockholders)
will be as set forth below. We will pay all of the expenses with respect to the
distribution, and such amounts, with the exception of the Securities and
Exchange Commission registration fee, are estimates.
SEC registration fee............................................. $1,495
Accounting fees and expenses..................................... *
Legal fees and expenses.......................................... *
Printing and related expenses.................................... *
Transfer agent fees and expenses................................. *
Miscellaneous.................................................... *
Total............................................................ $ *
-----------------
* To be filed by amendment
ITEM 26. RECENT SALES OF UNREGISTERED SECURITIES
On September 23, 2003, Natural Gas Systems, Inc., a Delaware corporation
("Old NGS"), a subsidiary of Natural Gas Systems, Inc., a Nevada corporation
(our "company"), issued 18,000,000 million shares to various founders. Included
in this issuance, Mr. Herlin also purchased 1,000,000 shares of common stock
(included in the issuance of 18,000,000 shares above) of Old NGS at a price of
$.001 per share, with Old NGS having a repurchase right under a reverse vesting
arrangement over 27 months. We issued and sold the foregoing securities pursuant
to an exemption from registration provided by Rule 506 of Regulation D and
Section 4(2) of the Securities Act of 1933.
Old NGS also granted on September 23, 2003 stock options to purchase
350,000 shares of Old NGS common stock at an exercise price of $0.001 per share.
Of these options, Robert S. Herlin was granted a stock option to purchase up to
250,000 shares of Old NGS common stock at an exercise price of $0.001 per share,
vesting over four years, pursuant to Mr. Herlin's executive employment
agreement. In addition, a stock option of 100,000 shares was granted to Mr. Lee,
the company's corporate counsel. These securities were issued pursuant to an
exemption from registration provided by Rule 701 of the Securities Act of 1933,
as amended..
On November 10, 2003, Old NGS granted Sterling McDonald a stock option to
purchase up to 250,000 shares of common stock of Old NGS at an exercise price of
$0.25 per share, vesting over 48 months, pursuant to Mr. McDonald's executive
employment agreement. We issued and sold the foregoing securities pursuant to an
exemption from registration provided by Rule 701 of the Securities Act of 1933,
as amended.
In early 2004, Old NGS issued 3,000,000 shares of our common stock at a
price of $1.00 per share to approximately 100 accredited investors. We issued
and sold the foregoing securities pursuant to an exemption from registration
provided by Rule 506 of Regulation D and Section 4(2) of the Securities Act of
1933. In May 2004, we sold 749,478 shares of our common stock at a price of
$1.00 per share (net of warrants exercised at $0.01 per share) to three
accredited investors We issued and sold the foregoing securities pursuant to an
exemption from registration provided by Rule 506 of Regulation D and Section
4(2) of the Securities Act of 1933. In connection with this two offerings, we
paid a placement agent fee to Chadbourn Securities, Inc., an NASD broker dealer,
and Laird Q. Cagan, chairman of our board of directors and a registered
representative of Chadbourn Securities, Inc., and their assigns (collectively,
the "Placement Agent") comprised of seven-year warrants to acquire up to 79,931
shares of our common stock at an exercise price of $1.00 per share, and cash in
the amount of $60,000.
In 2004, we, as Reality Interactive, Inc., issued our then-president
7,000,000 shares of our common stock for services rendered valued at $7,000. We
issued and sold the foregoing securities pursuant to an exemption from
registration provided by Rule 506 of Regulation D and Section 4(2) of the
Securities Act of 1933. In 2004, we, as Reality Interactive, Inc., also issued a
total of 695,000 shares of our common stock upon conversion of $230,000 of
indebtedness. We issued and sold the foregoing securities pursuant to an
exemption from registration provided by Rule 506 of Regulation D and Section
4(2) of the Securities Act of 1933.
