**U. S. SECURITIES AND EXCHANGE COMMISSION**

**Washington, D. C.  20549**

 

**FORM10-QSB**

 

**ý****  QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15 (D)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended June 30, 2004**

 

**o****  TRANSITION REPORT UNDER SECTION13 OR 15(d) OF THE EXCHANGE ACT**

 

**For the transition period from                     to                    **

 

**Commission File No.  0-6404**

 

**GATEWAYENERGY CORPORATION**

(Exact name of small business issuer as specified in its charter)

 
| **Delaware**                                                    | ** ** | **44-0651207**                           |
|-----------------------------------------------------------------|------------|------------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer Identification  Number) |

 

**500 Dallas Street, Suite 2615Houston, TX  77002**

(Address of principal executive offices)

 

**(713) 336-0844**

(Issuer’s telephone number)

 

Check whetherthe issuer (1) filed all reports required to be filed by Section 13 or 15(d) ofthe Exchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes  ý      No  o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act.) Yes    o     No    ý

 

As of August10, 2004, the Issuer had 15,778,349 shares of its common stock outstanding.

 

TransitionalSmall Business Disclosure Format: Yes   o      No  ý

 

 

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**FORM 10-QSB**

 

**Part  I**

 

**Item 1.****                                FinancialStatements**

 
| Unaudited Consolidated Balance Sheet  as of June 30, 2004                                                                    |   |
|------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                         |   |
| Unaudited  Consolidated Statements of Operations  for the three months and six months ended June 30, 2004  and June 30, 2003 |   |
|                                                                                                                         |   |
| Unaudited Consolidated Statements of Cash  Flows  for the six months ended June 30, 2004  and June 30, 2003                  |   |
|                                                                                                                         |   |
| Notes  to Consolidated Financial Statements                                                                                  |   |

 

2

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**GATEWAY ENERGY CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETJune 30, 2004****(Unaudited)**

 
| **ASSETS**                                                                                                   |   |        |      |
|--------------------------------------------------------------------------------------------------------------|--------|-------------|-----------|
| Current Assets                                                                                               |   |        |      |
| Cash and cash equivalents                                                                                    |   | $           | 91,225    |   |
| Certificates of deposit                                                                                      |   | 5,745       |      |
| Trade accounts receivable                                                                                    |   | 1,127,226   |      |
| Inventories, at average cost                                                                                 |   | 49,624      |      |
| Prepaid expenses and other  assets                                                                           |   | 135,879     |      |
| Total current assets                                                                                         |   | 1,409,699   |      |
|                                                                                                         |   |        |      |
| Property and Equipment, at cost                                                                              |   |        |      |
| Gas gathering, processing and  transportation                                                                |   | 10,328,157  |      |
| Office furniture and other  equipment                                                                        |   | 815,566     |      |
|                                                                                                         |   | 11,143,723  |      |
| Less accumulated depreciation  and amortization                                                              |   | 3,976,875   |      |
|                                                                                                         |   | 7,166,848   |      |
| Other Assets                                                                                                 |   |        |      |
| Investment in AET license, net  of accumulated amortization of $135,544                                      |   | 285,506     |      |
| Other                                                                                                        |   | 193,542     |      |
|                                                                                                         |   | 479,048     |      |
|                                                                                                         |   | $           | 9,055,595 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                               |   |        |      |
| Current Liabilities                                                                                          |   |        |      |
| Accounts payable                                                                                             |   | $           | 1,076,546 |   |
| Accrued expenses and other  liabilities                                                                      |   | 196,407     |      |
| Notes payable                                                                                                |   | 221,388     |      |
| Current maturities of long-term  debt                                                                        |   | 1,132,719   |      |
| Current maturities of long-term  lease                                                                       |   | 10,179      |      |
| Total current liabilities                                                                                    |   | 2,637,239   |      |
|                                                                                                         |   |        |      |
| Noncurrent Liabilities                                                                                       |   |        |      |
| Future asset retirement  obligations                                                                         |   | 309,937     |      |
| Payable to ADAC                                                                                              |   | 118,559     |      |
|                                                                                                         |   | 428,496     |      |
|                                                                                                         |   |        |      |
| Long-term debt, less current  maturities                                                                     |   | 1,899,217   |      |
| Long-term capital lease, less  current maturities                                                            |   | 80,411      |      |
|                                                                                                         |   |        |      |
| Commitment and contingencies                                                                                 |   | —      |      |
|                                                                                                         |   |        |      |
| Stockholders’ Equity                                                                                    |   |        |      |
| Preferred stock – $1.00 par  value; 10,000 shares authorized; no shares issued and outstanding          |   | —      |      |
| Common stock – $0.25 par value;  35,000,000 shares authorized; 15,778,349 shares issued and outstanding |   | 3,944,585   |      |
| Additional paid-in capital                                                                                   |   | 16,024,591  |      |
| Accumulated deficit                                                                                          |   | (15,958,944 | )         |
|                                                                                                         |   | 4,010,232   |      |
|                                                                                                         |   | $           | 9,055,595 |   |

 

The accompanying notes are an integral partof these financial statements.

 

3

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**GATEWAY ENERGY CORPORATION AND SUBSIDIARIES****CONSOLIDATED STATEMENTS OF OPERATIONS****(Unaudited)**

 
| ** **                                                                         | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Operating revenues                                                                 |       |                             |       |                           |       |   |   |   |   |
| Natural gas sales                                                                  |       | $                                | 5,863,666  |                           | $          | 2,241,009 |   | $ | 10,909,475 |   | $ | 4,931,580 |   |
| Transportation of natural gas and liquids                                          |       | 89,187                           |       | 134,129                        |       | 180,160 |   | 241,281 |   |
| Treating and other                                                                 |       | 36,738                           |       | 42,357                         |       | 73,176 |   | 78,726 |   |
|                                                                               |       | 5,989,591                        |       | 2,417,495                      |       | 11,162,811 |   | 5,251,587 |   |
| Operating costs and expenses                                                       |       |                             |       |                           |       |   |   |   |   |
| Cost of natural gas purchased                                                      |       | 5,363,934                        |       | 1,972,725                      |       | 9,802,472 |   | 4,081,535 |   |
| Operation and maintenance                                                          |       | 235,109                          |       | 232,276                        |       | 462,773 |   | 460,676 |   |
| Depreciation and amortization                                                      |       | 157,183                          |       | 143,123                        |       | 316,167 |   | 276,943 |   |
| Accretion                                                                          |       | 5,361                            |       | 3,618                          |       | 10,719 |   | 7,236 |   |
| General and administrative                                                         |       | 443,063                          |       | 454,873                        |       | 828,149 |   | 850,229 |   |
|                                                                               |       | 6,204,650                        |       | 2,806,615                      |       | 11,420,280 |   | 5,676,619 |   |
| Operating loss                                                                     |       | (215,059                         | )          | (389,120                       | )          | (257,469 | ) | (425,032 | ) |
|                                                                               |       |                             |       |                           |       |   |   |   |   |
| Other income (expense)                                                             |       |                             |       |                           |       |   |   |   |   |
| Interest income                                                                    |       | 110                              |       | 5,672                          |       | 1,161 |   | 12,626 |   |
| Interest expense                                                                   |       | (106,403                         | )          | (79,116                        | )          | (223,859 | ) | (133,510 | ) |
| Interest capitalized                                                               |       | —                           |       | 13,240                         |       | — |   | 24,466 |   |
| Gain on disposal of assets                                                         |       | —                           |       | —                         |       | — |   | 5,807 |   |
| Other income (expense), net                                                        |       | (512                             | )          | 7,862                          |       | 78,554 |   | 9,016 |   |
|                                                                               |       | (106,805                         | )          | (52,342                        | )          | (144,144 | ) | (81,595 | ) |
| Loss from continuing operations                                                    |       | (321,864                         | )          | (441,462                       | )          | (401,613 | ) | (506,627 | ) |
|                                                                               |       |                             |       |                           |       |   |   |   |   |
| Discontinued operations                                                            |       |                             |       |                           |       |   |   |   |   |
| Gain (loss) on disposal of  properties                                             |       | (1,224                           | )          | —                         |       | 42,480 |   | — |   |
|                                                                               |       |                             |       |                           |       |   |   |   |   |
| Loss before cumulative effect  of change in accounting principle                   |       | (323,088                         | )          | (441,462                       | )          | (359,133 | ) | (506,627 | ) |
|                                                                               |       |                             |       |                           |       |   |   |   |   |
| Cumulative effect of change in  accounting for future asset retirement obligations |       | —                           |       | —                         |       | — |   | (105,777 | ) |
|                                                                               |       |                             |       |                           |       |   |   |   |   |
| Net loss                                                                           |       | $                                | (323,088   | )                              | $          | (441,462 | ) | $ | (359,133 | ) | $ | (612,404 | ) |
|                                                                               |       |                             |       |                           |       |   |   |   |   |
| Basic and diluted loss per  share                                                  |       |                             |       |                           |       |   |   |   |   |
| Continuing operations                                                              |       | $                                | (0.02      | )                              | $          | (0.03 | ) | $ | (0.02 | ) | $ | (0.03 | ) |
| Discontinued operations                                                            |       | —                           |       | —                         |       | — |   | — |   |
| Cumulative effect of change in  accounting principle                               |       | —                           |       | —                         |       | — |   | (0.01 | ) |
| Net loss                                                                           |       | $                                | (0.02      | )                              | $          | (0.03 | ) | $ | (0.02 | ) | $ | (0.04 | ) |
|                                                                               |       |                             |       |                           |       |   |   |   |   |
| Weighted average number of  common shares outstanding                              |       |                             |       |                           |       |   |   |   |   |
| Basic and diluted                                                                  |       | 15,714,442                       |       | 15,426,317                     |       | 15,700,320 |   | 15,426,317 |   |

 

The accompanying notes are an integral partof these financial statements.

