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| KYUS.OB > SEC Filings for KYUS.OB > Form 10-Q on 21-Sep-2009 | All Recent SEC Filings |
21-Sep-2009
Quarterly Report
Statement Regarding Forward-Looking Information
This report contains forward-looking statements. All statements other than statements of historical facts included in this Quarterly Report on Form 10-Q, including without limitation, statements in this Management's Discussion and Analysis of Financial Condition and Results of Operations regarding our financial position, estimated working capital, business strategy, the plans and objectives of our management for future operations and those statements preceded by, followed by or that otherwise include the words "believe", "expects", "anticipates", "intends", "estimates", "projects", "target", "goal", "plans", "objective", "should", or similar expressions or variations on such expressions are forward-looking statements. We can give no assurances that the assumptions upon which the forward-looking statements are based will prove to be correct. Because forward-looking statements are subject to risks and uncertainties, actual results may differ materially from those expressed or implied by the forward-looking statements. There are a number of risks, uncertainties and other important factors that could cause our actual results to differ materially from the forward-looking statements, including, but not limited to, the availability and pricing of additional capital to finance operations, including the drilling of our initial gas wells, longer term drilling programs and additional leasehold acquisitions, the viability of the shale gas fields in the Illinois Basin in western Kentucky, our ability to build and maintain a successful operations infrastructure and to effectively drill and develop producing wells, the successful negotiation and execution of cost-effective third-party gas drilling, processing and distribution agreements, the continued commitment of drill rig operators and future economic conditions and the volatility and decreases in energy prices.
Except as otherwise required by the federal securities laws, we disclaim any obligations or undertaking to publicly release any updates or revisions to any forward-looking statement contained in this Quarterly Report on Form 10-Q to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.
Background
Kentucky USA Energy, Inc. (the "Company" or "we") was incorporated in the State of Delaware on September 29, 2006 under the name Las Rocas Mining Corp. On October 26, 2007, the Company changed its name to Kentucky USA Energy, Inc. to facilitate the merger discussions with KY USA Energy, Inc. ("KY USA"). On May 2, 2008, the Company, KY Acquisition Corp., a wholly-owned subsidiary of the Company ("Acquisition Sub"), and KY USA entered into an Agreement and Plan of Merger and Reorganization (the "Merger Agreement"), which closed on May 2, 2008. Pursuant to the terms of the Merger Agreement, Acquisition Sub merged with and into KY USA, which became a wholly-owned subsidiary of the Company (the "Merger").
KY USA was incorporated in the Commonwealth of Kentucky on October 5, 2007 to acquire, explore and develop oil and gas resource properties, with a primary focus initially on shale gas in the Illinois Basin in western Kentucky. KY USA has secured a 75% net revenue interest in a leasehold in Western Kentucky covering approximately 3,000 acres targeting gas extraction from the New Albany Shale (the "Leasehold"). We have identified approximately 40-50 drilling locations on the Leasehold. Our net recoverable "proved developed producing reserves1" on the Leasehold as of October 31, 2008, are estimated at 1.825 billion cubic feet of gas ("Bcf")2, while "proved undeveloped primary reserves3" are estimated at 23.725 Bcf, for a total proved developed and undeveloped reserves of 25.550 Bcf. The Leasehold is directly adjacent to third-party producing wells.
Following the closing of the Offering (discussed below), we began drilling activities at our initial well locations. We have continued these drilling efforts using the net proceeds from our Initial Loan and first Installment Loan under the Credit Facility (discussed below).
To date, we have drilled 16 wells to total depths ("TD") from 2,340 to 3,460 feet in the New Albany shale formation on our Leasehold. All of these wells have been logged; 15 of these wells have been logged and cased with 4 ½" production casing, cemented, perforated and fractured; and 11 have been tested. We utilize nitrogen fracturing of the shale formation to create open spaces for the gas to escape and have not, to this point, encountered any water in our formations.