On May 26, 2004, we, as Reality Interactive, Inc., entered into a merger
with Old NGS whereby the shareholders of Old NGS received 21,749,478 shares of
our common stock in exchange for all of the 21,749,748 shares of Old NGS common
stock then outstanding. All stock options of Old NGS were exchanged in the
merger for stock options exercisable for shares of our common stock. The
operations and management of Old NGS became our own, and we changed our name to
Natural Gas Systems, Inc. All of the shareholders of Old NGS were accredited
investors. In connection with consulting services related to the merger, we
issued seven-year warrants to acquire up to 240,000 shares of our common stock
at an exercise price of $1.00 per share (including 165,000 warrants to Cagan
McAfee Capital Partners, an entity 50% owned and controlled by the Company's
chairman, Laird Q. Cagan, and cash in the amount of $300,000. We issued and sold
the foregoing securities pursuant to an exemption from registration provided by
Rule 506 of Regulation D and Section 4(2) of the Securities Act of 1933.
In June 2004, we sold 249,667 shares of our common stock at a price of
$1.00 per share (net of warrants exercised at $0.01 per share) to one accredited
investor. We issued and sold the foregoing securities pursuant to an exemption
from registration provided by Rule 506 of Regulation D and Section 4(2) of the
Securities Act of 1933. In connection with this offering, we paid our Placement
Agent $20,000.
In July 2004, we sold 200,000 shares of our common stock at a price of
$1.50 per share (net of warrants exercised at $0.01 per share) to one accredited
investor. We issued and sold the foregoing securities pursuant to an exemption
from registration provided by Rule 506 of Regulation D and Section 4(2) of the
Securities Act of 1933. In connection with this two offerings, we paid our
Placement Agent seven-year warrants to acquire up to 12,536 shares of our common
stock at an exercise price of $1.50 per share.
During the nine months ended March 31, 2005, Mr. Cagan loaned us, through
a series of advances, $920,000 pursuant to a secured promissory note bearing
interest at 10% per annum. We issued and sold the foregoing security pursuant to
an exemption from registration provided by Rule 506 of Regulation D and Section
4(2) of the Securities Act of 1933.
On October 22, 2004, our board of directors approved the grant of options
to purchase up to 100,000 shares of our common stock at an exercise price of
$1.27 per share, to each of our two independent board members, Messrs. Gene
Stoever and Jed DiPaolo. The options vest annually over a two-year period
beginning May 26, 2004, the date of the directors' election to our board. We
issued and sold the foregoing securities pursuant to an exemption from
registration provided by Rule 506 of Regulation D and Section 4(2) of the
Securities Act of 1933.
On April 4, 2005, as compensation for services rendered, we effectuated a
grant to (i) Tatum Partners of a warrant to purchase up to 262,500 shares of our
common stock at an exercise price of $.001 per share, (ii) Robert S. Herlin, our
president and chief executive officer, of a stock option to purchase up to
500,000 shares of our common stock at an exercise price of $1.80 per share and a
warrant to purchase up to 287,500 shares of our common stock at an exercise
price of $1.80 per share and (iii) Sterling McDonald, our chief financial
officer, of a stock option to purchase up to 350,000 shares of our common stock
at an exercise price of $1.80 per share. In addition, options to purchase
150,000 shares of Company common stock, with an exercise price equal to $1.80
were granted to a key employee and independent contractor. We granted the
foregoing securities pursuant to an exemption from registration provided by Rule
506 of Regulation D and Section 4(2) of the Securities Act of 1933.
From October 2004 to February 2005, we sold a total of 139,400 Units, at a
price of $2.00 per Unit, to a total of 11 investors. All investors were
accredited investors. Each Unit consisted of one share of our common stock and
warrants to acquire up to one-third of a share of our common stock at an
exercise price of $0.01 per share. All of the Warrants were immediately
exercised, resulting in the issuance by us of an additional 54,800 shares of our
common stock. In connection with this offering, we paid a fee to the Placement
Agent comprised of seven-year warrants to acquire up to 12,536 shares of our
common stock at an exercise price of $1.50 per share, and cash in the amount of
$17,840. We issued and sold the foregoing securities pursuant to an exemption
from registration provided by Rule 506 of Regulation D and Section 4(2) of the
Securities Act of 1933.
