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**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-K**

 

**x****ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For thefiscal year ended June 30, 2008**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT**

 

**For thetransition period from             to             **

 

**CommissionFile Number 001-32942**

 

**EVOLUTIONPETROLEUM CORPORATION**

(Exact name ofregistrant as specified in its charter)

 

| **Nevada**                                                      | ** ** | **41-1781991**                     |
|-----------------------------------------------------------------|------------|------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |       | (IRS Employer  Identification No.) |

 

**2500CityWest Blvd., Suite 1300, Houston, Texas 77042**

(Address ofprincipal executive offices and zip code)

 

**(713)935-0122**

(Registrant’stelephone number, including area code)

 

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.

Yes:  o No: x

 

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act.

Yes:  o No: x

 

Indicate by check mark whether the registrant (1) filedall reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes:  x No: o

 

Indicate by check mark if disclosure ofdelinquent filers pursuant to Item 405 of Regulation S-K is not contained inthis form, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K.o

 

Indicatebycheckmarkwhethertheregistrantisalargeacceleratedfiler,anacceleratedfiler,anon-acceleratedfiler,orasmallerreportingcompany.  Seethedefinitionsof“largeacceleratedfiler,”“acceleratedfiler,”and“smallerreportingcompany”inRule12b-2oftheExchangeAct.(Checkone):

 
| Large accelerated  filer  o |   | Accelerated  filer  o |   | Non-accelerated  filer  o |   | Smaller reporting  company  x |
|---------------------------------------|--------|---------------------------------|--------|-------------------------------------|--------|-----------------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act.).  Yes: o  No: x

 

The aggregate marketvalue of the voting and non-voting common equity held by non-affiliates on December 31,2007, the last business day of the registrant’s most recently completed secondfiscal quarter, based on the closing price on that date of $5.05 on theAmerican Stock Exchange was $66,387,795

 

The number of shares outstanding of the registrant’scommon stock, par value $0.001, as of September 24, was 26,917,234.

 

 

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**2008ANNUAL REPORT ON FORM 10-K**

**TABLE OFCONTENTS**

 
|                   | ** **                                                                                                          | **Page**   |
|-------------------|---------------------------------------------------------------------------------------------------------------------|------------|
| **PART I**   | ** **                                                                                                          | ** ** |
|              |                                                                                                                |       |
| ITEM 1.           | BUSINESS                                                                                                            | 5          |
|              |                                                                                                                |       |
| ITEM 1A.          | RISK FACTORS                                                                                                        | 8          |
|              |                                                                                                                |       |
| ITEM 1B.          | UNRESOLVED  STAFF COMMENTS                                                                                          | 15         |
|              |                                                                                                                |       |
| ITEM  2.          | PROPERTIES                                                                                                          | 16         |
|              |                                                                                                                |       |
| ITEM 3.           | LEGAL PROCEEDINGS                                                                                                   | 21         |
|              |                                                                                                                |       |
| ITEM 4.           | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                                | 22         |
|              |                                                                                                                |       |
| **PART II**  | ** **                                                                                                          | ** ** |
|              |                                                                                                                |       |
| ITEM 5.           | MARKET FOR  REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES  OF EQUITY SECURITIES | 22         |
|              |                                                                                                                |       |
| ITEM 6.           | SELECTED FINANCIAL  DATA                                                                                            | 24         |
|              |                                                                                                                |       |
| ITEM 7.           | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                         | 26         |
|              |                                                                                                                |       |
| ITEM 7A.          | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                         | 34         |
|              |                                                                                                                |       |
| ITEM 8.           | FINANCIAL STATEMENTS  AND SUPPLEMENTARY DATA                                                                        | 35         |
|              |                                                                                                                |       |
| ITEM 9.           | CHANGES IN  AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                               | 57         |
|              |                                                                                                                |       |
| ITEM 9A.          | CONTROLS AND  PROCEDURES                                                                                            | 57         |
|              |                                                                                                                |       |
| ITEM 9B.          | OTHER INFORMATION                                                                                                   | 58         |
|              |                                                                                                                |       |
| **PART III** |                                                                                                                |       |
|              |                                                                                                                |       |
| ITEM 10.          | DIRECTORS,  EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE                                                             | 58         |
|              |                                                                                                                |       |
| ITEM 11.          | EXECUTIVE COMPENSATION                                                                                              | 58         |
|              |                                                                                                                |       |
| ITEM 12.          | SECURITY  OWNERSHIP OF CERTAIN BENEFICAL OWNERS AND MANAGMENT AND RELATED STOCKHOLDER  MATTERS                      | 58         |
|              |                                                                                                                |       |
| ITEM 13.          | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE                                          | 58         |
|              |                                                                                                                |       |
| ITEM 14.          | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                                             | 58         |
|              |                                                                                                                |       |
| **PART IV**  |                                                                                                                |       |
|              |                                                                                                                |       |
| ITEM 15.          | EXHIBITS  AND FINANCIAL STATEMENT SCHEDULES                                                                         | 59         |

 

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*This Form 10-K and theinformation referenced herein contain forward-looking statements within themeaning of the Private Securities Litigations Reform Act of 1995, Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934. The words “plan,” “expect,” “project,” “estimate,” “assume,” “believe,”“anticipate,” “intend,” “budget,” “forecast,” “predict” and other similarexpressions are intended to identify forward-looking statements. Thesestatements appear in a number of places and include statements regarding ourplans, beliefs or current expectations, including the plans, beliefs andexpectations of our officers and directors.* *When considering anyforward-looking statement, you should keep in mind the risk factors that couldcause our actual results to differ materially from those contained in anyforward-looking statement. Important factors that could cause actual results todiffer materially from those in the forward-looking statements herein includethe timing and extent of changes in commodity prices for oil and natural gas,operating risks and other risk factors as described in our 2007 Annual Reporton Form 10-KSB for the year ended June 30, 2007 as filed with theSecurities and Exchange Commission. Furthermore, the assumptions that supportour forward-looking statements are based upon information that is currentlyavailable and is subject to change. We specifically disclaim all responsibilityto publicly update any information contained in a forward-looking statement orany forward-looking statement in its entirety and therefore disclaim anyresulting liability for potentially related damages. All forward-lookingstatements attributable to Evolution Petroleum Corporation are expresslyqualified in their entirety by this cautionary statement.*

 

**GLOSSARYOF SELECTED PETROLEUM TERMS**

 

The followingabbreviations and definitions are terms commonly used in the crude oil andnatural gas industry and throughout this prospectus:

 

“BBL.” A standard measureof volume for crude oil and liquid petroleum products; one barrel equals 42U.S. gallons.

 

“BCF.” Billion Cubic Feetof natural gas at standard temperature and pressure.

 

“BOE.” Barrels of oilequivalent. BOE is calculated by converting 6 MCF of natural gas to 1 BBL ofoil.

 

“BTU” or “British ThermalUnit.” The standard unit of measure of energy equal to the amount of heatrequired 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 1MMBTU.

 

“CO2.” Carbondioxide, a gas that can be found in naturally occurring reservoirs, typicallyassociated with ancient volcanoes, and also is a major byproduct frommanufacturing and power production, also utilized in enhanced oil recoverythrough injection into an oil reservoir.

 

“EOR.” Enhanced OilRecovery projects involve injection of heat, miscible or immiscible gas, orchemicals into oil reservoirs, typically following full primary and secondarywaterflood recovery efforts, in order to gain incremental recovery of oil fromthe reservoir.

 

“Field.” An areaconsisting of a single reservoir or multiple reservoirs all grouped on orrelated to the same individual geologic structural feature and/or stratigraphicfeature.

 

 “Farmout.” Sale or transfer of all or part ofthe operating rights from the working interest owner (the assignor or farmoutparty), to an assignee (the farmin party) who assumes all or some of the burdenof development, in return for an interest in the property. The assignor mayretain an overriding royalty or any other type of interest. For Federal taxpurposes, a farmout may be structured as a sale or lease, depending on thespecific rights and carved out interests retained by the assignor.

 

“Gross Acres or GrossWells.” The total acres or number of wells participated in, regardless of theamount of working interest owned.

 

“Horizontal Drilling”Involves drilling horizontally out from an existing vertical well bore, therebypotentially increasing the area and reach of the well bore that is in contactwith the reservoir.

 

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“Hydraulic Fracturing”Involves pumping a fluid with or without particulates into a formation at highpressure, thereby creating fractures in the rock and leaving the particulatesin the fractures to ensure that the fractures remain open, thereby potentiallyincreasing the ability of the reservoir to produce oil or gas.

 

“LOE.” Means leaseoperating expense(s), a current period expense incurred to operate a well.

 

“MBOE.” One thousandbarrels of oil equivalent.

 

“MCF.” One thousand cubicfeet of natural gas at standard conditions, being approximately sea levelpressure and 60 degrees Fahrenheit temperature. Standard pressure in the stateof Louisiana is deemed to be 15.025 psi by regulation, but varies in otherstates.

 

“MMBTU.” One millionBritish thermal units.

 

“MMCF.” One million cubicfeet of natural gas at standard temperature and pressure.

 

“Net Acres or Net Wells.”The sum of the fractional working interests owned in gross acres or grosswells.

 

“NGL.” Natural gasliquids, being the combination of ethane, propane, butane and natural gasoline’sthat can be removed from natural gas through processing, typically throughrefrigeration plants that utilize low temperatures, or through J-T plants thatutilize compression, temperature reduction and expansion to a lower pressure.

 

“NYMEX.” New YorkMercantile Exchange.

 

“Operator.”  An oiland gas joint venture participant that manages the joint venture, pays venturecosts and bills the venture’s non-operators for their share of venture costs.The operator is also responsible to market all oil and gas production, exceptfor those non-operators who take their production in-kind.

 

“Overriding Royalty.” Aroyalty interest that is created out of the operating or working interest.Unlike a royalty interest, an overriding royalty interest terminates with theoperating interest from which it was created or carved out of. See “royaltyinterest”.

 

“Permeability.” Themeasure of ease with which petroleum can move through a reservoir.

 

“Porosity.” (of sand orsandstone). The relative volume of the pore space (or open area) compared tothe total bulk volume of the reservoir.

 

“Proved DevelopedReserves.” Proved Reserves that can be expected to be recovered throughexisting wells with existing equipment and operating methods. Additional oiland gas expected to be obtained through the application of fluid injection or otherimproved recovery techniques for supplementing the natural forces andmechanisms of primary recovery should be included as “proved developed reserves”only after testing by pilot project or after the operation of an installedprogram has confirmed through production responses that increased recovery willbe achieved.

 

“Proved DevelopedNonproducing Reserves (“PDNP”).” Proved Reserves that have been developed andno material amount of capital expenditures are required to bring on production,but production has not yet been initiated due to timing, markets, or lack ofthird party completed connection to a gas sales pipeline.

 

“Proved DevelopedProducing Reserves (“PDP”).” Proved Reserves that have been developed andproduction has been initiated.

 

“Proved Reserves.”Estimated quantities of crude oil, natural gas, and natural gas liquids whichgeological and engineering data demonstrate with reasonable certainty to berecoverable in future years from known reservoirs under existing economic andoperating conditions, i.e., prices and costs as of the date the estimate ismade. Prices include consideration of changes in existing prices provided onlyby contractual arrangements, but not on escalations based upon futureconditions.

 

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“Proved UndevelopedReserves (“PUD”).” Reserves that are expected to be recovered from new wells onundrilled acreage or from existing wells where a relatively major expenditureis required for recompletion. Reserves on undrilled acreage are limited tothose drilling units offsetting productive units that are reasonably certain ofproduction when drilled.

 

Proved reserves for otherundrilled units can be claimed only where it can be demonstrated with certaintythat there is continuity of production from the existing productive formation.Proved undeveloped reserves may not include estimates attributable to anyacreage for which an application of fluid injection or other improved recoverytechnique is contemplated, unless such techniques have been proved effective byactual tests in the area and in the same reservoir.

 

“PSI,” or pounds per square inch, a measure ofpressure. Pressure is typically measured as “psig”, or the pressure in excessof standard atmospheric pressure.

 

“Present Value.” Whenused with respect to oil and gas reserves, present value means the estimatedfuture net revenues computed by applying current prices of oil and gas reserves(with consideration of price changes only to the extent provided by contractualarrangements) to estimated future production of proved oil and gas reserves asof the date of the latest balance sheet presented, less estimated futureexpenditures (based on current costs to be incurred in developing and producingthe proved reserves) computed using a discount factor and assuming continuationof existing economic conditions.

 

“Productive Well.” A wellthat is producing oil or gas or that is capable of production.

 

“PV-10.” Means a presentvalue, discounted at 10% per annum, and is not necessarily the same as marketvalue.

 

“Royalty” or “RoyaltyInterest.” The mineral owner’s share of oil or gas production (typicallybetween 1/8 and 1/4), free of costs, but subject to severance taxes unless thelessor is a government. In certain circumstances, the royalty owner bears aproportionate share of the costs of making the natural gas saleable, such asprocessing, compression and gathering. A royalty interest that is coterminouswith an operating or working interest is an “overriding royalty” interest.

 

“Shut-in Well.” A wellthat is not on production, but has not yet been plugged and abandoned. Wellsmay be shut-in in anticipation of future utility as a producing well, pluggingand abandonment or other use.

 

“Standardized Measure.”The standardized measure is an estimate of future net reserves from a property,and is calculated in the same exact fashion as a PV-10 value, except thatthe projected revenue stream is adjusted to account for the estimated amount offederal income tax that must be paid.

 

“Working Interest.” Theinterest in the oil and gas in place which is burdened with the cost ofdevelopment and operation of the property. Also called the operating interest.

 

“Workover.” A remedialoperation on a completed well to restore, maintain or improve the well’sproduction.

 

**ITEM1.  BUSINESS**

 

The terms “we,” “us,” “our,”“our Company” and “EPM” refer to Evolution Petroleum Corporation, a Nevadacorporation formerly known as Natural Gas Systems, Inc. (Nevada, “NGS”),and, unless the context indicates otherwise, also includes our wholly-ownedsubsidiaries.  Natural Gas Systems, Inc.(Delaware, “Old NGS”), a private Delaware corporation formed in September 2003was subsequently merged into NGS.

 

**Overview**

 

Our petroleum operationsbegan in September of 2003. We acquire established crude oil and naturalgas resources and exploit them through the application of conventional andspecialized technology, with the objective of increasing production, ultimaterecoveries, or both.

 

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Our team is broadlyexperienced in oil and gas operations, development, acquisitions and financing.We follow a strategy of outsourcing most of our property accounting, humanresources, administrative and non-core functions.

 

Our principal executiveoffices are located at 2500 City West Blvd, Suite 1300, Houston, Texas77042, and our telephone number is (713) 935-0122. We maintain a website atwww.EvolutionPetroleum.com, but information contained on our website does notconstitute part of this document.

 

Our stock is traded onthe American Stock Exchange under the ticker symbol “EPM”.  Prior to July 17, 2006, our stock wasquoted on the OTC Bulletin Board under the symbol “NGSY.OB”.  Prior to May 26, 2004, our stock wasquoted on the OTC Bulletin Board under the symbol “RLYI.OB”.

 

At June 30, 2008, wehad twelve full-time employees, not including contract personnel and outsourcedservice providers.

 

**CorporateHistory of Reverse Merger**

 

Reality Interactive, Inc.(“Reality”), a Nevada corporation that traded on the OTC Bulletin Board underthe symbol RLYI.OB and the predecessor of NGS, now Evolution PetroleumCorporation, was incorporated on May 24, 1994, for the purpose ofdeveloping technology-based knowledge solutions for the industrialmarketplace.  On April 30, 1999,Reality ceased business operations, sold substantially all of its assets andterminated all of its employees. Subsequent to ceasing operations, Reality explored other potentialbusiness opportunities to acquire or merge with another entity, whilecontinuing to file reports with the Securities and Exchange Commission (“SEC”).

 

On May 26, 2004, OldNGS was merged into a wholly owned subsidiary of Reality.  Reality was thereafter renamed Natural GasSystems, Inc. (“NGS”) and adopted a June 30 fiscal year end.  As part of the merger, the officers and directorsof Reality resigned, the officers and directors of Old NGS became the officersand directors of our Company, and the crude oil and natural gas business of OldNGS became that of our Company. Concurrently with the listing of our shares on the AMEX during July,2006, NGS was renamed Evolution Petroleum Corporation to avoid confusion withsimilar names traded on the AMEX and to better reflect our business model.

 

All regulatory filingsand other historical information prior to May 26, 2004 that applied toReality continue to apply to us after the merger.

 

**BusinessStrategy**

 

We are an independent oil and natural gas companyengaged primarily in the acquisition, exploitation and development ofproperties for the production of crude oil and natural gas. We acquire knownoil and natural gas resources and exploit them through the application ofconventional and specialized technology to increase production, ultimaterecoveries, or both.

 

We are focused on an overall strategy of acquiringcontrolling working interests in oil and natural gas resources withinestablished fields and redeveloping those fields through the application ofcapital and technology to convert a portion of the oil and natural gasresources into profitable producing reserves.

 

Within this overall strategy, we pursue three specificinitiatives:

 

| I      | Enhanced oil recovery (“EOR”), using miscible and  immiscible gas flooding;                                                                  |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                   |
| II     | Conventional redevelopment of bypassed primary  resources within mature oil and natural gas fields utilizing modern  technology and our expertise; and |
|   |                                                                                                                                                   |
| III    | Unconventional gas resource development, especially  in shale, using modern stimulation and completion technologies.                                   |

 

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Our strategy is intendedto generate scalable development opportunities at normally pressured depths,exhibiting relatively low completion risk, generally more predictableproduction lives, less expenditures on infrastructure and lower operationalrisks. We believe that the benefits of this approach include:

 

·                  Reduced exposure to the risk of whetherresources are present;

 

·                  Reduced capital expenditures per net BOEfor infrastructure, such as roads, water handling facilities and pipelines;

 

·                  Large inventory of developmentopportunities, which provides a more predictable future stream of drillingactivity and production, as well as potentially reducing risks from short-termoil and natural gas price volatility;

 

·                  Reduced operational risks and costs associated with lower pressures andlower temperatures; and

 

·                  Control of operations, development timingand technology selection.

 

**M****arkets and Customers**

 

Historically our crudeoil has been produced and sold from properties in the Delhi Field in Louisiana,the Tullos Field Area in Louisiana and the Giddings Field in Texas.  All of our natural gas has been produced andsold from our properties in the Delhi Field and the Giddings Field.  Since June 2006, we are no longer theoperator of the Delhi Field, due to the farmout we completed on June 12,2006 with Denbury Onshore LLC, a subsidiary of Denbury Resources Inc. (“Denbury”)(the “Delhi Farmout”), and, consequently, we have had no natural gas or naturalgas liquids production available to us for sales and marketing purposes in theDelhi Field since June 2006.  In March 2008we sold our properties in the Tullos Field Area and as a result have noproduction or properties from that area. With respect to our properties in the Giddings Field, we have beenproducing natural gas and natural gas liquids since our first well beganproduction in late February 2008, with two more wells beginning productionin mid March, and four wells that began production in May and June of2008.

 

Marketing of crude oiland natural gas production is influenced by many factors that are beyond ourcontrol, the exact effect of which is difficult to predict. These factorsinclude changes in supply and demand, market prices, government regulation andactions of major foreign producers.

 

Over the past 20 years,crude oil price fluctuations have been extremely volatile, with crude oilprices varying from less than $10 to in excess of $140 per barrel. Worldwidefactors such as geopolitical, macroeconomic, supply and demand, refiningcapacity, petrochemical production and derivatives trading, among others,influence prices for crude oil.  Localfactors also influence prices for crude oil and include quality differences,regulation and transportation issues unique to certain producing regions andreservoirs.

 

Also over the past 20years, domestic natural gas prices have been volatile, ranging from $1 to $15per MMBTU. The spot market for natural gas, changes in supply and demand,derivatives trading, pipeline availability, BTU content of the natural gas andweather patterns, among others, cause natural gas prices to be subject tosignificant fluctuations.  Due to thepractical difficulties in transporting natural gas, local factors tend toinfluence product prices more for natural gas than for crude oil.

 

In the U.S. market wherewe operate, crude oil and natural gas liquids are readily transportable andmarketable.  Since March 2005 andinto 2008, we sold all of our operated crude oil production to Plains MarketingLP, a crude oil purchaser, at competitive field prices.  In January of 2008, we also beganselling crude oil to Teppco Crude Oil, LLC, a crude oil gathering,transportation, storage and marketing company. Our agreements with both Plains Marketing LP and Teppco Crude Oil, LLCare under a normal (thirty day “evergreen”) sales contracts.  We believe that other crude oil purchasersare readily available.

 

Prior to fiscal year2007, we produced natural gas liquids from our Delhi Field, all ofwhich we sold to Dufour Petroleum, L.P., a subsidiary of Enbridge EnergyPartners, LP, at a market competitive price based on an index price of liquidcomponents, less a charge of $0.175 per gallon for transportation andfractionation.  Beginning in the secondquarter of our 2008 fiscal year we began selling our natural gas and naturalgas liquids to DCP Midstream, LP,  andETC Texas Pipeline, LTD., under the terms of normal evergreen sales contractsat competitive prices.  We have no otherbusiness relationships with our crude oil, natural gas or natural gas liquidspurchasers.

 

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**Competition**

 

Our competitors includemajor integrated crude oil and natural gas companies and numerous independentcrude oil and natural gas companies, individuals and drilling and incomeprograms. Many of our competitors are large, well-established companies withsubstantially larger operating staffs and greater capital resources than us.Competitors are national, regional or local in scope and compete on the basisof financial resources, technical prowess or local knowledge. The principalcompetitive factors in our industry are expertise in given geographical andgeological areas and the abilities to efficiently conduct operations, achievetechnological advantages, identify and acquire economically producible reservesand obtain affordable capital.

 

**GovernmentRegulation**

 

Crude oil and natural gasdrilling and production operations are regulated by various federal, state andlocal agencies. These agencies issue binding rules and regulations thatcarry penalties, often substantial, for failure to comply.  These regulations and rules requiremonthly, semiannual and annual reports on production amounts and water disposalamounts, and govern most aspects of operations, drilling and abandonment, aswell as crude oil spills.  We anticipatethe aggregate burden of federal, state and local regulation will continue andpotentially increase.  We also believethat our present operations materially comply with applicable regulations.  To date, such regulations have not had amaterial effect on our operations, or the costs thereof, other than as describedfurther in “Item 3. Legal Proceedings”. We do not believe that capital expenditures related to environmentalcontrol facilities or other regulatory matters will be material in the nearterm.  We cannot predict what subsequentlegislation or regulations may be enacted or what effect it will have on ouroperations or business.

 

**Insurance**

 

We maintain insurance onour properties and operations for risks and in amounts customary in theindustry.  Such insurance includesgeneral liability, excess liability, control of well, operators extra expenseand casualty coverage.  Not all lossesare insured, and we retain certain risks of loss through deductibles, limitsand self-retentions.  We do not carrylost profits coverage, and our aviation liability insurance coverage is limitedto $1million.

 

**ITEM1A. RISK FACTORS**

 

**Risksrelated to the Company**

 

**OPERATINGRESULTS FROM OIL AND GAS PRODUCTION MAY DECLINE.**

 

Due to the Delhi Farmout,our future development initiatives in the Delhi Field have been replaced with aCO2 enhanced oilrecovery (“CO2-EOR”) project, in which Denbury has undertaken anobligation to fund, install and operate. We have retained a 25% reversionary interest after a defined payout andseparately acquired overriding royalty interests totaling 7.4% in the Delhi CO2-EORproject.  As anticipated, the DelhiFarmout resulted in the reduction of net proved reserves, net production andnet revenues accruing to us from the Delhi Field until such time, if at all, asthe CO2-EOR project is completed and brought online.

 

Concurrent with the saleof our properties in the Tullos Field Area, we began establishing productionfrom newly drilled and completed wells in the Giddings Field.  The targeted reservoirs in the Giddings Fieldtypically experience flush production followed by steep harmonic decline ratesthat steadily flatten to much shallower decline rates.  While the newly drilled producing wells inthe Giddings Field substantially increased our net production above historiclevels, without further development activities in the Giddings Field or ourother properties or acquisitions of producing properties, our net production ofoil and natural gas will decline significantly over time, which could have amaterial adverse affect on our financial condition.

 

**THETYPES OF RESOURCES WE FOCUS ON HAVE SUBSTANTIAL OPERATIONAL RISKS.**

 

Our business plan focuseson the acquisition and development of known resources in partially depletedreservoirs, naturally fractured or low permeability reservoirs, or relativelyshallow reservoirs. Shallower reservoirs usually have lower pressure, whichtranslates into fewer natural gas volumes in place; low permeability reservoirsrequire more wells and substantial stimulation for development of commercialproduction; naturally fractured reservoirs require penetration of sufficientundepleted fractures to establish commercial production; and depletedreservoirs require successful application of newer technology to unlockincremental reserves.

 

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Our CO2-EOR projectin the Delhi Field, operated by Denbury, requires significant amounts of CO2 reserves, the source of which may becomeunavailable or be curtailed.  Denburycontrols the operations and CO2 for the project, and as a result, we have a limited ability to controlor influence the development and ultimate success of the project.  In order to deliver sufficient quantities ofCO2 from Denbury’sreserves from its Jackson Dome Field in Mississippi, a pipeline is beingconstructed to connect to the Delhi Field requiring large amounts of capitalresources and the acquisition of permits, right-of-ways, engineering designs,construction personnel and materials. Denbury’s failure to manage these andother technical, strategic and logistical risks may render ultimate enhancedrecoveries from the planned CO2-EOR project, if any, to fall short ofour expectations in volume and or timing.

 

The existing well boreswe are re-entering in the Giddings Field may have been originally drilled asfar back as the 1980’s.  As such, theycontain older casing that could be more subject to failure, or the well files,if available, may be incomplete or incorrect. Such problems can result in the complete loss of a well or a much higherdrilling and completion cost.  Our provedundeveloped locations in the Giddings Field are direct offsets to current orpreviously producing wells, and there may be unusually long fractures that willconnect our well to another producing or depleted well, thus reducing thepotential recovery, increasing our drilling costs, or delaying production dueto recovery of drilling fluid lost during drilling into the depleted fractures.

 

Our projects generallyrequire that we acquire new leases in and around established fields and drilland complete wells, some of which may be horizontal, as well as negotiate thepurchase of existing well bores and production equipment or install ourproprietary artificial lift technology that has yet to be proven in thefield.  Leases may not be available andrequired oil field services may not be obtainable on the desired schedule or atthe expected costs.  While the projecteddrilling results may be considered to be low to moderate in risk, there is noassurance as to what productive results may be obtained, if any.

 

**OURLIMITED OPERATING HISTORY AND NEWNESS OF OUR PRODUCTION MAKES IT DIFFICULT TOPREDICT FUTURE RESULTS AND INCREASES THE RISK OF AN INVESTMENT IN OUR COMPANY.**

 

We commenced our crudeoil and natural gas operations in late 2003 and have a limited operatinghistory.  All of our current productionis the result of recent drilling activities, thus our future production retainssubstantial variability.  Therefore, weface all the risks common to companies in their early stage of development,including uncertainty of funding sources, high initial expenditure levels anduncertain revenue streams, an unproven business model, and difficulties inmanaging growth.  Our prospects must beconsidered in light of the risks, expenses, delays and difficulties frequentlyencountered in establishing a new business. Any forward-looking statements inthis report do not reflect any possible effects on us from the outcome of thesetypes of uncertainty.  Prior to the DelhiFarmout, we had incurred significant losses since the inception of our oil andnatural gas operations and we have since resumed incurring losses, except forthe quarter ended June 30, 2008, in which we recognized positive operatingincome.  We cannot assure futureprofitability or success.  While membersof our management team have previously carried out or been involved withacquisition and production activities in the crude oil and natural gas industrywhile employed by us and other companies, we cannot assure you that ourintended acquisition targets and development plans will lead to the successfuldevelopment of crude oil and natural gas production or additional revenue.