The Company has completed the connection of its pipeline gathering system to 16 of its wells and has entered into a Gas Gathering & Treatment Agreement with Seminole Energy Services, LLC ("Seminole"). The recently concluded agreement provides for the gathering and treatment by Seminole of the Company's natural gas production from its Leasehold wells. The Company and Seminole have begun the final phases of work to interconnect the Company's field gathering lines with Seminole's Olive Grove Gathering & Treatment Facility (the "Olive Grove Treatment Facility"). The Company expects to complete the interconnection and to sign a contract with Seminole for the sale of its gas shortly.
On August 24, 2009, KY USA entered into a farm-out agreement with Thomasson Petroleum Enterprises, Inc. ("TPE") to acquire from TPE certain drilling rights on farm-out acreage in Todd, Muhlenberg and Christian counties in western Kentucky adjacent to the Company's existing Leasehold. Under the terms of the agreement with TPE, KY USA acquired the right to drill up to 40 wells on the subject leases to explore for oil and gas in, above and below the New Albany Shale. KY USA must drill ten (10) wells in each year of the agreement to be eligible to drill an additional ten wells in the following year, up to a maximum of 40 wells over four years. TPE will retain a 25% net revenue interest in the wells that KY USA drills into the Albany shale on the TPE acreage and an 18.75% net revenue interest in any oil "twin wells" drilled above the top of the Albany shale.
KY USA recently entered into a joint venture ("JV") agreement with 7921 Energy LLC ("7921") to develop natural gas and oil prospects in, above and below the New Albany Shale formation on the TPE acreage. The wells to be drilled under the JV agreement will utilize the Company's field gathering system that is currently in final phases of being connected to the Olive Grove Treatment Facility. Under the terms of the JV agreement, 7921 will have the right to participate with KY USA in drilling and developing up to 40 wells on the newly acquired TPE farm-out acreage. Phase 1 under this JV agreement will consist of drilling and completing ten (10) wells. Under the terms of the JV, 7921 will earn a 50% working interest in each of the first ten wells, which translates to a 37.5% net revenue interest (assuming each well is funded by 7921 and drilled to completion), in exchange for providing KY USA with $1,675,000 in working capital to drill and complete the Phase 1 wells. 7921 will also retain the option to participate with KY USA in the drilling of the up to 30 additional wells on the TPE acreage.
Results of Operations for the Three and Nine Month Periods Ended July 31, 2009 and 2008
We are still in our exploration stage and have generated no revenues to date.
All productive and non-productive costs incurred in connection with the acquisitions of, exploration for and development of our gas reserves are capitalized using the full cost method of accounting. These costs include lease acquisitions, geological and geophysical work, and the costs of drilling, completing and equipping our gas wells. For the three month periods ended July 31, 2009 and 2008, we incurred such total capitalized costs of $879,716 and $291,758, respectively. For the nine month periods ended July 31, 2009 and 2008, we incurred such total capitalized costs of $3,576,484 and $300,668 respectively. The increases from 2008 to 2009 were the result of our beginning to drill our first wells.
We incurred general and administrative expenses of $29,315 and $31,347 for the three month periods ended July 31, 2009 and 2008, respectively, and of $95,644 and $38,896 for the nine month periods ended July 31, 2009 and 2008, respectively. These expenses consisted of costs incurred in connection with the start-up and day to day operation of our business.
Amortization of loan fees for the three and nine month periods ended July 31, 2009 totaled $109,045 and $327,132 respectively. These costs are related to the Note and the Loan (discussed below). Amortization of loan fees for the three and nine month periods ended July 31, 2008 totaled $109,045 in each such period.
We incurred legal and professional expenses of $361,807 and $181,582 for the three month periods ended July 31, 2009 and 2008, respectively, and of $1,358,768 and $242,808 for the nine month periods ended July 31, 2009 and 2008, respectively. The increase in these expenses primarily resulted from increased periodic SEC filing requirements.
