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

**Washington, D. C. 20549**

 

**FORM 10-QSB**

 
| **ý****  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                                                         |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                        |   |
| **For  the quarterly period ended March 31, 2003**                                                                                                                                                          |
|                                                                                                                                                                                                        |   |   |   |
| **o****  TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT**                                                                                                                       |
|                                                                                                                                                                                                        |   |
| **For  the transition period from**              **to**              |
|                                                                                                                                                                                                        |   |
| **Commission  File No.    1-4766**                                                                                                                                                      |

 

**GATEWAY ENERGY CORPORATION**

(Exact name ofsmall 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 2615  Houston, TX  77002**       |
| (Address of  principal executive offices)                         |
|                                                              |
| **(713)  336-0844**                                               |
| (Issuer’s  telephone number)                                 |

 

APPLICABLE ONLY TOCORPORATE ISSUERS

 

As of May 5, 2003,the Issuer had 15,426,317 shares of its common stock outstanding.

 

Transitional SmallBusiness Disclosure Format: Yes  o   No  ý

 

 

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**FORM 10-QSB**

**Part I**

 
| **Item 1** | **Financial Statements**                                                                                      |
|------------|---------------------------------------------------------------------------------------------------------------|
|       |                                                                                                          |
|       | Unaudited Consolidated  Balance Sheet as of March 31, 2003                                                    |
|       |                                                                                                          |
|       | Unaudited  Consolidated Statements of Operations for the three months ended March 31,  2003 and March 31,2002 |
|       |                                                                                                          |
|       | Unaudited  Consolidated Statements of Cash Flows for the three months ended March 31,  2003 and March 31,2002 |
|       |                                                                                                          |
|       | Notes to  Unaudited Consolidated Financial Statements                                                         |

 

2

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**GATEWAY ENERGY CORPORATION AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEET**

**March 31, 2003**

**(Unaudited)**

 
| **ASSETS**                                                                                                   |   |        |       |
|--------------------------------------------------------------------------------------------------------------|--------|-------------|------------|
| Current Assets                                                                                               |   |        |       |
| Cash and cash equivalents                                                                                    |   | $           | 96,677     |   |
| Certificates of deposit                                                                                      |   | 654,258     |       |
| Trade accounts receivable, net of reserve of  $130,832                                                  |   | 1,673,616   |       |
| Inventories, at average cost                                                                                 |   | 51,388      |       |
| Prepaid expenses and other assets                                                                            |   | 300,741     |       |
| Total current assets                                                                                         |   | 2,776,680   |       |
|                                                                                                         |   |        |       |
| Property and Equipment, at  cost                                                                             |   |        |       |
| Gas gathering, processing and transportation                                                                 |   | 9,502,666   |       |
| Office furniture and other equipment                                                                         |   | 802,177     |       |
|                                                                                                         |   | 10,304,843  |       |
| Less accumulated depreciation and amortization                                                               |   | 3,268,190   |       |
|                                                                                                         |   | 7,036,653   |       |
| Other Assets                                                                                                 |   |        |       |
| Investment in AET license, net of accumulated  amortization of $99,658                                       |   | 321,392     |       |
| Other                                                                                                        |   | 76,203      |       |
|                                                                                                         |   | 397,595     |       |
|                                                                                                         |   | $           | 10,210,928 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                |   |        |       |
| Current Liabilities                                                                                          |   |        |       |
| Accounts payable                                                                                             |   | $           | 2,058,345  |   |
| Accrued expenses and other liabilities                                                                       |   | 89,688      |       |
| Notes payable                                                                                                |   | 610,364     |       |
| Current maturities of long-term debt                                                                         |   | 981,593     |       |
| Total current liabilities                                                                                    |   | 3,739,990   |       |
|                                                                                                         |   |        |       |
| Noncurrent Liabilities                                                                                       |   |        |       |
| Future asset retirement obligations                                                                          |   | 205,625     |       |
|                                                                                                         |   |        |       |
| Long-term Debt, less current  maturities                                                                     |   | 1,152,049   |       |
|                                                                                                         |   |        |       |
| 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; 15,426,317 shares issued and outstanding |   | 3,856,579   |       |
| Additional paid-in capital                                                                                   |   | 15,989,100  |       |
| Accumulated deficit                                                                                          |   | (14,732,415 | )          |
|                                                                                                         |   | 5,113,264   |       |
|                                                                                                         |   | $           | 10,210,928 |   |

 

The accompanying notes are an integral part of this statement.