 

**WE MAY BEUNABLE TO CONTINUE LICENSING FROM THIRD PARTIES THE TECHNOLOGIES THAT WE USE INOUR BUSINESS OPERATIONS.**

 

As is customary in thecrude oil and natural gas industry, we utilize a variety of widely availabletechnologies in the crude oil and natural gas development and drilling process.  We do not have any patents or copyrights forthe technology we currently utilize. Instead, we license or purchase servicesfrom the holders of such technology, or outsource the technology integral toour business from third parties. Our commercial success will depend in part onthese sources of technology and assumes that such sources will not infringe onthe proprietary rights of others. We cannot be certain whether any third-partypatents will require us to utilize or develop alternative technology or toalter our business plan, obtain additional licenses, or cease activities thatinfringe on third-parties’ intellectual property rights. Our inability toacquire any third-party licenses, or to integrate the related third-partyproducts into our business plan, could result in delays in development unlessand until equivalent products can be identified, licensed, and integrated.Existing or future licenses may not continue to be available to us oncommercially reasonable terms or at all. Litigation, which could result insubstantial cost to us, may be necessary to enforce any patents licensed to usor to determine the scope and validity of third-party obligations.

 

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**REGULATORYAND ACCOUNTING REQUIREMENTS MAY REQUIRE SUBSTANTIAL REDUCTIONS IN REPORTEDPROVEN RESERVES (SEE GLOSSARY OF SELECTED PETROLEUM TERMS).**

 

We review on a periodicbasis the carrying value of our crude oil and natural gas properties under theapplicable rules of the various regulatory agencies, including the SEC.Under the full-cost method of accounting that we use, the carrying value ofproved reserves of crude oil and natural gas properties may not exceed thepresent value of estimated future net after-tax cash flows from provedreserves, discounted at 10%. Application of this “ceiling” test generallyrequires pricing future revenues at the un-escalated prices in effect as of theend of our fiscal quarter and requires a write down of the carrying value foraccounting purposes if the ceiling is exceeded, even if prices declined foronly a short period of time. We may in the future be required to write down thecarrying value of our crude oil and natural gas properties when crude oil andnatural gas prices are depressed or unusually volatile. Whether we will berequired to take such a charge will depend in part on the prices for crude oiland natural gas at the end of any fiscal period and the effect of reserveadditions or revisions and capital expenditures during such period. If a writedown is required, it would result in a charge to our earnings but would notimpact our cash flow from operating activities.

 

**OUR PROFITABILITY IS HIGHLY**DEPENDENT**ON THE PRICESOF CRUDE OIL, NATURAL GAS, AND NATURAL GAS LIQUIDS, WHICH HAVE HISTORICALLYBEEN VERY VOLATILE.**

 

Our estimated provedreserves, revenues, profitability, operating cash flow and future rate ofgrowth are highly dependent on the prices of crude oil, natural gas and NGLs,which are affected by numerous factors beyond our control.  Historically, these prices have been veryvolatile and are likely to remain volatile in the future.  A significant and extended downward trend incommodity prices would have a material adverse effect on our revenues,profitability and cash flow, and could result in a reduction in the carryingvalue of our oil and natural gas properties and the amounts of our estimatedproved oil and natural gas reserves.  Tothe extent that we have not hedged our production with derivative contracts orfixed-price contracts, any significant and extended decline in oil and naturalgas prices may adversely affect our financial position.

 

**WE MAY BEUNABLE TO ACQUIRE AND DEVELOP THE ADDITIONAL OIL AND GAS RESERVES THAT AREREQUIRED IN ORDER TO SUSTAIN OUR BUSINESS OPERATIONS.**

 

In general, the volumesof production from crude oil and natural gas properties decline as reserves aredepleted with the rate of decline depending on reservoir characteristics.Except to the extent we acquire properties containing proved reserves orconduct successful development activities, or both, our proved reserves willdecline. Our future crude oil and natural gas production is, therefore, highlydependent upon our level of success in finding or acquiring additionalreserves. Due to the Delhi Farmout and the sale of our properties in the TullosField Area, our near-term future growth and financial condition is highlydependent on our ability to develop additional oil and natural gas reserves.

 

**WE ARESUBJECT TO SUBSTANTIAL OPERATING RISKS THAT MAY ADVERSELY AFFECT OURRESULTS OF OPERATIONS.**

 

The crude oil and naturalgas business involves numerous operating hazards such as well blowouts,mechanical failures, explosions, uncontrollable flows of crude oil, natural gasor well fluids, fires, formations with abnormal pressures, hurricanes,flooding, pollution, releases of toxic gas and other environmental hazards andrisks. 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 expensecoverage typical in our industry, we are not fully insured against all risksincident to our business.

 

We may not be theoperator of some of our wells in the future. As a result, our operating risksfor those wells and our ability to influence the operations for these wellswill be less subject to our control. Operators of these wells may act in waysthat are not in our best interests. If this occurs, the development of, andproduction of crude oil and natural gas from, some wells may not occur whichwould have an adverse affect on our results of operations.

 

**THE LOSSOF KEY PERSONNEL COULD ADVERSELY AFFECT US.**

 

We depend to a largeextent on the services of certain key management personnel, including ourexecutive officers, the loss of any of whom could have a material adverseaffect on our operations.  In particular,our future success is dependent upon Robert S. Herlin, our President and ChiefExecutive Officer, Sterling H. McDonald, our Chief Financial Officer, and DarylV. Mazzanti, our Vice-President of Operations, for sourcing, evaluating andclosing deals, capital raising, and oversight of development andoperations.  Presently, the Company isnot a beneficiary of any key man insurance.

 

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**THE LOSSOF ANY OF OUR SKILLED TECHNICAL PERSONNEL COULD ADVERSELY AFFECT OUR BUSINESS.**

 

We depend to a largeextent on the services of skilled technical personnel to lease, drill,complete, operate and maintain our crude oil and natural gas fields. We do nothave the resources to perform all of these services and therefore we outsourcemany of our requirements. Additionally, as our production increases, so doesour need for such services. Generally, we do not have long-term agreements withour drilling and maintenance service providers. Accordingly, there is a riskthat any of our service providers could discontinue servicing our crude oil andnatural gas fields for any reason. Although we believe that we could establishalternative sources for most of our operational and maintenance needs, anydelay in locating, establishing relationships, and training our sources couldresult in production shortages and maintenance problems, with a resulting lossof revenue to us. We also rely on third-party carriers for the transportationand distribution of our production, the loss of any of which could have amaterial adverse affect on our operations.

 

**WE MAY HAVEDIFFICULTY MANAGING FUTURE GROWTH AND THE RELATED DEMANDS ON OUR RESOURCES AND MAY HAVEDIFFICULTY IN ACHIEVING FUTURE GROWTH.**

 

Although we hope toexperience growth through acquisitions and development activity, any suchgrowth may place a significant strain on our financial, technical, operationaland administrative resources. Our ability to grow will depend upon a number offactors, including:

 

·                  our ability to identify and acquire newdevelopment or acquisition projects;

·                  our ability to develop existingproperties;

·                  our ability to continue to retain andattract skilled personnel;

·                  the results of our development programand acquisition efforts;

·                  the success of our technologies;

·                  hydrocarbon prices;

·                  drilling, completion and equipmentprices;

·                  our ability to successfully integrate newproperties; and

·                  our access to capital.

 

We can not assure youthat we will be able to successfully grow or manage any such growth.

 

**WE FACESTRONG COMPETITION FROM LARGER CRUDE OIL AND NATURAL GAS COMPANIES.**

 

Our competitors includemajor integrated crude oil and natural gas companies and numerous independentcrude oil and natural gas companies, individuals and drilling and incomeprograms. Many of our competitors are large, well-established companies withsubstantially larger operating staffs and greater capital resources than wehave. We may not be able to successfully conduct our operations, evaluate and selectsuitable properties and consummate transactions in this highly competitiveenvironment. Specifically, these larger competitors may be able to pay more fordevelopment projects and productive crude oil and natural gas properties andmay be able to define, evaluate, bid for and purchase a greater number ofproperties and prospects than our financial or human resources permit. Inaddition, such companies may be able to expend greater resources on hiringcontract service providers, obtaining oilfield equipment and acquiring theexisting and changing technologies that we believe are and will be increasinglyimportant to attaining success in our industry.

 

**THECRUDE OIL AND NATURAL GAS RESERVES INCLUDED IN THIS REPORT ARE ONLY ESTIMATESAND MAY PROVE TO BE INACCURATE.**

 

There are numerousuncertainties inherent in estimating crude oil and natural gas reserves andtheir estimated values. The reserves discussed in this report are onlyestimates that may prove to be inaccurate because of these uncertainties.Reservoir engineering is a subjective and inexact process of estimatingunderground accumulations of crude oil and natural gas that cannot be measuredin an exact manner. Estimates of economically recoverable crude oil and naturalgas reserves depend upon a number of variable factors, such as historicalproduction from the area compared with production from other producing areasand assumptions concerning effects of regulations by governmental agencies,future crude oil and natural gas prices, future operating costs, severance andexcise taxes, development costs and work-over and remedial costs. Some or allof these assumptions may in fact vary considerably from actual results. Forthese reasons, estimates of the economically recoverable quantities of crudeoil and natural gas attributable to any particular group of properties,classifications of such reserves based on risk of recovery, and estimates ofthe future net cash flows expected there from prepared by different

 

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engineers or by the sameengineers but at different times, may vary substantially. Accordingly, reserveestimates may be subject to downward or upward adjustment. Actual production,revenue and expenditures with respect to our reserves will likely vary fromestimates, and such variances may be material. The information regardingdiscounted future net cash flows included in this report should not be consideredas the current market value of the estimated crude oil and natural gas reservesattributable to our properties. As required by the SEC, the estimateddiscounted future net cash flows from proved reserves are based on prices andcosts as of the date of the estimate, while actual future prices and costs maybe materially higher or lower. Actual future net cash flows also will beaffected by factors such as the amount and timing of actual production, supplyand demand for crude oil and natural gas, increases or decreases inconsumption, and changes in governmental regulations or taxation. In addition,the 10% discount factor, which is required by the SEC to be used in calculatingdiscounted future net cash flows for reporting purposes, is not necessarily themost appropriate discount factor based on interest rates in effect from time totime and risks associated with us or the crude oil and natural gas industry ingeneral.

 

**WECANNOT MARKET THE CRUDE OIL AND NATURAL GAS THAT WE PRODUCE WITHOUT THEASSISTANCE OF THIRD PARTIES.**

 

The marketability of thecrude oil and natural gas that we produce depends upon the proximity of ourreserves to, and the capacity of, facilities and third-party services,including crude oil and natural gas gathering systems, pipelines, trucking orterminal facilities, and processing facilities. The unavailability or lack ofcapacity of such services and facilities could result in the shut-in ofproducing wells or the delay or discontinuance of development plans forproperties. A shut-in or delay or discontinuance could adversely affect ourfinancial condition. In addition, federal and state regulation of crude oil andnatural gas production and transportation could affect our ability to produceand market our crude oil and natural gas on a profitable basis.

 

**RisksRelating to the Oil and Gas Industry**

 

**CRUDEOIL AND NATURAL GAS DEVELOPMENT, RE-COMPLETION OF WELLS FROM ONE RESERVOIR TOANOTHER RESERVOIR, RESTORING WELLS TO PRODUCTION AND DRILLING AND COMPLETINGNEW WELLS ARE SPECULATIVE ACTIVITIES AND INVOLVE NUMEROUS RISKS AND SUBSTANTIALAND UNCERTAIN COSTS.**

 

Our growth will bematerially dependent upon the success of our future development program.  Drilling for crude oil and natural gas andre-working existing wells involve numerous risks, including the risk that nocommercially productive crude oil or natural gas reservoirs will beencountered.  The cost of drilling,completing and operating wells is substantial and uncertain, and drillingoperations may be curtailed, delayed or cancelled as a result of a variety offactors beyond our control, including:

 

·                  unexpected drilling conditions;

·                  pressure fluctuations or irregularitiesin formations;

·                  equipment failures or accidents;

·                  inability to obtain leases on economicterms, where applicable;

·                  adverse weather conditions;

·                  compliance with governmentalrequirements; and

·                  shortages or delays in the availabilityof drilling rigs or crews and the delivery of equipment.

 

Drilling or re-working isa highly speculative activity.  Even whenfully and correctly utilized, modern well completion techniques such asHydraulic Fracturing and Horizontal Drilling do not guarantee that we will findcrude oil and/or natural gas in our wells. Our future drilling activities may not be successful and, if unsuccessful,such failure would have an adverse affect on our future results of operationsand financial condition.  We cannotassure you that our overall drilling success rate or our drilling success ratefor activities within a particular geographic area will not decline.  We may identify and develop prospects througha number of methods, some of which do not include Horizontal Drilling orHydraulic Fracturing, and some of which may be unproven.  The drilling and results for these prospectsmay be particularly uncertain.  Ourdrilling schedule and costs may vary from our capital budget.  The final determination with respect to thedrilling of any scheduled or budgeted prospects will be dependent on a numberof factors, including, but not limited to:

 

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·                  the results of previous developmentefforts and the acquisition, review and analysis of data;

·                  the availability of sufficient capitalresources to us and the other participants, if any, for the drilling of theprospects;

·                  the approval of the prospects by otherparticipants, if any, after additional data has been compiled;

·                  economic and industry conditions at thetime of drilling, including prevailing and anticipated prices for crude oil andnatural gas and the availability of drilling rigs and crews;

·                  our financial resources and results;

·                  the availability of leases and permits onreasonable terms for the prospects; and

·                  the success of our drilling technology.

 

We cannot assure you thatthese projects can be successfully developed or that the wells discussed will,if drilled, encounter reservoirs of commercially productive crude oil ornatural gas.  There are numerousuncertainties in estimating quantities of proved reserves, including manyfactors beyond our control.

 

**CRUDEOIL AND NATURAL GAS PRICES ARE HIGHLY VOLATILE IN GENERAL AND LOW PRICES WILLNEGATIVELY AFFECT OUR FINANCIAL RESULTS.**

 

Our revenues, operating results,profitability, cash flow, future rate of growth and ability to borrow funds orobtain additional capital, as well as the carrying value of our properties, aresubstantially dependent upon prevailing prices of crude oil and natural gas.  Lower crude oil and natural gas prices alsomay reduce the amount of crude oil and natural gas that we can produceeconomically.  Historically, the marketsfor crude oil and natural gas have been very volatile, and such markets arelikely to continue to be volatile in the future.  Prices for crude oil and natural gas aresubject to wide fluctuation in response to relatively minor changes in thesupply of and demand for crude oil and natural gas, market uncertainty and avariety of additional factors that are beyond our control, including:

 

·                  worldwide and domestic supplies of crudeoil and natural gas;

·                  the level of consumer product demand;

·                  weather conditions;

·                  domestic and foreign governmentalregulations;

·                  the price and availability of alternativefuels;

·                  political instability or armed conflictin oil-producing regions;

·                  the price and level of foreign imports;and

·                  overall domestic and global economicconditions.

 

It is extremely difficultto predict future crude oil and natural gas price movements with any certainty.  Declines in crude oil and natural gas pricesmay materially adversely affect our financial condition, liquidity, ability tofinance planned capital expenditures and results of operations.  Further, crude oil and natural gas prices donot move in tandem.  Becauseapproximately 24% of our reserves at July 1, 2008 are crude oil reservesand 33% are natural gas liquids reserves, we are heavily impacted by movementsin crude oil prices, which also influence natural gas liquids prices.  While our new projects are evaluated based onthe assumption of oil and natural gas prices considerably less than in thecurrent market or projected in the futures market, we do assume commodityprices will be higher than historic levels prior to 2004.

 

**OILFIELDSERVICE AND MATERIALS’ PRICES HAVE BEEN ESCALATING, AND THE AVAILABILITY OFSUCH SERVICES MAY BE INADEQUATE TO MEET OUR NEEDS.**

 

Our business plan toredevelop mature crude oil and natural gas resources requires third partyoilfield service vendors and various materials such as steel tubulars, which wedo not control.  Long lead times and spotshortages may prevent us from, or delay us in, maintaining or increasing theproduction volumes we expect.  Inaddition, the recent escalating costs for such services and materials mayrender certain or all of our projects uneconomic, as compared to the earlierprices we may have assumed when deciding to redevelop newly purchased orexisting properties.  Further adverseeconomic outcomes may result from the long lead times often necessary toexecute and complete our redevelop plans.

 

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**GOVERNMENTREGULATION AND LIABILITY FOR ENVIRONMENTAL MATTERS MAY ADVERSELY AFFECTOUR BUSINESS AND RESULTS OF OPERATIONS.**

 

Crude oil and natural gasoperations are subject to extensive federal, state and local governmentregulations, which may be changed from time to time. Matters subject toregulation include discharge permits for drilling operations, drilling bonds,reports concerning operations, the spacing of wells, unitization and pooling ofproperties and taxation. From time to time, regulatory agencies have imposedprice controls and limitations on production by restricting the rate of flow ofcrude oil and natural gas wells below actual production capacity in order toconserve supplies of crude oil and natural gas. There are federal, state andlocal laws and regulations primarily relating to protection of human health andthe environment applicable to the development, production, handling, storage,transportation and disposal of crude oil and natural gas, by-products thereofand other substances and materials produced or used in connection with crude oiland natural gas operations. In addition, we may inherit liability forenvironmental damages, whether actual or not, caused by previous owners ofproperty we purchase or lease or nearby properties. As a result, we may incursubstantial liabilities to third parties or governmental entities. We are alsosubject to changing and extensive tax laws, the effects of which cannot bepredicted. The implementation of new, or the modification of existing, laws orregulations could have a material adverse affect on us.

 

**RisksAssociated with Our Stock**

 

**OURSTOCK PRICE HAS BEEN AND MAY CONTINUE TO BE VERY VOLATILE.**

 

Our common stock isthinly traded and the market price has been, and is likely to continue to be,highly volatile. For example, during the year prior to June 30, 2008, ourstock price as traded on the American Stock Exchange ranged from $2.15 to$7.17.  The variance in our stock pricemakes it extremely difficult to forecast with any certainty the stock price atwhich an investor may be able to buy or sell shares of our common stock.  The market price for our common stock couldbe subject to wide fluctuations as a result of factors that are out of ourcontrol, such as:

 

·                  actual or anticipated variations in ourresults of operations;

·                  naked short selling of our common stockand stock price manipulation;

·                  changes or fluctuations in the commodityprices of crude oil and natural gas;

·                  general conditions and trends in the crudeoil and natural gas industry; and

·                  general economic, political and marketconditions.

 

**OUREXECUTIVE OFFICERS, DIRECTORS AND AFFILIATES MAY BE ABLE TO CONTROL THEELECTION OF OUR DIRECTORS AND ALL OTHER MATTERS SUBMITTED TO OUR STOCKHOLDERSFOR APPROVAL.**

 

The following sharecalculations treat shares issuable upon the exercise of options or warrants asoutstanding (both in the numerator and denominator for percentages) and assumeactual vesting.

 

Our executive officersand directors, in the aggregate, beneficially own approximately 12.4 millionshares or approximately 38% of our fully diluted common stock, inclusive ofwhich our Chairman of the Board, Mr. Laird Q. Cagan, Managing Director ofCagan McAfee Capital Partners, LLC (“CMCP”) currently owns or controls,directly or indirectly, approximately 7.2 million shares, or approximately 22%of our fully diluted common stock.  Mr. EricMcAfee, a Managing Director of CMCP, currently owns or controls, directly orindirectly, approximately 5.0 million shares, or approximately 15% of our fullydiluted common stock, but is neither an officer, employee nor a member of ourboard of directors.  Collectively, thetwo managing directors of CMCP currently own or control, directly orindirectly, approximately 12.2 million shares, or approximately 37% of ourfully diluted common stock. As a result, these holders, if they were to acttogether, could exercise effective control over all matters submitted to ourstockholders for approval (including the election and removal of directors andany merger, consolidation or sale of all or substantially all of our assets).This concentration of ownership may have the effect of delaying, deferring orpreventing a change in control of our company, impede a merger, consolidation,takeover or other business combination involving our company or discourage apotential acquirer from making a tender offer or otherwise attempting to obtaincontrol of our company, which in turn could have an adverse effect on themarket price of our common stock.

 

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**THE MARKET FOR OUR COMMON STOCKIS LIMITED AND MAY NOT PROVIDE ADEQUATE LIQUIDITY.**

 

Our common stock iscurrently thinly traded on the American Stock Exchange. In the year prior to June 30,2008, the actual trading volume in our common stock ranged from a low of 100shares of common stock traded to a high of 353,300 shares of common stocktraded, with only 66 days exceeding a trading volume of 50,000 shares. On mostdays, this trading volume means there is limited liquidity in our shares ofcommon stock. Selling our shares is more difficult because smaller quantitiesof 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 andtherefore holders of our stock may be unable to sell shares purchased, shouldthey desire to do so.

 

**IFSECURITIES OR INDUSTRY ANALYSTS DO NOT PUBLISH RESEARCH REPORTS ABOUT OURBUSINESS OR IF THEY DOWNGRADE OUR STOCK, THE PRICE OF OUR COMMON STOCK COULDDECLINE.**

 

Small, relatively unknowncompanies can achieve visibility in the trading market through research andreports that industry or securities analysts publish.  However, to our knowledge, only four non-companypaid analysts cover our company.  Thelack of published reports by independent securities analysts could limit theinterest in our common stock and negatively affect our stock price.  We do not have any control over the researchand reports these analysts publish or whether they will be published at all. Ifany analyst who does cover us downgrades our stock, our stock price coulddecline.  If any analyst ceases coverageof our company or fails to regularly publish reports on us, we could losevisibility in the financial markets, which in turn could cause our stock priceto decline.

 

**THEISSUANCE OF ADDITIONAL COMMON AND PREFERRED STOCK WOULD DILUTE EXISTINGSTOCKHOLDERS.**

 

We are authorized toissue up to 100,000,000 shares of common stock. To the extent of such authorization, our board of directors has theability, without seeking stockholder approval, to issue additional shares ofcommon stock in the future for such consideration as our board may considersufficient.  The issuance of additionalcommon stock in the future would reduce the proportionate ownership and votingpower of the common stock now outstanding. We are also authorized to issue up to 5,000,000 shares of preferredstock, the rights and preferences of which may be designated in series by ourboard of directors.  Such designation ofnew series of preferred stock may be made without stockholder approval, andcould create additional securities which would have dividend and liquidationpreferences over the common stock now outstanding. Preferred stockholders couldadversely affect the rights of holders of common stock by:

 

·                  exercisingvoting, redemption and conversion rights to the detriment of the holders ofcommon stock;

·                  receivingpreferences over the holders of common stock regarding our surplus funds in theevent of our dissolution, liquidation or the payment of dividends to Preferredstockholders;

·                  delaying,deferring or preventing a change in control of our company; and

·                  discouragingbids for our common stock.

 

**WE DONOT PLAN TO PAY ANY CASH DIVIDENDS ON OUR COMMON STOCK.**

 

We have not paid anydividends on our common stock to date and do not anticipate that we will bepaying dividends in the foreseeable future. Any payment of cash dividends on our common stock in the future will bedependent upon the amount of funds legally available, our earnings, if any, ourfinancial condition, our anticipated capital requirements and other factorsthat our board of directors may think are relevant.  However, we currently intend for theforeseeable 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 notexpect to pay any dividends on our common stock in the foreseeable future.

 

**ITEM1B.  UNRESOLVED STAFF COMMENTS**

 

None.

 

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**ITEM2.  PROPERTIES**

 

***Enhanced Oil Recovery (“EOR”) Property***

 

Our EOR Initiativetargets the use of miscible and immiscible gas flooding to achieve economicredevelopment and production of tertiary crude oil resources. Field candidatesare likely to have already completed primary and secondary recovery operations,generally through water flooding.

 

DelhiField

 

The Delhi Holt BryantUnit in the Delhi Field in Louisiana, currently our most significant asset, isbeing redeveloped by Denbury, as operator, through an EOR project utilizing CO2 technology:

 
| · |   | As of December 31,  2007, Denbury reported to us that approximately $73.0 million of capital has  been charged to the project, excluding the $50 million they paid to us in  2006.                  |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                     |
| · |   | Denbury announced an $80  million capital budget in the Delhi Field for calendar year 2008.                                                                                                              |
|   |   |                                                                                                                                                                                                     |
| · |   | Denbury anticipates  that first CO2 injection in the Delhi Field should occur in  the first half of calendar 2009, with first EOR production from the Delhi  Field projected on or about late 2009. |

 

We, and the companiesthat submitted offers to participate with us, believe that the Delhi HoltBryant Unit is an excellent candidate for a CO2-EOR project due to its favorable rockcharacteristics, large unproven reserves remaining in place, miscibilitypotential, low cost of drilling due to a relatively shallow depth andrelatively close location to naturally occurring CO2 reserves approximately 100 miles east of theDelhi Field.  In June 2006, weconveyed a farmout to Denbury for all of our working interests in the DelhiHolt Bryant Unit and its proved reserves and 75% of our working interests incertain other depths of the Delhi Field, as described in more detail below.

 

According to publishedreports and field records, the Delhi Field was discovered in the mid-1940’s andwas extensively developed by various operators including the Sun Oil and MurphyOil companies through the drilling and completion of approximately 450 wells,most within the first few years after discovery. According to W. D. Von Gonten &Co., the third party reservoir engineering firm that prepares our independentestimate of proved reserves, the Delhi Field has produced approximately 200million barrels of crude oil and substantial amounts of natural gas to date.Much of the natural gas production was processed to remove natural gas liquidsand re-injected for pressure maintenance. Beginning in the late 1950’s, thefield was unitized to conduct a pressure maintenance project through theinjection of water into the producing reservoir in down dip injection wells(unitization is the process of combining multiple leases into a singleownership entity in order to simplify operations and equitably distributeroyalties when common operations are conducted over multiple leases). Drillingoperations resulted in primarily 40-acre spacing across the unit’s 13,636acres. A few wells were drilled below the targeted Tuscaloosa and Paluxyformations. The water injection pressure maintenance operations did not utilizea more traditional and effective five spot flood pattern water flood thatgenerally results in a more complete reservoir sweep and oil recovery.

 

At the time we began ouroil and natural gas operations in late September 2003, we purchasedessentially all of the working interests and an 80% net revenue interest in theDelhi Field (from the surface to the top of the Massive Anhydride formation,but excepting the Mengel Unit), for approximately $2.8 million, including theassumption of a plugging and abandonment reclamation bond.  All but 43 wells in Richland, Franklin and MadisonParishes, Louisiana had been plugged and abandoned and production averagedapproximately 18 BOPD with no natural gas being sold due to a lack of naturalgas processing and transportation facilities. The best producing well was immediately lost during a periodic sand washwork-over when water from a lower reservoir broke through along the casingexterior and into the producing reservoir.

 

In October of 2003,we applied an unproven lateral re-entry technology that resulted in no increasein production.  In December 2003, weinitiated a development program based on re-completion of wells to otherreservoirs and restoring non-producing wells to producing status.  During 2004, we refurbished a gas injectionline, converting it to a gas gathering and sales line, and placed a gasprocessing plant in the field to begin natural gas production in July of2004.  During 2005, we began a five welldevelopment drilling program aimed at reaching mostly proved undevelopedreserves left in primary “attic” positions. The culmination of these activities caused production to increase from18 BOPD to a monthly average rate of 145 BOEPD during our peak production monthin late 2005.