 

4

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**GATEWAY ENERGY CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**

 
| ** **                                                                                 | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                 | ** ** | **2004**                      | ** ** | **2003** | ** ** |
| Cash flows from operating  activities                                                      |       |                          |       |   |   |
| Net loss                                                                                   |       | $                             | (359,133   | ) | $ | (612,404 | ) |
| Adjustments to reconcile net  loss to net cash (used in) provided by operating activities: |       |                          |       |   |   |
| Cumulative effect of change in  accounting principle                                       |       | —                        |       | 105,777 |   |
| Depreciation and amortization                                                              |       | 316,167                       |       | 276,943 |   |
| Gain on disposal of assets                                                                 |       | —                        |       | (5,807 | ) |
| Discontinued operations-gain on  sale of properties                                        |       | (42,480                       | )          | — |   |
| Stock option compensation  expense                                                         |       | —                        |       | 21,425 |   |
| Issuance of common stock                                                                   |       | 29,997                        |       | — |   |
| Accretion expense                                                                          |       | 10,720                        |       | 7,236 |   |
| Payable to ADAC                                                                            |       | 28,593                        |       | — |   |
| Other non-cash expenses, net                                                               |       | 19,954                        |       | 13,838 |   |
| Change in assets and  liabilities:                                                         |       |                          |       |   |   |
| Trade accounts receivable                                                                  |       | 893,807                       |       | (293,337 | ) |
| Inventories                                                                                |       | (3,379                        | )          | (2,428 | ) |
| Prepaid expenses and other  current assets                                                 |       | (71,770                       | )          | (27,395 | ) |
| Accounts payable                                                                           |       | (870,022                      | )          | 637,232 |   |
| Accrued expenses and other  liabilities                                                    |       | 71,720                        |       | 148,404 |   |
| Net cash (used in) provided by  operating activities                                       |       | 24,174                        |       | 269,484 |   |
|                                                                                       |       |                          |       |   |   |
| Cash flows from investing  activities                                                      |       |                          |       |   |   |
| Capital expenditures                                                                       |       | (41,383                       | )          | (1,911,594 | ) |
| Proceeds from sale of  properties                                                          |       | —                        |       | 14,500 |   |
| Proceeds from contingent  payment                                                          |       | 42,480                        |       | — |   |
| Decrease in certificates of  deposit                                                       |       | 125,000                       |       | 522,932 |   |
| Other assets                                                                               |       | 1,328                         |       | 1,249 |   |
| Net cash provided by (used in)  investing activities                                       |       | 127,425                       |       | (1,372,913 | ) |
|                                                                                       |       |                          |       |   |   |
| Cash flows from financing  activities                                                      |       |                          |       |   |   |
| Proceeds from borrowings                                                                   |       | 167,000                       |       | 2,192,886 |   |
| Payments on borrowings                                                                     |       | (344,181                      | )          | (819,139 | ) |
| Deferred financing costs                                                                   |       | (85,566                       | )          | (39,480 | ) |
| Net cash (used in) provided by  financing activities                                       |       | (262,747                      | )          | 1,334,267 |   |
|                                                                                       |       |                          |       |   |   |
| Net (decrease) increase in cash  and cash equivalents                                      |       | (111,148                      | )          | 230,838 |   |
| Cash and cash equivalents at  beginning of period                                          |       | 202,373                       |       | 80,888 |   |
|                                                                                       |       |                          |       |   |   |
| Cash and cash equivalents at  end of period                                                |       | $                             | 91,225     |   | $ | 311,726 |   |
|                                                                                       |       |                          |       |   |   |
| Supplemental Disclosures of  Cash Flow Information:                                        |       |                          |       |   |   |
| Cash paid for interest  (including capitalized interest)                                   |       | $                             | 127,114    |   | $ | 118,482 |   |

 

The accompanying notes are an integral partof these financial statements.

 

5

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**GATEWAY ENERGY CORPORATION AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

 

**(1)****                                 Principlesof Consolidation and Nature of Business**

 

Theconsolidated financial statements include the accounts of Gateway EnergyCorporation and its wholly owned subsidiary companies, Gateway PipelineCompany, Gateway Offshore Pipeline Company, Gateway Energy Marketing Company,Fort Cobb Fuel Authority, L.L.C. and Gateway Processing Company.  All significant intercompany transactionshave been eliminated in consolidation.

 

Theaccompanying consolidated financial statements have been prepared by theCompany, without audit.  In the opinionof management, such financial statements reflect all adjustments necessary fora fair presentation of the financial position and results of operations inaccordance with U.S. generally accepted accounting principles.  The financial statements should be read inconjunction with the financial statements and the notes thereto included in theCompany’s Annual Report on Form 10-KSB for the year ended December 31, 2003.

 

The Companyowns and operates natural gas gathering, transportation and distributionsystems and related facilities in Texas and Oklahoma, and offshore in Texas andfederal waters of the Gulf of Mexico. The Company also has an exclusive license in the U.S. for a patentedtechnology for the rejection of nitrogen from natural gas streams.

 

**(2)****                                 Summaryof Significant Accounting Policies**

 

A summary ofthe significant accounting policies consistently applied in the preparation ofthe accompanying consolidated financial statements follows.  Certain reclassifications have been made tothe prior period statements to be consistent with the current presentation.

 

*Revenue Recognition Policy*

 

Sales revenuesare recognized at the redelivery point, which is the point at which title tothe gas transfers.  The Company’stransportation revenues are generated under contracts which have a stated feeper unit of production (Mcf, MMBtu, or Bbl) gathered or transported.  Transportation revenues are recognized at theredelivery point, which is the point at which another party takes physicalcustody of the gas or liquid hydrocarbons.

 

*Property and Equipment*

 

Property andequipment is stated at cost, plus capitalized interest costs on major projectsduring their construction period. Additions and improvements that add to the productive capacity or extendthe useful life of an asset are capitalized. Expenditures for maintenance and repairs are charged to expense asincurred.  At June 30, 2004, property andequipment included $96,389of equipment financed under a capital lease, net of $3,611 of accumulated amortization.  Depreciation and amortization is providedusing the straight-line method over estimated useful lives ranging from 6 to 30years for pipeline systems, gas plant and processing equipment, and from 2 to10 years for office furniture and other equipment.  Upon disposition or retirement of pipelinecomponents or gas plant components, any gain or loss is charged or credited toaccumulated depreciation.  When entirepipeline systems, gas plants or other property and equipment are retired orsold, any resulting gain or loss is credited to or charged against operations.

 

For the sixmonths ended June 30, 2004 and 2003, depreciation expense was $300,146 and $262,311, respectively.

 

Impairment losses arerecognized for long-lived assets used in operations when indicators ofimpairment are present and the undiscounted cash flows are not sufficient torecover the assets’ carrying value.  Theamount of impairment is measured by comparing the fair value of the asset toits carrying amount, and any impairment so determined is recorded in thecurrent period.  There have been noimpairments of long-lived assets required during the six months ended June 30,2004 and 2003.

 

*Asset Retirement Obligation*

 

The Companyprovides for the future asset retirement obligations related to the Shipwreckoffshore production platform because, eventually, law or regulation willrequire its abandonment.  The presentvalue of the estimated future asset retirement obligation, as of the date ofacquisition, was capitalized to gasgathering, processing and transportation equipment.  The present value of the estimated futureasset retirement obligation, as of the balance

 

6

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sheet date, is presented as anoncurrent liability.  Until the platformis ultimately sold or retired, the Company will recognize (i) depreciationexpense on the additional capitalized costs; (ii) accretion expense as thepresent value of the future asset retirement obligation increases with thepassage of time, and; (iii) the impact, if any, of changes in estimates of theliability.  The following table setsforth a reconciliation of the beginning and ending aggregate carrying amount ofasset retirement obligations for the six months ended June 30, 2004 and 2003:

 
| ** **        | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------|------------|-------------------------------|------------|
| ** **        | ** ** | **2004**                      | ** ** | **2003** | ** ** |
| Beginning balance |       | $                             | 299,218    |   | $ | 202,007 |   |
| Accretion         |       | 10,719                        |       | 7,236 |   |
| Ending balance    |       | $                             | 309,937    |   | $ | 209,243 |   |

 

EffectiveJanuary 1, 2003, the Company adopted Statement of Financial AccountingStandards, or SFAS, No. 143, which requires recognition of future assetretirement obligations.  The cumulativeeffect of adopting this statement was to increase net loss for the six monthsended June 30, 2003 by $105,777, or $0.01 per common share.

 

*Other Assets*

 

The Company’sprimary other asset, its license for a patented process to remove nitrogen fromstreams of natural gas, is being amortized to expense over the average 18-yearremaining life of the underlying patents.

 

*Cash Equivalents and Supplemental Disclosure of Noncash Investing andFinancing Activities*

 

For purposesof the consolidated statements of cash flows, the Company considers all highlyliquid debt instruments purchased with original maturities of three months orless to be cash equivalents.

 

During the sixmonths ended June 30, 2003, the Company recognized future asset retirementobligations related to prior periods totaling $202,007 pursuant to SFAS No.143, discussed above.  A portion of suchcosts—$96,230 (net of accumulated depreciation of $15,883)—was capitalized togas gathering, processing and transportation assets.  The remainder of these prior year costs wasexpensed as the cumulative, noncash effect of change in accounting principle.