On October 20, 2004, we entered into a Stock Purchase Agreement with
Seaside Investments PLC ("Seaside"). The Seaside agreement provided for the
issuance by NGS to Seaside of 1,000,000 shares of NGS common stock ("NGS Common
Stock") in exchange for up to 1,484,031 ordinary shares of Seaside ("Seaside
Ordinary Shares"). The Seaside Agreement and related Escrow Agreement provided
for the shares of NGS Common Stock and the Seaside Ordinary Shares to be placed
in escrow pending the satisfaction of certain closing conditions, including the
admission of the Seaside Ordinary Shares for listing on the London Stock
Exchange (the "Seaside Listing"). The Seaside Agreement provided that in the
event the Seaside Listing was not obtained by October 30, 2004, we would have
the option to terminate the Seaside Agreement, in which case the Seaside
Ordinary Shares and the shares of NGS Common Stock would be returned to Seaside
and NGS, respectively. As of October 30, 2004, the Seaside Listing had not been
obtained, and on November 12, 2004, NGS notified Seaside that, effective as of
that date, NGS was terminating the Seaside Agreement. Accordingly, the shares of
NGS Common Stock placed in escrow have been cancelled by NGS. We issued and sold
the foregoing securities pursuant to an exemption from registration provided by
Rule 506 of Regulation D and Section 4(2) of the Securities Act of 1933.
On February 2, 2005, we entered into a senior secured loan agreement (the
"Loan Agreement") with Prospect Energy Corporation ("Prospect") providing for
borrowings by us of up to $4.8 million (the "Secured Loan"). On February 3,
2005, we borrowed $3.0 million under the Loan Agreement. The Secured Loan bears
interest at an annual rate equal to the greater of (a) 14% and (b) the Treasury
Rate plus 9%, with interest payable in arrears on the last day of each month.
The Secured Loan is due in full on February 2, 2010. Pursuant to the terms of
the Loan Agreement, we were required to (i) pay Prospect a $96,000 cash fee,
(ii) reimburse Prospect for its legal fees incurred in connection with the
transaction, and (iii) issue Prospect five-year warrants to purchase up to
450,000 shares of our common stock at an exercise price of $0.75 per share, and
"revocable warrants" to purchase up to an additional 300,000 shares of our
common stock at an exercise price of $0.75 per share. The revocable warrants are
subject to cancellation by us prior to their exercise if we meet and maintain
certain operating cash flow targets. On March 16, 2005, we borrowed an
additional $1.0 million under the Loan Agreement and issued additional warrants
and "revocable warrants" to Prospect (to purchase up to 150,000 shares and
100,000 shares, respectively). In connection with the Secured Loan, we also paid
a third-party consultant a $30,000 cash fee and issued such party warrants to
acquire up to 50,000 shares of our common stock at an exercise price of $2.00
per share. We issued and sold the foregoing securities pursuant to an exemption
from registration provided by Rule 506 of Regulation D and Section 4(2) of the
Securities Act of 1933.
In May 2005, we sold 1,200,000 shares of our common stock at a price of
$2.50 per share, to one accredited investor. In connection with this offering,
we paid a fee to the Placement Agent comprised of seven-year warrants to acquire
up to 96,000 shares of our common stock at an exercise price of $2.50 per share,
and cash in the amount of $240,000. We issued and sold the foregoing securities
pursuant to an exemption from registration provided by Rule 506 of Regulation D
and Section 4(2) of the Securities Act of 1933.
On May 5, 2005, we issued 120,000 shares of our common stock to Liviakis
Financial Communications, our investor relations firm, at a purchase price of
$.001 per share, as additional compensation for services rendered to us. The
shares are subject to monthly vesting over a 12 month period. We issued and sold
the foregoing securities pursuant to an exemption from registration provided by
Rule 506 of Regulation D and Section 4(2) of the Securities Act of 1933.