 

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Concurrent with theseactivities, we completed internal studies indicating that the reservoirs in theDelhi Holt Bryant Unit, the dominant oil producing reservoirs, were believed tobe less than 50% depleted.  Based onpositive CO2 pilots conducted by Sun Oil in 1985, andfavorable rock characteristics shown in multiple cores taken throughout theDelhi Field, we began discussions in late 2004 with industry partners skilledin tertiary/EOR recovery methods, especially with respect to CO2 injection.

 

With positive industryreception, and following extended negotiations with three candidates asprospective partners, we accelerated our redevelopment plan in June 2006by selling a major portion of our Delhi Field interests, in the form of afarmout, to a subsidiary of Denbury (the “Delhi Farmout”). Important aspects ofthis transaction include:

 

·                    Wereceived approximately $50 million in cash (pre-tax) to redeploy to otherprojects and repay all of our then outstanding debt.

 

·                    Denburycommitted to install a CO2-EOR project in theHolt Bryant Unit and expend a minimum additional $100 million on the projectover the next 6-1/2 years, subject to penalty payments to us for shortfalls insuch expenditures. All capital expenditures related to the project are borne byDenbury prior to payout.

 

·                    Denburyis the dominant CO2-EOR operator on the Gulf Coastand currently operates a large number of CO2-EORprojects and owns naturally occurring CO2 reserves that we believe to be sufficient tomeet the needs of the Delhi project and which have been dedicated to the Delhiproject.

 

·                    Weretained significant participating interests through separately acquiredroyalty and overriding royalty interests aggregating 7.4%, and a reversionaryworking interest equal to 25% of Denbury’s working interest (20% revenueinterest net to us). We expect the value of these interests will substantiallyexceed the $50 million cash component of the Delhi Farmout.

 

·                    Ourreversionary working interest in the CO2-EORproject is based on a defined $200 million threshold, subject only to expansionof the project through acquisitions, and our reversionary working interest occurswhen cumulative project net revenues less direct operating costs in the field reachthe threshold.

 

·                    Wefurther retained a 25% working interest (20% net revenue interest) in certainother depths outside of the Holt Bryant Unit within the Delhi Field, andbelieve that additional development potential may exist in the shallowerdepths.

 

·                    Weexpect to be able to claim proved reserves following the first EOR productionresponse, projected to occur in late calendar 2009 or shortly thereafter.

 

***ConventionalRedevelopment Property***

 

Our ConventionalRedevelopment Initiative targets the economic development or redevelopment ofprimary petroleum resources previously bypassed by industry in mature,historically productive formations generally due to inadequate technology orcommodity prices.

 

GiddingsField

 

Following the closing ofour Delhi Farmout in June 2006, we began the process of identifying newConventional Redevelopment projects.  Inselecting our candidates:

 

·                     Weleveraged our staff’s extensive experience, gained over many years whileemployed at UPRC and Anadarko Petroleum Corporation, in the pioneering ofhorizontal drilling practices adapted to further develop and produce the AustinChalk and Georgetown formations in the Giddings Field in central Texas;

 

·                     Wesought projects that could provide substantial early revenues, production andnet cash flows prior to peak production from the Delhi Field; and

 

·                     Wesought exposure to both crude oil and natural gas opportunities.

 

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We began leasingactivities in the Giddings Field in December 2006 and acquired 17,903 netacres as of June 30, 2008.  In late2007, we initiated a redevelopment drilling program in the Giddings Fieldtargeting the Austin Chalk and Georgetown formations.  As of June 30, 2008, we have completedthat initial drilling program and placed seven wells into production, includingfive wells that were re-entered, one well that was drilled and one well thatwas restored to production through a workover.

 

Essentially all of ourproved reserves are located in the Giddings Field and our operations there haveincreased our total proved reserves by 133% over June 30, 2007, from totalproved reserves of 1,723,867 BOE as of July 1, 2007 to 4,018,233 BOE as of July 1,2008.

 

TullosField Area

 

On March 3, 2008, wecompleted the sale of our properties in the Tullos Field Area in LaSalle andWinn Parishes, Louisiana, for gross cash proceeds of approximately $4.6million.

 

Producing about 100 grossand 79 net barrels of oil production per day from over 150 producing wells atthe time of our divestiture, the Tullos Field Area required a disproportionateamount of staff effort and vendor services, thereby adversely affecting ourability to develop other projects utilizing our expertise and working capital,particularly in the Giddings Field.  Furthermore, we believe that thepotential upside in the Tullos Field Area was substantially less than thatoffered in our other projects, particularly the Giddings Field drilling program,where the cash proceeds from the sale of our properties in the Tullos FieldArea could be expected to yield a much higher return.  Last, we hadcompleted the testing of our completion technology utilizing the one well wedrilled in the Tullos Field Area and determined that the potential of thattechnology would be best realized in other fields having less depletion.

 

***Unconventional Natural Gas Resource Property***

 

Our UnconventionalNatural Gas Resource Initiative targets the use of modern stimulation andcompletion technologies for the economic development and production of tightgas formations.

 

Two Woodford ShaleProjects in Oklahoma

 

Following the closing ofour Delhi Farmout in June 2006, we began the process of identifyingUnconventional Natural Gas Resource Initiative projects.  We chose two projects in the Woodford Shaletrend in Oklahoma.  In choosing these twoprojects:

 

·                     Weare leveraging our staff’s expertise in horizontal drilling and tight gasdevelopment, a prerequisite to successfully exploiting and developing theseresources;

 

·                     Weare focusing on locations of source rock formations that are well known,especially gas shales;

 

·                     Wehave considered that these projects require large amounts of capital over longperiods of time, thereby providing reinvestment opportunities to absorb thesubstantial cash flows we expect from our future Delhi EOR and BypassedResource production; and

 

·                     Weare adding additional natural gas exposure to balance our existing crude oilexposure.

 

We began actively acquiring leases in these twoprojects in May 2007.  At June 30,2008, we had acquired approximately 27,999 and 16,565 gross and net acres,respectively, across the two projects.

 

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***Estimated ProvedOil and Natural Gas Reserves and Future Net Revenues***

 

We engaged W. D. VonGonten & Co. (“Von Gonten”) to prepare an independent report of ourproved reserves as of July 1, 2008 (the “Reserve Report”). Von Gonten alsopreviously prepared independent reports for all of our proved reserves at July 1,2007, July 1, 2006, July 1, 2005, July 1, 2004 and January 1,2004.

 

Estimates of reservequantities and values must be viewed as being subject to significant change asmore data about the properties becomes available.

 

Denominated in equivalent barrels using a six MCF ofgas and 42 gallons of natural gas liquids to one barrel of oil conversionratio, at July 1, 2008, natural gas represented 43%, natural gas liquidsrepresented 33%, and crude oil represented 24% of total proved reserves, ascompared to natural gas of 37% and crude oil of 63% of total proved reserves atJuly 1, 2007. The increase in proved reserves was due to the leasing,redevelopment and drilling activities in our properties in the Giddings Field,thereby more than offsetting our production and the divestment of provedreserves through our sale of properties in the Tullos Field Area in March 2008.  The change in mix of proved reserves is due,in part, to the identification and separation of natural gas liquids in the2008 report, whereas natural gas liquids were included in the natural gasvolumes in the 2007 report.

 

The following table setsforth, as of July 1, 2008, information regarding our proved reserves basedon our Reserve Report. See Note 16 to the consolidated financial statements, whereadditional reserve information is provided. The average NYMEX prices used tocalculate estimated future net revenues were $138.73 per barrel of crude oil,$84.39 per barrel of natural gas liquid, and $14.00 per MMBTU of natural gas asof June 30, 2008.  The NYMEX pricesused were adjusted for transportation, market differentials and BTU content ofgas produced.

 
| ** **                                       | ** ** | **Proved Developed** | ** ** | **Proved**        | ** ** | **Proved**      | ** ** | **Total Proved** | ** **  |
|--------------------------------------------------|------------|---------------------------|------------|-------------------|------------|-----------------|------------|-----------------------|-------------|
| **July 1, 2008**                                 | ** ** | **Producing**             | ** ** | **Non-producing** | ** ** | **Undeveloped** | ** ** | **Reserves**          | ** **  |
|                                             |       |                      |       |              |       |            |       |                  |        |
| Crude Oil (Bbls)                                 |       | 96,167                    |       | —            |       | 855,874         |       | 952,041               |        |
| NGLs (Bbls)                                      |       | 98,416                    |       | 11,300            |       | 1,200,744       |       | 1,310,460             |        |
| Natural gas  (Mcf)                               |       | 485,701                   |       | 75,300            |       | 9,973,390       |       | 10,534,391            |        |
| Total (BOE)                                      |       | 275,533                   |       | 23,850            |       | 3,718,850       |       | 4,018,233             |        |
|                                             |       |                      |       |              |       |            |       |                  |        |
| Estimated future  net revenues                   |       | $                         | 23,317,256 |              | $          | 1,504,919       |       | $                     | 241,476,331 |   | $ | 266,298,506 |   |
| Estimated future  net revenues discounted at 10% |       | $                         | 17,423,119 |              | $          | 1,372,766       |       | $                     | 141,457,021 |   | $ | 160,252,906 |   |

 

The following table setsforth, as of July 1, 2007, information regarding our proved reserves basedon an independent report prepared by Von Gonten. See Note 16 to theconsolidated financial statements, where additional reserve information isprovided. The average NYMEX prices used to calculate estimated future netrevenues were $70.68 per barrel of oil $6.80 per MMBTU of natural gas as of June 30,2007.  The average NYMEX prices used wereadjusted for transportation, market differentials and BTU content of gasproduced.

 
| ** **                                       | ** ** | **Proved Developed** | ** ** | **Proved**        | ** ** | **Proved**      | ** ** | **Total Proved** | ** ** |
|--------------------------------------------------|------------|---------------------------|------------|-------------------|------------|-----------------|------------|-----------------------|------------|
| **July 1, 2007**                                 | ** ** | **Producing**             | ** ** | **Non-producing** | ** ** | **Undeveloped** | ** ** | **Reserves**          | ** ** |
|                                             |       |                      |       |              |       |            |       |                  |       |
| Crude Oil (Bbls)                                 |       | 324,500                   |       | 65,200            |       | 694,500         |       | 1,084,200             |       |
| Natural gas  (Mcf)                               |       | —                    |       | —            |       | 3,838,000       |       | 3,838,000             |       |
| Total (BOE)                                      |       | 324,500                   |       | 65,200            |       | 1,334,167       |       | 1,723,867             |       |
|                                             |       |                      |       |              |       |            |       |                  |       |
| Estimated future  net revenues                   |       | $                         | 9,787,195  |              | $          | 1,106,563       |       | $                     | 39,116,121 |   | $ | 50,009,879 |   |
| Estimated future  net revenues discounted at 10% |       | $                         | 5,437,733  |              | $          | 797,927         |       | $                     | 27,091,697 |   | $ | 33,327,357 |   |

 

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Estimated future netrevenues discounted at 10% (“PV-10”) is a non-GAAP financial measure.  We believe that the presentation of thenon-GAAP financial measure of PV-10 provides useful information to investorsbecause it is widely used by analysts and investors in evaluating oil andnatural gas companies.  We believe thatPV-10 is relevant and useful for evaluating the relative monetary significanceof oil and natural gas properties. Further, analysts and investors may utilizethe measure as a basis for comparison of the relative size and value of ourreserves to other companies’ reserves. We also use this pre-tax measure when assessing the potential return oninvestment related to oil and natural gas properties and in evaluatingacquisition opportunities.  Because thereare many unique factors that can impact an individual company when estimatingthe amount of future income taxes to be paid, we believe the use of a pre-tax measureis valuable for evaluating our Company. PV-10 is not a measure of financial or operating performance under GAAP,nor is it intended to represent the current market value of our estimated oiland natural gas reserves. PV-10 should not be considered in isolation or as asubstitute for the standardized measure of discounted future net cash flows asdefined under GAAP.

 

The following table provides a reconciliation of PV-10to the Standardized Measure of Discounted Future Net Cash Flows as shown in Note16 of the consolidated financial statements.

 
| ** **                                                     | ** ** | **For the Years Ended June 30** | ** **  |
|----------------------------------------------------------------|------------|----------------------------------------------------------|-------------|
| ** **                                                     | ** ** | **2008**                                                 | ** **  | **2007** | ** ** |
|                                                           |       |                                                     |        |   |   |
| Estimated future  net revenues                                 |       | $                                                        | 266,298,506 |   | $ | 50,009,879 |   |
| 10% annual  discount for estimated timing of future cash flows |       | (106,045,600                                             | )           | (16,682,522 | ) |
| Estimated future  net revenues discounted at 10%               |       | 160,252,906                                              |        | 33,327,357 |   |
| Estimated future  income tax expenses discounted at 10%        |       | (63,180,265                                              | )           | (11,337,059 | ) |
| Standardized  measure of discounted future net cash flows      |       | $                                                        | 97,072,641  |   | $ | 21,990,298 |   |

 

Duringfiscal 2008, we sold production and leaseholds with reserves in place of 51,614BOE and 433,600 barrels of crude oil, respectively.  During fiscal 2007, we sold 28,800 barrels ofcrude oil.

 

***Sales Volumes,Average Sales Prices and Average Production Costs***

 

The following table setforth certain information regarding sales volumes, average sales pricesreceived for crude oil, natural gas liquids, and natural gas, and expenses forthe periods indicated:

 
| ** **                  | ** ** | **Year Ended**         | ** ** | **Year Ended**         | ** ** |
|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                  | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** |
| **Product**                 | ** ** | **Volume**                  | ** ** | **Price**                   | ** ** | **Volume** | ** ** | **Price** | ** ** |
|                        |       |                        |       |                        |       |   |   |   |   |
| Crude oil (Bbls)            |       | 29,466                      |       | $                           | 99.03      |   | 28,800 |   | $ | 64.82 |   |
|                        |       |                        |       |                        |       |   |   |   |   |
| Natural gas  liquids (Bbls) |       | 10,639                      |       | $                           | 63.02      |   | — |   | — |   |
|                        |       |                        |       |                        |       |   |   |   |   |
| Natural gas  (Mcf)          |       | 69,051                      |       | $                           | 9.67       |   | — |   | — |   |
|                             |            |                             |            |                             |            |  |  |  |  |  |  |

 

Average production costs,including production taxes, per unit of production (using a six to oneconversion ratio of Mcf’s to barrels) were approximately $25 and $49 per BOEfor the years ended June 30, 2008 and 2007, respectively.

 

Increased volumes for theyear ended June 30, 2008, as compared to the year ended June 30,2007, were attributable to the development of our properties in the GiddingsField.

 

***Productive Wellsand Developed Acreage***

 

Our developed acreage at June 30,2008 totaled 3,469 net and gross acres, all of which is in the Giddings Field,consisting of a 100% working interest in seven producing wells.  Proved undeveloped acreage includestwenty-seven proved drilling locations. Additional drilling locations are associated with our acreage, butrequire further leasing before being considered for inclusion in our provedreserves.

 

At June 30, 2007, weowned working interests in 260 net and gross wells consisting of 158 crude oilwells, 23 salt water disposal wells and 93 shut-in wells with uncertain futureutility, all located in the Tullos Field Area. Our properties in the Tullos Field Area were sold on March 3, 2008.

 

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***UndevelopedAcreage***

 

As of June 30, 2008,we held approximately 57,756 gross and 34,408 net undeveloped acres in the GulfCoast and Mid-Continent regions of the United States, as follows:

 
| **Field**      | ** ** | **Gross Acreage** | ** ** | **Net Acreage** | ** ** |
|----------------|------------|------------------------|------------|----------------------|------------|
| Giddings Field |       | 16,121                 |       | 14,434               |       |
| Woodford Shale |       | 27,999                 |       | 16,565               |       |
| Delhi Field*   |       | 13,636                 |       | 3,409                |       |
| Total          |       | 57,756                 |       | 34,408               |       |

 

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* Includes from thesurface of the Earth to the top of the Massive Anhydride, less and except theDelhi Holt Bryant CO2 and Mengel Units. With respect to the DelhiHolt Bryant Unit, currently scheduled for CO2-EORoperations within this same acreage, we currently own royalty and overridingroyalty interests aggregating approximately 7.4%.  Separately, we own a 25% working interest(20% net revenue interest) that will revert to us, as, if and when payoutoccurs, as defined. We are not the operator of the Delhi CO2-EORproject.

 

Formorecompleteinformationregardingcurrentyearactivities,includingcrudeoilandnaturalgasproduction,referto“Management’sDiscussionandAnalysisofFinancialConditionandResultsofOperations.”

 

***CorporateOffice***

 

Effective on March 1,2007, we entered into a sublease agreement with Aspen Technology, Inc to rentapproximately 8,400 square feet of Class “A” office space in the WestchaseDistrict area in West Houston. The sublease expires by its term on July 1,2016.  Prior to March 1, 2007, weoccupied a leased headquarters containing 2,259 square feet in an officebuilding located on the west side of Houston, Texas.  In April 2007, this lease expired.

 

**ITEM3. LEGAL PROCEEDINGS.**

 

On August 3, 2007, we were advised of an oilspill in the Tullos Field Area near one of our leases. At the request of fieldagents of the Louisiana Department of Environmental Quality and theEnvironmental Protection Agency (“EPA”), we agreed to commence a clean-upoperation that was completed by the end of August 2007. A detailedanalysis of the oil in the spill compared to the Company’s produced oil wasconducted by an EPA approved laboratory. We believe that the oil in the spill did not originate from ouroperations, supported by the formal findings of the laboratory.  We received insurance reimbursements of$484,197 in October 2007 and $217,668 in March 2008.  These reimbursements covered all of ouractual cleanup costs except a $5,000 insurance deductible and excluding ourlegal fees, in-house administrative costs, and any possible EPA expensereimbursements and fines that might be billed. On May 5, 2008, we received a letter from the EPA proposing a$5,500 fine related to the oil spill.  Wehave also received a bill from the United States Coast Guard of approximately$70,000 for expense reimbursement.  Webelieve these claims are not supported by independent investigation.  As of the date of this filing, we haverequested further verification from the United States Coast Guard to supporttheir claims, and have entered into a settlement with the EPA where we haveagreed to pay the $5,500 fine with no admission of liability.

 

In July 2008, a multi-plaintiff lawsuit was filedin the twenty-eighth Judicial District Court, Lasalle Parish, Louisiana,against 15 defendants, including Four Star Development Corporation, a formerindirect wholly owned subsidiary of the Company, which was sold on March 3,2008, as part of our sale of the Tullos Field Area.  Plaintiffs claim that the defendants’ oil andnatural gas exploration, development and production activities on theirproperties have caused soil and ground water contamination as a result of therelease of hydrocarbons and drilling fluids. Plaintiffs seek damages fortesting, clean-up and remediation of the properties as well as diminution intheir value and mental anguish and emotional distress to the individualplaintiffs, unjust enrichment and punitive damages for alleged concealment ofongoing activities.  At this time, we arenot a party to the litigation and are unable at this time to determine theexposure, if any, to the Company.

 

In November 2005, amulti-plaintiff lawsuit was filed in the Fifth Judicial District Court,Richland Parish, Louisiana, against 18 defendants including NGS Sub Corp. andArkla Petroleum LLC, the Company’s direct and indirect wholly ownedsubsidiaries (the “Subsidiaries”), as working interest owners/operators ofvarious oil and natural gas leases in the Delhi Field.  Plaintiffs claim that the defendants’ oil andnatural gas exploration, development and production activities on theirproperties have caused soil and ground water contamination as a result of therelease of hydrocarbons and drilling fluids. Plaintiffs seek

 

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damages for testing,clean-up and remediation of the properties as well as diminution in their valueand mental anguish to the individual plaintiffs, unjust enrichment and punitivedamages for alleged concealment of ongoing activities.  Defendants have answered plaintiffs’ suitdenying plaintiffs’ claims.****Trial is set before a jury inRichland Parish for July13, 2009, and we intend to continue contestingplaintiffs’ claims vigorously.  Discoveryis in process, with Plaintiffs’ expert’s report due to be filed with the Courtby September 26, 2008. Defendants have performed field testing whichindicates that any contamination is far less pervasive than we believeplaintiffs are claiming, although Plaintiff’s complaints are vague and a fullanalysis of plaintiffs’ claims cannot be completed until their expert report isavailable for analysis. While the Delhi Field has been in production forapproximately sixty years, NGS Sub Corp. and ARKLA were owner and operatorsince 2003 and 2002, respectively, until June of 2006. We believe that nocontamination of significance has occurred during our ownership of the DelhiField, and that potential liability for exposure of NGS Sub Corp. resultslargely through any contractual indemnity of prior working interest ownerswhich NGS Sub Corp. may have assumed for historical operations in the field inits acquisition of the subject oil and gas working interests.  At this time, the likelihood or amount of anyjudgment which might be rendered cannot be determined with any certainty.

 

**ITEM4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.**

 

No matters were submitted to a vote of our securityholders, through solicitation of proxies or otherwise, during the fourthquarter ended June 30, 2008.

 

**PART II**

 

**ITEM5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS ANDISSUER PURCHASES OF EQUITY SECURITIES.**

 

**CommonStock**

 

Our common stock iscurrently traded on the American Stock Exchange under the ticker symbol “EPM”.

 

We initiated trading ofour common stock on the OTC Bulletin Board in May 2004, under the symbol “NGSY”.  On July 17, 2006 we qualified fortrading on the American Stock Exchange. The following table shows, for eachquarter of fiscal year 2008 and 2007, the high and low closing sales prices asreported by the American Stock Exchange.

 

**AmericanStock Exchange**

 
| **2008:**                                    | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------------------------------------|------------|----------|------------|---------|------------|
| Fourth quarter  ended June 30, 2008     |       | $        | 7.17       |    | $          | 4.16 |   |
| Third quarter  ended March 31, 2008     |       | $        | 5.85       |    | $          | 3.76 |   |
| Second quarter  ended December 31, 2007 |       | $        | 5.60       |    | $          | 3.02 |   |
| First quarter  ended September 30, 2007 |       | $        | 3.24       |    | $          | 2.15 |   |

 
| **2007:**                                    | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------------------------------------|------------|----------|------------|---------|------------|
| Fourth quarter  ended June 30, 2007     |       | $        | 3.66       |    | $          | 2.42 |   |
| Third quarter  ended March 31, 2007     |       | $        | 3.18       |    | $          | 2.49 |   |
| Second quarter  ended December 31, 2006 |       | $        | 3.04       |    | $          | 2.38 |   |
| First quarter  ended September 30, 2006 |       | $        | 3.30       |    | $          | 2.64 |   |

 

**Holders**

 

As of June 30, 2008,there were 26,870,439 shares of common stock issued and outstanding, held by155 holders of record.

 

**Dividends**

 

We have never declared orpaid any cash dividends with respect to our common stock. We anticipate that wewill retain future earnings for use in the operation and expansion of ourbusiness and do not anticipate paying cash dividends on the common stock in theforeseeable future. Any future determination with regard to the payment ofdividends will be at the discretion of the board of directors and will bedependent upon our future earnings, financial condition, applicable dividendrestrictions and capital requirements and other factors deemed relevant by theboard of directors.

 

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**SecuritiesAuthorized For Issuance Under Equity Compensation Plans**

 
| ** **                                                  | ** ** | **Number of**      | ** ** | ** **                 | ** ** | **Number of securities** | ** ** |
|-------------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|------------------------------------|------------|
| ** **                                                  | ** ** | **securities to**  | ** ** | **Weighted-average**       | ** ** | **remaining**                      | ** ** |
| ** **                                                  | ** ** | **be issued**      | ** ** | **exercise**               | ** ** | **available for future** | ** ** |
| ** **                                                  | ** ** | **upon exercise**  | ** ** | **price of**          | ** ** | **issuance under**            | ** ** |
| ** **                                                  | ** ** | **of outstanding** | ** ** | **outstanding**            | ** ** | **equity compensation**       | ** ** |
| ** **                                                  | ** ** | **options,**            | ** ** | **options, warrants** | ** ** | **plans (excluding**          | ** ** |
| ** **                                                  | ** ** | **warrants and**   | ** ** | **and**                    | ** ** | **securities reflected**      | ** ** |
| ** **                                                  | ** ** | **rights**              | ** ** | **rights**                 | ** ** | **in column (a))**       | ** ** |
| **Plan category**                                      | ** ** | **(a)**                 | ** ** | **(b)**                    | ** ** | **(c)**                            | ** ** |
|                                                        |       |                    |       |                       |       |                               |       |
| Equity  compensation plans approved by security holders     |       | 4,446,000               | (1)        | $                          | 1.87       |                               | 1,325,859  |   |
|                                                        |       |                    |       |                       |       |                               |       |
| Equity  compensation plans not approved by security holders |       | 1,438,558               | (2)        | $                          | 1.51       |                               | —     |   |
| Total                                                       |       | 5,884,558               |       | $                          | 1.79       |                               | 1,325,859  |   |

 

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(1) On May 26,2004, we, as Reality Interactive, Inc., executed an Agreement and Plan ofMerger with Natural Gas Systems, Inc., a Delaware corporation (the “Merger”).In connection with the Merger, we assumed the obligations of 600,000 stockoptions under our acquired subsidiary’s 2003 Stock Option Plan. As of June 30,2008, 500,000 shares remain issuable upon exercise of stock options under the2003 Stock Option Plan and no further options shall be issued there under. Asof June 30, 2008, there were 3,946,000 shares of common stock issuableupon exercise of outstanding options and 228,141shares of restricted commonstock issued directly under the 2004 Stock Plan, leaving 1,325,859 shares ofcommon stock available for issuance.

 

(2) In addition toassuming certain obligations listed in footnote 1 above, in connection with theMerger, we also assumed outstanding warrants to purchase shares of common stockissued in connection with arranging the merger and in connection with capitalraising services.  Total warrantsoutstanding as of June 30, 2008 related to these services was 401,058 witha weighted average exercise price of $1.40. This also includes a warrant to purchase 287,500 shares of common stockin connection with Mr. Herlin’s employment agreement with the Company, awarrant to purchase 200,000 shares in connection with Mr. Mazzanti’semployment agreement with the Company, a warrant to purchase 400,000 shares ofcommon stock in connection with Mr. Herlin’s annual performance incentives,including warrants in lieu of a cash bonus, and a warrant to purchase 150,000shares of common stock in connection with Sterling McDonald’s annualperformance incentives, including warrants in lieu of a cash bonus.

 

**RecentSales of Unregistered Securities**

 

In February 2008, wemade a direct stock grant for 50,000 shares to Liviakis FinancialCommunications, Inc. for investor relations services.

 

In January 2008, weissued 3,099 shares of our common stock upon exercise of warrants totaling5,000.

 

In December 2007, weissued 5,207 shares of our common stock upon exercise of warrants totaling9,463.

 

The shares issued duringthe period were exempted from registration in reliance upon Section 4(2) ofthe Securities Act of 1933, as amended, and Regulation D promulgatedthereunder.