 

The Company agreed to pay toADAC $24,000, in exchange for its consent to modify the terms of theMadisonville term loan, ratably over a twelve-month period beginning theearlier of the month following maturity of the balloon note or the monthfollowing ADAC’s exercise of their option to prepay the balloon note asdiscussed in Note 4.  The present valueof this obligation at inception was $18,641, using an imputed interest rate of10%, and is included in the amount payable to ADAC, with a corresponding amountcapitalized to deferred loan costs on the accompanying balance sheet.  This amount will be amortized to interestexpense ratably over the life of the term loan.

 

*Income Taxes*

 

Deferred taxassets and liabilities are recognized for the expected future tax consequencesof events that have been included in the financial statements or income taxreturns. Under this method, deferred tax assets and liabilities are determinedbased on the difference between the financial statement and tax bases of assetsand liabilities as measured by the enacted tax rates expected to apply whenthese differences reverse. Deferred tax assets are reduced by a valuationallowance when it is more likely than not that they will not be realized.  The deferred tax provision is the result ofchanges in deferred tax assets and liabilities.

 

*Stock-Based Compensation*

 

The Companyaccounts for its stock-based employee compensation plan under the recognitionand measurement principles of Accounting Principles Board (“APB”) Opinion No.25, “Accounting for Stock Issued to Employees,” and relatedInterpretations.  No stock-based employeecompensation cost (except for the compensation expense related to certainrepriced options) is reflected in net loss, as all options granted under the planhad an exercise price equal to the market value of the underlying common stockat the date of grant.

 

7

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During May2004, the Company issued 92,310 shares of common stock to its nonemployeedirectors as part of their annual compensation for service to the Company.  A total of $29,997 was charged to general andadministrative expense for the three months and six months ended June 30, 2004in connection with these shares.

 

At June 30,2004, the fair value of the Company’s stock-based awards to employees wasestimated using a Black-Scholes option pricing model.  The Black-Scholes model was developed for usein estimating the fair value of traded options which have no vestingrestrictions and are fully transferable. In addition, the Black-Scholes model requires the input of highlysubjective assumptions including the expected stock price volatility.  Because the Company’s stock-based awards havecharacteristics significantly different from those of traded options, andbecause changes in the subjective input can materially affect the fair valueestimate, in management’s opinion, the existing models do not necessarilyprovide a reliable single measure of the fair value of its stock-based awardsto employees.  The fair value of theCompany’s stock-based awards (including the repriced options) was estimatedassuming no expected dividends and the following weighted average assumptionsas of June 30, 2004 and 2003:

 
| ** **                      | ** ** | **June 30,** | ** ** |
|---------------------------------|------------|--------------|------------|
| ** **                      | ** ** | **2004**     | ** ** | **2003** | ** ** |
| Expected life in years          |       | 4.5          |       | 5.5 |   |
| Expected stock price volatility |       | 85           | %          | 92 | % |
| Risk-free interest rate         |       | 2.97         | %          | 3.82 | % |
| Average fair value per option   |       | $            | 0.14       |   | $ | 0.26 |   |
|                                 |            |              |            |  |  |  |  |

 

For pro formapurposes, the estimated value of the Company’s stock-based awards to employeesis amortized over the options’ vesting period. The following table illustrates the effect on net loss and net loss pershare if the Company had applied the fair value recognition provisions of SFASNo. 123, “Accounting for Stock-Based Compensation,” to its stock-based employeecompensation for the three months and six months ended June 30, 2004 and 2003:

 
| ** **                                                                                                                                   | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                   | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                                         |       |                             |       |                           |       |   |   |   |   |
| Net loss – as reported                                                                                                                  |       | $                                | (323,088   | )                              | $          | (441,462 | ) | $ | (359,133 | ) | $ | (612,404 | ) |
| Deduct total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (4,604                           | )          | (5,228                         | )          | (10,535 | ) | (8,994 | ) |
| Net loss – pro forma                                                                                                                    |       | $                                | (327,692   | )                              | $          | (446,690 | ) | $ | (369,668 | ) | $ | (621,398 | ) |
|                                                                                                                                         |       |                             |       |                           |       |   |   |   |   |
| Basic and diluted net loss per share – as  reported                                                                                     |       | $                                | (0.02      | )                              | $          | (0.03 | ) | $ | (0.02 | ) | $ | (0.04 | ) |
| Basic and diluted net loss per share – pro  forma                                                                                       |       | $                                | (0.02      | )                              | $          | (0.03 | ) | $ | (0.02 | ) | $ | (0.04 | ) |

* *

*Earnings Per Share*

 

Basic earningsper share is computed by dividing net earnings or loss by the weighted averagenumber of common shares outstanding during the period.  Diluted earnings per share is computed bydividing net earnings or loss by the weighted average number of sharesoutstanding, after giving effect to potentially dilutive common shareequivalents outstanding during the period. Potentially dilutive common share equivalents are not included in thecomputation of diluted earnings per share if they are anti-dilutive.  Diluted loss per common share is the same asbasic for all periods presented because the effect of potentially dilutivecommon shares arising from outstanding stock options and warrants wasanti-dilutive.  For the three monthsended June 30, 2004 and 2003, the potentially dilutive common shares were31,243 and 32,292, respectively.  For thesix months ended June 30, 2004 and 2003, the potentially dilutive common shareswere 36,082 and 27,082, respectively.

 

8

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*Use of Estimates*

 

Thepreparation of financial statements in conformity with U.S. generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and the disclosureof contingent assets and liabilities at the date of the financial statementsand the reported amounts of revenues and expenses during the reportingperiod.  Actual results could differ fromthose estimates.

 

**(3)****                                 Acquisitionsand Divestitures**

 

The Companymade total capital expenditures of $1,911,594 during the six months ended June30, 2003, primarily in connection with the construction of the pipelinesservicing the Madisonville Plant—a four-inch gathering line, a three-inchinjection line and a ten-inch pipeline to transport the pipeline quality gas.

 

**(4)****                                 Debt**

 

*Notes Payable*

 

The Company’srevolving credit agreement provides for maximum available borrowings of up to$250,000 through May 22, 2005.  Principaloutstanding under the agreement accrues interest at a variable rate, based onthe bank’s prime rate index plus 1.25%, with a minimum rate of 8%.  The balance under the agreement is due upondemand, or if no demand is made, at maturity, and is renewable annually.  Costs of obtaining this debt are beingcharged to interest expense ratably over the maturity period of the note.  Fort Cobb uses the proceeds from time to timefor general working capital purposes. The agreement, along with the Fort Cobb Term Note discussed below, iscollateralized with the assets of Fort Cobb and guaranteed by the Company.  The Company had $28,612 of availableborrowings under the agreement as of June 30, 2004.

 

*Long-term Debt*

 

Long-term debtat June 30, 2004 consisted of the following:

 
| Subordinated notes                  |   | $         | 234,327   |   |
|-------------------------------------|--------|-----------|-----------|--------|
| Term note – Fort Cobb          |   | 517,164   |      |
| Term note – Madisonville       |   | 1,269,457 |      |
| Balloon note – Madisonville    |   | 900,000   |      |
| Term note – Fort Cobb vehicles |   | 41,474    |      |
| Trade note payable                  |   | 69,514    |      |
|                                |   | 3,031,936 |      |
| Less current maturities             |   | 1,132,719 |      |
|                                |   | $         | 1,899,217 |   |

 

*Subordinated Notes*

 

In connectionwith the Recapitalization that was effective March 1, 1997, the Company issuedsubordinated promissory notes with a face amount of $1,171,700.  The stated interest rate is 10% payablequarterly with equal annual principal payments beginning on March 1, 2000 andcontinuing through March 1, 2004.  TheCompany calculated the fair market value of the notes to be $978,000 at March1, 1997 and recorded the difference between fair value and the face amount asdiscount on subordinated notes.  Thediscount is being amortized to interest expense using the effective interestmethod over the term of the subordinated notes. Such charge to interest expense was $4,611 for the six months ended June30, 2004 and $6,917 for the six months ended June 30, 2003.  As a result, the effective interest rate ofthe subordinated notes is 13.9% for the six months ended June 30, 2004 and 15%for the six months ended June 30, 2003.

 

At June 30,2004, the final principal payment totaling $234,327, which was due under thesenotes on March 1, 2004, remained unpaid. Under the terms of the subordinated notes, the Company had a sixty-dayperiod in which to make this payment and prevent acceleration of the remainingoutstanding principal.  Due to thesubordinated rights of the note holders, the Company was able to obtain a limitedwaiver from the bank for the violation of a Madisonville term loan agreementcovenant not to allow such a default. This final payment of principal and interest is expected to be paid fromthe proceeds of the financing described in Note 5.  The subordinated note holders have

 

9

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been separately notified thatthey will continue to receive interest at an annual rate of 10% on the finalprincipal installment outstanding until such time as it is paid.

 

*Term Note – Fort Cobb*

 

Effective June1, 2001, Fort Cobb borrowed $750,000 from a bank.  Principal outstanding under the note accruesinterest at a variable rate, based on the bank’s prime rate index plus 11⁄4%,with a minimum rate of 8%.  The interestrate at June 30, 2004 was 8%.  The noterequires monthly payments of approximately $13,000, with the balance under thenote due June 1, 2008.  Costs ofobtaining this debt are being charged to interest expense ratably over thematurity period of the note.  Fort Cobb usedthe proceeds to refinance its borrowings from the Company, and the Company usedthe proceeds for general corporate purposes.