 

3

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## **GATEWAYENERGY CORPORATION AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
|                                                                                                  |   | **Three  Months Ended March 31,** |      |
|-------------------------------------------------------------------------------------------------------|--------|-----------------------------------|-----------|
|                                                                                                  |   | **2003**                          |      | **2002** |   |
| Operating  revenues                                                                                   |   |                              |      |   |   |
| Sales  of natural gas                                                                                 |   | $                                 | 2,690,571 |   | $ | 1,200,391 |   |
| Transportation of  natural gas and liquids                                                            |   | 107,151                           |      | 159,845 |   |
| Treating  and other                                                                                   |   | 36,369                            |      | 63,678 |   |
|                                                                                                  |   | 2,834,091                         |      | 1,423,914 |   |
| Operating costs and expenses                                                                          |   |                              |      |   |   |
| Cost  of natural gas purchased                                                                        |   | 2,108,808                         |      | 783,193 |   |
| Operation  and maintenance                                                                            |   | 228,400                           |      | 218,090 |   |
| Depreciation  and amortization                                                                        |   | 133,821                           |      | 132,847 |   |
| General  and administrative                                                                           |   | 395,358                           |      | 488,426 |   |
|                                                                                                  |   | 2,866,387                         |      | 1,622,556 |   |
| Operating loss                                                                                        |   | (32,296                           | )         | (198,642 | ) |
|                                                                                                  |   |                              |      |   |   |
| Other  income (expense)                                                                               |   |                              |      |   |   |
| Interest  income                                                                                      |   | 6,953                             |      | 15,571 |   |
| Interest  expense                                                                                     |   | (58,012                           | )         | (47,924 | ) |
| Interest  capitalized                                                                                 |   | 11,226                            |      | 3,079 |   |
| Gain  (loss) on disposal of assets                                                                    |   | 5,807                             |      | 919 |   |
| Other  income (expense), net                                                                          |   | 1,157                             |      | 18,441 |   |
|                                                                                                  |   | (32,869                           | )         | (9,914 | ) |
| Loss from continuing  operations                                                                      |   | (65,165                           | )         | (208,556 | ) |
|                                                                                                  |   |                              |      |   |   |
| Discontinued  operations                                                                              |   |                              |      |   |   |
| Operations  of properties sold – see Note 3                                                      |   | —                            |      | (20,575 | ) |
|                                                                                                  |   |                              |      |   |   |
| Loss before cumulative effect of change in  accounting principle                                      |   | (65,165                           | )         | (229,131 | ) |
|                                                                                                  |   |                              |      |   |   |
| Cumulative  effect of change in accounting for future asset retirement obligations – see  Note 2 |   | (105,777                          | )         | — |   |
|                                                                                                  |   |                              |      |   |   |
| Net Loss                                                                                              |   | $                                 | (170,942  | ) | $ | (229,131 | ) |
|                                                                                                  |   |                              |      |   |   |
| Basic and diluted loss per share                                                                      |   |                              |      |   |   |
| Continuing operations                                                                                 |   | $                                 | —    |   | $ | (0.01 | ) |
| Discontinued operations                                                                               |   | —                            |      | — |   |
| Cumulative effect of change in accounting  principle                                                  |   | (0.01                             | )         | — |   |
| Net loss                                                                                              |   | $                                 | (0.01     | ) | $ | (0.01 | ) |
|                                                                                                  |   |                              |      |   |   |
| Pro Forma amounts assuming the new principle is  applied retroactively                                |   |                              |      |   |   |
| Loss from continuing operations                                                                       |   | $                                 | (65,165   | ) | $ | (212,400 | ) |
| Loss per basic and diluted common share  outstanding                                                  |   | $                                 | —    |   | $ | (0.01 | ) |
| Net Loss                                                                                              |   | $                                 | (65,165   | ) | $ | (232,975 | ) |
| Net loss per basic and diluted common share outstanding                                               |   | $                                 | —    |   | $ | (0.01 | ) |
|                                                                                                  |   |                              |      |   |   |
| Weighted average number of common shares  outstanding:                                                |   |                              |      |   |   |
| Basic                                                                                                 |   | 15,426,317                        |      | 15,354,880 |   |
| Diluted                                                                                               |   | 15,449,662                        |      | 15,389,755 |   |

 

The accompanyingnotes are an integral part of these statements.