 

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**ITEM 6.SELECTED FINANCIAL DATA**

 

The selected consolidated financial data, set forthbelow should be read in conjunction with Item 7 “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” and with theconsolidated financial statements and notes to those consolidated financialstatements included elsewhere in this report.

 
| ** **                                                                                     | ** ** | **Year  Ended June 30** | ** **  | **For the  Period from September   23, 2003** | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------------------------|-------------|-----------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2008**                     | ** **  | **2007**                                      | ** ** | **2006  (as restated)** | ** ** | **2005** | ** ** | **(Inception)  to  June 30, 2004** | ** ** |
| **Income  Statement Data**                                                                     |       |                         |        |                                          |       |   |   |   |   |   |   |
| Revenues                                                                                       |       | $                            | 4,256,128   |                                          | $          | 1,866,878 |   | $ | 2,861,414 |   | $ | 1,635,187 |   | $ | 142,387 |   |
| Lease operating  expense                                                                       |       | $                            | 1,255,787   |                                          | $          | 1,352,907 |   | $ | 1,698,044 |   | $ | 853,052 |   | $ | 201,116 |   |
| Production taxes                                                                               |       | $                            | 90,252      |                                          | $          | 62,426 |   | $ | 86,562 |   | $ | 68,386 |   | $ | 17,583 |   |
| Depreciation,  depletion, and amortization                                                     |       | $                            | 903,214     |                                          | $          | 291,150 |   | $ | 407,467 |   | $ | 260,124 |   | $ | 55,509 |   |
| Accretion  expense                                                                             |       | $                            | 20,196      |                                          | $          | 17,319 |   | $ | 27,716 |   | $ | 21,824 |   | $ | 9,607 |   |
| General and  administrative expense (“G&A”) (excluding stock-based compensation) |       | $                            | 3,705,751   |                                          | $          | 2,878,107 |   | $ | 2,279,518 |   | $ | 1,513,663 |   | $ | 992,840 |   |
| G&A:  Stock-based compensation                                                             |       | $                            | 1,791,486   |                                          | $          | 1,613,493 |   | $ | 546,567 |   | $ | 707,117 |   | $ | 159,014 |   |
| Gain from sale  of oil and natural gas properties                                              |       | $                            | —      |                                          | $          | — |   | $ | 45,325,468 |   | $ | — |   | $ | — |   |
| Income (loss)  from operations                                                                 |       | $                            | (3,510,558  | )                                             | $          | (4,348,524 | ) | $ | 43,141,008 |   | $ | (1,788,979 | ) | $ | (1,293,282 | ) |
| Other income  (expense), net                                                                   |       | $                            | 854,130     |                                          | $          | 1,899,460 |   | $ | (2,434,867 | ) | $ | (375,592 | ) | $ | (71,305 | ) |
| Income tax  provision (benefit)                                                                |       | $                            | (1,085,454  | )                                             | $          | (638,853 | ) | $ | 15,007,775 |   | $ | — |   | $ | — |   |
| Net income  (loss)                                                                             |       | $                            | (1,570,974  | )                                             | $          | (1,810,211 | ) | $ | 25,698,366 |   | $ | (2,164,571 | ) | $ | (1,364,587 | ) |
| Earnings (loss)  per common share - Basic                                                      |       | $                            | (0.06       | )                                             | $          | (0.07 | ) | $ | 1.03 |   | $ | (0.09 | ) | $ | (0.06 | ) |
| Earnings (loss)  per common share - Diluted                                                    |       | $                            | (0.06       | )                                             | $          | (0.07 | ) | $ | 1.01 |   | $ | (0.09 | ) | $ | (0.06 | ) |
| **Cash  Flows Data**                                                                           |       |                         |        |                                          |       |   |   |   |   |   |   |
| Operating  Activities:                                                                         |       |                         |        |                                          |       |   |   |   |   |   |   |
| Before changes  in operating assets and liabilities                                            |       | $                            | 3,707,850   |                                          | $          | (11,865,115 | ) | $ | (3,893,417 | ) | $ | (1,096,624 | ) | $ | (1,109,374 | ) |
| Changes in  operating assets and liabilities                                                   |       | (4,570,886                   | )           | (2,626,933                                    | )          | 3,156,213 |   | 19,089 |   | 8,021 |   |
| *Cash  used in operating activities*                                                           |       | (863,036                     | )           | (14,492,048                                   | )          | (737,204 | ) | (1,077,535 | ) | (1,101,353 | ) |
| Investing  Activities:                                                                         |       |                         |        |                                          |       |   |   |   |   |   |   |
| Development of  oil and natural gas properties                                                 |       | (11,187,291                  | )           | (417,964                                      | )          | (2,611,369 | ) | (503,394 | ) | — |   |
| Acquisition of  oil and natural gas properties                                                 |       | (8,789,501                   | )           | (1,918,757                                    | )          | (1,448,239 | ) | (1,554,149 | ) | (1,499,754 | ) |
| Proceeds from  sale of oil and natural gas properties                                          |       | 4,452,450                    |        | 155,378                                       |       | 49,993,134 |   | — |   | — |   |
| Cash in  qualified intermediary account for “like-kind” exchanges                    |       | —                       |        | 34,662,368                                    |       | (34,662,368 | ) | — |   | — |   |
| Other                                                                                          |       | (87,360                      | )           | (120,050                                      | )          | 551,467 |   | (721,080 | ) | (309,925 | ) |
| *Cash  provided by (used in) investing activities*                                             |       | (15,611,702                  | )           | 32,360,975                                    |       | 11,822,625 |   | (2,778,623 | ) | (1,809,679 | ) |
| Financing  Activities:                                                                         |       |                         |        |                                          |       |   |   |   |   |   |   |
| Payments on  notes payable                                                                     |       | —                       |        | —                                        |       | (5,634,654 | ) | (1,725,167 | ) | (710,327 | ) |
| Proceeds from  notes payable                                                                   |       | —                       |        | —                                        |       | 1,003,563 |   | 3,526,754 |   | 49,490 |   |
| Equity  transactions                                                                           |       | 76                           |        | (15,532                                       | )          | 890,529 |   | 4,235,428 |   | 3,939,700 |   |
| *Cash  provided by (used in) financing activities*                                             |       | 76                           |        | (15,532                                       | )          | (3,740,562 | ) | 6,037,015 |   | 3,278,863 |   |
| Increase  (decrease) in cash and cash equivalents                                              |       | $                            | (16,474,662 | )                                             | $          | 17,853,395 |   | $ | 7,344,859 |   | $ | 2,180,857 |   | $ | 367,831 |   |

 
| ** **                                                                           | ** ** | ** **                  | ** ** | ** **                  | ** ** | **June 30, 2006** | ** ** | ** **                  | ** ** | ** **                  | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                           | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** | **(as restated)**      | ** ** | **June 30, 2005** | ** ** | **June 30, 2004** | ** ** |
| **Balance  Sheet Data**                                                              |       |                        |       |                        |       |                        |       |                        |       |                        |       |
| Total current  assets                                                                |       | $                           | 17,801,070 |                        | $          | 28,921,518                  |       | $                           | 10,321,359 |                        | $          | 3,212,558 |   | $ | 582,144 |   |
| Total assets                                                                         |       | $                           | 40,365,848 |                        | $          | 34,905,992                  |       | $                           | 48,957,958 |                        | $          | 9,465,224 |   | $ | 4,011,065 |   |
| Total current  liabilities                                                           |       | $                           | 4,171,048  |                        | $          | 1,596,558                   |       | $                           | 3,476,727  |                        | $          | 613,326 |   | $ | 965,496 |   |
| Total  liabilities                                                                   |       | $                           | 7,362,114  |                        | $          | 2,122,846                   |       | $                           | 15,962,562 |                        | $          | 3,953,124 |   | $ | 1,276,938 |   |
| Temporary equity  (351,335 shares of common stock outstanding at June 30, 2006) |       | $                           | —     |                        | $          | —                      |       | $                           | 790,500    |                        | $          | — |   | $ | — |   |
| Stockholders’  equity                                                           |       | $                           | 33,003,734 |                        | $          | 32,783,146                  |       | $                           | 32,204,896 |                        | $          | 5,512,100 |   | $ | 2,734,127 |   |
| Common stock  outstanding                                                            |       | 26,870,439                  |       | 26,776,234                  |       | 26,300,670                  |       | 24,774,606                  |       | 22,945,406                  |       |

 

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| ** **                                                        | ** ** | **Quarter Ended**  | ** ** |
|-------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                        | ** ** | **June 30,  2008** | ** ** | **March 31,  2008** | ** ** | **December 31,  2007** | ** ** | **September 30,  2007** | ** ** | **June 30,  2007** | ** ** |
| Revenues                                                          |       |                    |       |   |   |   |   |   |   |   |   |
| Crude oil                                                         |       | $                       | 1,253,478  |   | $ | 554,498 |   | $ | 607,878 |   | $ | 502,273 |   | $ | 508,459 |   |
| Natural gas  liquids (“NGLs”)                           |       | 558,736                 |       | 90,405 |   | 21,293 |   | — |   | — |   |
| Natural gas                                                       |       | 544,290                 |       | 99,799 |   | 23,478 |   | — |   | — |   |
| Total operating  revenues                                         |       | 2,356,504               |       | 744,702 |   | 652,649 |   | 502,273 |   | 508,459 |   |
| Operating  Expense                                                |       |                    |       |   |   |   |   |   |   |   |   |
| Lease operating  expense (“LOE”)                        |       | 284,099                 |       | 300,186 |   | 361,192 |   | 310,310 |   | 313,680 |   |
| Production taxes                                                  |       | 44,021                  |       | 12,867 |   | 15,808 |   | 17,556 |   | 18,166 |   |
| Depreciation,  depletion, and amortization (“DD&A”) |       | 530,569                 |       | 139,086 |   | 123,115 |   | 110,444 |   | 126,357 |   |
| Accretion  expense                                                |       | 3,540                   |       | 7,110 |   | 4,851 |   | 4,695 |   | 4,545 |   |
| G&A (excluding  stock-based compensation)                     |       | 954,771                 |       | 772,555 |   | 1,026,115 |   | 952,310 |   | 1,181,832 |   |
| G&A: Stock-based  compensation                                |       | 480,043                 |       | 493,872 |   | 441,564 |   | 376,007 |   | 376,007 |   |
| Total operating  expense                                          |       | 2,297,043               |       | 1,725,676 |   | 1,972,645 |   | 1,771,322 |   | 2,020,587 |   |
| Operating income  (loss)                                          |       | 59,461                  |       | (980,974 | ) | (1,319,996 | ) | (1,269,049 | ) | (1,512,128 | ) |
| Interest income,  net                                             |       | 81,295                  |       | 165,014 |   | 266,740 |   | 341,081 |   | 399,343 |   |
| Net income (loss) before income taxes                             |       | $                       | 140,756    |   | $ | (815,960 | ) | $ | (1,053,256 | ) | $ | (927,968 | ) | $ | (1,112,785 | ) |
|                                                              |       |                    |       |   |   |   |   |   |   |   |   |
| Sales volumes  per day                                            |       |                    |       |   |   |   |   |   |   |   |   |
| Oil (Bbls)                                                        |       | 105.4                   |       | 65.0 |   | 75.3 |   | 76.5 |   | 90.2 |   |
| NGL (Bbls)                                                        |       | 95.0                    |       | 17.6 |   | 4.2 |   | — |   | — |   |
| Natural gas  (Mcf)                                                |       | 584.0                   |       | 135.0 |   | 39.3 |   | — |   | — |   |
| Total (BOE)                                                       |       | 297.7                   |       | 105.2 |   | 86.1 |   | 76.5 |   | 90.2 |   |
|                                                              |       |                    |       |   |   |   |   |   |   |   |   |
| Average sales  price                                              |       |                    |       |   |   |   |   |   |   |   |   |
| Oil per Bbl                                                       |       | $                       | 130.71     |   | $ | 93.74 |   | $ | 87.75 |   | $ | 71.41 |   | $ | 61.93 |   |
| NGL per Bbl                                                       |       | 64.63                   |       | 56.29 |   | 54.88 |   | — |   | — |   |
| Natural gas per  Mcf                                              |       | 10.24                   |       | 8.12 |   | 6.49 |   | — |   | — |   |
| Total per BOE                                                     |       | 86.98                   |       | 77.83 |   | 82.43 |   | 71.41 |   | 61.93 |   |
| Per BOE                                                           |       |                    |       |   |   |   |   |   |   |   |   |
| LOE and  production taxes                                         |       | 12.11                   |       | 32.72 |   | 47.61 |   | 46.61 |   | 40.42 |   |
| DD&A                                                          |       | 19.58                   |       | 14.54 |   | 15.55 |   | 15.70 |   | 15.39 |   |
| Accretion  expense                                                |       | 0.13                    |       | 0.74 |   | 0.61 |   | 0.67 |   | 0.55 |   |
| General and  administrative                                       |       | 52.96                   |       | 132.35 |   | 185.36 |   | 188.84 |   | 189.75 |   |
| Total operating  expense                                          |       | 84.78                   |       | 180.35 |   | 249.13 |   | 251.82 |   | 246.11 |   |
| Operating (loss)  income                                          |       | $                       | 2.20       |   | $ | (102.52 | ) | $ | (166.70 | ) | $ | (180.41 | ) | $ | (184.18 | ) |
| Net income  (loss) before income taxes                            |       | $                       | 5.20       |   | $ | (85.27 | ) | $ | (133.02 | ) | $ | (131.93 | ) | $ | (135.54 | ) |

 

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**ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

 

**Executive Overview**

 

*General*

 

We are a petroleum company engaged primarily in theacquisition, exploitation and development of properties for the production ofcrude oil and natural gas. We acquire known, underdeveloped oil and natural gasresources and exploit them through the application of capital and technology toincrease production, ultimate recoveries, or both.

 

Our strategy is intended to generate scalabledevelopment opportunities at normally pressured depths, exhibiting relativelylow completion risk, generally longer and more predictable production lives,less expenditures on infrastructure and lower operational risks.

 

Within this overall strategy, we pursue three specificinitiatives:

 
|        |   | I      | Enhanced oil recovery (“EOR”), using miscible and  immiscible gas flooding;                                                                 |
|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                  |
|   |   | II     | Conventional redevelopment of bypassed primary  resource within mature oil and natural gas fields utilizing modern technology  and our expertise; and |
|   |   |   |                                                                                                                                                  |
|   |   | III    | Unconventional gas resource development, using  modern stimulation and completion technologies.                                                       |

 

Our most significant asset is within our EORInitiative in the 13,636 acre Delhi Field, located in northeast Louisiana.  Our non-operated interests consist of 7.4% inoverriding and mineral royalty interests and a 25% after pay-out reversionaryworking interest in the Delhi Field Holt Bryant Unit, along with a 25% workinginterest in certain other depths in the Delhi Field resulting from the DelhiFarmout.  The Holt Bryant Unit iscurrently being redeveloped by the operator, Denbury Resources Inc. (“Denbury”),using CO2 enhanced oil recovery technology and adedicated portion of Denbury’s proved CO2 reserves in theJackson Dome, approximately 100 miles east of Delhi. Injection of CO2 is expected to begin during the first half ofcalendar 2009, followed by projected increases in oil production on or aboutlate calendar 2009.

 

Since our closing of the Delhi Farmout, we havefocused on developing projects in our other initiatives, particularly throughconventional redevelopment of bypassed resources in the Giddings Field usinghorizontal drilling methods, and the leasing of unconventional gas shaleprojects in the Woodford Shale Trend in Oklahoma.  Conceptually, our plan going forward can beillustrated as follows:

 

 

As indicated by the above chart, (volumes arerepresentative and not to scale), we are funding our current developmentprojects in the Giddings Field and leasing in our gas shale projects with ourworking capital resources.  We expectthat net cash flows from our properties in the Giddings Field, our current cashresources and cash flows from the Delhi Project will be used to fund our gasshale projects and other new projects.

 

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*Highlights for the year ended June 30, 2008*

 

·                  **We reported earnings for thequarter ended June 30, 2008**

 

***We reported positive earnings from operations for the quarter ended June 30,2008***.  During the quarter ended June 30, 2008,operating income was $59,461 and net income before income taxes was $140,756.  This compares to an operating loss of$1,512,128 and net loss before income taxes of $1,112,785 for the comparablefiscal 2007 period.

 

·                  **We substantially increased ourproved reserves and high-graded our production and reserve base, redeployingassets from the Tullos Field Area to the Giddings Field, within our BypassedResource Initiative**

 

***Proved reserves increased133% from 1.72 MMBOE to 4.02 MMBOE, despite production, adjustments and sales ofminerals in place totaling approximately 0.68 MMBOE*****.** Through leasing and development activities in the Giddings Field duringfiscal 2008, we added 2.97 MMBOE to the 1.72 MMBOE of proved reserves we ownedat July 1, 2007.  Additions wereoffset by 0.68 MMBOE of reductions, consisting of 52 MBOE of production, 193MBOE of downward revisions and 433 MBOE of divested proved reserves from ourproperties in the Tullos Field Area. Proved locations in the Giddings Field increased from 12 locations atthe beginning of the year, to 27 locations and seven production wells (34 wellsand locations) at July 1, 2008. Proved developed reserves began the year at 389 MBOE, all located at ournow divested properties in the Tullos Field Area, and ended the year at 299MBOE, all located in the Giddings Field.

 

***Sales volumes increased230% & 79% during the three and twelve months ended June 30, 2008vs. 2007, respectively. ***Gains were solely attributable to our new productionin the Giddings Field, with primary production beginning almost simultaneouslywith the March 3, 2008 sale of our historical production base in theTullos Field Area.  Our first well in theGiddings Field began production in late February, two more wells beganproduction in mid March, and four wells began production in May andJune.  Despite the delay in obtainingfull productive rates in several of our first wells in the Giddings Field dueto drilling fluid production, June averaged 468 net BOEPD of production(approximately 580 gross BOEPD).

 

***We lowered per barrellifting costs by 74%, or 34.50 per BOE, during our most recent fiscal quarter,while depletion increased less than $4 per BOE.*******Lifting costs were $12.11 per BOE during thequarter ended June 30, 2008, our first quarter that included onlyproduction from our properties in the Giddings Field.  During the quarter ended September 30,2007, the last quarter that included only production from our properties in theTullos Field Area, lifting costs averaged $46.61 per BO.  Due to additions of reserves at the Giddingsfield during the period, which are higher than our historical acquisition costsof our properties in the Tullos Field Area, our depletion rate rose from $15.70to $19.58 per BOE.

 

***The forgoing was a resultof redeploying our working capital and the proceeds from the sale of ourproperties in the Tullos Field Area into acquisitions and drilling at ourproperties in the Giddings Field.***  On March 3, 2008, wecompleted the sale of our properties in the Tullos Field Area for gross cashproceeds of approximately $4.6 million. While only producing about 100 gross and 79 net barrels of oilproduction per day from over 150 producing wells, these properties required adisproportionate amount of staff effort and vendor services, thereby adverselyaffecting our ability to develop other projects utilizing our expertise andworking capital.  Furthermore, webelieved the potential upside in the Tullos Field Area was substantially lessthan our other projects, particularly as compared to our properties in theGiddings Field.  We also completed thetesting of our completion technology utilizing the one well we drilled in theTullos Field Area and determined that the potential of that technology would bebest realized in other, less depleted fields.

 

In late 2006 we bean leasingin the Giddings Field, and in late calendar 2007 we initiated a redevelopmentdrilling program targeting the Austin Chalk formation.  Initially composed of ten re-entries, wesubsequently revised the program to six wells with an aggregate horizontalfootage exceeding the initial ten well program. This drilling was completed by fiscal year end, albeit at a highercapital cost than originally expected due to higher well service and materials’costs, unexpected downhole problems in the wells being re-entered, overalllearning curve costs associated with starting a new program and higher loss ofdrilling fluid than expected.  As of June 30,2008, seven wells have been placed in production, including five wells thatwere re-entered for additional drilling and recompletion, one new well that wasdrilled and completed, and one well that was restored to production.

 

To date, results of thedrilling program are consistent with our expectations and we continue to moveforward in our program of converting existing proved undeveloped locations toproducing well status.

 

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**·      Our DelhiEOR-CO****2 project continued to progress**

 

***Denbury charged $73.0 million of capital to Delhi during calendar 2007,and announced an $80 million budget for 2008. ***Weunderstand that the Mississippi River crossing permits have been obtained bythe Corps of Engineers, and that the final leg of the CO2 supplypipeline and field preparations were actively being constructed.  Denbury, the operator of the Delhi HoltBryant Unit, reported to us that, as of December 31, 2007, approximately $73.0million of capital has been charged to the Delhi Project, excluding the $50million they paid to us in 2006. Denbury, disclosed a capital expenditure budget of $80 million forcalendar year 2008 for the completion of the CO2 supply pipeline to Delhi and related fieldactivities.  Although we don’t controlthe operations, we expect that oil production response will occur within sixmonths of first injection and that the field oil production rate will steadilyincrease from that point.  We have noexpected capital expenditure requirements related to the ongoing CO2-EOR development at the Delhi Field, although we retain our separate7.4% overriding and mineral royalty interests and 25% reversionary interestafter payout.

 

·      **We continued to advanceour Unconventional Gas shale projects**

 

***We substantially increasedour net acreage in our two Woodford Shale projects in Oklahoma.***  At June 30,2008, we owned approximately 27,999 gross and 16,565 net acres in theseprojects, as compared to 2,290 gross and 1,145 net acres at June 30,2007.  Offset operators have announcedthe drilling and completion of numerous wells in the immediate areas.

 

·      **We remained financiallystrong**

 

***We protected our short-term investments during difficult credit marketconditions.***  We maintained our cash liquidity bycontinuing to avoid structurally enhanced investment securities, auction ratesecurities and other questionable credit instruments.  Instead, we relied upon lower yielding U.S.Government Agency money market funds during fiscal 2008.  In July 2008, we moved our investmentsinto U.S. Treasury money market funds to avoid Agency exposure.

 

***Weremained debt free.***

 

·      **Looking forward in Fiscal2009**

 

***We expect to increasedevelopment drilling expenditures by 21%, and decrease land expenditures by65%.***  We currently expect capital expenditures of$19 million during fiscal 2009, of which approximately $16 million will bededicated to development drilling and the balance to leaseholdacquisitions.  This compares toapproximately $13.2 million of development drilling expenditures andapproximately $8.6 million of land acquisition expenditures during fiscal2008.  Drilling expenditures ofapproximately $15.0 million will be focused on our properties in the GiddingsField, with additional expenditures for initial test drilling in our WoodfordShale projects.  Although at a lesserpace, we will continue to acquire additional proved locations in the GiddingsField.

 

***We expect to begin a newproject within our Bypassed Resource Initiative.*** Our capital budget includes the acquisitionof leases within a new project and application of the technology we tested atthe Tullos Field Area.  Expenditures forthis project are scheduled for late fiscal 2009 on a mature field in Texas.

 

***We expect first injectionof CO2 at Delhi in the first half of calendar 2009.***** **Based on theoperator’s current plans, Denbury should be injecting CO2 at Delhi in the firsthalf of calendar 2009, with expected oil production accruing to us from our7.4% overriding and royalty interests on or about late calendar 2009.

 

***We expect to preserve ourfinancial strength.***  We recognize that the world and U.S.economies are experiencing unprecedented credit market stress and volatility,which makes us even more determined to live within our means.  Consequently, we may reduce capitalexpenditures from our budget based on a number of factors, including changes inthe commodity prices that we expect to receive, drilling and productionperformance results from new and existing wells, unexpected changes in ourworking capital, insufficient joint venture capital, or such other factors aswe deem appropriate.  We believe anyretrenchment would be brief, only serving as a bridge to reach our expectedannuity from Delhi production, which appears to be around the corner for thebenefit of our shareholders.

 

**Liquidity and Capital Resources**

 

At June 30, 2008,our working capital, predominately cash and cash equivalents, was approximately$13.6 million and we continued to be debt free. This compares to working capital of approximately $27.3 million at June 30,2007.  Of the $13.7 million decrease inworking capital since June 2007, approximately $20.0 million was used forcapital expenditures on oil and natural gas leasehold and development costs,approximately $0.1 million was used for capital expenditures on other propertyand equipment, and approximately $0.9 million was used in operations, offset bynet proceeds from the sale of our properties in the Tullos Field Area ofapproximately $4.5 million and an increase of approximately $2.8 million in netoperating assets.

 

For the year ended June 30,2008, approximately $0.9 million was used in operations.  This compares to approximately $14.5 millionused in operations for the year ended June 30, 2007, which includedapproximately $14.6 million paid for income taxes.

 

Cash flows used ininvesting activities totaled approximately $15.6 million during the year ended June 30,2008.  This compared to approximately$32.4 million provided by investing activities for the year ended June 30,2007.  During the current fiscal periodapproximately $20.0 million of cash was used for investments to acquire and developoil and natural gas property interests, which does not include approximately$1.6 million net change in accounts payable from July 1, 2007 relating toexpenditures for oil and natural gas properties, and approximately $0.2 millionof asset retirement costs.  We alsoacquired approximately $0.1 million in other property and equipment.  The sale of our properties in the TullosField Area partially offset our acquisition and development activities byproviding net proceeds of approximately $4.5 million.

 

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During the year ended June 30,2007, we received $34.7 million from the qualified intermediary accountrepresenting unspent 1031 “like-kind” exchange funds from the Delhi Farmout,partially offset by approximately $2.3 million of cash used for investments toacquire and develop oil and natural gas property interests and other propertyand equipment.

 

There were no significantcash flows from financing activities during the years ended June 30, 2008and 2007.

 

We incurred approximately$21.8 million in capital expenditures for oil and natural gas leasehold anddevelopment costs during the year ended June 30, 2008 compared toapproximately $2.3 million during the year ended June 30, 2007, includingapproximately $8.6 million for leasehold acquisitions and approximately $13.2million for development activities.  Weexpect our capital expenditures for oil and natural gas leasehold anddevelopment costs to continue during the 2009 fiscal year related to diminishedincremental leasing in the Giddings Field and in our gas shale projects inOklahoma.  Based on our current plans, weexpect capital expenditures to approximate $19 million during fiscal 2009, withapproximately $16 million dedicated to development drilling and the balance toleasehold acquisitions.  We expect tofund our development drilling and acquisition activities for fiscal year 2009primarily from current working capital and cash provided by our operations inthe Giddings Field, supplemented by up to $5.0 million from joint ventures.

 

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**Results of Operations**

 

*Year ended June 30, 2008 compared with theyear ended June 30, 2007*

 

The following table sets forth certain financialinformation with respect to our oil and natural gas operations:

 
| ** **                                               | ** ** | **Year Ended** | ** ** | ** ** | ** ** | ** **   | ** ** |
|----------------------------------------------------------|------------|---------------------|------------|------------|------------|--------------|------------|
| ** **                                               | ** ** | **June 30**    | ** ** | ** ** | ** ** | **%**        | ** ** |
| ** **                                               | ** ** | **2008**            | ** ** | **2007**   | ** ** | **Variance** | ** ** | **change** | ** ** |
|                                                     |       |                |       |       |       |         |       |   |   |
| **Production  Volumes, net to the Company:**             |       |                |       |       |       |         |       |   |   |
|                                                     |       |                |       |       |       |         |       |   |   |
| Crude oil and  natural gas liquids (Bbl)                 |       | 30,810              |       | 29,148     |       | 1,662        |       | 6 | % |
|                                                     |       |                |       |       |       |         |       |   |   |
| Natural gas  liquids (“NGLs”) (Bbl)            |       | 10,639              |       | —     |       | 10,639       |       | — |   |
|                                                     |       |                |       |       |       |         |       |   |   |
| Natural gas  (Mcf)                                       |       | 69,051              |       | —     |       | 69,051       |       | — |   |
| Crude oil, NGLs  and natural gas (BOE)                   |       | 52,958              |       | 29,148     |       | 23,810       |       | 82 | % |
|                                                     |       |                |       |       |       |         |       |   |   |
| **Sales  Volumes, net to the Company:**                  |       |                |       |       |       |         |       |   |   |
|                                                     |       |                |       |       |       |         |       |   |   |
| Crude oil (Bbl)                                          |       | 29,466              |       | 28,800     |       | 666          |       | 2 | % |
|                                                     |       |                |       |       |       |         |       |   |   |
| NGLs (Bbl)                                               |       | 10,639              |       | —     |       | 10,639       |       | — |   |
|                                                     |       |                |       |       |       |         |       |   |   |
| Natural gas  (Mcf)                                       |       | 69,051              |       | —     |       | 69,051       |       | — |   |
| Crude oil, NGLs  and natural gas (BOE)                   |       | 51,614              |       | 28,800     |       | 22,814       |       | 79 | % |
|                                                     |       |                |       |       |       |         |       |   |   |
| **Revenue  data (a):**                                   |       |                |       |       |       |         |       |   |   |
|                                                     |       |                |       |       |       |         |       |   |   |
| Crude oil                                                |       | $                   | 2,918,127  |       | $          | 1,866,878    |       | $ | 1,051,249 |   | 56 | % |
|                                                     |       |                |       |       |       |         |       |   |   |
| NGLs                                                     |       | 670,434             |       | —     |       | 670,434      |       | — |   |
|                                                     |       |                |       |       |       |         |       |   |   |
| Natural gas                                              |       | 667,567             |       | —     |       | 667,567      |       | — |   |
| Total revenues                                           |       | $                   | 4,256,128  |       | $          | 1,866,878    |       | $ | 2,389,250 |   | 128 | % |
|                                                     |       |                |       |       |       |         |       |   |   |
| **Average  prices (a):**                                 |       |                |       |       |       |         |       |   |   |
| Crude oil (per  Bbl)                                     |       | $                   | 99.03      |       | $          | 64.82        |       | $ | 34.21 |   | 53 | % |
| NGLs (per Bbl)                                           |       | 63.02               |       | —     |       | —       |       | — |   |
| Natural gas (per  Mcf)                                   |       | 9.67                |       | —     |       | —       |       | — |   |
| Crude oil, NGLs  and natural gas (per BOE)               |       | $                   | 82.46      |       | $          | 64.82        |       | $ | 17.64 |   | 27 | % |
|                                                     |       |                |       |       |       |         |       |   |   |
| **Expenses  (per BOE)**                                  |       |                |       |       |       |         |       |   |   |
| Lease operating  expenses and production taxes (b)       |       | $                   | 25.39      |       | $          | 49.14        |       | $ | (23.75 | ) | (48 | )% |
| Depletion  expense on oil and natural gas properties (c) |       | $                   | 16.44      |       | $          | 9.68         |       | $ | 6.76 |   | 70 | % |

 

----

(a)          Includes the cash settlement of hedgingcontracts in 2007.