 

*Term Note –Madisonville*

 

Effective February 21, 2002,Gateway Pipeline Company and Gateway Processing Company, as the borrowers,entered into a term note agreement with a bank. Effective November 15, 2003, the term note agreement was amended tomodify provisions governing intercompany debt payments from the borrowers toGateway Energy Corporation.  EffectiveMarch 31, 2004, the term note agreement was amended to extend an interest-onlyperiod for the months of April through July 2004.  All other terms and conditions of the termnote, including the maturity date, remained the same.  The term note agreement was modified toprovide the Company additional working capital during the period thatadditional costs are likely to be incurred to effect the financing described inNote 5.  The Company agreed to pay toADAC $24,000, in exchange for its consent to modify the loan terms, ratablyover a twelve-month period beginning the earlier of the month followingmaturity of the balloon note or the month following ADAC’s exercise of theiroption to prepay the balloon note as discussed below.  The present value of this obligation atinception was $18,641, using an imputed interest rate of 10%, and is includedin the amount payable to ADAC, with a corresponding amount capitalized todeferred loan costs on the accompanying balance sheet, to be recognized asinterest expense ratably over the term of the agreement.

 

Under the term note, asamended effective March 31, 2004, the borrowers received $1.5 million inmultiple advances.  The January, Februaryand March 2004 payments of principal and interest were each $54,819.  The monthly note payments for April throughJuly 2004 will be interest only at a fixed annual rate of 7.25%.  Thereafter the note requires 16 monthlypayments of principal and interest of $70,000, with a final payment ofapproximately $226,000, representing unpaid principal and accrued, but unpaid,interest due at the December 31, 2005 maturity date.  Costs of securing this debt are being chargedto interest expense ratably over the maturity period of the note.  The proceeds were used to finance theconstruction of the Madisonville pipeline facilities.  The term note is collateralized with theCompany’s economic interest in the Madisonville project and the Waxahachiepipeline system, and the Company has guaranteed the loan and pledged the commonstock of the borrowers.  The term note agreementcontains cross collateral and cross default provisions linking it to theballoon note, described below.

 

Some or all of the term noteis expected to be retired before the end of 2004 with the proceeds of thefinancing described in Note 5.

 

*Balloon Note – Madisonville*

 

EffectiveMarch 31, 2003, the Company entered into a balloon credit agreement, referredto herein as the balloon note.  Under theballoon note agreement, the borrowers received $900,000 in multiple advances.  Principal outstanding under the balloon noteaccrues interest at a fixed annual rate of 71⁄4% and the note will mature afterthirty-six months.  The monthly notepayments represent interest only on the total balance outstanding.  Costs of securing this debt are being chargedto interest expense ratably over the maturity period of the note.  The proceeds were used to finance the remainingconstruction costs of the Pipeline Facilities, and to fund the principal andinterest payments which were due under the Company’s subordinated note agreementson March 1, 2003.

 

The balloonnote is collateralized with letters of credit obtained through Allen DrillingAcquisition Company, a Nebraska corporation (“ADAC”).  Charles A. Holtgraves, a director of theCompany, is President and a director of ADAC, and Larry J. Horbach, a directorof the Company, is Secretary and a director of ADAC.  Mr. Holtgraves owns directly no shares ofADAC common stock, and owns 14.65% of an entity that owns 55.56% of the ADACsenior preferred stock.  Such preferredstock has a stated dividend rate equal to two-thirds (66-2/3%) of any

 

10

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Madisonville payments receivedby ADAC pursuant to the Agreement discussed below.  Mr. Horbach does not own, directly orindirectly, any ADAC common or preferred stock.

 

Under the terms of theagreement with ADAC, dated March 6, 2003 (the “Agreement”), ADAC agreed toprovide security acceptable to the Company’s primary bank to allow the Companyto borrow the proceeds of the balloon note. In exchange, ADAC will receive, during the term of the balloon note,one-half (50%) of the price upside portion only, if any, of the monthly fee tobe received by the Company pursuant to the Madisonville projectagreements.  Under the Agreement, ADACwill have the option to either: (i) receive at the end of the term of theballoon note a lump-sum payment, which when added to the payments received, ifany, for the price upside portion, will result in a 15% pre-tax internal rateof return on the $900,000, or (ii) pay off the balloon note on or before theend of the balloon note term in exchange for a one-third (33-1/3%) ownershipinterest in the Pipeline Facilities from that date forward.  The Company is obligated to pay the periodicinterest payments to the bank during the three-year term of the balloonnote.  Further, the Company grantedliens, subordinate to the Company’s bank liens, on the Company’s economicinterest in the Madisonville project, its Waxahachie pipeline system, and itsFort Cobb subsidiary.  The agreementcontains cross collateral and cross default provisions linking it to theMadisonville Term Note, described above.

 

*Term Note– Fort Cobb Vehicles*

 

Effective March 2003, FortCobb borrowed $57,900 from a bank to buy three replacement service vehicles.  The note requires monthly principal andinterest payments of $1,387, reflecting interest at 6.99%, and matures on March25, 2007.

 

*Trade NotePayable*

 

Effective October 2003, inconnection with the settlement of a dispute mediation, the Company executed atrade note for $100,000, bearing no interest, payable in eighteen monthlyinstallments of $5,200 and one final installment of $6,400.  The note is secured by a lien on theCompany’s Crystal Beach terminal facility. Interest expense is being recognized over the life of the note at animputed rate of 10%; accordingly, the obligation was recorded at its presentvalue of $91,290.

 

*Letters of Credit*

 

As of June 30,2004, the Company had outstanding letters of credit totaling $800,000.

 

**(5)****                                 Statusof InvestLinc Financing**

 

EffectiveMarch 9, 2004, the Company entered into a letter of intent with a subsidiary ofThe InvestLinc Group under which InvestLinc was to assist the Company inraising approximately $12,000,000 through a combination of a rights/follow-onoffering of its common stock and the formation of a new limited liabilitycompany funded with capital from the Company and InvestLinc.  A description of the material terms of theletter of intent is contained in a Form 8-K filed March 12, 2004.

 

As reported inthe Company’s current report on Form 8-K, dated July 27, 2004, on June 24,2004, the board of directors of the Company determined, by a 5-3 vote, toadvise InvestLinc that the Board had changed its position and was no longerwilling to grant to the new limited liability company an exclusive sublicenseto utilize the Company’s nitrogen rejection technology which it has a right touse under an exclusive license agreement with Advanced Extraction Technologies,Inc. (“AET”).  Further, the Board determinedto advise InvestLinc that there was no agreement as to new employmentagreements with Michael T. Fadden and Scott D. Heflin as required under theletter of intent.  The resolution furtherstated that: (i) the Company desires to work with InvestLinc and would bewilling to negotiate with InvestLinc on ten high nitrogen natural gas deals,and; (ii) the board will not pursue the follow-on offering proposed in theMarch 9 letter of intent.  The Companyformally notified InvestLinc of these matters on July 12, 2004.

 

On July 18,2004, InvestLinc advised the Company that it did not desire to change the termsof the letter of intent and requested that the Company acknowledge that itintended to follow through with the terms of the letter of intent.  On July 27, 2004, the Company notifiedInvestLinc that it was still willing to negotiate with respect to ten highnitrogen natural gas deals but was not willing to grant the exclusivesublicense.  The Company stated that it

 

11

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intended to allow the letter ofintent to expire by its terms on July 31, 2004. On July 28, 2004, InvestLinc made a demand upon the Company for a$250,000 break-up fee and $48,615 in expenses incurred by InvestLinc inconnection with the letter of intent.  OnAugust 4, 2004, on advice of counsel, the Company notified InvestLinc that theterms of the letter of intent did not support InvestLinc’s claim for thebreak-up fee and expenses.  The Companyreiterated its willingness to negotiate new terms for up to ten high nitrogennatural gas deals.

 

During August2004, representatives of the Company’s board of directors and Invest LincSecurities, an InvestLinc subsidiary, intend to meet and attempt to craft a newletter of intent between the Company and InvestLinc Securities to  fund the Company’s high nitrogen natural gasprojects.  There is no guarantee that theparties will agree on essential terms of a new letter of intent.  The board of directors intends to proceedwith the registered rights offering to existing stockholders, but will notpursue the follow-on offering.  The boardof directors is also considering bridge financing from one or more sources tosecure cash, if necessary, during the last half of 2004.

 

**(6)****                                 Commitmentsand Contingencies**

 

In connection with securingthe balloon note described in Note 4 that was used to finance part of theconstruction costs of the Madisonville pipeline facilities, the Company isobligated at ADAC’s option to either: (i) pay at the end of the term of the balloonnote a lump-sum, which when added to the payments made, if any, for the priceupside portion, will result in ADAC receiving a 15% pre-tax internal rate ofreturn on the $900,000, or (ii) convey to ADAC a one-third ownership interestin the pipeline facilities in exchange for ADAC paying off the balloon note onor before the end of the balloon note term. The Company is obligated to pay the periodic interest payments to thebank during the three-year term of the balloon note.

 

The Company believes that itis likely that ADAC will elect to pay off the balloon note in exchange for anownership interest in the pipeline facilities; however, it is beyond theCompany’s control.  Therefore, theminimum return guaranteed to ADAC by the Company is being accrued ratably overthe three-year term of the balloon note, and reduced by periodic price upsidepayments, if any, paid to ADAC.  Suchaccruals increased interest expense in the accompanying financial statementsfor the three months and six months ended June 30, 2004 by $33,750 and $67,500,respectively.  In the accompanyingconsolidated balance sheet as of June 30, 2004, the noncurrent payable to ADACincludes a reserve of $92,150 for such amounts not yet paid.  If ADAC elects to pay off the balloon note atmaturity or before, the reserve portion of the ADAC payable will be credited toincome.