ITEM 27. EXHIBITS
EXHIBIT DESCRIPTION
NUMBER
3.1 Amended and Restated Articles of Incorporation*
3.2 Amended Bylaws*
II-1
4.1 Specimen form of the Company's Common Stock Certificate*
5.1 Opinion of Troy & Gould Professional Corporation*
10.1 Securities Purchase Agreement dated as of May 6, 2005, by and between
the Company and Rubicon Master Fund (2)
10.2 Registration Rights Agreement dated as of May 6, 2005, by and between
the Company and Rubicon Master Fund (2)
10.3 Amendment to Consulting Agreement, dated as of May 4, 2005, by and
between the Company and Liviakis Financial Communications, Inc. (2)
10.4 Stock Grant Agreement, dated as of May 4, 2005, by and between the
Company and Liviakis Financial Communications, Inc. (2)
10.5 Executive Employment Agreement, Robert S. Herlin, dated April 4, 2005
(3)
10.6 Herlin Stock Option Agreement, dated April 4, 2005 (3)
10.7 Herlin Warrant Agreement, dated April 4, 2005 (3)
10.8 Amended and Restated Tatum Resources Agreement, dated April 4, 2005
(3)
10.9 Tatum Warrant Agreement, dated April 4, 2005 (3)
10.10 Executive Employment Agreement, Sterling H. McDonald, dated April 4,
2005 (3)
10.11 McDonald Stock Option Agreement, dated April 4, 2005 (3)
10.12 Certificate of Draw Request, dated as of February 16, 2005, between
the Company and Prospect Energy Corporation ("Prospect") (4)
10.13 Loan Agreement, dated as of February 2, 2005, between the Company and
Prospect (5)
10.14 Mortgage, Collateral Assignment, Security Agreement and Financing
Statement by NGS Sub. Corp., dated as of February 2, 2005 (5)
10.15 Company Promissory Note in favor of Prospect (5)
10.16 Security Agreement, dated as of February 2, 2005, between NGS Sub.
Corp. and Prospect (5)
10.17 Security Agreement, dated as of February 2, 2005, between Natural Gas
Systems, Inc., a Delaware corporation, and Prospect (5)
10.18 Guaranty Agreement, dated as of February 2, 2005, by Natural Gas
Systems, Inc., a Delaware corporation, NGS Sub. Corp., Arkla
Petroleum, L.L.C. and Four Star Development Corporation, in favor of
Prospect (5)
10.19 Warrant Agreement, dated as of February 2, 2005, between the Company
and Prospect (5)
II-2
10.20 Company Common Stock Purchase Warrant in favor of Prospect, dated as
of February 2, 2005 (5)
10.21 Revocable Warrant Agreement, dated as of February 2, 2005, between
the Company and Prospect (5)`
10.22 Company Revocable Common Stock Purchase Warrant in favor of Prospect,
dated as of February 2, 2005 (5)
10.23 Registration Rights Agreement, dated as of February 2, 2005, between
the Company and Prospect (5)
10.24 Definitive Asset Purchase Agreement, dated as of February 2, 2005, by
and between Chadco, Inc., Alan Chadwick McCartney, Sonya Lynn McCarty
McCartney and NGS Sub. Corp. (5)
10.25 Amendment to Secured Promissory Note - Laird Q. Cagan, dated
September 20, 2004 (6)
10.26 Form of Subscription Agreement (7)
10.27 Form of Registration Rights Agreement (7)
10.28 Asset Purchase Agreement for Delhi Field, dated September 24, 2003
(8)
10.29 Asset Purchase Agreement for Tullos Field, dated September 3, 2004
(8)
10.30 Engagement Agreement - Cagan McAfee Capital Partners, LLC, dated
September 23, 2003 (8)
10.31 Addendum to Engagement Agreement - Cagan McAfee Capital Partners,
LLC, dated May 5, 2004 (8)
10.32 Lateral Drilling Services Agreement - Verdisys, Inc., January 27,
2004 (8)
10.33 Secured Promissory Note - Laird Q. Cagan, dated August 10, 2004 (8)
10.35 Agreement and Plan of Reorganization dated as of April 12, 2004 among
Reality Interactive, Inc., Reality Acquisition Corp., Global
Marketing Associates, Inc., Dean H. Becker and the Company (9)
10.36 Plains Marketing Agreement*
10.37 2004 Stock Plan (10)
10.38 2003 Stock Option Plan
21.1 List of Subsidiaries*
23.1 Consent of Hein & Associates, LLP, independent auditors (1)
23.2 Consent of Troy & Gould Professional Corporation (reference is made
to Exhibit 5.1)*
24.1 Power of Attorney (reference is made to signature page)
----------------------
II-3
* To be filed by amendment
(1) Filed herewith.