(b)         Excludes non-recurring oil spill expenses inthe current period of $35,417.

(c)          Excludes depreciation of furniture andfixtures of $54,668 and $12,335 for the year ended June 30, 2008 and 2007,respectively.

 

Net Loss. For the year ended June 30,2008, we reported a net loss of $1,570,974, or $0.06 loss per share (whichincludes approximately $2.7 million of non-cash charges related to stock basedcompensation, depreciation, depletion, and amortization, and accretion on assetretirement obligations) on total oil and natural gas revenues of $4,256,128, ascompared to a net loss of $1,810,211, or $0.07 loss per share (which includesapproximately $1.9 million of non-cash charges related to stock basedcompensation, depreciation, depletion, and amortization, and accretion on assetretirement obligations) on total oil and natural gas revenues of $1,866,878 forthe year ended June 30, 2007.  Thedecrease in our net loss is primarily attributable to increases in revenues of$2,389,250 and an increase in our income tax benefit of $446,601, partiallyoffset by an increase in depreciation, depletion and amortization of $612,064,an increase in general and administrative expenses of $1,005,637 and a decreasein interest income earned of $1,066,465. Additional details of the components of net loss are explained ingreater detail below.

 

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Sales Volumes.  Crude oil, natural gas liquids, and naturalgas sales volumes, net to our interest, for the year ended June 30, 2008increased 79% to 51,614 BOE, compared to 28,800 BOE for the year ended June 30,2007.  The increase in sales volumes isdue primarily to new production of crude oil, NGLs and natural gas from our propertiesin the Giddings Field.  Of the 51,614 BOEsold during the year ended June 30, 2008, the Tullos Field Area, which wassold on March 3, 2008, accounted for approximately 17,995 BOE orapproximately 35% of total sales volumes. For the year ended June 30, 2007, the Tullos Field Area accountedfor 28,507 BOE or approximately 99% of total sales volumes.

 

Our first well in the Giddings Field began productionin late February 2008, two more wells began production in mid March, andfour wells began production in May and June, with June average netsales volumes of 212 Bbls/D of crude oil, 137 Bbls/D of NGLs and 630 Mcf/D or atotal of 454 net BOEPD.  In contrast,average daily net sales volumes from our properties in the Tullos Field Area inFebruary 2008, our last full month of production prior to its sale on March 3,2008, was 66 Bbls/D.  During ourownership, we had no NGL or natural gas production from our properties in theTullos Field Area.

 

Production.  Oil production will vary from oil salesvolumes by changes in crude oil inventories, which are not carried on ourbalance sheet.  Crude oil, NGL andnatural gas production for the year ended June 30, 2008 increased 82% to52,958 BOE, compared to 29,148 BOE for the year ended June 30, 2007.  The increase is primarily due to oil, NGL andnatural gas production from our properties in the Giddings Field.  Production from the Tullos Field Area, whichwas sold on March 3, 2008, accounted for approximately 36% of productionfor the year ended June 30, 2008 compared to approximately 98% for theyear ended June 30, 2007.

 

Oil, NGL and Natural GasRevenues.  Revenuespresented in the table above and discussed herein represent revenue from salesof our oil and natural gas production volumes, net to our interest.  In the previous year, production sold underfixed price delivery contracts, which have been designated for the normalpurchase and sale exemption under Statement of Financial Accounting Standards (“SFAS”)No. 133, *Accounting for Derivative Instruments andHedging Activities*, are also included in these amounts.  Realized prices may differ from market pricesin effect during the periods, depending on when the fixed delivery contract wasexecuted.

 

Crude oil, NGL and natural gas revenues for the yearended June 30, 2008 increased 128% from the previous fiscal year.  This was due to a 53% increase in the priceof a Bbl of oil, from $65 per Bbl to $99 per Bbl, along with sales of NGLs andnatural gas during the year ended June 30, 2008, whereas there were nosales of NGLs and natural gas during the year ended June 30, 2007.  Oil revenues from our properties in theTullos Field Area, which was sold in March 2008, were $1,477,355, orapproximately 35% of total revenues, for the year ended June 30, 2008,compared to $1,828,245, or approximately 98% of total revenues, for the yearended June 30, 2007.

 

Lease Operating Expenses (including productionseverance taxes). Lease operating expenses for the year ended June 30, 2008 decreasedapproximately 5% from the comparable 2007 period. The overall decrease in leaseoperating expenses in 2008 is primarily attributable to lower field expenses inthe Giddings Field as compared to the Tullos Field Area and the inclusion ofonly eight months of field expense due to the sale of our properties in theTullos Field Area in early March 2008. On a BOE basis, lease operating expenses decreased by 48% over thecomparable 2007 period, due to lower lease operating costs and higher salesvolumes.

 

General and Administrative Expenses (“G&A”).  G&A expenses increased 22% toapproximately $5.5 million for the year ended June 30, 2008, compared toapproximately $4.5 million for the year ended June 30, 2007.  Higher overall compensation expenses forestimated bonuses and new hires accounted for the majority of theincrease.  New hires are associated witha build up of our infrastructure to execute our drilling program in theGiddings Field.  Non-cash stock-basedcompensation expense was $1,791,486 and $1,613,493 for the years ended June 30,2008 and 2007, respectively.

 

Depreciation, Depletion & AmortizationExpense (“DD&A”). DD&A expense increased $612,064 to $903,214 for the year ended June 30,2008 from $291,150 for the year ended June 30, 2007.  The increase is primarily due to a higherdepletion rate ($16 vs. $10) per BOE and a 79% increase in sales volumes.  The increase in the depletion rate is due tothe higher development cost of PUDs in the Giddings Field that we added inreplacement of our lower cost PDP’s from our properties in the Tullos FieldArea, which we sold in March 2008.

 

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Interest Income.  Interest income for the year ended June 30,2008 decreased $1,066,465 to $854,448, compared to $1,920,913 for the yearended June 30, 2007.  The decreasein interest income is due to lower available cash balances averagingapproximately $19.5 million during the year ended June 30, 2008, ascompared to cash balances averaging approximately $36.2 million during the yearended June 30, 2007, combined with a lower interest rate environmentduring the year ended June 30, 2008. The lower cash balance is mostly due to cash used to pay income taxesarising from the $50 million we received from the Delhi Farmout and foradditions to our oil and natural gas properties.

 

Inflation. Although the general inflation rate in the United States, as measured bythe Consumer Price Index and the Producer Price Index, has been relatively lowin recent years, the oil and gas industry has experienced unusually high priceincreases for oilfield equipment, tubulars, labor and services for the yearsended June 30, 2008 and 2007. Similarly, the prices we received for our products during this periodhas also increased dramatically, thereby offsetting material impacts on ourresults of operations.

 

Seasonality.  Our business is generally not seasonal,except for certain rare instances when weather conditions may adversely affectaccess to our properties.  Although we donot generally modify our production for changes in market demand, we doexperience seasonality in the product prices we receive, generally based onhigher demand for natural gas in the summer and winter and higher demand fordownstream oil products during the summer driving season.

 

**Critical Accounting Policies and Estimates**

 

The preparation of financial statements in accordancewith accounting principles generally accepted in the United States of Americarequires that we select certain accounting policies and make estimates andassumptions that affect the reported amounts of the assets and liabilities anddisclosures of contingent assets and liabilities as of the date of the balancesheet as well as the reported amounts of revenues and expenses during thereporting period.    These policies, together with our estimateshave a significant affect on our consolidated financial statements.  Our significant accounting policies areincluded in Note 2 to the consolidated financial statements.  Following is a discussion of our mostcritical accounting estimates, judgments and uncertainties that are inherent inthe preparation of our consolidated financial statements.

 

*Oil and Natural Gas Properties*.  Companiesengaged in the production of oil and natural gas are required to followaccounting rules that are unique to the oil and gas industry.  We apply the full-cost method of accountingfor our oil and natural gas properties. Another acceptable method of accountingfor oil and natural gas production activities is the successful efforts methodof accounting. In general, the primary differences between the two methods arerelated to the capitalization of costs and the evaluation for assetimpairment.  Under the full-cost method,all geological and geophysical costs, exploratory dry holes and delay rentalsare capitalized to the full cost pool, whereas under the successful effortsmethod such costs are expensed as incurred. In the assessment of impairment of oil and natural gas properties, thesuccessful efforts method follows the guidance of SFAS No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets*,under which the net book value of assets are measured for impairment againstthe undiscounted future cash flows using commodity prices consistent withmanagement expectations.  Under thefull-cost method, the full-cost pool (net book value of oil and natural gasproperties) is measured against future net cash flows discounted at 10% usingcommodity prices in effect at the end of the reporting period.  The financial results for a given periodcould be substantially different depending on the method of accounting that acompany adopts.

 

*Oil and Natural Gas Reserves,Depletion, and the Ceiling Test.*  Under full-costaccounting, the estimated quantities of proved oil and natural gas reserves andthe related present value of estimated future net cash flows used to calculatedepletion and to perform the full-cost ceiling test have a significant impacton the underlying financial statements. The process of estimating oil and natural gas reserves is very complex,requiring significant decisions in the evaluation of all available geological,geophysical, engineering and economic data. Estimated reserves are oftensubject to future revisions, which could be substantial, based on theavailability of additional information, including reservoir performance,additional development activity, new geological and geophysical data,additional drilling, technological advancements, price changes and othereconomic factors.  As a result, materialrevisions to existing reserve estimates may occur from time to time. Althoughevery reasonable effort is made to ensure that the reported reserve estimatesrepresent the most accurate assessments possible, including the hiring ofindependent engineers to prepare the report, the subjective decisions andvariances in available data for the properties make these estimates generallyless precise than other estimates included in our financial statements.

 

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Material revisions to reserve estimates and orsignificant changes in commodity prices could substantially affect ourestimated future net cash flows of our proved reserves, affecting our quarterlyfull-cost ceiling test calculation and could significantly affect our DD&Arate.  A 10% decrease in commodity pricesas of June 30, 2008, would not result in an impairment of our oil andnatural gas properties.  A 10% increasein our estimate of proved reserves quantities would have lowered our fourthquarter 2008 DD&A rate from $19.58 per BOE to $17.70 per BOE, and a 10%decrease in our proved reserve quantities would have increased our DD&Arate to approximately $21.53 per BOE.

 

*Unproved Properties. *On a quarterly basis, thecosts of unproved properties are evaluated for inclusion in the costs to beamortized resulting from the determination of proved reserves or impairment. Tothe extent that the evaluation indicates these properties are impaired, the amountof the impairment is added to the capitalized costs to be amortized.  Impairments and abandonments of unprovedproperties are accounted for as an adjustment to capitalized costs related toproved oil and natural gas properties, with no losses recognized.

 

*Valuation of Deferred Tax Assets*.  Wemake certain estimates and judgments in determining our income tax expense forfinancial reporting purposes.  Theseestimates and judgments occur in the calculation of certain tax assets andliabilities that arise from differences in the timing and recognition ofrevenue and expense for tax and financial reporting purposes.  Our federal and state income tax returns aregenerally not prepared or filed before the consolidated financial statementsare prepared or filed; therefore, we estimate the tax basis of our assets andliabilities at the end of each period as well as the effects of tax ratechanges, tax credits, and net operating loss carry backs and carryforwards.  Adjustments related to theseestimates are recorded in our tax provision in the period in which we file ourincome tax returns. Further, we must assess the likelihood that we will be ableto recover or utilize our deferred tax assets (primarily our net operatingloss).  If recovery is not likely, wemust record a valuation allowance against such deferred tax assets for theamount we would not expect to recover, which would result in an increase to ourincome tax expense.  As of June 30,2008, we have recorded a valuation allowance for the portion of our netoperating loss that is limited by IRS Section 382.

 

Management considers the scheduled reversal ofdeferred tax liabilities, projected future taxable income, and tax planningstrategies in making the assessment of the ultimate realization of deferred taxassets.  Based upon the level ofhistorical taxable income and projections for future taxable income over theperiods for which the deferred tax assets are deductible, as of end of thecurrent fiscal year, we believe that it is more likely than not that theCompany will realize the benefits of its net deferred tax assets. If ourestimates and judgments change regarding our ability to utilize our deferredtax assets, our tax provision would increase in the period it is determinedthat recovery is not probable.

 

*Stock-based Compensation.*  Weestimate the fair value of stock option awards on the date of grant using theBlack-Scholes option pricing model.  Thisvaluation method requires the input of certain assumptions, including expectedstock price volatility, expected term of the award, the expected risk-freeinterest rate, and the expected dividend yield of the Company’s stock .  The risk-free interest rates used is the U.S.Treasury yield for bonds matching the expected term of the option on the dateof grant.  Our dividend yield is zero, aswe do not pay a dividend.  Because of ourlimited trading experience of our common stock and limited exercise history ofour stock option awards, estimating the volatility and expected term is verysubjective.  We base our estimate of ourexpected future volatility, on peer companies whose common stock has beentrading longer than ours, along with our own limited trading history whileoperating as an oil and natural gas producer. Future estimates of our stock volatility could be substantiallydifferent from our current estimate, which could significantly affect theamount of expense we recognize for our stock-based compensation awards.  An increase of 10% in our current estimated volatilityfrom the current volatility of 89% to 99% would increase the fair value offuture grants of stock options approximately 6%.  Conversely, a decrease of 10% in our currentestimated volatility would decrease the fair value of future grants of stockoptions approximately 7%.

 

**Off Balance Sheet Arrangements**

 

The Company has nooff-balance sheet arrangements at June 30, 2008.

 

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**ITEM 7A.**** QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISKS**

 

*InterestRate Risk*

 

We are exposed to changesin interest rates. Changes in interest rates affect the interest earned on ourcash and cash equivalents.  Under ourcurrent policies, we do not use interest rate derivative instruments to manageexposure to interest rate changes.

 

*CommodityPrice Risk*

 

Our revenues,profitability and future growth depend substantially on prevailing prices foroil and natural gas. Prices also affect the amount of cash flow available forcapital expenditures and our ability to borrow and raise additional capital,as, if and when needed. Lower prices may also reduce the amount of oil andnatural gas that we can economically produce. Although our current production base may not be sufficient enough toeffectively allow hedging, we may periodically use derivative instruments tohedge our commodity price risk. We may hedge a portion of our projected oil andnatural gas production through a variety of financial and physical arrangementsintended to support oil and natural gas prices at targeted levels and to manageour exposure to price fluctuations. We may use futures contracts, swaps andfixed price physical contracts to hedge our commodity prices. Realized gainsand losses from our price risk management activities are recognized in oil andnatural gas sales when the associated production occurs. We do not hold orissue derivative instruments for speculative purposes.

 

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**ITEM8. FINANCIAL STATEMENTS**

 

**Index toConsolidated Financial Statements**

 
| Report of Independent Registered Public Accounting  Firm                                              |   | 36     |
|-------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                  |   |   |
| Consolidated Balance Sheets as of June 30, 2008  and 2007                                        |   | 37     |
|                                                                                                  |   |   |
| Consolidated Statements of Operations for the Years  ended June 30, 2008 and 2007                |   | 38     |
|                                                                                                  |   |   |
| Consolidated Statements of Cash Flows for the Years  ended June 30, 2008 and 2007                |   | 39     |
|                                                                                                  |   |   |
| Consolidated Statements of Stockholders’ Equity for  the Years ended June 30, 2008 and 2007 |   | 40     |
|                                                                                                  |   |   |
| Notes to Consolidated Financial Statements                                                            |   | 41     |

 

35

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM

 

The Board of Directors and Stockholders 

Evolution Petroleum Corporation 

Houston, Texas 

 

We have audited the accompanying consolidated balancesheets of Evolution Petroleum Corporation as of June 30, 2008 and 2007 and therelated consolidated statements of operations, stockholders' equity, and cashflows for the years ended June 30, 2008 and 2007. These consolidated financialstatements are the responsibility of the Company's management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits. 

 

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audits to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement. The Company has determined that it is not required tohave, nor were we engaged to perform, an audit of its internal control overfinancial reporting. Our audit included consideration of internal control overfinancial reporting as a basis for designing audit procedures that areappropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company's internal control over financialreporting. Accordingly, we express no such opinion. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion. 

 

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of Evolution Petroleum Corporation and subsidiaries as ofJune 30, 2008 and 2007, and the consolidated results of their operations andtheir cash flows for each of the years then ended in conformity with accountingprinciples generally accepted in the United States of America.

 

As discussed in Note 2 to the consolidated financialstatements, the Company adopted Financial Accounting Standards Board (“FASB”)Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes-an interpretation of FASB Statement No. 109, Accounting for IncomeTaxes*, during the year ended June 30, 2008.

 

 

HEIN& ASSOCIATES LLP 

 

Houston, Texas 

September 22, 2008 

 

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**EvolutionPetroleum Corporation and Subsidiaries**

**ConsolidatedBalance Sheets**

 
| ** **                                                                                                                                                                        | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                                                                                                                        | ** ** | **2008**          | ** ** | **2007**          | ** ** |
| **Assets**                                                                                                                                                                        | ** ** | ** **        | ** ** | ** **        | ** ** |
| Current Assets                                                                                                                                                                    |       |              |       |              |       |
| Cash and cash  equivalents                                                                                                                                                        |       | $                 | 11,272,280 |              | $          | 27,746,942 |   |
| Receivables                                                                                                                                                                       |       |              |       |              |       |
| Oil and natural  gas sales                                                                                                                                                        |       | 2,066,300         |       | 190,210           |       |
| Income tax                                                                                                                                                                        |       | 478,599           |       | 421,325           |       |
| Other                                                                                                                                                                             |       | 86,966            |       | 22,375            |       |
| Income taxes  recoverable                                                                                                                                                         |       | 3,625,987         |       | —            |       |
| Prepaid expenses  and other current assets                                                                                                                                        |       | 270,938           |       | 540,666           |       |
| Total current  assets                                                                                                                                                             |       | 17,801,070        |       | 28,921,518        |       |
|                                                                                                                                                                              |       |              |       |              |       |
| Property and  equipment, net of depreciation, depletion, and amortization                                                                                                         |       |              |       |              |       |
| Oil and natural  gas properties – full cost method of accounting                                                                                                             |       | 22,047,233        |       | 5,459,553         |       |
| Other property  and equipment                                                                                                                                                     |       | 161,027           |       | 154,872           |       |
| Total property  and equipment                                                                                                                                                     |       | 22,208,260        |       | 5,614,425         |       |
|                                                                                                                                                                              |       |              |       |              |       |
| Other assets,  net                                                                                                                                                                |       | 356,518           |       | 370,049           |       |
|                                                                                                                                                                              |       |              |       |              |       |
| Total assets                                                                                                                                                                      |       | $                 | 40,365,848 |              | $          | 34,905,992 |   |
|                                                                                                                                                                              |       |              |       |              |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                     |       |              |       |              |       |
| Current  liabilities                                                                                                                                                              |       |              |       |              |       |
| Accounts payable                                                                                                                                                                  |       | $                 | 2,892,459  |              | $          | 1,064,918 |   |
| Accrued expenses                                                                                                                                                                  |       | 805,262           |       | 524,809           |       |
| Royalties  payable                                                                                                                                                                |       | 473,327           |       | 6,831             |       |
| Total current  liabilities                                                                                                                                                        |       | 4,171,048         |       | 1,596,558         |       |
|                                                                                                                                                                              |       |              |       |              |       |
| Long term  liabilities                                                                                                                                                            |       |              |       |              |       |
| Deferred income  taxes                                                                                                                                                            |       | 2,901,929         |       | 338,001           |       |
| Deferred rent                                                                                                                                                                     |       | 74,081            |       | 47,289            |       |
| Asset retirement  obligations                                                                                                                                                     |       | 215,056           |       | 140,998           |       |
|                                                                                                                                                                              |       |              |       |              |       |
| Total  liabilities                                                                                                                                                                |       | 7,362,114         |       | 2,122,846         |       |
|                                                                                                                                                                              |       |              |       |              |       |
| Commitments and  contingencies (Note 13)                                                                                                                                          |       |              |       |              |       |
|                                                                                                                                                                              |       |              |       |              |       |
| Stockholders’  equity                                                                                                                                                        |       |              |       |              |       |
| Common Stock;  par value $0.001; 100,000,000 shares authorized; 26,870,439 and 26,776,234  issued and outstanding as of June 30, 2008 and June 30, 2007,  respectively. |       | 26,870            |       | 26,776            |       |
| Additional  paid-in capital                                                                                                                                                       |       | 14,188,841        |       | 12,397,373        |       |
| Retained  earnings                                                                                                                                                                |       | 18,788,023        |       | 20,358,997        |       |
|                                                                                                                                                                              |       |              |       |              |       |
| Total  stockholders’ equity                                                                                                                                                  |       | 33,003,734        |       | 32,783,146        |       |
|                                                                                                                                                                              |       |              |       |              |       |
| Total  liabilities and stockholders’ equity                                                                                                                                  |       | $                 | 40,365,848 |              | $          | 34,905,992 |   |

 

See accompanyingnotes to consolidated financial statements.

 

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**EvolutionPetroleum Corporation and Subsidiaries**

**Consolidated Statements of Operations**

** **
| ** **                                | ** ** | **Year Ended** | ** ** |
|-------------------------------------------|------------|---------------------|------------|
| ** **                                | ** ** | **June 30,**   | ** ** |
| ** **                                | ** ** | **2008**            | ** ** | **2007** | ** ** |
| Revenues                                  |       |                |       |   |   |
| Crude oil                                 |       | $                   | 2,918,127  |   | $ | 1,866,892 |   |
| Natural gas  liquids                      |       | 670,434             |       | — |   |
| Natural gas                               |       | 667,567             |       | — |   |
| Price risk  management activities         |       | —              |       | (14 | ) |
| Total revenues                            |       | 4,256,128           |       | 1,866,878 |   |
|                                      |       |                |       |   |   |
| Operating Costs                           |       |                |       |   |   |
| Lease operating  expense                  |       | 1,255,787           |       | 1,352,907 |   |
| Production taxes                          |       | 90,252              |       | 62,426 |   |
| Depreciation,  depletion and amortization |       | 903,214             |       | 291,150 |   |
| Accretion of  asset retirement obligation |       | 20,196              |       | 17,319 |   |
| General and  administrative *             |       | 5,497,237           |       | 4,491,600 |   |
| Total operating  costs                    |       | 7,766,686           |       | 6,215,402 |   |
|                                      |       |                |       |   |   |
| Loss from operations                      |       | (3,510,558          | )          | (4,348,524 | ) |
|                                      |       |                |       |   |   |
| Other income  (expense)                   |       |                |       |   |   |
| Interest income                           |       | 854,448             |       | 1,920,913 |   |
| Other                                     |       | (318                | )          | (21,453 | ) |
|                                      |       |                |       |   |   |
| Net loss before  income tax benefit       |       | (2,656,428          | )          | (2,449,064 | ) |
|                                      |       |                |       |   |   |
| Income tax  benefit                       |       | (1,085,454          | )          | (638,853 | ) |
|                                      |       |                |       |   |   |
| Net loss                                  |       | $                   | (1,570,974 | ) | $ | (1,810,211 | ) |
|                                      |       |                |       |   |   |
| Loss per common  share                    |       |                |       |   |   |
| Basic and  Diluted                        |       | $                   | (0.06      | ) | $ | (0.07 | ) |
|                                      |       |                |       |   |   |
| Weighted average  number of common shares |       |                |       |   |   |
| Basic and  Diluted                        |       | 26,786,270          |       | 26,706,713 |   |

 

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*General andadministrative expenses for year ended June 30, 2008 and 2007 included noncash stock-based compensation expense of $1,791,486 and $1,613,493,respectively.

 

See accompanyingnotes to consolidated financial statements.

 

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**EvolutionPetroleum Corporation and Subsidiaries**

**Consolidated Statements of Cash Flow**

** **
| ** **                                                                                                                             | ** ** | **Year Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                             | ** ** | **2008**                           | ** ** | **2007** | ** ** |
| Cash flows from operating activities                                                                               |       |                               |       |   |   |
| Net loss                                                                                                                               |       | $                                  | (1,570,974 | ) | $ | (1,810,211 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities                                                            |       |                               |       |   |   |
| Depreciation,  depletion and amortization                                                                                              |       | 903,214                            |       | 291,150 |   |
| Stock-based  compensation                                                                                                              |       | 1,791,486                          |       | 1,613,493 |   |
| Accretion of  asset retirement obligations                                                                                             |       | 20,196                             |       | 17,319 |   |
| Deferred income  taxes                                                                                                                 |       | 2,563,928                          |       | (12,024,155 | ) |
| Deferred rent                                                                                                                          |       | 26,792                             |       | 47,289 |   |
| Changes in  operating assets and liabilities:                                                                                          |       |                               |       |   |   |
| Receivables                                                                                                                            |       | (5,623,942                         | )          | (501,539 | ) |
| Prepaid expenses  and other current assets                                                                                             |       | 90,902                             |       | (245,225 | ) |
| Accounts payable  and accrued expenses                                                                                                 |       | 468,866                            |       | 805,673 |   |
| Royalties  payable                                                                                                                     |       | 466,496                            |       | (40,223 | ) |
| Income tax  payable                                                                                                                    |       | —                             |       | (2,645,619 | ) |
| Net cash used in  operating activities                                                                                                 |       | (863,036                           | )          | (14,492,048 | ) |
|                                                                                                                                   |       |                               |       |   |   |
| Cash flows from  investing activities                                                                                                  |       |                               |       |   |   |
| Net proceeds  from the sale of the Tullos Assets                                                                                       |       | 4,420,868                          |       | — |   |
| Proceeds from  other asset divestitures                                                                                                |       | 31,582                             |       | 155,378 |   |
| Development of  oil and natural gas properties                                                                                         |       | (11,187,291                        | )          | (417,964 | ) |
| Acquisitions of  oil and natural gas properties                                                                                        |       | (8,789,501                         | )          | (1,918,757 | ) |
| Capital  expenditures for other equipment                                                                                              |       | (87,544                            | )          | (156,644 | ) |
| Cash in  qualified intermediary account for “like-kind” exchanges                                                            |       | —                             |       | 34,662,368 |   |
| Other assets                                                                                                                           |       | 184                                |       | 36,594 |   |
| Net cash (used  in) provided by investing activities                                                                                   |       | (15,611,702                        | )          | 32,360,975 |   |
|                                                                                                                                   |       |                               |       |   |   |
| Cash flows from  financing activities                                                                                                  |       |                               |       |   |   |
| Equity  transaction costs                                                                                                              |       | —                             |       | (15,657 | ) |
| Proceeds from  issuance of common stock                                                                                                |       | 76                                 |       | 125 |   |
| Net cash  provided by (used in) financing activities                                                                                   |       | 76                                 |       | (15,532 | ) |
|                                                                                                                                   |       |                               |       |   |   |
| Net (decrease)  increase in cash and cash equivalents                                                                                  |       | (16,474,662                        | )          | 17,853,395 |   |
|                                                                                                                                   |       |                               |       |   |   |
| Cash and cash  equivalents, beginning of period                                                                                        |       | 27,746,942                         |       | 9,893,547 |   |
|                                                                                                                                   |       |                               |       |   |   |
| Cash and cash  equivalents, end of period                                                                                              |       | $                                  | 11,272,280 |   | $ | 27,746,942 |   |
|                                                                                                                                   |       |                               |       |   |   |
| Supplemental  disclosure of cash flow information:                                                                                     |       |                               |       |   |   |   |   |
| Income taxes  paid                                                                                                                     |       | $                                  | 33,879     |   | $ | 14,560,000 |   |
|                                                                                                                                   |       |                               |       |   |   |
| Non-cash  transactions:                                                                                                                |       |                               |       |   |   |
| Increase in  accounts payable incurred to acquire oil and natural gas leasehold interests  and develop oil and natural gas properties. |       | $                                  | 1,639,128  |   | $ | — |   |

 

See accompanyingnotes to consolidated financial statements.