Our interest expense for the three month periods ended July 31, 2009 and 2008, was $132,680 and $7,083,821 respectively, and for the nine month periods ended July 31, 2009 and 2008, was $376,093 and $7,126,834 respectively. This cost is attributable to interest due and paid on the Note and the Loan, as well as non-cash amortization of the note discount. The higher interest costs in the nine month periods were due to the beneficial conversion features of certain warrants that we had issued that were expensed during these periods. During the three and nine month periods ended July 31, 2009, we recognized a net gain on a derivative liability relating to the Note in the amount of $37,088 and $298,231, respectively, due to a revaluation of the derivative liability to market at July 31, 2009.
We have generated no revenues to date. Our net operating loss from inception through July 31, 2009 was $5,232,431.
Liquidity and Capital Resources
Our cash and cash equivalents balance as of July 31, 2009 was $57,296.
On May 9, 2008, KY USA borrowed $100,000 from one individual as a bridge loan to be used for working capital purposes. In addition, upon the closing of the Merger, this lender received warrants to purchase 200,000 shares of our Common Stock, such warrants having an initial exercise price of $1.00 per share and expiring five years after issuance.
On May 29, 2008 we closed a private offering (the "Offering") of an 8% senior secured convertible note (the "Note") and warrants (the "Warrants") to purchase 2,500,000 shares of the Company's common stock, $0.0001 par value per share (the "Common Stock"), to one institutional investor (the "Investor") for aggregate gross proceeds of $2.5 million, as more fully described in our Form 8-K filed with the SEC on June 4, 2008. We have used the net proceeds of the Offering of approximately $1,857,600 (after expenses of the Offering) to repay bridge loans made to KY USA, to begin drilling our initial wells, and for general working capital purposes. The initial installment payment date on the Note was extended from May 29, 2009 to May 29, 2010.
On June 27, 2008, KY USA closed on a senior secured credit facility (the "Credit Facility") with NSES 12, LLC, a funding vehicle of New Stream Capital (the "Lender"), pursuant to which KY USA may borrow up to $10,000,000 in the aggregate, under certain conditions, as more fully described in our Form 8-K filed with the SEC on July 1, 2008. Under the Credit Facility, KY USA borrowed $2,500,000 on June 27, 2008 (the "Initial Loan") and may borrow up to an additional aggregate amount of $7,500,000 in installments of a minimum of $2,500,000 each (each, an "Installment Loan"), solely at the discretion of the Lender. The proceeds of the Initial Loan amount, net after expenses of the transaction, including a $200,000 credit facility fee paid to the Lender at closing and a $200,000 consulting fee paid to one consultant, have been used by KY USA for ongoing working capital purposes, including the costs and expenses relating to the drilling of our initial gas wells in the New Albany shale on KY USA's leasehold in western Kentucky.
On February 12, 2008, KY USA received the first Installment Loan in an amount of $2.5 million. On August 14, 2009, KY USA received an advance of $600,000 against an expected second Installment Loan. This advance is being used to complete the connection of the pipeline gathering system to the Olive Grove Treatment Facility. To date, we have received $5,600,000 under the Credit Facility.
The credit agreement governing the Credit Facility (the "Credit Agreement") requires that KY USA comply with financial covenants relating to, among other things, collateral and current ratio coverage. As of July 31, 2009, KY USA was not in compliance with the 1.0 to 1.0 current ratio requirement of the Credit Agreement. This breach of the current ratio covenant contained in the Credit Agreement constitutes an event of default under the Credit Agreement. The breach would permit the Lender under the Credit Agreement to declare all amounts borrowed thereunder to be immediately due and payable. We intend to request from the Lender a waiver of this current ratio covenant, but we cannot assure you that we will be successful in obtaining such waiver. Additionally, even if we obtain a waiver from the Lender, we may not be able to satisfy these or other covenants in the future or be able to pursue our strategies within the constraints of these covenants. These circumstances could materially and adversely impair our liquidity and, among other factors, raise substantial doubt regarding our ability to continue as a going concern.