(2) Previously filed as an exhibit to the Company's Current Report on Form 8-K
on May 11, 2005, which exhibit is hereby incorporated herein by reference.
(3) Previously filed as an exhibit to the Company's Current Report on Form 8-K
on April 8, 2005, which exhibit is hereby incorporated herein by
reference.
(4) Previously filed as an exhibit to the Company's Current Report on Form 8-K
on March 21, 2005, which exhibit is hereby incorporated herein by
reference.
(5) Previously filed as an exhibit to the Company's Current Report on Form 8-K
on February 8, 2005, which exhibit is hereby incorporated herein by
reference.
(6) Previously filed as an exhibit to the Company's Quarterly Report on Form
10-QSB on November 17, 2004, which exhibit is hereby incorporated herein
by reference.
(7) Previously filed as an exhibit to the Company's Current Report on Form 8-K
on October 26, 2004, which exhibit is hereby incorporated herein by
reference.
(8) Previously filed as an exhibit to the Company's Report on Form 10-KSB on
September 28, 2004, which exhibit is hereby incorporated herein by
reference.
(9) Previously filed as an exhibit to the Company's Current Report on Form
8-K/A on April 27, 2004, which exhibit is hereby incorporated herein by
reference.
(10) Previously filed as an exhibit to the Company's Definitive Information
Statement on Schedule 14C, which exhibit is hereby incorporated by
reference.
ITEM 28. UNDERTAKINGS
B. Rule 415 Offering
We hereby undertake:
(1) To file, during any period in which offers or sales are being
made, a post-effective amendment to this registration statement:
(i) To include any prospectus required by Section 10(a)(3) of
the Securities Act of 1933.
(ii) To reflect in the prospectus any facts or events arising
after the effective date of the registration statement (or the most recent post
effective amendment thereof) which, individually or in the aggregate, represent
a fundamental change in the information set forth in the registration statement.
Notwithstanding the foregoing, any increase or decrease in volume of securities
offered (if the total dollar value of securities offered would not exceed that
which was registered) and any deviation from the low or high end of the
estimated maximum offering range may be reflected in the form of prospectus
filed with the Commission pursuant to Rule 424(b) if, in the aggregate, the
changes in volume and price represent no more than a 20% change in the maximum
aggregate offering price set forth in the "Calculation of Registration Fee"
table in the effective registration statement.
II-4
(iii) To include any material information with respect to the
plan of distribution not previously disclosed in the registration statement or
any material change to such information in the registration statement.
Provided, however, that paragraphs (1)(i) and (1)(ii) do not apply if the
registration statement is on Form S-3 or Form S-8, and the information required
to be included in a post-effective amendment by those paragraphs is contained in
periodic reports filed by the Company pursuant to Section 13 or Section 15(d) of
the Securities Exchange Act of 1934 that are incorporated by reference in the
registration statement.
(2) That, for the purpose of determining any liability under the
Securities Act of 1933, each such post-effective amendment shall be deemed to be
a new registration statement relating to the securities offered therein, and the
offering of such securities at that time shall be deemed to be the initial bona
fide offering thereof.
(3) To remove from registration by means of a post effective
amendment any of the securities being registered which remain unsold at the
termination of the offering.
C. Request for Acceleration of Effective Date
Insofar as indemnification for liabilities arising under the Securities
Act of 1933 may be permitted to directors, officers and controlling persons of
the Company pursuant to the foregoing provisions, or otherwise, the Company has
been advised that in the opinion of the Securities and Exchange Commission such
indemnification is against public policy as expressed in the Securities Act of
1933 and is, therefore, unenforceable. In the event that a claim for
indemnification against such liabilities (other than the payment by the Company
of expenses incurred or paid by a director, officer or controlling person of the
Company in the successful defense of any action, suit or proceeding) is asserted
by such director, officer or controlling person in connection with the
securities being registered, the Company will, unless in the opinion of its
counsel the matter has been settled by controlling precedent, submit to a court
of appropriate jurisdiction the question whether such indemnification by it is
against public policy as expressed in the Securities Act of 1933 and will be
governed by the final adjudication of such issue.