 

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**EvolutionPetroleum Corporation and Subsidiaries**

**Consolidated Statements of Changes inStockholders’ Equity**

**Forthe Years ended June 30, 2008 and 2007**

** **
| ****                                 | ** ** | ****                  | ** ** | ****               | ** ** | **Additional** | ** ** | ****                   | ** ** | **Total**  | ** ** |
|--------------------------------------|------------|-----------------------|------------|--------------------|------------|----------------|------------|------------------------|------------|------------|------------|
| ** **                           | ** ** | **Common Stock** | ** ** | **Paid-in**        | ** ** | **Retained**   | ** ** | **Stockholders’** | ** ** |
| ** **                           | ** ** | **Shares**            | ** ** | **Par Value** | ** ** | **Capital**    | ** ** | **Earnings**           | ** ** | **Equity** | ** ** |
| Balance,  June 30, 2006         |       | 26,300,670            |       | $                  | 26,300     |           | $          | 10,009,388             |       | $          | 22,169,208 |   | $ | 32,204,896 |   |
| Issuance of  restricted common stock |       | 107,242               |       | 108                |       | —         |       | —                 |       | 108        |       |
| Exercise of  warrants                |       | 16,987                |       | 17                 |       | —         |       | —                 |       | 17         |       |
| Reclassify  temporary equity         |       | 351,335               |       | 351                |       | 790,149        |       | —                 |       | 790,500    |       |
| Stock issuance  costs                |       | —                |       | —             |       | (15,657        | )          | —                 |       | (15,657    | )          |
| Stock based  compensation            |       | —                |       | —             |       | 1,613,493      |       | —                 |       | 1,613,493  |       |
| Net loss                             |       | —                |       | —             |       | —         |       | (1,810,211             | )          | (1,810,211 | )          |
| Balance,  June 30, 2007         |       | 26,776,234            |       | $                  | 26,776     |           | $          | 12,397,373             |       | $          | 20,358,997 |   | $ | 32,783,146 |   |
| Issuance of  restricted common stock |       | 75,899                |       | 76                 |       | —         |       | —                 |       | 76         |       |
| Exercise of  warrants                |       | 8,306                 |       | 8                  |       | (8             | )          | —                 |       | —     |       |
| Exercise of  stock options           |       | 10,000                |       | 10                 |       | (10            | )          | —                 |       | —     |       |
| Stock based  compensation            |       | —                |       | —             |       | 1,791,486      |       | —                 |       | 1,791,486  |       |
| Net loss                             |       | —                |       | —             |       | —         |       | (1,570,974             | )          | (1,570,974 | )          |
| Balance,  June 30, 2008         |       | 26,870,439            |       | $                  | 26,870     |           | $          | 14,188,841             |       | $          | 18,788,023 |   | $ | 33,003,734 |   |

 

See accompanyingnotes to consolidated financial statements.

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1 – Organization and Basis ofPreparation**

 

***Nature ofOperations.***  Evolution Petroleum Corporation (“EPM”)and its subsidiaries, formerly Natural Gas Systems, Inc. (the “Company”, “we”or “us”), is an independent petroleum company headquartered in Houston, Texasand incorporated under the laws of the State of Nevada.  We are engaged primarily in the acquisition,exploitation and development of properties for the production of crude oil andnatural gas.  We acquire properties withknown oil and natural gas resources and exploit them through the application ofconventional and specialized technology to increase production, ultimaterecoveries, or both.

 

***Principles ofConsolidation and Reporting.***  Our consolidated financial statements includethe accounts of EPM and its wholly-owned subsidiaries. All significantintercompany transactions have been eliminated in consolidation. Theconsolidated financial statements for the previous year include certainreclassifications that were made to conform to the current presentation.  Such reclassifications have no impact onpreviously reported income or stockholders’ equity.

 

***Use ofEstimates. ***Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America (“GAAP”) requires us to makeestimates and assumptions that affect the reported amounts of assets andliabilities at the dates of the financial statements and the reported amountsof revenues and expenses during the reporting periods.  Significant estimates include reservequantities and estimated future cash flows associated with proved reserves,which significantly impact depletion expense and potential impairments of oiland natural gas properties, income taxes and the valuation of deferred taxassets, stock-based compensation and commitments and contingencies.  We analyze our estimates based on historicalexperience and various other assumptions that we believed to be reasonable.While we believe that our estimates and assumptions used in preparation of theconsolidated financial statements are appropriate, actual results could differfrom those estimates.

 

**Note 2 – Summary of Significant AccountingPolicies**

 

***Cash and Cash Equivalents.***  We consider all highly liquid investments,with original maturities of 90 days or less when purchased, to be cash and cashequivalents.

 

***Allowance for Doubtful Accounts.***  We establish provisions for losses onaccounts receivables if it is determined that collection of all or a part of anoutstanding balance is not probable. Collectibility is reviewed regularly and an allowance is established oradjusted, as necessary, using the specific identification method.  As of June 30, 2008 and 2007, noallowance for doubtful accounts was necessary.

 

***Oil and Natural Gas Properties*.**  We use the full-cost method of accounting forour investments in oil and natural gas properties.  Under this method of accounting, all costsincurred in the acquisition, exploration and development of oil and natural gasproperties, including unproductive wells, are capitalized.  This includes any internal costs that aredirectly related to property acquisition, exploration and developmentactivities but does not include any costs related to production, generalcorporate overhead or similar activities. Gain or loss on the sale or other disposition of oil and natural gasproperties is not recognized, unless the gain or loss would significantly alterthe relationship between capitalized costs and proved reserves.

 

Oil and natural gas properties include costs that areexcluded from costs being depleted or amortized. Oil and natural gas propertycosts excluded represent investments in unproved properties and includenon-producing leasehold, geological and geophysical costs associated withleasehold or drilling interests and exploration drilling costs. We excludethese costs until the project is evaluated and proved reserves are establishedor impairment is determined. Excluded costs are reviewed at least quarterly todetermine if impairment has occurred. The amount of any evaluated or impairedoil and natural gas properties is transferred to capitalized costs beingamortized.

 

***Limitation on Capitalized Costs******. ***Under the full-cost method ofaccounting, we are required to periodically perform a “ceiling test” whichdetermines a limit on the book value of our oil and natural gas properties. Ifthe net capitalized cost of proved oil and natural gas properties, net ofrelated deferred income taxes, plus the cost of unproved oil and natural gasproperties, exceeds the present value of estimated future net cash flowsdiscounted at 10 percent, net of related tax effects,

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 2 – Summary of Significant AccountingPolicies** (Continued)

 

plus the cost of unproved oil and gas properties, theexcess is charged to expense and reflected as additional accumulateddepreciation, depletion and amortization (“DD&A”). Future net cash flowsare based on period-end commodity prices and exclude future cash outflowsrelated to estimated abandonment costs. We did not have a ceiling testimpairment during the years ended June 30, 2008 and 2007.

 

***Other Property and Equipment.***  Other property and equipment includesbuildings, data processing and telecommunications equipment, office furnitureand equipment, and other fixed assets. These items are recorded at cost and aredepreciated using the straight-line method based on expected lives of theindividual assets or group of assets, which ranges from three to five years.Repairs and maintenance costs are expensed in the period incurred.

 

***Asset Retirement Obligations*.**  Our investment in oil and natural gasproperties includes an estimate of the future cost associated withdismantlement, abandonment and restoration of our properties. These costs arerecorded as provided in Statement of Financial Accounting Standards (“SFAS”) No. 143,Accounting*for Asset Retirement Obligations*.. The present value of the future costs (the “asset retirement cost”) is addedto the capitalized cost of our oil and natural gas properties and recorded as along-term or current liability.  Theasset retirement cost is depleted over the life of our oil and natural gasproperties. The estimation of future costs associated with dismantlement,abandonment and restoration requires the use of estimated costs in futureperiods that, in some cases, will not be incurred until a substantial number ofyears in the future. Such cost estimates could be subject to significantrevisions in subsequent years due to changes in regulatory requirements,technological advances and other factors which may be difficult to predict.

 

***Fair Value of FinancialInstruments.***  Ourfinancial instruments consist of cash and cash equivalents, accountsreceivable, and accounts payable. The carrying amounts of cash and cashequivalents, accounts receivable and accounts payable approximate fair valuedue to the highly liquid nature of these short-term instruments.

 

***Stock-based Compensation.**** *EffectiveJuly 1, 2006, we adopted SFAS No. 123(R), *Share-BasedPayment* (“SFAS No. 123(R)”), using the modified prospectivetransition method which requires, among other things, current recognition ofcompensation expense for share-based compensation granted after July 1,2006, and for that portion of prior period share-based compensation for whichthe requisite service had not been rendered as of July 1, 2006.  SFAS No. 123(R) requires that werecord all share-based payment expense in our financial statements based on thefair value of the award on the grant date. We use the Black-Scholes option-pricing model as the most appropriatefair-value method for our awards and recognize compensation cost on astraight-line basis over our awards’ vesting periods.

 

***Revenue Recognition.***  We recognize oil and natural gas revenue fromour interests in producing wells at the time that title passes to thepurchaser.  As a result, we accruerevenues related to production sold for which we have not received payment.

 

***Depreciation, Depletion andAmortization.***  Thedepreciable base for oil and natural gas properties includes the sum of allcapitalized costs net of DD&A, estimated future development costs and assetretirement costs not included in oil and natural gas properties, less costsexcluded from amortization. The depreciable base of oil and natural gasproperties is amortized using the unit-of-production method. Other propertyincluding, leasehold improvements, office and computer equipment and vehicleswhich are stated at original cost and depreciated using the straight-linemethod over the useful life of the assets, which ranges from three to five years.

 

***Income Taxes*.**  We account for income taxes in accordancewith SFAS No. 109,*Accounting forIncome Taxes* (“SFAS No. 109”)and, as of July 1, 2007, the Financial Accounting Standards Board (“FASB”)Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes* (“FIN 48”). We recognize deferred tax assets and liabilities based on thedifferences between the tax basis of assets and liabilities and their reportedamounts in the financial statements that may result in taxable or deductibleamounts in future years. The measurement of deferred tax assets may be reducedby a valuation allowance based upon management’s assessment of availableevidence if it is deemed more likely than not some or all of the deferred taxassets will not be realizable.

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 2 – Summary of Significant AccountingPolicies** (Continued)

 

FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with SFAS No. 109.  FIN 48 prescribes a recognition threshold andmeasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return.  FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition.  Werecognize estimated interest and penalties related to any potentialunderpayment on unrecognized tax benefits as a component of income tax expensein the Consolidated Statement of Operations.

 

***Earnings (loss) per share.***  Earnings (loss) per share (“EPS”) of commonStock is computed in accordance with SFAS No. 128 *Earnings per Share*(“SFAS No. 128”).  Under the provisions of SFAS No. 128,basic EPS is computed by dividing earnings or loss by the weighted-averagenumber of common shares outstanding less any non-vested restricted common stockoutstanding.  The computation of dilutedEPS is similar to the computation of basic EPS except that the denominator isincreased to include the number of additional common shares that would havebeen outstanding if potential dilutive common shares had been issued.  Our potential dilutive common shares are ouroutstanding stock options, warrants, and non-vested restricted commonstock.  The dilutive effect of ourpotential dilutive common shares is reflected in diluted EPS by application ofthe treasury stock method.  Under the treasury stock method exercise ofstock options and warrants shall be assumed at the beginning of the period (orat time of issuance, if later) and common shares shall be assumed to be issued;the proceeds from exercise shall be assumed to be used to purchase common stockat the average market price during the period; and the incremental shares (thedifference between the number of shares assumed issued and the number of sharesassumed purchased) shall be included in the denominator of the diluted EPScomputation.  Potential dilutive commonshares are excluded from the computation if their effect is antidilutive.   Including potential dilutive common sharesin the denominator of a diluted EPS computation for continuing operationsalways will result in an antidilutive per-share amount when an entity has aloss from continuing operations and no potential dilutive common shares shallbe included in the computation of diluted EPS when a loss from continuingoperations exists.

 

**Note 3 –Recent Accounting Pronouncements**

 

***New AccountingStandards.**** *Thefollowing discloses the existence and effect of accounting standards issued butnot yet adopted by us with respect to accounting standards that may have animpact on the Company when adopted in the future.

 

***Accounting for Business Combinations.***  InDecember 2007, the FASB issued SFAS No. 141R,*Business Combinations* (“SFAS No. 141R”),which replaces SFAS No. 141,*  Business Combinations*.  SFAS No. 141R establishes principles andrequirements for determining how an enterprise recognizes and measures the fairvalue of certain assets and liabilities acquired in a business combination,including non-controlling interests, contingent consideration, and certainacquired contingencies.  SFAS No. 141Ralso requires acquisition-related transaction expenses and restructuring costsbe expensed as incurred rather than capitalized as a component of the businesscombination.  SFAS No. 141R will beapplicable prospectively to business combinations for which the acquisitiondate is on or after the beginning of the first annual reporting periodbeginning on or after December 15, 2008. SFAS No. 141R would have an impact on accounting for any businessesacquired after the effective date of this pronouncement.

 

***Accounting for Fair Value Measurements*. **In September 2006, the FASB issuedSFAS No. 157,*Fair Value Measurements*(“SFAS No. 157”).  SFAS No. 157 defines fair value,establishes a framework for measuring fair value in GAAP and expandsdisclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued forfiscal years beginning after November 15, 2007. The provisions of SFAS No. 157 will be applied prospectively as ofthe beginning of the fiscal year in which it is initially applied except for,among other items, a financial instrument that was measured at fair value atinitial recognition under Statement 133 using the transaction price inaccordance with the guidance in footnote 3 of Issue 02-3 prior to initialapplication of SFAS No. 157.  In February 2008,the FASB deferred the effective date of SFAS No. 157 by one year fornonfinancial assets and nonfinancial liabilities that are recognized ordisclosed at fair value in the financial statements on a financial statementson a nonrecurring basis and amended SFAS No. 157 to exclude SFAS No. 13,*Accounting for Leases,* and its relatedinterpretive accounting pronouncements that address leasing transactions.  SFAS No. 157 did not have an impact onour financial statements when adopted on July 1, 2008.  We are currently evaluating what the impact,if any, of SFAS No. 157 for nonfinancial assets and nonfinancialliabilities will have on our financial statements.

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 3 –Recent Accounting Pronouncements**(Continued)

 

****Accountingfor the Fair Value Option for Financial Assets and Financial Liabilities********.****  In February 2007, the FASB issued SFAS No.159, *The Fair Value Option for Financial Assets andFinancial Liabilities* (“SFAS No. 159”), which permits allentities to choose, at specified election dates, to measure eligible items atfair value.  SFAS No. 159 permitsentities to choose to measure many financial instruments and certain otheritems at fair value that are not currently required to be measured at fairvalue, and thereby mitigate volatility in reported earnings caused by measuringrelated assets and liabilities differently without having to apply complexhedge accounting provisions. This Statement also establishes presentation anddisclosure requirements designed to facilitate comparisons between entitiesthat choose different measurement attributes for similar types of assets andliabilities.  SFAS No. 159 iseffective as of the beginning of an entity’s first fiscal year that beginsafter November 15, 2007.  TheStatement did not have an impact on our financial statements when adopted on July 1,2008.

 

**Note 4 –Sale of Oil and Natural Gas Properties**

 

On March 3, 2008,NGS Sub Corp., a Delaware corporation a wholly owned by EPM (“NGS Sub”),pursuant to an Asset Purchase and Sale Agreement (the “Asset Sale Agreement”)dated February 15, 2008, completed the sale of its 100% working interestand approximately 79% average net revenue interest in producing and shut-incrude oil wells, water disposal wells, equipment and improvements located inthe Tullos Urania, Colgrade and Crossroads Fields in LaSalle and Winn Parishes,Louisiana (the “Tullos Field Area”).  Thefollowing table presents the transaction and its affect on our financialstatements.

 
| **Proceeds  from sale of properties in the Tullos Field Area**                       |   | $          | 4,649,241 |   |
|--------------------------------------------------------------------------------------|--------|------------|-----------|--------|
| Less payout of a  third party carried interest arrangement                           |   | (168,106   | )         |
| Less  miscellaneous transaction costs                                                |   | (60,267    | )         |
| *Net  proceeds*                                                                      |   | 4,420,868  |      |
| **Net  book value of our properties in the Tullos Field Area on March 3, 2008** |   |       |      |
| Asset retirement  obligation                                                         |   | 153,886    |      |
| Oil and natural  gas properties                                                      |   | (1,721,990 | )         |
| Other property  and equipment                                                        |   | (26,721    | )         |
| Prepaid expenses  and other current assets                                           |   | (178,826   | )         |
| Other assets                                                                         |   | (13,347    | )         |
| **Remaining  credit recorded to oil and natural gas properties**                     |   | $          | 2,633,870 |   |

 

The following unauditedpro forma consolidated financial information is presented for illustrativepurposes only and presents the pro forma operating results for the Company forthe year ended June 30, 2008 and 2007 as though the disposition of ourproperties in the Tullos Field Area occurred at the beginning of the period.The unaudited pro forma consolidated financial information is not intended tobe indicative of the operating results that actually would have occurred if thetransaction had been consummated at the beginning of the period presented, noris the information intended to be indicative of future operating results.

 

The pro formaconsolidated financial information for the year ended June 30, 2008 and2007 are as follows:

 
| ** **                                      | ** ** | **Year Ended**         | ** ** | **Year Ended**         | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** |
| ** **                                      | ** ** | **As  Reported**            | ** ** | **Pro  Forma**              | ** ** | **As  Reported** | ** ** | **Pro  Forma** | ** ** |
| Oil and natural  gas revenues                   |       | $                           | 4,256,128  |                        | $          | 2,778,773 |   | $ | 1,866,878 |   | $ | 38,633 |   |
| Loss from  operations                           |       | $                           | (3,510,558 | )                           | $          | (3,740,623 | ) | $ | (4,348,524 | ) | $ | (4,352,996 | ) |
| Net loss                                        |       | $                           | (1,570,974 | )                           | $          | (1,705,917 | ) | $ | (1,810,211 | ) | $ | (1,813,163 | ) |
|                                            |       |                        |       |                        |       |   |   |   |   |
| Loss per common  share – basic and diluted |       | $                           | (.06       | )                           | $          | (.07 | ) | $ | (.07 | ) | $ | (.07 | ) |

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 5 –****Property and Equipment**

 

As of June 30, 2008and 2007 our oil and natural gas properties and other property and equipmentconsisted of the following:

 
| ** **                                                   | ** ** | **June 30,  2008** | ** ** | **June 30,  2007** | ** ** |
|--------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| **Oil and  natural gas properties**                          |       |                    |       |                    |       |
| Property costs  subject to amortization                      |       | $                       | 15,105,766 |                    | $          | 4,187,440 |   |
| Less:  Accumulated depreciation, depletion, and amortization |       | (632,040                | )          | (652,439                | )          |
| Unproved  properties not subject to amortization             |       | 7,573,507               |       | 1,924,552               |       |
| Oil and natural  gas properties, net                         |       | $                       | 22,047,233 |                    | $          | 5,459,553 |   |
|                                                         |       |                    |       |                    |       |
| **Other  property and equipment**                            |       |                    |       |                    |       |
| Furniture, fixtures  and equipment, at cost                  |       | 231,841                 |       | 173,205                 |       |
| Less:  Accumulated depreciation                              |       | (70,814                 | )          | (18,333                 | )          |
| Other property  and equipment, net                           |       | $                       | 161,027    |                    | $          | 154,872 |   |

 

**Note 6 – Asset Retirement Obligations**

 

Our asset retirementobligations represent the estimated present value of the amount we will incurto plug, abandon and remediate our producing properties at the end of theirproductive lives in accordance with applicable laws. The following is areconciliation of the beginning and ending asset retirement obligation for theyear ended June 30, 2008:

 
| ** **                                                   | ** ** | **Year Ended** | ** ** |
|--------------------------------------------------------------|------------|---------------------|------------|
| ** **                                                   | ** ** | **2008**            | ** ** | **2007** | ** ** |
| **Asset  retirement obligations – beginning of period** |       | $                   | 140,998    |   | $ | 123,679 |   |
| Liabilities  incurred                                        |       | 170,890             |       | — |   |
| Liabilities  settled                                         |       | —              |       | — |   |
| Liabilities sold  (See Note 4)                               |       | (153,886            | )          | — |   |
| Accretion                                                    |       | 20,196              |       | 17,319 |   |
| Revisions to  previous estimates                             |       | 36,858              |       | — |   |
| **Asset  retirement obligations – end of period**       |       | $                   | 215,056    |   | $ | 140,998 |   |

 

**Note 7 – Stockholders’ Equity**

 

During the year ended June 30, 2008, threeoutside directors each received 8,633 shares of restricted common stock as partof a compensation plan for directors. The same outside directors each received 12,414 shares of restrictedcommon stock as part of their compensation plan during the year ended June 30,2007.  All issuances of common stock weresubject to vesting terms per individual stock agreements.

 

We entered into a one-year consulting agreement in February 2008for investor relations services.  Ascompensation for services, we issued the consultant 50,000 shares of restrictedcommon stock, which is subject to vesting, through December 2008.  Previously, we had entered into a one-yearconsulting agreement with the same service provider, effective November 1,2006, for 50,000 shares of restricted common stock, which were subject tovesting over a twelve month period.

 

During the year ended June 30,2008 and 2007, 8,306 shares of common stock were issued through exercises of14,463 warrants.

 

During the year ended June 30,2007, 16,987 shares of common stock were issued through exercises of 25,000warrants.

 

During the year ended June 30,2007, we reclassified $790,500 from temporary to permanent equity.  Under the terms of a private placement of351,335 shares of our common stock, which we closed on June 10, 2006, thestock subscription agreement was subject to a registration rights agreementrequiring us to use our reasonable efforts to register the stock

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 7 – Stockholders’ Equity**(Continued)

 

subsequent to the demandof 40% of the holders of such stock. Such demand could not become effective,however, until the price of our common stock exceeded at least $14.23 pershare, (approximately 6.3 times the subscription price). There were nospecified damages for our failure to register, nor a specified timetable forobtaining such registration, except that the registration was to be undertakenby us as soon as practicable and was to stay effective for 120 days, or if suchregistration statement was on Form S-3 and provided for sales ofsecurities from time to time pursuant to Rule 415 under the SecuritiesAct, for up to one year. Until the demand registration right terminated, weclassified the proceeds as “temporary equity”. We believe the demandregistration rights terminated as of June 10, 2007, as all holders wereable to freely sell their shares under Rule 144.  Consequently, we reclassified the shares fromtemporary equity to permanent equity on our balance sheet at June 30,2007.

 

**Note 8 – Stock-Based Incentive Plan**

 

We have granted optionawards to purchase common stock (the “Stock Options”) and restricted commonstock awards (“Restricted Stock”) to employees, directors, and consultants ofthe Company and its subsidiaries under the Natural Gas Systems Inc. 2003 StockPlan (the “2003 Stock Plan”) and the Evolution Petroleum Corporation Amendedand Restated 2004 Stock Plan (the “2004 Stock Plan” or together, the “EPM StockPlans”).  A total of 600,000 awards topurchase an equal number of shares of common stock were issued under the 2003Stock Plan.  The 2004 Stock Planauthorized the issuance of 5,500,000 shares of common stock.  There are no shares available for grant underthe 2003 Stock Plan and, as of June 30, 2008, 1,325,859 shares remainavailable for grant under the 2004 Stock Plan.

 

We have also grantedcommon stock warrants, as authorized by the Board of Directors, to employees inlieu of cash bonuses or as incentive awards to reward previous service orprovide incentives to individuals to acquire a proprietary interest in theCompany’s success and to remain in the service of the Company (the “IncentiveWarrants”).  These Incentive Warrantshave similar characteristics of the Stock Options.  A total of 1,037,500 Incentive Warrants havebeen issued, through June 30, 2008, with Board of Directors approval,outside of the EPM Stock Plans.

 

***StockOptions and Incentive Warrants***

 

Stock-based compensationexpense related to Stock Options and Incentive Warrants for the year ended June 30,2008 and 2007 was $1,522,661 and $1,286,810, respectively.

 

During the year ended June 30,2008, we granted Stock Options to purchase 1,435,000 shares of common stockunder the 2004 Stock Plan with a weighted average exercise price of $2.58.  During the year ended June 30, 2007, wegranted Stock Options to purchase 150,000 shares of common stock under the 2004Stock Plan with a weighted average exercise price of $2.71.  The exercise price was determined based onthe market price of the Company’s common stock on the date of grant.  The Stock Options granted during the yearended June 30, 2008 and 2007 generally vest quarterly, on a straight linebasis, over a period of four years and have a contractual life of tenyears.  The weighted average assumptionsused to calculate the fair value of these Stock Options and the weightedaverage fair value of each Stock Option granted is as follows:

 

| ** **                   | ** ** | **Year Ended** | ** ** |
|------------------------------|------------|---------------------|------------|
| ** **                   | ** ** | **June 30,**   | ** ** |
| ** **                   | ** ** | **2008**            | ** ** | **2007** | ** ** |
| Expected  volatility         |       | 93.3                | %          | 96.0 | % |
| Expected  dividends          |       | —              |       | — |   |
| Expected term  (in years)    |       | 6.10                |       | 6.10 |   |
| Risk-free rate               |       | 4.10                | %          | 4.56 | % |
| Fair value per  Stock Option |       | $                   | 2.01       |   | $ | 2.15 |   |
|                              |            |                     |            |  |  |  |  |

 

We estimated the fairvalue of Stock Options and Incentive Warrants issued to employees and directorsunder SFAS No. 123R at the date of grant using a Black-Scholes-Mertonvaluation model.  The risk-free rate isbased on the U.S. Treasury yield curve in effect at the time of grant.  The expected term (estimated period of timeoutstanding) of Stock Options and Incentive Warrants is based on the “simplified”method of estimated expected term for “plain vanilla” options allowed by the

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 8 – Stock-Based Incentive Plan**(Continued)

 

Securities and ExchangeCommission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 107 and SAB No. 110,and varied based on the vesting period and contractual term of the Stock Optionsor Incentive Warrants.  Expectedvolatility is based on the historical volatility of the Company’s closingcommon stock price and that of an evaluation of a peer group of similarcompanies trading activity.  We have notdeclared any cash dividends on the Company’s common stock.