 

The Company isactively engaged in attempting to raise capital.  See Note 5.

 

The Companyand its subsidiaries are parties to litigation and claims arising in the normalcourse of business.  Management, afterconsultation with legal counsel, believes that the liabilities, if any, arisingfrom such litigation and claims, will not be material to the consolidatedfinancial statements.

 

**(7)****                                 RelatedParty Transactions**

 

Effective March 31, 2004,the Company agreed to pay to ADAC $24,000, in exchange for its consent tomodify the terms of the Madisonville term loan, ratably over a twelve-monthperiod beginning the earlier of the month following maturity of the balloonnote or the month following ADAC’s exercise of their option to prepay theballoon note as discussed in Note 4.  Thepresent value of this obligation at inception was $18,641, using an imputedinterest rate of 10%, and is included in the amount payable to ADAC, with a correspondingamount capitalized to deferred loan costs on the accompanying balance sheet.

 

Accruedexpenses and other liabilities as of June 30, 2004 included unpaid directors’fees of $49,500.

 

**(8)****                                 SegmentDisclosures**

 

All of theCompany’s operations are in the continental U.S. and the Gulf of Mexico inTexas and federal waters.  The Company’smanagement reviews and evaluates the operations separately of three mainsegments—onshore operations, offshore operations and Fort Cobb operations.  Each segment is an aggregation of operationssubject to similar economic and regulatory conditions such that they are likelyto have similar long-term prospects for financial performance.  Onshore operations include natural gas gathering,transportation and distribution activities in Texas and Oklahoma.  Offshore operations include natural gas andliquid hydrocarbon gathering and transportation activities in the Gulf ofMexico in Texas and federal waters.  Theprincipal markets for the onshore

 

12

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segment are industrialcustomers, and for the offshore segment they are affiliates of large intrastateand interstate pipeline companies.  FortCobb operations are comprised of a local natural gas distribution company inOklahoma.  This segment supplies naturalgas to approximately 2,350 customers, principally for irrigation and cropdrying fuel for farming cooperatives, and residential fuel.

 

The accountingpolicies of the reportable segments are the same as those described in Note2.  The Company evaluates the segmentsbased on operating margin, defined as revenues less cost of purchased gas andoperating and maintenance expenses.  Suchamounts are before general and administrative expense, depreciation, interestincome or expense or income taxes. Inter-segment sales of $274,000 and $155,000 were eliminated duringconsolidation for the three months ended June 30, 2004 and 2003.  Inter-segment sales of $696,000 and $638,000were eliminated during consolidation for the six months ended June 30, 2004 and2003.

 

Summarizedfinancial information of the Company’s reportable segments, and areconciliation of operating margin to consolidated net loss, is presentedbelow:

 
| ** **                                                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                    | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Onshore  Operations**                                       |       |                             |       |                           |       |   |   |   |   |
| Revenues                                                      |       | $                                | 5,609,734  |                           | $          | 1,967,097 |   | $ | 10,068,353 |   | $ | 3,947,828 |   |
| Operating margin                                              |       | 372,482                          |       | 144,287                        |       | 704,355 |   | 362,068 |   |
| Depreciation and amortization                                 |       | 69,867                           |       | 58,681                         |       | 141,536 |   | 108,094 |   |
| Interest expense                                              |       | 93,289                           |       | 60,011                         |       | 192,342 |   | 96,469 |   |
| Capital expenditures                                          |       | 13,906                           |       | 774,732                        |       | 31,684 |   | 1,824,559 |   |
| Total assets                                                  |       | 5,627,899                        |       | 6,151,209                      |       | 5,627,899 |   | 6,151,209 |   |
|                                                          |       |                             |       |                           |       |   |   |   |   |
| **Offshore  Operations**                                      |       |                             |       |                           |       |   |   |   |   |
| Revenues                                                      |       | 111,830                          |       | 164,806                        |       | 225,975 |   | 308,071 |   |
| Operating margin                                              |       | 50,310                           |       | 101,022                        |       | 100,620 |   | 178,024 |   |
| Depreciation and amortization                                 |       | 37,693                           |       | 35,941                         |       | 75,385 |   | 71,850 |   |
| Total assets                                                  |       | 1,430,344                        |       | 1,729,238                      |       | 1,430,344 |   | 1,729,238 |   |
|                                                          |       |                             |       |                           |       |   |   |   |   |
| **Fort  Cobb Operations**                                     |       |                             |       |                           |       |   |   |   |   |
| Revenues                                                      |       | 268,027                          |       | 285,592                        |       | 868,483 |   | 995,688 |   |
| Operating margin                                              |       | (32,244                          | )          | (32,815                        | )          | 92,591 |   | 169,284 |   |
| Depreciation and amortization                                 |       | 49,623                           |       | 48,501                         |       | 99,246 |   | 96,999 |   |
| Interest expense                                              |       | 13,114                           |       | 19,105                         |       | 31,517 |   | 37,041 |   |
| Capital expenditures                                          |       | 405                              |       | 12,376                         |       | 9,699 |   | 87,035 |   |
| Total assets                                                  |       | 1,997,352                        |       | 2,140,607                      |       | 1,997,352 |   | 2,140,607 |   |
|                                                          |       |                             |       |                           |       |   |   |   |   |
| **Total**                                                     |       |                             |       |                           |       |   |   |   |   |
| Revenues                                                      |       | 5,989,591                        |       | 2,417,495                      |       | 11,162,811 |   | 5,251,587 |   |
| Operating margin                                              |       | 390,548                          |       | 212,494                        |       | 897,566 |   | 709,376 |   |
| Depreciation and amortization                                 |       | 157,183                          |       | 143,123                        |       | 316,167 |   | 276,943 |   |
| Interest expense                                              |       | 106,403                          |       | 79,116                         |       | 223,859 |   | 133,510 |   |
| Capital expenditures                                          |       | 14,311                           |       | 787,108                        |       | 41,383 |   | 1,911,594 |   |
| Total assets                                                  |       | 9,055,595                        |       | 10,021,054                     |       | 9,055,595 |   | 10,021,054 |   |
|                                                          |       |                             |       |                           |       |   |   |   |   |
| **Reconciliation  to net loss**                               |       |                             |       |                           |       |   |   |   |   |
| Operating margin                                              |       | $                                | 390,548    |                           | $          | 212,494 |   | $ | 897,566 |   | $ | 709,376 |   |
| Depreciation and amortization                                 |       | 157,183                          |       | 143,123                        |       | 316,167 |   | 276,943 |   |
| Accretion                                                     |       | 5,361                            |       | 3,618                          |       | 10,719 |   | 7,236 |   |
| General and administrative                                    |       | 443,063                          |       | 454,873                        |       | 828,149 |   | 850,229 |   |
| Other income (expense), net                                   |       | (106,805                         | )          | (52,342                        | )          | (144,144 | ) | (81,595 | ) |
| Discontinued operations – gain (loss) on  sale of assets |       | (1,224                           | )          | —                         |       | 42,480 |   | — |   |
| Cumulative effect of change in accounting  principle          |       | —                           |       | —                         |       | — |   | (105,777 | ) |
| Net loss                                                      |       | $                                | (323,088   | )                              | $          | (441,462 | ) | $ | (359,133 | ) | $ | (612,404 | ) |

 

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**Item 2.****                                   Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

 

The following management’sdiscussion and analysis contains trend analysis and other forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities Exchange Act of 1934, as amended.  Actual results could differ materially fromthose projected in the forward-looking statements throughout this document as aresult of the risk factors set forth below in the section entitled *Factors Affecting Future Results* and elsewhere in thisdocument.

 

**CriticalAccounting Policies**

 

The followingaccounting policies are considered by management to be the most critical to thefair presentation of the Company’s financial condition, results of operationsand cash flows.  The policies areconsistently applied in the preparation of the accompanying consolidatedfinancial statements; however, certain reclassifications have been made to theprior period statements to be consistent with the current presentation.

 

*Revenue Recognition Policy*

 

Sales revenuesare recognized at the redelivery point, which is the point at which title tothe gas transfers.  The Company’stransportation revenues are generated under contracts which have a stated feeper unit of production (Mcf, MMBtu, or Bbl) gathered or transported.  Transportation revenues are recognized at theredelivery point, which is the point at which another party takes physicalcustody of the gas or liquid hydrocarbons.

 

*Property and Equipment*

 

Property andequipment is stated at cost, plus capitalized interest costs on major pipelineprojects during their construction period. Additions and improvements that add to the productive capacity or extendthe useful life of an asset are capitalized. Expenditures for maintenance and repairs are charged to expense asincurred.  Depreciation is provided usingthe straight-line method over estimated useful lives ranging from 6 to 30 yearsfor pipeline systems, gas plant and processing equipment, and from 2 to 10years for office furniture and other equipment. Upon disposition or retirement of pipeline components or gas plantcomponents, any gain or loss is charged or credited to accumulateddepreciation.  When entire pipelinesystems, gas plants or other property and equipment are retired or sold, anyresulting gain or loss is credited to or charged against operations.

 

Impairmentlosses are recognized for long-lived assets used in operations when indicatorsof impairment are present and the undiscounted cash flows are not sufficient torecover the assets’ carrying value.  Theamount of impairment is measured by comparing the fair value of the asset toits carrying amount.