II-5
SIGNATURES
In accordance with the requirements of the Securities Act of 1933, the
registrant certifies that it has reasonable grounds to believe that it meets all
of the requirements of filing on Form SB-2 and authorized this registration
statement to be signed on its behalf by the undersigned, in Houston, Texas, on
June 6, 2005.
NATURAL GAS SYSTEMS, INC.
By: /s/ Robert S. Herlin
-------------------------------------
Robert S. Herlin, President
POWER OF ATTORNEY
The officers and directors of Natural Gas Systems, Inc., whose signatures
appear below, hereby constitute and appoint Robert S. Herlin and Sterling
McDonald, and each of them, their true and lawful attorneys and agents, each
with power to act alone, to sign, execute and cause to be filed on behalf of the
undersigned any amendment or amendments, including post-effective amendments, to
this registration statement of Natural Gas Systems, Inc. on Form SB-2. Each of
the undersigned does hereby ratify and confirm all that said attorneys and
agents shall do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Act of 1933, this
registration statement has been signed by the following persons in the
capacities and on the dates indicated.
SIGNATURE TITLE DATE
/s/ Robert S. Herlin President (principal executive officer) and June 6 2005
---------------------------------- Chief Executive Officer and Director
Robert S. Herlin
/s/ Laird Q. Cagan Chairman of the Board June 6, 2005
----------------------------------
Laird Q. Cagan
/s/ Sterling McDonald Chief Financial Officer (principal financial June 6,2005
---------------------------------- and accounting officer)
Sterling McDonald
/s/ John Pimentel Director June 6, 2005
----------------------------------
John Pimentel
Director June 6, 2005
----------------------------------
E.J. DiPaolo
/s/ Gene Stoever Director June 6,2005
----------------------------------
Gene Stoever
EXHIBIT INDEX
EXHIBIT DESCRIPTION
NUMBER
3.1 Amended and Restated Articles of Incorporation (1)
3.2 Amended Bylaws (1)
4.1 Specimen form of the Company's Common Stock Certificate*
5.1 Opinion of Troy & Gould Professional Corporation*
10.1 Securities Purchase Agreement dated as of May 6, 2005, by and between
the Company and Rubicon Master Fund (2)
10.2 Registration Rights Agreement dated as of May 6, 2005, by and between
the Company and Rubicon Master Fund (2)
10.3 Amendment to Consulting Agreement, dated as of May 4, 2005, by and
between the Company and Liviakis Financial Communications, Inc. (2)
10.4 Stock Grant Agreement, dated as of May 4, 2005, by and between the
Company and Liviakis Financial Communications, Inc. (2)
10.5 Executive Employment Agreement, Robert S. Herlin, dated April 4, 2005
(3)
10.6 Herlin Stock Option Agreement, dated April 4, 2005 (3)
10.7 Herlin Warrant Agreement, dated April 4, 2005 (3)
10.8 Amended and Restated Tatum Resources Agreement, dated April 4, 2005
(3)
10.9 Tatum Warrant Agreement, dated April 4, 2005 (3)
10.10 Executive Employment Agreement, Sterling H. McDonald, dated April 4,
2005 (3)
10.11 McDonald Stock Option Agreement, dated April 4, 2005 (3)
10.12 Certificate of Draw Request, dated as of February 16, 2005, between
the Company and Prospect Energy Corporation ("Prospect") (4)
10.13 Loan Agreement, dated as of February 2, 2005, between the Company and
Prospect (5)
10.14 Mortgage, Collateral Assignment, Security Agreement and Financing
Statement by NGS Sub. Corp., dated as of February 2, 2005 (5)