 

4

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**GATEWAY ENERGY CORPORATION AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
|                                                                                          |   | **Three Months Ended March 31,** |     |
|-----------------------------------------------------------------------------------------------|--------|----------------------------------|----------|
|                                                                                          |   | **2003**                         |     | **2002** |   |
|                                                                                          |   |                             |     |   |   |
| Cash flows from operating activities                                                          |   |                             |     |   |   |
| Net loss                                                                                      |   | $                                | (170,942 | ) | $ | (229,131 | ) |
| Adjustments to reconcile net loss to net cash provided  (used) by operating activities:       |   |                             |     |   |   |
| Cumulative effect of change in accounting principal                                           |   | 105,777                          |     | — |   |
| Depreciation and amortization (including $48,375  related to discontinued operations in 2002) |   | 133,821                          |     | 181,222 |   |
| Gain on disposal of assets                                                                    |   | (5,807                           | )        | (919 | ) |
| Stock option compensation                                                                     |   | (15,803                          | )        | — |   |
| Accretion expense                                                                             |   | 3,618                            |     | — |   |
| Other noncash expenses, net                                                                   |   | 6,917                            |     | 4,318 |   |
| Change in assets and liabilities:                                                             |   |                             |     |   |   |
| Trade accounts receivable                                                                     |   | (731,371                         | )        | 7,673 |   |
| Inventories                                                                                   |   | (2,543                           | )        | (671 | ) |
| Prepaid expenses and other current assets                                                     |   | (154,541                         | )        | (102,056 | ) |
| Accounts payable                                                                              |   | 1,316,913                        |     | 55,465 |   |
| Accrued expenses and other liabilities                                                        |   | (40,654                          | )        | (43,027 | ) |
| Net cash provided (used) by operating activities                                              |   | 445,385                          |     | (127,126 | ) |
|                                                                                          |   |                             |     |   |   |
| Cash flows from investing activities                                                          |   |                             |     |   |   |
| Capital expenditures                                                                          |   | (1,124,570                       | )        | (191,795 | ) |
| Proceeds from sale of properties                                                              |   | 14,500                           |     | 1,000 |   |
| Note receivable                                                                               |   | —                           |     | 26,991 |   |
| Increase in certificate of deposit                                                            |   | (663                             | )        | — |   |
| Net cash used in investing activities                                                         |   | (1,110,733                       | )        | (163,804 | ) |
|                                                                                          |   |                             |     |   |   |
| Cash flows from financing activities                                                          |   |                             |     |   |   |
| Proceeds from borrowings                                                                      |   | 744,160                          |     | 828,000 |   |
| Payments on borrowings                                                                        |   | (64,857                          | )        | (286,916 | ) |
| Debt issue costs                                                                              |   | 1,834                            |     | — |   |
| Net cash provided by financing activities                                                     |   | 681,137                          |     | 541,084 |   |
|                                                                                          |   |                             |     |   |   |
| Net increase in cash and cash equivalents                                                     |   | 15,789                           |     | 250,154 |   |
| Cash and cash equivalents at beginning of period                                              |   | 80,888                           |     | 141,337 |   |
|                                                                                          |   |                             |     |   |   |
| Cash and cash equivalents at end of period                                                    |   | $                                | 96,677   |   | $ | 391,491 |   |
|                                                                                          |   |                             |     |   |   |
| Supplemental Disclosures of Cash Flow Information:                                            |   |                             |     |   |   |
| Cash paid for interest (including capitalized  interest)                                      |   | $                                | 45,229   |   | $ | 43,266 |   |

 

The accompanyingnotes are an integral part of these statements.

 

5

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**GATEWAY ENERGY CORPORATION AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

 

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

 

The consolidatedfinancial statements include the accounts of Gateway Energy Corporation and itswholly owned subsidiary companies, Gateway Pipeline Company, Gateway OffshorePipeline Company, Gateway Energy Marketing Company, Fort Cobb Fuel Authority,L.L.C. and Gateway Processing Company. All significant intercompany transactions have been eliminated inconsolidation.

 

The accompanying consolidated financial statementshave been prepared by the Company, without audit.  In the opinion of management, such financial statements reflectall adjustments necessary for a fair presentation of the financial position andresults of operations in accordance with accounting principles generallyaccepted in the United States of America. The financial statements should beread in conjunction with the financial statements and the notes theretoincluded in the Company’s Annual Report on Form 10-KSB for the year endedDecember 31, 2002.