 

*Asset Retirement Obligation*

 

The Companyprovides for the future asset retirement obligations related to the Shipwreckoffshore production platform because, eventually, law or regulation willrequire its abandonment.  The presentvalue of the estimated future asset retirement obligation, as of the date ofacquisition, was capitalized to gasgathering, processing and transportation equipment.  The present value of the estimated futureasset retirement obligation, as of the balance sheet date, is presented as anoncurrent liability.  Until the platformis ultimately sold or retired, the Company will recognize (i) depreciationexpense on the additional capitalized costs; (ii) accretion expense as thepresent value of the future asset retirement obligation increases with thepassage of time, and; (iii) the impact, if any, of changes in estimates of theliability.  The following table setsforth a reconciliation of the beginning and ending aggregate carrying amount ofasset retirement obligations for the six months ended June 30, 2004 and 2003:

 

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| ** **        | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------|------------|-------------------------------|------------|
| ** **        | ** ** | **2004**                      | ** ** | **2003** | ** ** |
| Beginning balance |       | $                             | 299,218    |   | $ | 202,007 |   |
| Accretion         |       | 10,719                        |       | 7,236 |   |
| Ending balance    |       | $                             | 309,937    |   | $ | 209,243 |   |

 

EffectiveJanuary 1, 2003, the Company adopted Statement of Financial AccountingStandards, or SFAS, No. 143, which requires recognition of future assetretirement obligations.  The cumulativeeffect of adopting this statement was to increase net loss for the six monthsended June 30, 2003 by $105,777, or $0.01 per common share.

 

*Other Assets*

 

The Company’sprimary other asset, its license for a patented process to remove nitrogen fromstreams of natural gas, is being amortized to expense over the average 18-yearremaining life of the underlying patents.

 

*Use of Estimates*

 

Thepreparation of financial statements in conformity with U.S. generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and the disclosureof contingent assets and liabilities at the date of the financial statementsand the reported amounts of revenues and expenses during the reportingperiod.  Actual results could differ fromthose estimates.

 

**Results ofOperations**

 

*General*

 

The Henry Hubclosing index price for natural gas during the six months ended June 30, 2004averaged $5.84 per MMBtu, compared to $5.99 for the same period of the prioryear.  In the accompanying financialstatements, the Company’s revenues from sales of natural gas, along with thecost of purchased gas, increased proportionately from prior year levels.  Apart from the Madisonville pipeline facilities,where the Company receives an additional amount equal to 4.5% of the aggregatesales proceeds of gas sold from the Madisonville plant for an average priceabove $3.75 per MMBtu, the Company’s net operating margin is relativelyinsensitive to fluctuations in the market price of gas because the sales pricesand purchase costs of gas move in tandem, or else revenues are generated undercontracts which have a stated fee per unit of production (Mcf, MMBtu, or Bbl)gathered or transported.  Accordingly,the Company evaluates each of its activities based on the operating margin itproduces.  The Company defines operatingmargin as revenues, less the cost of purchased gas and operating andmaintenance expenses.  Management reviewsand evaluates the operations of three main segments—Onshore operations,Offshore operations and Fort Cobb operations.

 

**ThreeMonths Ended June 30, 2004 Compared to June 30, 2003**

 

*Total Operations*

 

The followingtable sets forth information for the three months ended June 30, 2004 and 2003:

 
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Revenues                      |       | $        | 5,989,591  |     | $          | 2,417,495 |   |
| Operating margin              |       | 390,548  |       | 212,494  |       |
| Depreciation and amortization |       | 157,183  |       | 143,123  |       |
|                               |            |          |            |          |            |  |  |

 

Operatingmargin for the three months ended June 30, 2004 increased $178,000 compared tothe same period of the prior year. Onshore operating margin increased $228,000, Fort Cobb operating marginincreased $1,000, and Offshore operating margin decreased $51,000.  Revenues were higher than the prior perioddue to higher average sales prices of natural gas, and the startup during May2003 of the Madisonville Plant.  Theaverage Henry Hub index price was $6.00 for the three months ended June 30,2004, compared to $5.40 for the prior period. Operating margin was not proportionally affected due to the correspondingincrease in the cost of purchased gas. These segments are discussed individually below in greater detail.

 

*Onshore Operations*

 

The followingtable sets forth information for the three months ended June 30, 2004 and 2003:

 
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Revenues                      |       | $        | 5,609,734  |     | $          | 1,967,097 |   |
| Operating margin              |       | 372,482  |       | 144,287  |       |
| Depreciation and amortization |       | 69,867   |       | 58,681   |       |
|                               |            |          |            |          |            |  |  |

 

15

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Operatingmargin for Onshore operations increased during the second quarter by $228,000 comparedto the same period of the prior year, mainly due to the contribution of theMadisonville Plant ($170,000) and stronger margins from the Waxahachie system($50,000).  The Madisonville plant beganoperations during May 2003, contributing partially to the quarter ended June30, 2003, compared to a full three months of operations for the quarter endedJune 30, 2004.

 

*Offshore Operations*

 

The followingtable sets forth information for the three months ended June 30, 2004 and 2003:

 
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Revenues                      |       | $        | 111,830    |     | $          | 164,806 |   |
| Operating margin              |       | 50,310   |       | 101,022  |       |
| Depreciation and amortization |       | 37,693   |       | 35,941   |       |
|                               |            |          |            |          |            |  |  |

 

Operatingmargin for Offshore operations decreased during the quarter ended June 30, 2004by $51,000 compared to the same period of the prior year.  The decrease was primarily due to declines innatural gas and liquids volumes transported through the Company’s Pirates’Beach system ($28,000) and the Shipwreck system ($15,000).

 

*Fort Cobb Operations*

 

The followingtable sets forth information for the three months ended June 30, 2004 and 2003:

 
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Revenues                      |       | $        | 268,027    |     | $          | 285,592 |   |
| Operating margin              |       | (32,244  | )          | (32,815  | )          |
| Depreciation and amortization |       | 49,623   |       | 48,501   |       |
|                               |            |          |            |          |            |  |  |

 

Operatingmargin for Fort Cobb operations increased $1,000 during the three months endedJune 30, 2004 compared to the same period of the prior year, due to slightlyhigher gas sales volumes.  Fort Cobb’sbusiness peaks in the third and fourth quarters because a significant portionof its load comes from supplying natural gas to irrigation and crop-dryingcustomers.

 

*Operations Support*

 

The followingtable sets forth information for the three months ended June 30, 2004 and 2003:

 
| ** **                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|
| General and administrative  |       | $        | 443,063    |     | $          | 454,873 |   |
| Interest income             |       | 110      |       | 5,672    |       |
| Interest expense            |       | (106,403 | )          | (79,116  | )          |
| Interest capitalized        |       | —   |       | 13,240   |       |
| Other income (expense), net |       | (512     | )          | 7,862    |       |
| Discontinued operations     |       | (1,224   | )          | —   |       |
|                             |            |          |            |          |            |  |  |

 

General andadministrative expenses for the quarter ended June 30, 2004 are 3% lower thanfor the comparable period last year, primarily due to lower employee relatedand legal costs, partially offset by higher board and office expenses.

 

Interestincome varies directly with the balance on deposit in the Company’scertificates of deposit and short-term money market accounts.  Interest expense fluctuates directly with theamount of outstanding long-term debt and the amount of borrowings underthe Company’s revolving credit agreement. Interest capitalized in the prior period related to the construction ofthe Madisonville pipeline facilities.

 

Other incomefor the prior period includes late fees and penalties charged its customers byFort Cobb and miscellaneous adjustments.

 

Discontinuedoperations presented above reflect amounts written off related to the Company’ssale of 14 non-core natural gas gathering systems located in Texas, Oklahomaand Louisiana, effective August 1, 2002.

 

16

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**SixMonths Ended June 30, 2004 Compared to June 30, 2003**

 

*Total Operations*

 

The followingtable sets forth information for the six months ended June 30, 2004 and 2003:

 
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Revenues                      |       | $        | 11,162,811 |     | $          | 5,251,587 |   |
| Operating margin              |       | 897,566  |       | 709,376  |       |
| Depreciation and amortization |       | 316,167  |       | 276,943  |       |
|                               |            |          |            |          |            |  |  |

 

Operatingmargin for the six months ended June 30, 2004 increased $188,000 compared tothe same period of the prior year. Onshore operating margin increased $342,000, Offshore operating margindecreased $77,000, and Fort Cobb margin decreased by $77,000.  Revenues were higher than the prior period dueto the startup during May 2003 of the Madisonville Plant.  Operating margins were not proportionallyaffected due to the corresponding increase in gas purchases.  The average Henry Hub index price was $5.84 forthe six months ended June 30, 2004, compared to $5.99 for the priorperiod.  These segments are discussedindividually below in greater detail.

 

*Onshore Operations*

 

The followingtable sets forth information for the six months ended June 30, 2004 and 2003:

 
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Revenues                      |       | $        | 10,068,353 |     | $          | 3,947,828 |   |
| Operating margin              |       | 704,355  |       | 362,068  |       |
| Depreciation and amortization |       | 141,536  |       | 108,094  |       |
|                               |            |          |            |          |            |  |  |

 

Operatingmargin for onshore operations increased $342,000 during the six months endedJune 30, 2004 compared to the same period of the prior year, mainly due to thestartup during May 2003 of the Madisonville Plant ($379,000), partially offsetby lower margins from the Waxahachie system due to a customer contract change($25,000).