10.15 Company Promissory Note in favor of Prospect (5)
10.16 Security Agreement, dated as of February 2, 2005, between NGS Sub.
Corp. and Prospect (5)
10.17 Security Agreement, dated as of February 2, 2005, between Natural Gas
Systems, Inc., a Delaware corporation, and Prospect (5)
10.18 Guaranty Agreement, dated as of February 2, 2005, by Natural Gas
Systems, Inc., a Delaware corporation, NGS Sub. Corp., Arkla
Petroleum, L.L.C. and Four Star Development Corporation, in favor of
Prospect (5)
10.19 Warrant Agreement, dated as of February 2, 2005, between the Company
and Prospect (5)
10.20 Company Common Stock Purchase Warrant in favor of Prospect, dated as
of February 2, 2005 (5)
10.21 Revocable Warrant Agreement, dated as of February 2, 2005, between
the Company and Prospect (5)`
10.22 Company Revocable Common Stock Purchase Warrant in favor of Prospect,
dated as of February 2, 2005 (5)
10.23 Registration Rights Agreement, dated as of February 2, 2005, between
the Company and Prospect (5)
10.24 Definitive Asset Purchase Agreement, dated as of February 2, 2005, by
and between Chadco, Inc., Alan Chadwick McCartney, Sonya Lynn McCarty
McCartney and NGS Sub. Corp. (5)
10.25 Amendment to Secured Promissory Note - Laird Q. Cagan, dated
September 20, 2004 (6)
10.26 Form of Subscription Agreement (7)
10.27 Form of Registration Rights Agreement (7)
10.28 Asset Purchase Agreement for Delhi Field, dated September 24, 2003
(8)
10.29 Asset Purchase Agreement for Tullos Field, dated September 3, 2004
(8)
10.30 Engagement Agreement - Cagan McAfee Capital Partners, LLC, dated
September 23, 2003 (8)
10.31 Addendum to Engagement Agreement - Cagan McAfee Capital Partners,
LLC, dated May 5, 2004 (8)
10.32 Lateral Drilling Services Agreement - Verdisys, Inc., January 27,
2004 (8)
10.33 Secured Promissory Note - Laird Q. Cagan, dated August 10, 2004 (8)
10.35 Agreement and Plan of Reorganization dated as of April 12, 2004 among
Reality Interactive, Inc., Reality Acquisition Corp., Global
Marketing Associates, Inc., Dean H. Becker and the Company (9)
10.36 Plains Marketing Agreement*
10.37 2004 Stock Plan
10.38 2003 Stock Option Plan
21.1 List of Subsidiaries*
23.1 Consent of Hein & Associates, LLP, independent auditors (1)
23.2 Consent of Troy & Gould Professional Corporation (reference is made
to Exhibit 5.1)*
24.1 Power of Attorney (reference is made to signature page)
--------------------------------
(1) Filed herewith.
(2) Previously filed as an exhibit to the Company's Current Report on Form 8-K
on May 11, 2005, which exhibit is hereby incorporated herein by reference.
(3) Previously filed as an exhibit to the Company's Current Report on Form 8-K
on April 8, 2005, which exhibit is hereby incorporated herein by
reference.
(4) Previously filed as an exhibit to the Company's Current Report on Form 8-K
on March 21, 2005, which exhibit is hereby incorporated herein by
reference.
(5) Previously filed as an exhibit to the Company's Current Report on Form 8-K
on February 8, 2005, which exhibit is hereby incorporated herein by
reference.
(6) Previously filed as an exhibit to the Company's Quarterly Report on Form
10-QSB on November 17, 2004, which exhibit is hereby incorporated herein
by reference.
(7) Previously filed as an exhibit to the Company's Current Report on Form 8-K
on October 26, 2004, which exhibit is hereby incorporated herein by
reference.
(8) Previously filed as an exhibit to the Company's Report on Form 10-KSB on
September 28, 2004, which exhibit is hereby incorporated herein by
reference.
(9) Previously filed as an exhibit to the Company's Current Report on Form
8-K/A on April 27, 2004, which exhibit is hereby incorporated herein by
reference.