 

The Company owns andoperates natural gas gathering, transportation and distribution systems andrelated facilities in Texas and Oklahoma, and offshore in Texas state andfederal waters of the Gulf of Mexico. The Company also pursues projects thatemploy its nitrogen rejection technology, and is actively evaluating severalsuch projects.  These projects arelocated in geographic areas with well known concentrations of high nitrogennatural gas reserves.  The Company has atechnological advantage in this niche, due to its exclusive U.S. license forthe nitrogen rejection process. Additionally, a substantial portion of the natural gas reserves in thelower 48 states contains nitrogen, either alone or in conjunction with othercontaminants, in excess of the maximum percentage by volume acceptable to mostpipeline companies.

 

**(2)**                                 Summary of Significant Accounting Policies

 

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

 

***Revenue Recognition Policy***

 

The Company’s salesrevenues are generated under back-to-back purchase and sales contracts.  Sales revenues are recognized at theredelivery point, which is the point at which title to the gas transfers.  The Company’s transportation revenues aregenerated under contracts which have a stated fee per unit of production (Mcf,MMBtu, or Bbl) gathered or transported. Transportation revenues are recognized at the redelivery point, which isthe point at which another party takes physical custody of the gas or liquidhydrocarbons.

 

*Property and Equipment*

 

Property and equipment isstated at cost, plus capitalized interest costs on major pipeline 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.  Depreciation 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 pipeline components or gasplant components, 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.

 

For the three monthsended March 31, 2003 and 2002, depreciation expense was $126,644 and $174,045,respectively.

 

6

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Impairment losses arerecognized for long-lived assets used in operations when indicators ofimpairment are present and the undiscounted cash flows are not sufficient to recoverthe assets’ carrying value.  The amountof impairment is measured by comparing the fair value of the asset to itscarrying amount.

 

***Other Assets***

 

The Company’s primaryother asset, its license for a patented process to remove nitrogen from streamsof natural gas, is being amortized to expense over the average 17-year life ofthe underlying patents.

* *

*Cash Equivalents and Supplemental Disclosure of NoncashInvesting and Financing Activities*

 

For purposes of theconsolidated statements of cash flows, the Company considers all highly liquiddebt instruments purchased with original maturities of three months or less tobe cash equivalents.

 

The Company recognizedfuture asset retirement obligations related to prior periods totaling $202,007pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 143,discussed below.  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 was expensed as thecumulative (noncash) effect of change in accounting principle.

 

*Income Taxes*

 

Deferred tax assets andliabilities are recognized for the expected future tax consequences of eventsthat have been included in the financial statements or income tax returns.Under this method, deferred tax assets and liabilities are determined based onthe difference between the financial statement and tax bases of assets andliabilities as measured by the enacted tax rates expected to apply when thesedifferences reverse. Deferred tax assets are reduced by a valuation allowancewhen 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 Company accounts forits stock-based employee compensation plan under the recognition andmeasurement principles of Accounting Principles Board (“APB”) Opinion No. 25,“Accounting for Stock Issued to Employees”, and related Interpretations.  No stock-based employee compensation cost(except for the compensation expense related to certain repriced options) isreflected in net loss, as all options granted under the plan had an exerciseprice equal to the market value of the underlying common stock at the date ofgrant.

 

At March 31, 2003, thefair value of the Company’s stock-based awards to employees was estimated usinga Black-Scholes option pricing model. The Black-Scholes model was developed for use in estimating the fairvalue of traded options which have no vesting restrictions and are fullytransferable.  In addition, theBlack-Scholes model requires the input of highly subjective assumptionsincluding the expected stock price volatility. Because the Company’s stock-based awards have characteristicssignificantly different from those of traded options, and because changes inthe subjective input can materially affect the fair value estimate, inmanagement’s opinion, the existing models do not necessarily provide a reliablesingle measure of the fair value of its stock-based awards to employees.  The fair value of the Company’s stock-basedawards (including the repriced options) was estimated assuming no expecteddividends and the following weighted average assumptions for the three monthsended March 31, 2003 and 2002:

 

7

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|                            |   | **March 31,** |   |
|---------------------------------|--------|---------------|--------|
|                            |   | **2003**      |   | **2002** |   |
| Expected life in years          |   | 5.1           |   | 5.9 |   |
| Expected stock price volatility |   | 96            | %      | 99 | % |
| Risk-free interest rate         |   | 3.82          | %      | 4.56 | % |
| Average fair value per option   |   | $             | 0.19   |   | $ | 0.23 |   |
|                                 |        |               |        |  |  |  |  |