 

*Offshore Operations*

 

The followingtable sets forth information for the six months ended June 30, 2004 and 2003:

 
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Revenues                      |       | $        | 225,975    |     | $          | 308,071 |   |
| Operating margin              |       | 100,620  |       | 178,024  |       |
| Depreciation and amortization |       | 75,385   |       | 71,850   |       |
|                               |            |          |            |          |            |  |  |

 

Operatingmargin for Offshore operations decreased $77,000 during the six months endedJune 30, 2004 compared to the same period of the prior year.  The decrease was primarily due to declines innatural gas and liquids volumes transported through the Company’s Pirates’Beach system ($42,000) and the Shipwreck system ($29,000).

 

*Fort Cobb Operations*

 

The followingtable sets forth information for the six months ended June 30, 2004 and 2003:

 
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Revenues                      |       | $        | 868,483    |     | $          | 995,688 |   |
| Operating margin              |       | 92,591   |       | 169,284  |       |
| Depreciation and amortization |       | 99,246   |       | 96,999   |       |
|                               |            |          |            |          |            |  |  |

 

Operatingmargin for Fort Cobb operations decreased $77,000 during the six months endedJune 30, 2004 compared to the same period of the prior year, due to lower gassales volumes.  Fort Cobb’s businesspeaks in the third and fourth quarters because a significant portion of itsload comes from supplying irrigation and crop-drying customers.

 

*OperationsSupport*

 

The followingtable sets forth information for the six months ended June 30, 2004 and 2003:

 
| ** **                                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|
| General and administrative                                 |       | $        | 828,149    |     | $          | 850,229 |   |
| Interest income                                            |       | 1,161    |       | 12,626   |       |
| Interest expense                                           |       | (223,859 | )          | (133,510 | )          |
| Interest capitalized                                       |       | —   |       | 24,466   |       |
| Gain on disposal of assets                                 |       | —   |       | 5,807    |       |
| Other income, net                                          |       | 78,554   |       | 9,016    |       |
| Discontinued operations – gain on sale of  properties |       | 42,480   |       | —   |       |
| Cumulative effect of change in accounting  principle       |       | —   |       | (105,777 | )          |
|                                                            |            |          |            |          |            |  |  |

 

17

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General andadministrative expenses decreased 3% during the six months ended June 30, 2004compared to the same period of the prior year, primarily due to lower employeerelated and legal costs, partially offset by higher board and office expenses.

 

Interestincome varies directly with the balance on deposit in the Company’s certificatesof deposit and short-term money market accounts.  Interest expense fluctuates directly with theamount of outstanding long-term debt and the amount of borrowings under theCompany’s operating line of credit and revolving credit agreement. Interestcapitalized in the prior period related to the construction of the Madisonvillepipeline facilities.

 

On April 21,2004, but effective March 31, 2004, the Company factored the majority of itsreceivable from Enron North America Corp. and received $24,433, representing$0.20 on the dollar for its claim.  Thisamount is reflected in the accompanying statement of operations as other incomefor the six months ended June 30, 2004.  Otherincome for the period also includes the adjustment of approximately $48,000 ofamounts previously charged to expense, and late fees and penalties charged itscustomers by Fort Cobb and miscellaneous adjustments.

 

Discontinuedoperations presented above reflect additional cash proceeds related to theCompany’s sale of 14 non-core natural gas gathering systems located in Texas,Oklahoma and Louisiana, effective August 1, 2002.

 

The cumulativeeffect of change in accounting principle represents the aggregate difference inretained earnings that resulted from retroactively applying the provisions ofSFAS No. 143 to all prior years affected by the new accounting rules.

 

**Liquidityand Capital Resources**

 

As describedin Note 5, until June 2004, the Company anticipated that substantial reductionof its debtwould result from, and the growth of its high nitrogen natural gasbusiness would be driven by, financing secured through InvestLinc.  The letter of intent dated March 9, 2004expired by its terms on July 31, 2004. During August 2004, representatives of the Company’s board of directorsand Invest Linc Securities, an InvestLinc subsidiary, intend to meet andattempt to craft a new letter of intent between the Company and InvestLincSecurities to fund the Company’s high nitrogen natural gas projects.  There is no guarantee that the parties willagree on essential terms of a new letter of intent.  The board of directors intends to proceedwith the registered rights offering to existing stockholders, but will notpursue the follow-on offering.  The boardof directors is also considering bridge financing from one or more sources tosecure cash, if necessary, during the last half of 2004.  The Company does not know whether any of theabove sources of financing will be successful or, if successful, how muchfunding can be obtained.  The Companyalso does not know at this time what the cost of bridge financing might be.

 

The board ofdirectors is searching for new capital, the proceeds from which are necessary,in the short term, to repay the remaining $234,327 of subordinated debt plusinterest and, commencing August 31, 2004, principal and interest payments of$70,000 per month on the Company’s term note with a bank. Capital is alsoneeded to:

 

•                  fund $320,000for an additional letter of credit demanded by the supplier of natural gas forthe Company’s Waxahachie distribution operations;

 

•                  fund anestimated $150,000 for construction of a gathering pipeline to connect a secondnatural gas well being drilled near the Madisonville plant;

 

•                  negotiate, ifnecessary, an extension of the requirement to add 4,700 Mcf of high nitrogengas capacity and throughput by December 31, 2004 required to maintainexclusivity of the Company’s license with AET; and

 

•                  exploit anddevelop the Company’s high nitrogen natural gas projects.

 

18

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Until we areable to successfully raise additional growth capital, we expect to execute ourgrowth strategy through strategic alliances in high nitrogen natural gasprojects.  Also, any currently ownedproperties are subject to sale under the right circumstances (valuation andtiming) if the proceeds from any such sale could be effectively redeployed intoone or more high nitrogen natural gas projects. We may not be able to raise outside capital or be able to sell assets onterms favorable to the Company.  Withouta significant infusion of new capital, we believe we can participate in theconstruction of new nitrogen rejection facilities and generate new cash flowsto the Company, but progress will be significantly slower.

 

If we are ableto increase our involvement in this high nitrogen natural gas niche, we expectthat a majority of our operating income will be derived from our ownershipinterest in and management fees from high nitrogen natural gas projects.  Over time, we expect that our fee-basedoperating income from our current gathering, transportation, distribution andmarketing activities will become less significant, except as they support suchhigh nitrogen natural gas projects.

 

At June 30,2004, the Company’s long-term debt to total capitalization, including long-termobligations under capital leases, was approximately 34%.

 

The Company’s revolvingcredit agreement provides for maximum available borrowings of up to $250,000through May 22, 2005, and is renewable annually.  Principal outstanding under the agreementaccrues interest at a variable rate, based on the bank’s prime rate index plus1.25%, with a minimum rate of 8%.  Theinterest rate at June 30, 2004 was 8%. The balance under the agreement is due upon demand, or if no demand ismade, at maturity, and is renewable annually. Costs of obtaining this debt are being charged to interest expenseratably over the maturity period of the note. Fort Cobb uses the proceeds from time to time for general workingcapital purposes.  The agreement, alongwith the Fort Cobb term note discussed below, is collateralized with the assetsof Fort Cobb and guaranteed by the Company. The Company had $28,612 of available borrowings under the agreementas of June 30, 2004.

 

Effective June 1, 2001, FortCobb borrowed $750,000 from a bank. Principal outstanding under the note accrues interest at a variablerate, based on the bank’s prime rate index plus 1.25%, with a minimum rate of8%.  The interest rate at June 30, 2004was 8%.  The note requires monthlypayments of approximately $13,000, with the balance under the note due June 1,2008.  Costs of obtaining this debt arebeing charged to interest expense ratably over the maturity period of the note.  Fort Cobb used the proceeds to refinance itsprevious borrowings from the Company, and then the Company used the proceedsfor general corporate purposes.

 

The Company,through its subsidiaries Gateway Pipeline Company and Gateway ProcessingCompany, has a term note with a bank with a principal balance at June 30, 2004of $1,269,457.  Monthly note payments forApril through July 2004 were interest-only at a fixed annual rate of7.25%.  Thereafter, the note requires 16monthly payments of principal and interest of $70,000 with a final payment of approximately$226,000 on December 31, 2005.  The termnote is collateralized with the Company’s economic interest in the Madisonvilleproject and the Waxahachie pipeline system. The Company has guaranteed the loan and pledged the common stock of itsborrower-subsidiaries.  The term note andagreement contains cross-collateral and cross-default provisions linking it tothe ADAC balloon note described below.

 

Some or all ofthe term note is expected to be retired with proceeds from the anticipatedrights offering and any bridge financing.

 

The Companyhas a balloon note agreement with a bank under which it borrowed $900,000.  Principal accrues interest at a fixed annualrate of 7.25%, and the note matures March 31, 2006.  The balloon note is collateralized withletters of credit obtained through ADAC.

 

Under the terms of the ADACagreement, ADAC will receive, during the term of the balloon note, one-half ofthe price upside portion only, if any, of the monthly fee to be received by theCompany pursuant to the Madisonville project agreements.  Under the ADAC agreement, ADAC will have theoption to either: (i) receive at the end of the term of the balloon note alump-sum payment, which when added to the payments received, if any, for theprice upside portion, will result in a 15% pre-tax internal rate of return onthe $900,000, or (ii) pay off the balloon note on or before the end of theballoon note term in exchange for a one-third ownership interest in thepipeline facilities from that date forward. The Company is obligated to pay the periodic interest payments to thebank during the three-year term of the balloon note.  Further, the Company granted liens,subordinate to the Company’s bank liens, on the Company’s economic interest inthe Madisonville project, its Waxahachie pipeline

 

19

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system, and its Fort Cobb subsidiary.  The Agreement contains cross collateral andcross default provisions linking it to the Madisonville term note, describedabove.