 

The following summarypresents information regarding outstanding Stock Options and Incentive Warrantsas of June 30, 2008, and the changes during the year then ended:

 
| ** **                                                              | ** ** | **Number of Stock  Options  and Incentive  Warrants** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Aggregate  Intrinsic Value  (1)** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  years)** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                              | ** ** | ** **                                                           | ** ** | ** **                                     | ** ** | ** **                               | ** ** | ** **                                                           | ** ** |
| Stock Options  and Incentive Warrants outstanding at July 1, 2007  |       | 4,058,500                                                            |       | $                                              | 1.53       |                                     |       |                                                                 |       |   |
|                                                                    |       |                                                                 |       |                                           |       |                                     |       |                                                                 |       |
| Granted                                                                 |       | 1,435,000                                                            |       | $                                              | 2.58       |                                     |       |                                                                 |       |   |
| Exercised                                                               |       | (10,000                                                              | )          | $                                              | 0.001      |                                     |       |                                                                 |       |   |
| Canceled,  forfeited, or expired                                        |       | —                                                               |       | —                                         |       |                                     |       |                                                                 |       |
|                                                                    |       |                                                                 |       |                                           |       |                                     |       |                                                                 |       |
| Stock Options  and Incentive Warrants outstanding at June 30, 2008 |       | 5,483,500                                                            |       | $                                              | 1.81       |                                     | $          | 23,514,050                                                           |       | 7.5 |   |
|                                                                    |       |                                                                 |       |                                           |       |                                     |       |                                                                 |       |
| Vested or  expected to vest at June 30, 2008                       |       | 5,483,500                                                            |       | $                                              | 1.81       |                                     | $          | 23,514,050                                                           |       |   |   |
|                                                                    |       |                                                                 |       |                                           |       |                                     |       |                                                                 |       |
| Exercisable at  June 30, 2008                                      |       | 3,480,063                                                            |       | $                                              | 1.52       |                                     | $          | 15,928,791                                                           |       | 7.0 |   |

 

----

(1) Basedupon the difference between the market price of our common stock on the lasttrading date of the year and the Stock Option or Incentive Warrant exerciseprice of in-the-money Stock Options and Incentive Warrants.

 

The aggregate intrinsicvalue of Stock Options and Incentive Warrants that were exercised during theyear ended June 30, 2008 was $58,790. There were no Stock Options or Incentive Warrants that were exercisedduring the year ended June 30, 2007.

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 8 – Stock-Based Incentive Plan**(Continued)

 

A summary of the statusof our unvested Stock Options and Incentive Warrants as of June 30, 2008and 2007, and the changes during the year ended June 30, 2008 and 2007, ispresented below:

 
| ** **                       | ** ** | **Number of  Stock Options  and Incentive  Warrants** | ** ** | **Weighted  Average Grant-  Date Fair Value** | ** ** |
|----------------------------------|------------|-------------------------------------------------------|------------|--------------------------------------------------------------|------------|
|                             |       |                                                  |       |                                                         |       |
| Unvested at  July 1, 2006   |       | 2,407,458                                             |       | $                                                            | 1.41       |   |
|                             |       |                                                  |       |                                                         |       |
| Granted                          |       | 150,000                                               |       | $                                                            | 2.15       |   |
|                             |       |                                                  |       |                                                         |       |
| Vested                           |       | (984,333                                              | )          | $                                                            | 1.38       |   |
|                             |       |                                                  |       |                                                         |       |
| Canceled,  forfeited, or expired |       | —                                                |       | —                                                       |       |
|                             |       |                                                  |       |                                                         |       |
| Unvested at  June 30, 2007  |       | 1,573,125                                             |       | $                                                            | 1.50       |   |
|                             |       |                                                  |       |                                                         |       |
| Granted                          |       | 1,435,000                                             |       | $                                                            | 2.01       |   |
|                             |       |                                                  |       |                                                         |       |
| Vested                           |       | (1,004,688                                            | )          | $                                                            | 1.57       |   |
|                             |       |                                                  |       |                                                         |       |
| Canceled,  forfeited, or expired |       | —                                                |       | —                                                       |       |
|                             |       |                                                  |       |                                                         |       |
| Unvested at June 30,  2008  |       | 2,003,437                                             |       | $                                                            | 1.83       |   |

 

The total unrecognizedcompensation cost at June 30, 2008, relating to non-vested share-basedcompensation arrangements granted under the EPM Stock Plans and IncentiveWarrants was $3,546,465.  Suchunrecognized expense is expected to be recognized over a weighted averageperiod of 2.8 years.

 

**Restricted Stock**

 

For the year ended June 30,2008, we granted a total of 75,899 shares of Restricted Stock, of which, 25,899were under our 2004 Stock Plan.  For theyear ended June 30, 2007, we granted a total of 107,242 shares ofRestricted Stock, of which, 57,242 were under our 2004 Stock Plan.  All issuances of common stock are subject tovesting terms per individual Restricted Stock agreements.

 

During the year ended June 30,2008 and 2007, we recognized compensation expense of $268,825 and $326,683,respectively, related to Restricted Stock grants.

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 8 – Stock-Based Incentive Plan**(Continued)

 

The following table setsforth the restricted stock transactions for the years ended June 30, 2008 and2007:

 
| ** **                      | ** ** | **Number of  Restricted  Shares** | ** ** | **Weighted  Average  Grant-Date  Fair Value** | ** ** |
|---------------------------------|------------|----------------------------------------|------------|----------------------------------------------------|------------|
|                            |       |                                   |       |                                               |       |
| Unvested at  July 1, 2006  |       | 78,000                                 |       | $                                                  | 2.62       |   |
|                            |       |                                   |       |                                               |       |
| Granted                         |       | 107,242                                |       | $                                                  | 2.79       |   |
|                            |       |                                   |       |                                               |       |
| Vested                          |       | (125,793                               | )          | $                                                  | 2.69       |   |
|                            |       |                                   |       |                                               |       |
| Forfeited                       |       | —                                 |       | —                                             |       |
|                            |       |                                   |       |                                               |       |
| Unvested at  June 30, 2007 |       | 59,449                                 |       | $                                                  | 2.78       |   |
|                            |       |                                   |       |                                               |       |
| Granted                         |       | 75,899                                 |       | $                                                  | 4.10       |   |
|                            |       |                                   |       |                                               |       |
| Vested                          |       | (84,450                                | )          | $                                                  | 3.16       |   |
|                            |       |                                   |       |                                               |       |
| Forfeited                       |       | —                                 |       | —                                             |       |
|                            |       |                                   |       |                                               |       |
| Unvested at  June 30, 2008 |       | 50,898                                 |       | $                                                  | 4.11       |   |

 

At June 30, 2008,unrecognized stock compensation expense related to Restricted Stock grantstotaled $155,462.  Such unrecognizedexpense will be recognized over a weighted average period of 0.5 years.

 

**Note 9 – Commodity Hedging and Price RiskManagement Activities**

 

As of February 28,2007, all of our commodity hedging and price risk management activities hadexpired and were not renewed.

 

**Note 10 – Income Taxes**

 

We file a consolidatedfederal income tax return in the United States and various combined andseparate filings in several state and local jurisdictions.

 

There were nounrecognized tax benefits nor any accrued interest or penalties associated withunrecognized tax benefits as of the date of adoption of FIN 48 and through June 30,2008.

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 10 – Income Taxes**(Continued)

 

The components of ourincome tax provision (benefit) are as follows:

 
| ** **                                       | ** ** | **June 30,  2008** | ** ** | **June 30,  2007** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| **Current:**                                     |       |                    |       |                    |       |
| Federal                                          |       | $                       | (3,551,036 | )                       | $          | 9,950,221 |   |
| State                                            |       | (98,346                 | )          | 1,435,081               |       |
| *Total  current income tax (benefit) provision*  |       | (3,649,382              | )          | 11,385,302              |       |
| **Deferred:**                                    |       |                    |       |                    |       |
| Federal                                          |       | 2,573,023               |       | (10,452,433             | )          |
| State                                            |       | (9,095                  | )          | (1,571,722              | )          |
| *Total  deferred income tax provision (benefit)* |       | 2,563,928               |       | (12,024,155             | )          |
| **Total  income tax benefit**                    |       | $                       | (1,085,454 | )                       | $          | (638,853 | ) |

 

The following is areconciliation of statutory income tax expense to our income tax provision:

 
| ** **                                                      | ** ** | **June 30,  2008** | ** ** | **June 30,  2007** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| **Income  tax benefit computed at the statutory federal rate:** |       | $                       | (929,750   | )                       | $          | (857,172 | ) |
| Reconciling  items:                                             |       |                    |       |                    |       |
| State income  taxes, net of federal tax benefit                 |       | (87,377                 | )          | (88,817                 | )          |
| Stock based  compensation                                       |       | 425,236                 |       | 282,784                 |       |
| Deferred tax  asset valuation adjustment                        |       | (417,058                | )          | 151,196                 |       |
| IRC section 199  deduction                                      |       | (69,771                 | )          | (155,284                | )          |
| Other                                                           |       | (6,734                  | )          | 28,440                  |       |
| **Income  tax benefit**                                         |       | $                       | (1,085,454 | )                       | $          | (638,853 | ) |

 

Deferred income taxesprimarily represent the net tax effect of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes. The components of our deferred taxesare detailed in the table below:

 
| ** **                        | ** ** | **June 30,  2008** | ** ** | **June 30,  2007** | ** ** |
|-----------------------------------|------------|-------------------------|------------|-------------------------|------------|
| **Deferred  tax assets:**         |       |                    |       |                    |       |
| Stock based  compensation         |       | $                       | 286,148    |                    | $          | 178,452 |   |
| Accrued bonuses                   |       | —                  |       | 175,000                 |       |
| Net operating  loss carryforwards |       | 5,547,567               |       | 5,547,567               |       |
| Other                             |       | 14,487                  |       | 34,696                  |       |
| *Gross  deferred tax assets*      |       | 5,848,202               |       | 5,935,715               |       |
| Valuation  allowance              |       | (5,340,571              | )          | (5,757,629              | )          |
| *Total  deferred tax assets*      |       | 507,631                 |       | 178,086                 |       |
| **Deferred  tax liability:**      |       |                    |       |                    |       |
| Oil and natural  gas properties   |       | (3,409,560              | )          | (516,087                | )          |
| *Total  deferred tax liability*   |       | (3,409,560              | )          | (516,087                | )          |
| **Net deferred  tax liability**   |       | $                       | (2,901,929 | )                       | $          | (338,001 | ) |

 

We expect to recoverapproximately $3.6 million in federal and state income taxes paid during thetax year ended June 30, 2006, as a result of the carry-back of our 2008income tax loss.  Significant intangibledrilling costs were incurred during the 2008 fiscal year, of which, we electedto deduct (expense) approximately $10.9 million for federal and state incometax purposes.  Under GAAP, andspecifically the full-cost accounting method, intangible drilling costs arecapitalized as part of oil and natural gas properties, and depleted using theunit-of-production method.  The deductionof intangible drilling costs resulted in a significant difference in the incometax and book basis of our oil and natural gas properties, which resulted in anincrease in our net deferred tax liability as of June 30, 2008.

 

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** **

**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

** **

**Note 10 – Income Taxes**(Continued)

 

At June 30, 2008, wehave a federal tax loss carryforward of approximately $15.9 million we acquiredthrough reverse merger in May 2004, of which, approximately $0.6  million is available to us to use in equalamounts through 2023.  We have applied avaluation allowance against the portion of the federal tax loss carryforwardwhich has been disallowed through IRC Section 382.

 

**Note 11 – Related Party Transactions**

 

Laird Q. Cagan, Chairman of our Board of Directors, isa Managing Director and co-owner of Cagan McAfee Capital Partners, LLC (“CMCP”).CMCP performs financial advisory services to us pursuant to a written agreementamended in November 2005, providing for a retainer of $5,000 permonth.  In addition, Mr. Cagan, as aregistered representative of Chadbourn Securities Inc. (“Chadbourn”) and apartner of CMCP, has served as the Company’s placement agent in private equityfinancings.  Under the current agreement,CMCP may earn cash fees equal to 8% of gross equity proceeds, declining to 4%subject to the amount of equity raised through CMCP, and a fixed 4% warrantfee.  Mr. Cagan receives nocompensation for serving as a director or as the Chairman of our Board ofDirectors.

 

Eric A. McAfee, a major shareholder of the Company, isalso a Managing Director of CMCP.

 

During the year ended June, 2008 and 2007, we expensedand paid CMCP $60,000 through monthly retainers of $5,000.  There were no other earned fees by CMCPduring the year ended June 30, 2008 and 2007.

 

**Note 12 –****Net Loss Per Share**

 

The following table sets forth the computation ofbasic and diluted loss per share:

 
| ** **                                                         | ** ** | **Year Ended  June 30** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                         | ** ** | **2008**                          | ** ** | **2007** | ** ** |
| *Numerator*                                                        |       |                              |       |   |   |
| Net loss                                                           |       | $                                 | (1,570,974 | ) | $ | (1,810,211 | ) |
|                                                               |       |                              |       |   |   |
| *Denominator*                                                      |       |                              |       |   |   |
| Weighted average  number of common shares – basic and diluted |       | 26,786,270                        |       | 26,706,713 |   |
|                                                               |       |                              |       |   |   |
| Net Loss per  common share – basic and diluted                |       | $                                 | (0.06      | ) | $ | (0.07 | ) |

 

The following securitieswere not included in the computation of diluted loss per share as their effectwould have been anti-dilutive:

 
| **Potential Dilutive Securities**                                        | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Outstanding at  June 30, 2008** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------------|------------|
|                                                                               |       |                                       |       |                                             |       |
| Common stock  warrants issued in connection with equity and financing Transactions |       | $                                          | 1.40       |                                             | 401,058    |   |
| Stock Options  and Incentive Warrants                                              |       | $                                          | 1.81       |                                             | 5,483,500  |   |
| Non-vested  Restricted Stock                                                       |       | N/A                                        |       | 50,898                                           |       |
|                                                                               |       |                                       |       | 5,935,456                                        |       |

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note13 – Commitments and Contingencies**

 

***Environmental clean-up.***  On August 3, 2007, we were advised of anoil spill in the Tullos Field near one of our leases. At the request of fieldagents of the Louisiana Department of Environmental Quality and theEnvironmental Protection Agency (“EPA”), we agreed to commence a clean-upoperation that was completed by the end of August 2007. A detailedanalysis of the oil in the spill compared to the Company’s produced oil wasconducted by an EPA approved laboratory. We believe that the oil in the spill did not originate from ouroperations, supported by the formal findings of the laboratory.  We received insurance reimbursements of$484,197 in October 2007 and $217,668 in March 2008.  These reimbursements covered all of ouractual cleanup costs except a $5,000 insurance deductible and excluding ourlegal fees, in-house administrative costs, and any possible EPA expensereimbursements and fines that might be billed.

 

On May 5, 2008, we received a letter from the EPAproposing a $5,500 fine related to the oil spill.  We have also received a bill from the UnitedStates Coast Guard of approximately $70,000 for expense reimbursement.  We believe these claims are not supported byindependent investigation.  As of thedate of this filing, we have requested further verification from the UnitedStates Coast Guard to support their claims, and have entered into a settlementwith the EPA where we have agreed to pay the $5,500 fine with no admission ofliability.

 

***Litigation.***  The Company is subject to various lawsuitsand other claims in the normal course of business.  In addition, from time to time, we receivecommunications from government or regulatory agencies concerning investigationsor allegations of noncompliance with laws or regulations in jurisdiction inwhich we operate.  We establish reservesfor specific liabilities in connection with regulatory and legal actions thatwe deem to be probable and estimable.  Noamounts have been accrued in our financial statements with respect to any legalor regulatory matters as we believe the matters have a remote chance of resultingin a significant judgment.

 

In July 2008, a multi-plaintiff lawsuit was filedin the twenty-eighth Judicial District Court, Lasalle Parish, Louisiana,against 15 defendants, including Four Star Development Corporation, a formerindirect wholly owned subsidiary of the Company, which was sold on March 3,2008, as part of our sale of the Tullos Field Area.  Plaintiffs claim that the defendants’ oil andnatural gas exploration, development and production activities on theirproperties have caused soil and ground water contamination as a result of therelease of hydrocarbons and drilling fluids. Plaintiffs seek damages fortesting, clean-up and remediation of the properties as well as diminution intheir value and mental anguish and emotional distress to the individualplaintiffs, unjust enrichment and punitive damages for alleged concealment ofongoing activities.  At this time, we arenot a party to the litigation and are unable at this time to determine theexposure, if any, to the Company.

 

In November 2005, amulti-plaintiff lawsuit was filed in the Fifth Judicial District Court,Richland Parish, Louisiana, against 18 defendants including NGS Sub Corp. andArkla Petroleum LLC, the Company’s direct and indirect wholly ownedsubsidiaries (the “Subsidiaries”), as working interest owners/operators ofvarious oil and natural gas leases in the Delhi Field.  Plaintiffs claim that the defendants’ oil andnatural gas exploration, development and production activities on theirproperties have caused soil and ground water contamination as a result of therelease of hydrocarbons and drilling fluids. Plaintiffs seek damages fortesting, clean-up and remediation of the properties as well as diminution intheir value and mental anguish to the individual plaintiffs, unjust enrichmentand punitive damages for alleged concealment of ongoing activities.

 

Defendants have answeredplaintiffs’ suit denying plaintiffs’ claims.****Trial is set before a jury inRichland Parish for July13, 2009, and we intend to continue contesting plaintiffs’claims vigorously.  Discovery is inprocess, with Plaintiffs’ expert’s report due to be filed with the Court by September 26,2008. Defendants have performed field testing which indicates that anycontamination is far less pervasive than we believe plaintiffs are claiming,although Plaintiff’s complaints are vague and a full analysis of plaintiffs’claims cannot be completed until their expert report is available for analysis.

 

While the Delhi Field hasbeen in production for approximately sixty years, NGS Sub Corp. and ARKLA wereowner and operator since 2003 and 2002, respectively, until June of 2006.We believe that no contamination of significance has occurred during ourownership of the Delhi Field, and that potential liability for exposure of NGSSub Corp. results largely through any contractual indemnity of prior workinginterest owners which NGS Sub Corp. may have assumed for historical operationsin the field in its acquisition of the subject oil and gas working interests.  At this time, the likelihood or amount of anyjudgment which might be rendered cannot be determined with any certainty.

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 13 – Commitments andContingencies** (Continued)

 

***Lease Commitments.***  We have a non-cancelable operating lease foroffice space that expires on August 1, 2016. Future minimum leasecommitments as of March 31, 2008 under this operating lease are asfollows:

 
| **Year ended June 30,** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|------------|------------|
| 2009                                   |       | $          | 138,089    |   |
| 2010                                   |       | 138,089    |       |
| 2011                                   |       | 138,089    |       |
| 2012                                   |       | 157,268    |       |
| 2013                                   |       | 159,012    |       |
| Thereafter                             |       | 490,284    |       |
| Total                                  |       | $          | 1,220,831  |   |

 

Rent expense for the yearended June 30, 2008 and 2007 was $141,866 and $81,268, respectively.

 

***EmploymentContracts.***  We haveentered into employment agreements with the Company’s three seniorexecutives.  The employment contractsprovide for a severance package for termination by the Company for any reasonother than cause or permanent disability, that includes payment of base pay andcertain medical and disability benefits from six months to a year aftertermination.  The total contingentobligation under the employment contracts as of June 30, 2008 isapproximately $450,000.

 

**Note14 — Concentrations of Credit Risk**

 

***MajorCustomers.***  We market substantially all of our oiland natural gas production from the properties we operate.  The majority of our operated gas, oil andcondensate production is sold to a variety of purchasers under short-term (lessthan 12 months) contracts at market-based prices. The following tableidentifies customers from whom we derived 10 percent or more our net oil andnatural gas revenues during the years ended June 30, 2008 and 2007. Basedon the availability of other customers, we do not believe the loss of any ofthese customers would have a significant affect on our operations or financialcondition.

 
| ** **                | ** ** | **Percent of Total Revenue**  | ** ** |
|---------------------------|------------|----------------------------------------------|------------|
| **Customer**              | ** ** | **Year Ended  June 30, 2008** | ** ** | **Year Ended  June 30, 2007** | ** ** |
|                      |       |                                         |       |   |   |
| Plains Marketing  L.P.    |       | 67                                           | %          | 98 | % |
| ETC Texas  Pipeline, LTD. |       | 26                                           | %          | — |   |

 

***AccountsReceivable.*** Substantially all of our accounts receivable result from oil and naturalgas sales to third parties in the oil and natural gas industry. Thisconcentration of customers may impact our overall credit risk in that theseentities may be similarly affected by changes in economic and otherconditions.  Based on the current demandfor oil and natural gas, we do not expect that termination of sales to any ofour current purchasers would have a material adverse affect on our ability tofind replacement purchasers and to sell our production at favorable marketprices.

 

***Cash and CashEquivalents.***  Weare subject to concentrations of credit risk with respect to our cash and cashequivalents, which we attempt to minimize by maintaining our cash and cashequivalents in high quality money market funds. At times cash balances mayexceed limits federally insured by the Federal Deposit Insurance Corporation.

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 15 – Retirement Plan**

 

Effective February 1,2007, we implemented a 401(k) Savings Plan which covers all employees. Atour discretion, we may match a certain percentage of the employees’contributions to the plan. The matching percentage is currently 100% of thefirst 4% of each participant’s compensation, vesting fully upon ourcontributions. Our matching contribution to the plan was $59,437 and $15,584for the years ended June 30, 2008 and 2007, respectively.

 

**Note 16 – SupplementalDisclosures about Oil and Natural Gas Producing Properties (unaudited)**

 

***Costs incurred for oil and natural gas property acquisition,exploration and development activities***

 

The following table summarizes costsincurred and capitalized in oil and natural gas property acquisition,exploration and development activities. Property acquisition costs are those costs incurred to lease property,including both undeveloped leasehold and the purchase of reserves in place.  Exploration costs include costs ofidentifying areas that may warrant examination and examining specific areasthat are considered to have prospects containing oil and natural gas reserves,including costs of drilling exploratory wells, geological and geophysical costsand carrying costs on undeveloped properties. Development costs are incurred toobtain access to proved reserves, including the cost of drilling.

 
| ** **                                               | ** ** | **For the Years Ended June 30** | ** ** |
|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                               | ** ** | **2008**                                                 | ** ** | **2007** | ** ** |
|                                                     |       |                                                     |       |   |   |
| Oil and Natural  Gas Activities                          |       |                                                     |       |   |   |
| Property  acquisition costs:                             |       |                                                     |       |   |   |
| Proved property                                          |       | $                                                        | 2,958,538  |   | $ | 725,884 |   |
| Unproved  property                                       |       | 5,648,955                                                |       | 1,192,873 |   |
| Exploration  costs                                       |       | —                                                   |       | — |   |
| Development  costs                                       |       | 13,216,175                                               |       | 417,964 |   |
| Total costs  incurred for oil and natural gas activities |       | $                                                        | 21,823,668 |   | $ | 2,336,721 |   |

 

***Estimated NetQuantities of Proved Oil and Natural Gas Reserves (Unaudited)***

 

Proved oil and natural gas reserves are estimated quantities of crudeoil, natural gas and natural gas liquids that geological and engineering datademonstrate with reasonable certainty to be recoverable in future years fromknown reservoirs under existing economic and operating conditions. Proveddeveloped oil and natural gas reserves are reserves that can be expected to berecovered through existing wells with existing equipment and operating methods.There are uncertainties inherent in estimating quantities of proved oil andnatural gas reserves, projecting future production rates, and timing ofdevelopment expenditures. Accordingly, reserve estimates often differ from thequantities of oil and natural gas that are ultimately recovered.  All of our proved reserves are located in theUnited States. The following information about our proved and proved developedoil and natural gas reserves was developed from reserve reports prepared by independentreserve engineers:

 

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** **

**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 16 – Supplemental Disclosures about Oil and Natural Gas ProducingProperties (unaudited)**(Continued)

 
| ** **                       | ** ** | **Crude Oil  (Bbls)** | ** ** | **Natural Gas  Liquids  (Bbls)** | ** ** | **Natural Gas  (Mcf)** | ** ** | **BOE**   | ** ** |
|----------------------------------|------------|----------------------------|------------|---------------------------------------|------------|-----------------------------|------------|-----------|------------|
|                             |       |                       |       |                                  |       |                        |       |      |       |
| July 1,  2006               |       | 460,500                    |       | —                                |       | 25,800                      |       | 464,800   |       |
| Revisions of  previous estimates |       | (38,423                    | )          | —                                |       | (25,800                     | )          | (42,723   | )          |
| Purchases of  minerals in place  |       | 694,300                    |       | —                                |       | 3,838,000                   |       | 1,333,967 |       |
| Production  (sales volumes)      |       | (28,977                    | )          | —                                |       | —                      |       | (28,977   | )          |
| Sales of  minerals in place      |       | (3,200                     | )          | —                                |       | —                      |       | (3,200    | )          |
| July 1,  2007               |       | 1,084,200                  |       | —                                |       | 3,838,000                   |       | 1,723,867 |       |
| Revisions of  previous estimates |       | (298,793                   | )          | 274,699                               |       | (1,013,358                  | )          | (192,987  | )          |
| Purchases of  minerals in place  |       | 629,700                    |       | 1,046,400                             |       | 7,778,800                   |       | 2,972,567 |       |
| Production  (sales volumes)      |       | (29,466                    | )          | (10,639                               | )          | (69,051                     | )          | (51,614   | )          |
| Sales of  minerals in place      |       | (433,600                   | )          | —                                |       | —                      |       | (433,600  | )          |
| July 1,  2008               |       | 952,041                    |       | 1,310,460                             |       | 10,534,391                  |       | 4,018,233 |       |
|                             |       |                       |       |                                  |       |                        |       |      |       |
| **Proved  developed reserves:**  |       |                       |       |                                  |       |                        |       |      |       |
| July 1,  2006               |       | 460,500                    |       | —                                |       | 25,800                      |       | 464,800   |       |
| July 1, 2007                |       | 389,700                    |       | —                                |       | —                      |       | 389,700   |       |
| July 1,  2008               |       | 96,167                     |       | 109,716                               |       | 561,001                     |       | 299,383   |       |

 

The revisions of previous estimates were primarily dueto the identification and separation of natural gas liquids in 2008 and theeffects of the new SEC guideline on PUD locations within fractured reservoirs.  Natural gas liquids were not separatelyidentified in the July 1, 2007 independent report prepared by Von Gonten.

 

Purchases of minerals in place during 2007 and 2008,resulted from leasehold acquisitions of proved undeveloped reserves in theGiddings Field that directly offset currently or historically productive wellsin the same fractured trend.

 

***Standardized Measure ofDiscounted Future Net Cash Flows***

 

Future oil and natural gas sales and production anddevelopment costs have been estimated using prices and costs in effect at theend of the years indicated, as required by SFAS No. 69, *Disclosures about Oil and Gas Producing Activities* (“SFAS No. 69”).  SFAS No. 69 requires that netcash flow amounts be discounted at 10%. Future production and development costsare computed by estimating the expenditures to be incurred in developing andproducing our proved oil and natural gas reserves assuming continuation ofexisting economic conditions. Future income tax expenses are computed byapplying the appropriate period-end statutory tax rates to the future pretaxnet cash flow relating to our proved oil and natural gas reserves, less the taxbasis of the related properties. The future income tax expenses do not give effectto tax credits, allowances, or the impact of general and administrative costsof ongoing operations relating to the Company’s proved oil and natural gasreserves.  Changes in the demand for oiland natural gas, inflation, and other factors make such estimates inherentlyimprecise and subject to substantial revision. The table below should not beconstrued to be an estimate of the current market value of the our provedreserves.