 

For pro forma purposes,the estimated value of the Company’s stock-based awards to employees isamortized 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 ended March 31, 2003 and 2002:

 

|                                                                                                                                         |   | **March 31,** |     |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------|----------|
|                                                                                                                                         |   | **2003**      |     | **2002** |   |
| Net  loss – as reported                                                                                                                 |   | $             | (170,942 | ) | $ | (229,131 | ) |
| Deduct  total stock-based employee compensation expense determined under fair value  based method for all awards, net of related tax effects |   | (3,766        | )        | (5,013 | ) |
| Net  loss – pro forma                                                                                                                   |   | $             | (174,708 | ) | $ | (234,144 | ) |
|                                                                                                                                         |   |          |     |   |   |
| Basic and diluted net loss per share – as reported                                                                                      |   | $             | (0.01    | ) | $ | (0.01 | ) |
| Basic and diluted net loss per share – pro forma                                                                                        |   | $             | (0.01    | ) | $ | (0.02 | ) |

 

*Earnings Per Share*

 

Basic earnings per shareis computed by dividing net earnings or loss by the weighted average number ofcommon shares outstanding during the period. Diluted earnings per share is computed by dividing net earnings or lossby the weighted average number of shares outstanding, after giving effect topotentially dilutive common share equivalents outstanding during theperiod.  Potentially dilutive commonshare equivalents are not included in the computation of diluted earnings pershare if they are anti-dilutive.  Forthe three months ended March 31, 2003 and 2002, the diluted loss per commonshare is the same as basic since the effect of 23,345 and 34,875, respectively,potentially dilutive common shares arising from outstanding stock options andwarrants was anti-dilutive.

 

*Recent Accounting Pronouncements*

 

In June 2001, the Financial Accounting Standards Board(“FASB”) issued SFAS No. 143, “Accounting for Asset Retirement Obligations”,which requires that the fair value of the liability for asset retirement costsbe recognized in an entity’s balance sheet, as both a liability and an increasein the carrying values of such assets, in the periods in which such liabilitiescan be reasonably estimated.  It alsorequires allocation of such asset retirement cost to expense over its usefullife.  The Company has adopted thisstatement, which is effective for fiscal years beginning after June 15, 2002.

 

The cumulative effect of adopting this statement wasto decrease net income in the three months ended March 31, 2003 by $105,777, or$0.01 per common share.  The presentvalue of the estimated future asset retirement obligation is shown on thebalance sheet as a noncurrent liability, and the same

 

8

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amount has beencapitalized to gas gathering, processingand transportation equipment.  Infuture periods, until the assets are ultimately sold or retired, the Companywill recognize (i) depreciation expense on the additional capitalized costs;(ii) accretion expense as the present value of the future asset retirementobligation increases with the passage of time, and; (iii) the impact, if any,of changes in estimates of the liability. The pro forma amounts on the income statement show the effects ofretroactive application of the statement on loss from continuing operations andnet loss as if the new method was already in effect prior to the periodspresented.

 

*Use of Estimates*

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andthe disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period.  Actual resultscould differ from those estimates.

 

**(3)**                                 Acquisitions and Divestitures

 

The Company made totalcapital expenditures of approximately $1,124,570 in the three months endedMarch 31, 2003, primarily in connection with the construction of the pipelinesservicing the Madisonville Plant—a four-inch gathering line, a three-inchinjection line and the ten-inch pipeline to transport the pipeline quality gas(the “Pipeline Facilities”).  As ofMarch 31, 2003, approximately $2.4 million had been paid or accrued for theMadisonville project and the Company expects its capital commitment in thePipeline Facilities to be approximately $2.5 million.  The Pipeline Facilities are expected to become fully operationalduring May 2003 in conjunction with the startup of the Madisonville Plant.  See discussion of the project financing inNote 4 to the consolidated financial statements.

 

The Company sold from itsonshore segment 14 non-core natural gas gathering systems located in Texas,Oklahoma and Louisiana, effective August 1, 2002.  Cash of $839,000 was received at closing in the third quarter of2002, and a contingent payment of up to $260,000 may be received in the fourthquarter of 2003 based on the subsequent performance of the assets.  Additionally, effective September 30, 2002,the Company sold its interest in an onshore joint venture that owned a southTexas natural gas gathering system for $85,000 cash.  A net gain of $63,865 was recognized in the 2002 financialstatements in connection with these sales, not including the contingent payment.  A portion of the aggregate proceeds from thesales was used by the Company to finance construction of the PipelineFacilities.  The operations of theassets sold have been presented in the consolidated statement of operations asdiscontinued operations for the three months ended March 31, 2002.