 

The Company believes that itis likely that ADAC will elect to pay off the balloon note in exchange for anownership interest in the pipeline facilities; however, it is beyond theCompany’s control.  Therefore, theminimum return guaranteed to ADAC by the Company is being accrued ratably overthe three-year term of the balloon note, and reduced by periodic price upsidepayments, if any, paid to ADAC.  Suchaccruals increased interest expense in the accompanying financial statementsfor the three months and six months ended June 30, 2004 by $33,750 and $67,500,respectively.  Cash price upside paymentsto ADAC for the three months and six months ended June 30, 2004 totaled $37,875and $64,327, respectively.  If ADACelects to pay off the balloon note at maturity or before, the reserve for theADAC guarantee will be credited to income.

 

Effective March 2003, FortCobb borrowed $57,900 from a bank to buy three replacement servicevehicles.  The note requires monthlyprincipal and interest payments of $1,387, reflecting interest at 6.99%, andmatures on March 25, 2007.

 

Effective October 2003, inconnection with the settlement of a dispute mediation, the Company executed atrade note for $100,000, bearing no interest, payable in eighteen monthlyinstallments of $5,200 and one final installment of $6,400.  The note is secured by a lien on theCompany’s Crystal Beach terminal facility. Interest expense is being recognized over the life of the note at animputed rate of 10%; accordingly, the obligation was recorded at its presentvalue of $91,290.

 

As of June 30, 2004, theCompany had outstanding letters of credit totaling $800,000.

 

Natural gasprices as represented by the NYMEX Henry Hub index averaged $6.00 and $5.40 forthe three months ended June 30, 2004 and 2003, respectively.  The natural gas industry is generallyoptimistic about long-term prospects based on expected demand, the cost ofdeveloping prospects and the sales price of natural gas.  Apart from the Madisonville pipelinefacilities, where the Company receives an additional amount equal to 4.5% ofthe aggregate sales proceeds of gas sold from the Madisonville plant for anaverage price above $3.75 per MMBtu, the Company’s operating margin is notsignificantly affected by the price of natural gas since gas gathering andtransportation are generally based on fee arrangements and sales prices andpurchase costs of natural gas move in tandem. However, natural gas prices can affect exploration and development andresult in higher or lower volumes available for gathering and transportation.

 

**Off-BalanceSheet Arrangements**

 

In connectionwith securing the balloon note, the Company will be obligated at ADAC’s optionto either: (i) pay at the end of the term of the balloon note a lump-sum, whichwhen added to the payments made, if any, for the price upside portion, willresult in ADAC receiving a 15% pre-tax internal rate of return on the $900,000,or (ii) convey to ADAC a thirty-three and one-third percent ownership interestin the pipeline facilities in exchange for ADAC paying off the balloon note onor before the end of the balloon note term.

 

**FactorsAffecting Future Results**

 

Going forward,the Company’s strategy is to: maximize the potential of currently ownedpipeline properties; construct, own and operate new treating plants to removenitrogen from natural gas and related pipeline systems; and acquire and producehigh nitrogen natural gas reserves.  Theexclusive license for the patented process to reject nitrogen from natural gasstreams, together with our extensive database of sub-quality (high nitrogen)natural gas prone areas in the U.S., comprises the primary vehicle for thegrowth of our high nitrogen natural gas business, and will require significantadditional capital to exploit.  Forapproximately the past three years, we have been attempting to obtain capitalfunding for projects utilizing our nitrogen rejection technology.  During that time, one project, theMadisonville plant, has been developed using our licensed technology.

 

High nitrogengas is natural gas that contains nitrogen in excess of the maximum percentage,usually 4%, by volume acceptable to most pipeline companies.  About 16% of the domestic natural gasresource base (approximately 24 Tcf of proven reserves) is estimated by the GasTechnology Institute to be subquality because of the nitrogen content.  Most of the country’s current high nitrogennatural gas production is located in southwestern Kansas; however, there aresubstantial high nitrogen natural gas reserves in other parts of thecountry.  The Company’s target projectsare located in geographic areas with well known concentrations of high nitrogennatural gas reserves.  Much of this highnitrogen natural gas remains undeveloped or shut-in because it cannot meetpipeline quality specifications and it is geographically separated from thelarge (100,000 Mcf per day or larger) cryogenic

 

20

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nitrogen rejection plantslocated primarily in Kansas.  TheCompany’s process is well suited to treat these “stranded” reserves.

 

We have atechnological advantage in this niche due to our exclusive license in the U.S.for the nitrogen rejection process.  TheMehra Process competes favorably with other processes, as it can costeffectively adapt to variable gas flow rates and variable levels of nitrogencontent in the gas.  And, unlike themajor competing process, it is unaffected by the presence of carbon dioxide andcertain liquids in the gas.  It cantherefore economically treat relatively small volumes of gas—as little as 1,000Mcf per day—where variable gas flow and composition is common.  Successful completion of these projects willdepend upon the ability of the Company to market the technology to the producercommunity, and to obtain financing on terms satisfactory to the Company forconstruction of nitrogen rejection plants and/or acquisition of workinginterests in the high nitrogen natural gas properties.

 

Execution ofour strategies discussed above depends in part on our success raising capitalas discussed above in “Liquidity and Capital Resources.”  Any proceeds from currently anticipatedrights offering are expected to be sufficient to retire the subordinated notesbut may not be sufficient to retire the Madisonville term note.  If we cannot find a capital source to replacethe financing previously anticipated with InvestLinc, we will be dependent uponcapital from other sources including possible funds from the rights offering,costly project-by-project financing with middle-market capital providers orstrategic affiliations, any of which would require us to assign the majority ofthe economic benefits in the high nitrogen natural gas projects to others.  We could also sell selected properties, whichmight have an adverse effect upon our long-term financial position and cashflows.

 

Our operationsare significantly affected by factors that are outside the Company’scontrol.  Gas gathering and processing isdependent on throughput volume.  Pipelinethroughput is dependent on natural gas production that is significantlyaffected by natural gas prices as prices affect the willingness of producers toinvest the required capital to obtain geological and geophysical information,to drill development or exploratory wells, and to rework or maximize productionon existing wells. Natural gas prices are currently at levels that shouldprovide adequate incentive to producers; however, there is no assurance thatsuch prices will remain at current levels, and that producers will reactpositively to the current prices.

 

Natural gasretail sales are affected by weather. Much of the retail demand is for cropirrigation and drying.  Above normalprecipitation in the growing season and hot, dry weather in the fall cansignificantly reduce demand for natural gas on the Fort Cobb distributionsystem.

 

**Item3.  Controls and Procedures**

 

As of August13, 2004, under the supervision and with the participation of the Company’sChief Executive Officer and the Chief Financial Officer, management hasevaluated the effectiveness of the design and operation of the Company’sdisclosure controls and procedures. Based upon that evaluation, the Chief Executive Officer and the ChiefFinancial Officer concluded that the Company’s disclosure controls and procedureswere effective as of that date.  Therewere no significant changes in the Company’s internal controls during thefiscal quarter covered by this report that have materially affected, or arereasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

**Part II**

 

**Item 1.****                                                        LegalProceedings**

None

 

**Item 2.****                                                        Changesin Securities**

None

 

**Item 3.****                                                        DefaultsUpon Senior Securities**

None

 

21

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**Item 4.****                                                        Submissionof Matters to a Vote of Security Holders**

 

At the AnnualMeeting of Stockholders held on May 25, 2004, the eight individuals named belowwere elected to serve as directors for the upcoming year:

 
| **Name**              | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|-----------------------|------------|---------------|------------|--------------------|------------|
| Michael T. Fadden     |       | 8,487,249     |       | 4,231,410          |       |
| John B. Ewing, Jr.    |       | 10,099,400    |       | 2,619,259          |       |
| Scott D. Heflin       |       | 8,494,630     |       | 4,224,029          |       |
| Earl P. Hoffman       |       | 8,559,630     |       | 4,159,029          |       |
| Charles A. Holtgraves |       | 9,445,512     |       | 3,273,147          |       |
| Larry J. Horbach      |       | 10,318,589    |       | 2,400,070          |       |
| John A. Raasch        |       | 11,994,563    |       | 724,096            |       |
| Philip A. Wilson      |       | 11,198,916    |       | 1,519,743          |       |

 

At the AnnualMeeting of Stockholders held on May 25, 2004, the stockholders ratified theappointment of Pannell Kerr Forster of Texas, P.C. as the Company’s auditorswith a vote of 10,695,611 for, 1,722,708 against and 300,340 votes abstaining.

 

**Item 5.****                                                        OtherInformation**

None

 

**Item 6.****                                                        Exhibitsand Reports on Form 8-K.**

a)              Exhibits:

11                                    StatementRegarding Computation of Per Share Earnings

31.1                           Section302 Certification of Chief Executive Officer

31.2                           Section302 Certification of Chief Financial Officer

32.1                           Section906 Certification of Chief Executive Officer

32.2                           Section906 Certification of Chief Financial Officer

 

b)             Reportson Form 8-K:

None.

 

 

**SIGNATURES**

 

Pursuant to the requirements ofSection 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 

| /s/ Michael T. Fadden                 |   | /s/ Scott D. Heflin                   |
|---------------------------------------|--------|---------------------------------------|
| Chief Executive Officer and President |   | Chief Financial Officer and Treasurer |

 

 
| August 13, 2004 |   |   |
|-----------------|--------|--------|
| (Date)          |   |   |

 

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