On July 22, 2009, KY USA entered into the JV agreement with 7921 pursuant to which 7921 agreed to provide KY USA with $1,675,000 in working capital for the Phase 1 drilling of the first 10 wells on the TPE acreage. These funds may not be used for any other purpose and are to be disbursed to KY USA on a well by well basis prior to the drilling of a particular well. We expect to begin drilling under Phase 1 of this JV program prior to the end of our fiscal year.
Including the net proceeds from the Offering, the Credit Facility and the 7921 JV agreement, we believe that we have sufficient funds to conduct our operations for approximately the next three to six months.
If we are not successful in generating sufficient liquidity from KY USA operations or in raising sufficient capital resources on terms acceptable to us, our business, results of operations, liquidity and financial condition could suffer materially.
We presently do not have any available credit, bank financing or other external sources of liquidity, other than the net proceeds from the Offering, the New Stream Credit Facility and 7921 JV agreement. Due to our brief history and historical operating losses, our operations have not been a source of liquidity. We will need to obtain additional capital in order to expand operations and become profitable. In order to obtain capital, we may need to sell additional shares of our common stock or borrow funds from private lenders. There can be no assurance that we will be successful in obtaining additional funding in amounts or on terms acceptable to us, if at all.
Critical Accounting Policies
The Company prepares its Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States of America, which requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the year. Actual results could differ from those estimates. The Company considers the following policies to be the most critical in understanding the judgments that are involved in preparing the Company's financial statements and the uncertainties that could impact the Company's results of operations, financial condition and cash flows.
Full Cost Method of Accounting
The Company follows the full cost method of accounting for oil and gas property acquisition, exploration and development activities. Under this method, all productive and non-productive costs incurred in connection with the acquisition of, exploration for and development of oil and gas reserves for each cost center are capitalized. Capitalized costs include lease acquisitions, geological and geophysical work, day rate rentals and the costs of drilling, completing and equipping oil and gas wells. Costs, however, associated with production and general corporate activities are expensed in the period incurred. Interest costs related to unproved properties and properties under development are also capitalized to oil and gas properties. Gains or losses are recognized only upon sales or dispositions of significant amounts of oil and gas reserves representing an entire cost center. Proceeds from all other sales or dispositions are treated as reductions to capitalized costs. The capitalized oil and gas property, less accumulated depreciation, depletion and amortization and related deferred income taxes, if any, are generally limited to an amount (the ceiling limitation) equal to the sum of: (a) the present value of estimated future net revenues computed by applying current prices in effect as of the balance sheet date (with consideration of price changes only to the extent provided by contractual arrangements) to estimated future production of proved oil and gas reserves, less estimated future expenditures (based on current costs) to be incurred in developing and producing the reserves using a discount factor of 10% and assuming continuation of existing economic conditions; and (b) the cost of investments in unevaluated properties excluded from the costs being amortized. No ceiling write-downs have been recorded to date.
Oil and Gas Reserves
The Company's proved gas reserves as of October 31, 2008 were developed from information provided by Glenn Robinson - Robinson Engineering. Projecting the effects of commodity prices on production, and timing of development expenditures includes many factors beyond the Company's control. The future estimates of net cash flows from the Company's proved reserves and their present value are based upon various assumptions about future production levels, prices, and costs that may prove to be incorrect over time. Any significant variance from assumptions could result in the actual future net cash flows being materially different from the estimates.
Derivative Instruments
We value derivative instruments in accordance with the interpretative guidance of SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities, EITF 00-19 Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock, Accounting Principles Board Opinion No. 14 Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants, EITF 98-5 Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, and EITF 00-27 Application of Issue No. 98-5 to Certain Convertible Instruments and associated pronouncements related to the classification and measurement of warrants and instruments with embedded conversion features. We make certain assumptions and estimates to value our derivative liabilities. Factors affecting these liabilities and values include changes in the stock price and other assumptions.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements.
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