 

The standardized measure of discounted future net cashflows related to proved oil and natural gas reserves as of June 30, 2008and 2007 are as follows:

 
| ** **                                                | ** ** | **For the Years Ended June 30** | ** **  |
|-----------------------------------------------------------|------------|----------------------------------------------------------|-------------|
| ** **                                                | ** ** | **2008**                                                 | ** **  | **2007** | ** ** |
|                                                      |       |                                                     |        |   |   |
| Future cash  inflows                                      |       | $                                                        | 390,107,980 |   | $ | 97,669,992 |   |
| Future  production costs                                  |       | (61,351,774                                              | )           | (29,044,113 | ) |
| Future development  costs                                 |       | (62,457,700                                              | )           | (18,616,000 | ) |
| Future income  tax expenses                               |       | (95,022,328                                              | )           | (17,012,000 | ) |
| Future net cash  flows                                    |       | 171,276,178                                              |        | 32,997,879 |   |
| 10% annual  discount for estimated timing of cash flows   |       | (74,203,537                                              | )           | (11,007,581 | ) |
| Standardized  measure of discounted future net cash flows |       | $                                                        | 97,072,641  |   | $ | 21,990,298 |   |

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 16 – Supplemental Disclosures about Oil and Natural Gas ProducingProperties (unaudited)**(Continued)

 

The following table presents the average NYMEX crudeoil, natural gas liquid, and natural gas price used to compute future cashinflows for each period:

 
| ** **                                    | ** ** | **2008** | ** ** | **2007** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
|                                          |       |     |       |     |       |
| Average crude  oil price per barrel           |       | $        | 138.73     |     | $          | 70.68 |   |
| Average natural  gas liquids price per barrel |       | $        | 84.39      |     | $          | N/A |   |
| Average natural  gas price per MMbtu          |       | $        | 14.00      |     | $          | 6.80 |   |

 

A summary of the changes in the standardized measureof discounted future net cash flows applicable to proved crude oil and naturalgas reserves follows:

 
| ** **                                                                     | ** ** | **For the Years Ended June 30** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2008**                                                 | ** ** | **2007** | ** ** |
|                                                                           |       |                                                     |       |   |   |
| Balance,  beginning of year                                                    |       | $                                                        | 21,990,298 |   | $ | 6,511,360 |   |
| Net changes in  sales prices and production costs related to future production |       | 19,582,657                                               |       | 254,874 |   |
| Changes in  estimated future development costs                                 |       | (27,754,046                                              | )          | (16,050,414 | ) |
| Sales of oil and  gas produced during the period, net of production costs      |       | (2,910,089                                               | )          | (434,226 | ) |
| Net change due  to purchases of minerals in place                              |       | 146,355,022                                              |       | 43,710,638 |   |
| Net change due  to sales of minerals in place                                  |       | (7,302,851                                               | )          | (178,245 | ) |
| Net change due  to revisions in quantity estimates                             |       | (5,791,427                                               | )          | (3,013,757 | ) |
| Previously  estimated development costs incurred during the period             |       | 2,000,000                                                |       | 86,000 |   |
| Accretion of  discount                                                         |       | 2,746,274                                                |       | 651,136 |   |
| Net change in  income taxes                                                    |       | (51,843,197                                              | )          | (9,547,068 | ) |
| Balance, end of  Year                                                          |       | $                                                        | 97,072,641 |   | $ | 21,990,298 |   |

 

**Note 17 – Subsequent Events**

 

In July 2008 we granted 150,000 Stock Options toa new employee and in August 2008, the board of directors approved aresolution to issue a total of 441,079 shares of Stock Options to our employeesas part of their total compensation for employment.  The Stock Options are excisable at theclosing price of the common stock on the date of issuance or the date ofapproval by the board of directors.  TheStock Options vest in equal amounts quarterly over four years and are subjectto other standard terms and conditions as provided by the 2004 Stock Plan.  In August 2008, certain employees agreedto accept a total of 46,795 shares of common stock, in lieu of a portion oftheir fiscal 2008 bonus.

 

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**ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

 

**ITEM 9A. CONTROLS AND PROCEDURES**

 

**Disclosure Controls and Procedures**

 

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in ourExchange Act reports is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’s rules andforms and that such information is accumulated and communicated to this Company’smanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate to allow for timely decisions regarding required disclosure.

 

As required by Securities and Exchange Commission Rule 13a-15(b),we carried out an evaluation, under the supervision and with the participationof the Company’s management, including our Chief Executive Officer and theCompany’s Chief Financial Officer, of the effectiveness of the design andoperation of our disclosure controls and procedures as of the end of thequarter covered by this report. Based on the foregoing, our Chief ExecutiveOfficer and Chief Financial Officer concluded that our disclosure controls andprocedures are effective in ensuring that the information required to be disclosedin our reports filed or submitted under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission rules and forms.

 

**Management’s Report on InternalControl Over Financial Reporting**

 

The Company’s management is responsible forestablishing and maintaining adequate internal control over financialreporting, as such term is defined in Rule 13a-15(f) of theSecurities Exchange Act of 1934, as a process designed by, or under thesupervision of, the company’s principal executive and principal financialofficers and effected by the Company’s board of directors, management and otherpersonnel, to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for externalpurposes in accordance with accounting principles generally accepted in theUnited States of America and includes those policies and procedures that:

 
| · |   | Pertain to the maintenance of records that in reasonable  detail accurately and fairly reflect the transactions and dispositions of the  assets of the company;                                                                                                                                                                                                                 |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                            |
| · |   | Provide reasonable assurance that transactions are  recorded as necessary to permit preparation of financial statements in  accordance with accounting principles generally accepted in the United States  of America and that receipts and expenditures of the company are being made  only in accordance with authorizations of management and directors of the  company; and |
|   |   |                                                                                                                                                                                                                                                                                                                                                                            |
| · |   | Provide reasonable assurance regarding prevention or  timely detection of unauthorized acquisition, use or disposition of the  company’s assets that could have a material affect on the financial  statements.                                                                                                                                                            |

 

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Therefore,even those systems determined to be effective can provide only reasonableassurance with respect to financial statement preparation andpresentation.  Also, projections of anyevaluation of effectiveness to future periods are subject to risk that controlsmay become inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.  Under the supervision and with theparticipation of management, including the Chief Executive Officer and theChief Financial Officer, an evaluation was conducted on the effectiveness ofthe Company’s internal control over financial reporting based on criteriaestablished in the Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission.  Management concluded that the Companymaintained effective internal control over financial reporting as of June 30,2008.

 

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This annual report does not include an attestationreport of the Company’s registered public accounting firm regarding internalcontrol over financial reporting. Management’s report was not subject to attestation by the Company’sregistered public accounting firm pursuant to temporary rules of theSecurities and Exchange Commission that permit the Company to provide onlymanagement’s report in this annual report.

 

**Changes in Internal Control OverFinancial Reporting**

 

There has been no change in the Company’s internalcontrol over financial reporting during the quarter ended June 30, 2008that has materially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

**ITEM 9B. OTHER INFORMATION**

** **

None

 

**PART III**

 

**ITEM10.  DIRECTORS, EXECUTIVE OFFICERS  AND CORPORATE GOVERNANCE**

 

Incorporated by referenceto the Company’s Proxy Statement to be filed with the Commission pursuant toRegulation 14A within 120 days of the end of the Company’s 2008 fiscal year.

 

**ITEM11. EXECUTIVE COMPENSATION.**

 

Incorporated by referenceto the Company’s Proxy Statement to be filed with the Commission pursuant toRegulation 14A within 120 days of the end of the Company’s 2008 fiscal year.

 

**ITEM12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATEDSTOCKHOLDER MATTERS.**

 

Incorporated by referenceto the Company’s Proxy Statement to be filed with the Commission pursuant toRegulation 14A within 120 days of the end of the Company’s 2008 fiscal year.

 

**ITEM13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, DIRECTOR INDEPENDENCE.**

 

Incorporated by referenceto the Company’s Proxy Statement to be filed with the Commission pursuant toRegulation 14A within 120 days of the end of the Company’s 2008 fiscal year.

 

**ITEM14.  PRINCIPAL ACCOUNTANT FEES ANDSERVICES**

 

Incorporated by referenceto the Company’s Proxy Statement to be filed with the Commission pursuant toRegulation 14A within 120 days of the end of the Company’s 2008 fiscal year.

 

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**PART IV.**

 

**ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

 

(a) Thefollowing documents are filed as part of this report:

 
| **1.**     | **Financial  Statements.**                                                                                                                                                                                                                                                                                                                                                                                                                   |
|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| ** ** | **Our  consolidated financial statements are included in Part II, Item 8 of  this report:**                                                                                                                                                                                                                                                                                                                                             |
| ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|       | Report of Independent  Registered Public Accounting Firm                                                                                                                                                                                                                                                                                                                                                                                     |
|       |                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|       | Consolidated Balance  Sheets                                                                                                                                                                                                                                                                                                                                                                                                                 |
|       |                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|       | Consolidated Statements  of Operations                                                                                                                                                                                                                                                                                                                                                                                                       |
|       |                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|       | Consolidated Statements  of Cash Flows                                                                                                                                                                                                                                                                                                                                                                                                       |
|       |                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|       | Consolidated Statements  of Stockholders’ Equity                                                                                                                                                                                                                                                                                                                                                                                        |
|       |                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|       | Notes to the  Consolidated Financial Statements                                                                                                                                                                                                                                                                                                                                                                                              |
|       |                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| **2.**     | **Financial  Statements Schedules and supplementary information required to be submitted:**                                                                                                                                                                                                                                                                                                                                                  |
|       |                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|       | None.                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|       |                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| **3.**     | **Exhibits**                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|       |                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|       | A list of the exhibits  filed or furnished with this report on Form 10-K (or incorporated by  reference to exhibits previously filed or furnished by us) is provided in the  Exhibit Index beginning on page 60 of this report.  Those  exhibits incorporated by reference herein are indicated as such by the  information supplied in the parenthetical thereafter.  Otherwise, the  exhibits are filed herewith. |

 

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**SIGNATURES**

 

In accordance with Section 13or 15(d) of the Securities Exchange Act of 1934, the registrant causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized in the City of Houston, Texas, on the date indicated.

 
| **Evolution  Petroleum Corporation** |
|--------------------------------------|
|                                 |   |   |   |
|                                 | *By:* | */s/* | *ROBERT  S. HERLIN* |
|                                 | * * | * * | *Robert  S. Herlin* |
|                                 | * * | * * | *Chief  Executive Officer* |
|                                 | * * | * * | *(Principal  Executive Officer)* |
| * *                             | * * | * * | * * |
| * *                             | * * | * * | * * |
|                                 | *By:* | */s/* | *STERLING  H. MCDONALD* |
|                                 | * * | * * | *Sterling  H. McDonald* |
|                                 | * * | * * | *Vice  President and Chief Financial Officer* |
|                                 | * * | * * | *(Principal  Financial and* |
|                                 | * * | * * | *Accounting  Officer)* |
| *Date:  September 24, 2008*     | * * | * * | * * |

 

 

In accordance with theSecurities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities and on thedates indicated.

 
| **Date**                   | ** ** | **Signature**           | ** ** | **Title**                |
|----------------------------|------------|-------------------------|------------|--------------------------|
|                       |       |                    |       |                     |
| *September 24,  2008* | * *   | */s/ E.  J. DIPAOLO*    | * *   | *Director*               |
|                       | * *   | *E.  J. DiPaolo*        | * *   | * *                 |
| * *                   | * *   | * *                | * *   | * *                 |
| * *                   | * *   | * *                | * *   | * *                 |
| *September 24,  2008* | * *   | */s/ GENE  STOEVER*     | * *   | *Director*               |
|                       | * *   | *Gene  Stoever*         | * *   | * *                 |
| * *                   | * *   | * *                | * *   | * *                 |
| * *                   | * *   | * *                | * *   | * *                 |
| *September 24,  2008* | * *   | */s/ WILLIAM  DOZIER*   | * *   | *Director*               |
|                       | * *   | *William  Dozier*       | * *   | * *                 |
| * *                   | * *   | * *                | * *   | * *                 |
| * *                   | * *   | * *                | * *   | * *                 |
| *September 24,  2008* | * *   | */s/ LAIRD  Q. CAGAN*   | * *   | *Chairman  of the Board* |
| * *                   | * *   | *Laird  Q. Cagan*       | * *   | * *                 |
| * *                   | * *   | * *                | * *   | * *                 |
| * *                   | * *   | * *                | * *   | * *                 |
| *September 24,  2008* | * *   | */s/ ROBERT  S. HERLIN* | * *   | *Director*               |
|                       | * *   | *Robert  S. Herlin*     | * *   | * *                 |

 

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**INDEX OF EXHIBITS**

 

****MASTER EXHIBIT INDEX****

 
| ****EXHIBIT  NUMBER**** | **** **** | ****DESCRIPTION****                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|-------------------------|----------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                     |           | Asset Purchase  Agreement for Tullos Field, dated September 3, 2004 (Previously filed as  an exhibit to Form 8-K on September 9, 2004)                                                                                                                                                                                                                                                                                                                                                   |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.2                     |           | Definitive Asset  Purchase Agreement, dated as of February 2, 2005, by and between  Chadco, Inc., Alan Chadwick McCartney, Sonya McCartney and NGS Sub.  Corp. (Previously filed as an exhibit in Form 8-K on February 8,  2005)                                                                                                                                                                                                                                                    |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.3                     |           | Purchase and Sale  Agreement, by and between NGS Sub Corp. and Denbury Onshore, LLC, dated May 8,  2006 (Previously filed as an exhibit to Form 8-K on May 11, 2006)                                                                                                                                                                                                                                                                                                                     |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.4                     |           | Purchase and Sale  Agreement I, by and between NGS Sub Corp. and Denbury Onshore, LLC, dated  May 8, 2006 (Previously filed as an exhibit to Form 8-K on  June 16, 2006)                                                                                                                                                                                                                                                                                                                 |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.5                     |           | Purchase and Sale  Agreement II, by and between NGS Sub Corp. and Denbury Onshore, LLC, dated  May 8, 2006 (Previously filed as an exhibit to Form 8-K on  June 16, 2006)                                                                                                                                                                                                                                                                                                                |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.6                     |           | Conveyance, Assignment  and Bill of Sale Agreement, by and between NGS Sub Corp. and Denbury Onshore,  LLC, dated May 8, 2006 (Previously filed as an exhibit to Form 8-K  on June 16, 2006)                                                                                                                                                                                                                                                                                             |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2.7                     |           | 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 Natural Gas Systems, Inc.  (incorporated by reference to the Current Report on Form 8-K/A filed by  Natural Gas Systems, Inc. with the Securities and Exchange Commission on  April 27, 2004) (Previously filed as an exhibit to Form Schedule  13D on July 11, 2008) |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.1                     |           | Articles of  Incorporation (Previously filed as an exhibit to the Company’s Current Report  on Form 8-K on February 7, 2002)                                                                                                                                                                                                                                                                                                                                                             |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.2                     |           | Certificate of  Amendment to Articles of Incorporation (Previously filed as an exhibit to the  Company’s Current Report on Form 8-K on February 7, 2002)                                                                                                                                                                                                                                                                                                                                 |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.3                     |           | Certificate of  Amendment to Articles of Incorporation (Previously filed as an exhibit to  Form SB 2/A on October 19, 2005)                                                                                                                                                                                                                                                                                                                                                                   |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.4                     |           | Bylaws (Previously  filed as an exhibit to the Company’s Current Report on Form 8-K on  February 7, 2002)                                                                                                                                                                                                                                                                                                                                                                                |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 3.5                     |           | Amended Bylaws  (Previously filed as an exhibit to Form 10KSB on March 31, 2004)                                                                                                                                                                                                                                                                                                                                                                                                              |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 4.1                     |           | Form of Stock  Option Agreement for the Natural Gas Systems 2004 Stock Plan (Previously  filed as an exhibit to the Current Report on Form 8–K on April 8,  2005)                                                                                                                                                                                                                                                                                                                   |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 4.2                     |           | Articles of Merger  (Previously filed as an exhibit to Form SB – 2/A on October 19,  2005)                                                                                                                                                                                                                                                                                                                                                                                               |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 4.3                     |           | Form of Warrant  Agreement between Natural Gas Systems, Inc. and Tatum CFO Partners, LLP  (Previously filed as an exhibit to the Company’s Current Report on  Form 8-K on April 8, 2005)                                                                                                                                                                                                                                                                                       |
|                    |           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 4.4                     |           | Revocable Warrant  Agreement between Natural Gas Systems, Inc. and Daryl V. Mazzanti  (Previously filed as an exhibit to the Company’s Current Report on  Form 8-K on June 29, 2005)                                                                                                                                                                                                                                                                                                |

 

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| 4.5    |   | Specimen form of the  Company’s Common Stock Certificate (Previously filed herewith as an exhibit  to Form SB – 2/A on October 19, 2005)                                                                                                                               |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.6    |   | Securities Purchase  Agreement dated as of May 6, 2005, by and between Natural Gas  Systems, Inc. and Rubicon Master Fund (Previously filed as an exhibit to  the Company’s Current Report on Form 8-K on May 11, 2005)                                           |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.7    |   | Registration Rights  Agreement dated as of May 6, 2005, by and between Natural Gas  Systems, Inc. and Rubicon Master Fund (Previously filed as an exhibit to  the Company’s Current Report on Form 8-K on May 11, 2005)                                           |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.8    |   | Stock Grant Agreement,  dated as of May 4, 2005, by and between Natural Gas Systems, Inc.  and Liviakis Financial Communications, Inc. (Previously filed as an  exhibit to the Company’s Current Report on Form 8-K on May 11,  2005)                        |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.9    |   | Herlin Stock Option  Agreement, dated April 4, 2005 (Previously filed as an exhibit to the  Company’s Current Report on Form 8-K on April 8, 2005)                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.10   |   | Revocable Warrant  Agreement between Natural Gas Systems, Inc. and Robert S. Herlin, dated  April 4, 2005 (Previously filed as an exhibit to the Company’s Current  Report on Form 8-K on April 8, 2005)                                                          |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.11   |   | Amended and Restated  Tatum Resources Agreement, dated January 1, 2005 (Previously filed as an  exhibit to the Company’s Current Report on Form 8-K on April 8,  2005)                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.12   |   | Warrant Agreement  between Natural Gas Systems, Inc. and Tatum CFO Partners, LLP, dated  January 1, 2005 (Previously filed as an exhibit to the Company’s Current  Report on Form 8-K on April 8, 2005)                                                           |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.13   |   | McDonald Stock Option  Agreement, dated April 4, 2005 (Previously filed as an exhibit to the  Company’s Current Report on Form 8-K on April 8, 2005)                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.14   |   | Warrant Agreement,  dated as of February 2, 2005, between Natural Gas Systems, Inc. and  Prospect Energy Corporation (Previously filed as an exhibit to the Company’s  Current Report on Form 8-K on February 8, 2005)                                            |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.15   |   | Natural Gas  Systems, Inc. Common Stock Purchase Warrant in favor of Prospect Energy  Corporation, dated as of February 2, 2005 (Previously filed as an exhibit  to the Company’s Current Report on Form 8-K on February 8, 2005)                                 |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.16   |   | Revocable Warrant  Agreement, dated as of February 2, 2005, between Natural Gas  Systems, Inc. and Prospect Energy Corporation (Previously filed as an  exhibit to the Company’s Current Report on Form 8-K on February 8,  2005)                                 |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.17   |   | Natural Gas  Systems, Inc. Revocable Common Stock Purchase Warrant in favor of  Prospect Energy Corporation, dated as of February 2, 2005 (Previously  filed as an exhibit to the Company’s Current Report on Form 8-K on  February 8, 2005)                      |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.18   |   | Registration Rights  Agreement, dated as of February 2, 2005, between Natural Gas  Systems, Inc. and Holders of Common Stock of Natural Gas  Systems, Inc. (Previously filed as an exhibit to the Company’s Current  Report on Form 8-K on February 8, 2005) |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.19   |   | Form of  Registration Rights Agreement (Previously filed as an exhibit to the  Company’s Current Report on Form 8-K on October 26, 2004)                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.20   |   | 2004 Stock Plan  (Previously filed as an exhibit to the Company’s Definitive Information  Statement on Schedule 14C on August 9, 2004)                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                       |
| 4.21   |   | 2003 Stock Option Plan,  adopted September 25, 2003 (Previously filed as an exhibit to the  Company’s                                                                                                                                                                            |

 

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|   |   | Form 8-K on  January 24, 2007)                                                                                                                                                                                                                                        |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                            |
| 4.22   |   | Second Revocable  Warrant Agreement , dated as of September 27, 2005, between Natural Gas  Systems, Inc. and Prospect Energy Corporation (Previously filed as an  exhibit to the Company’s Report on Form 10-KSB on September 28,  2005)               |
|   |   |                                                                                                                                                                                                                                                                            |
| 4.23   |   | Stock Option Agreement,  dated June 23, 2005 between Natural Gas Systems, Inc. and Daryl V.  Mazzanti (Previously filed as an exhibit to the Company’s Current Report on  Form 8-K on June 29, 2005)                                                   |
|   |   |                                                                                                                                                                                                                                                                            |
| 4.24   |   | Stock Option Grant  Agreement, dated June 23, 2005 between Natural Gas Systems, Inc.  and Daryl V. Mazzanti (Previously filed as an exhibit to the Company’s  Current Report on Form 8-K on June 29, 2005)                                             |
|   |   |                                                                                                                                                                                                                                                                            |
| 4.25   |   | Securities Purchase  Agreement dated as of January 13, 2006, by and between Natural Gas  Systems, Inc. and Rubicon Master Fund (Previously filed as an exhibit to  the Company’s Current Report on Form 8-K on January 20, 2006)                       |
|   |   |                                                                                                                                                                                                                                                                            |
| 4.26   |   | Amended and Restated  Registration Rights Agreement dated as of January 13, 2006, by and  between Natural Gas Systems, Inc. and Rubicon Master Fund (Previously  filed as an exhibit to the Company’s Current Report on Form 8-K on  January 20, 2006) |
|   |   |                                                                                                                                                                                                                                                                            |
| 4.27   |   | Third Revocable Warrant  Agreement, by and between Prospect Energy Corporation and Natural Gas  Systems, Inc., dated January 31, 2006 (Previously filed as an  exhibit to Form SB – 2/A on March 3, 2006)                                              |
|   |   |                                                                                                                                                                                                                                                                            |
| 4.28   |   | Amendment No. 1 to  the Registration Rights Agreement, by and between Prospect Energy Corporation  and Natural Gas Systems, Inc., dated January 31, 2006 (Previously  filed as an exhibit to Form SB – 2/A on March 3, 2006)                      |
|   |   |                                                                                                                                                                                                                                                                            |
| 4.29   |   | Subordinated Promissory  Note, dated March 3, 2006, between Natural Gas Systems, Inc. and  Laird Q. Cagan (Previously filed as an exhibit to Form 8-K on  March 8, 2006)                                                                                    |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.1   |   | Third Amendment to  Consulting Agreement between Liviakis Financial Communications, Inc. and  Evolution Petroleum dated November 14, 2006 (Previously filed as an  exhibit to Form 10-QSB on February 14, 2007)                                             |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.2   |   | Executive Employment  Agreement of Robert S. Herlin, dated April 4, 2005 (Previously filed as  an exhibit to Form 8-K on April 8, 2005)                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.3   |   | Executive Employment  Agreement of Sterling H. McDonald, dated April 4, 2005 (Previously filed  as an exhibit to Form 8-K on April 8, 2005)                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.4   |   | Executive Employment  Agreement of Daryl V. Mazzanti, dated June 23, 2005 (Previously filed as  an exhibit to Form 8-K on June 29, 2005)                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.5   |   | Master Services  Agreement, dated September 29, 2005, by and between the NGS  Technologies, Inc. and MTEM, Ltd. (Previously filed as an exhibit on  Form 8-K on October 7, 2005)                                                                            |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.6   |   | Agreement with  Chadbourn Securities, Inc., dated February 13, 2006 (Previously  filed as an exhibit to Form 10QSB on February 14, 2006)                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.7   |   | Agreement with Cagan  McAfee Capital Partners, LLC, dated February 13, 2006 (Previously filed  as an exhibit to Form 10QSB on February 14, 2006)                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.8   |   | Unit Operating  Agreement, by and between NGS Sub Corp. and Denbury Onshore, LLC, dated  May 8, 2006 (Previously filed as an exhibit to Form 8-K on  June 16, 2006)                                                                                              |
|   |   |                                                                                                                                                                                                                                                                            |
| 10.9   |   | Form of  Indemnification Agreement for Officers and Directors, as adopted on  September 20, 2006 (Previously filed as an exhibit to Form 8-K on  September 22, 2006)                                                                                        |

 

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| 10.10  |   | Asset Purchase and Sale  Agreement by and between NGS SUB. CORP. (Seller) and MWM Energy, LLC (Buyer),  dated February 15, 2008 (Previously filed as an exhibit to  Form 10-Q on May 14, 2008)                             |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                      |
| 10.11  |   | Evolution Petroleum  Corporation Amended and Restated 2004 Stock Plan (Previously filed as Annex A  to Form Schedule 14A on October 29, 2007)                                                                                   |
|   |   |                                                                                                                                                                                                                                      |
| 14.1   |   | Code of Business  Conduct and Ethics for Natural Gas Systems, Inc. (Previously filed as an  exhibit to Form 8-K on May 4, 2006)                                                                                            |
|   |   |                                                                                                                                                                                                                                      |
| 21.1   |   | List of Subsidiaries of  Evolution Petroleum Corporation (Filed herein)                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                      |
| 23.1   |   | Consent of  Hein & Associates, LLP, independent auditors (Filed herein)                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                      |
| 23.2   |   | Consent of W. D. Von  Gonten & Co. (Filed herein)                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                      |
| 31.1   |   | Certification of Chief  Executive Officer Robert S. Herlin Pursuant to Rule 15D-14 of the  Securities Exchange Act of 1934, as Amended as Adopted Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 (Filed herein)     |
|   |   |                                                                                                                                                                                                                                      |
| 31.2   |   | Certification of Chief  Financial Officer Sterling H. McDonald Pursuant to Rule 15D-14 of the  Securities Exchange Act of 1934, as Amended as Adopted Pursuant to Section 302  of the Sarbanes-Oxley Act of 2002 (Filed herein) |
|   |   |                                                                                                                                                                                                                                      |
| 32.1   |   | Certification of Chief  Executive Officer Robert S. Herlin Pursuant to 18 U.S.C. Section 1350,  as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  (Filed herein)                                            |
|   |   |                                                                                                                                                                                                                                      |
| 32.2   |   | Certification of Chief  Financial Officer Sterling H. McDonald Pursuant to 18 U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 (Filed herein)                                        |
|   |   |                                                                                                                                                                                                                                      |
| 99.1   |   | Audit Committee Charter  of the Board of Directors of Natural Gas Systems, Inc. (Previously filed  as an exhibit to Form 8-K on May 4, 2006)                                                                               |
|   |   |                                                                                                                                                                                                                                      |
| 99.2   |   | Compensation Committee  Charter of the Board of Directors of Natural Gas Systems, Inc.  (Previously filed as an exhibit to Form 8-K on May 4, 2006)                                                                        |
|   |   |                                                                                                                                                                                                                                      |
| 99.3   |   | Nominating Committee  Charter of the Board of Directors of Natural Gas Systems, Inc.  (Previously filed as an exhibit to Form 8-K on May 4, 2006)                                                                          |

 

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