 

**(4)**                                 Debt

 

*NotesPayable*

 

The Company’soperating line of credit agreement provides for maximum available borrowings of$500,000 through June 2003.  Interest ispayable monthly at 5.3% per annum and principal is due on demand, or if nodemand is made, at maturity.  TheCompany intends to renew the line of credit on or before the maturitydate.  The line is collateralized by a$500,000 certificate of deposit earning interest at 4.3% per annum.  The Company had $7,486 of availableborrowings under the agreement as of March 31, 2003.

 

The Company’s revolvingcredit agreement provides for maximum available borrowings of up to $250,000through May 22, 2003.  Principaloutstanding under the agreement accrues interest at a variable

 

9

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rate, based on the bank’sprime 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 totime for 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 $132,150 of availableborrowings under the agreement as of March 31, 2003.

 

*Long-term Debt*

 

Long-term debt at March31, 2003 consisted of the following:

 

| Subordinated  notes                  |   | $         | 443,289   |   |
|--------------------------------------|--------|-----------|-----------|--------|
| Term  note – Fort Cobb          |   | 646,193   |      |
| Term  note – Madisonville       |   | 986,260   |      |
| Term  note – Fort Cobb vehicles |   | 57,900    |      |
|                                 |   | 2,133,642 |      |
| Less  current maturities             |   | 981,593   |      |
|                                 |   | $         | 1,152,049 |   |

 

*Subordinated Notes*

 

In connection with theRecapitalization 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 interest method overthe term of the subordinated notes. Such charge to interest expense was $6,917 for the three months endedMarch 31, 2003 and 2002.  As a result,the effective interest rate of the subordinated notes is 15%.

 

At March 31, 2003,principal and interest totaling $246,044 which was due under these notes onMarch 1, 2003 remained unpaid.  Underthe terms of the subordinated notes, the Company has a sixty-day period inwhich to make this payment and prevent acceleration of the remainingoutstanding principal.  The Company madethe March 1, 2003 payments on April 29, 2003 as soon as the Balloon Note,discussed below, was funded.

 

***Term Note – Fort Cobb***

 

Effective June 1, 2001,Fort Cobb 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 11⁄4%, with a minimum rate of8%.  The interest rate at March 31, 2003was 8%.  The note requires monthlypayments ranging from $7,500 to $13,008, with the balance under the note dueJune 1, 2008.  Costs of obtaining thisdebt are being charged to interest expense ratably over the maturity period ofthe note.  Fort Cobb used the proceedsto refinance its borrowings from the Company, and the Company used the proceedsfor general corporate purposes.

 

***Term Note – Madisonville***

 

Effective February 21, 2002,Gateway Pipeline Company and Gateway Processing Company (the “Borrowers”)entered into a term credit agreement with a bank.  Under the agreement, as amended effective March 31, 2003, theBorrowers may borrow through June 30, 2003 up to $1.5 million in one or

 

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more advances.  Principal outstanding under the note accruesinterest at a fixed rate of 71⁄4% and the note matures December 31, 2005.  The monthly note payments through June 30,2003 represent interest only, and thereafter the note requires monthly paymentsof principal and interest ranging from $9,063 to $54,819 if the maximumavailable under the agreement is borrowed. If less than the maximum amount is borrowed, the monthly payments areproportionately reduced.  Costs ofsecuring this debt are being charged to interest expense ratably over thematurity period of the note.  TheBorrowers are using the proceeds to finance the construction of the PipelineFacilities.  The agreement iscollateralized with the Company’s economic interest in the Madisonville projectand the Waxahachie pipeline system, and the Company has guaranteed the loan andpledged the common stock of the Borrowers. The agreement contains cross collateral and cross default provisionslinking it to the Balloon Note, described below.

 

*Balloon Note – Madisonville*

 

Effective March 31, 2003, the Company entered into aballoon credit agreement (the “Balloon Note”). Under the Balloon Note agreement, the Borrowers are able to borrowthrough April 26, 2006 up to $900,000 in one or more advances.  Principal outstanding under the Balloon Notewill accrue interest at a fixed rate of 71⁄4% and the note will mature afterthirty-six months.  The monthly notepayments will represent interest only on the total balance outstanding.   Costs of securing this debt will be chargedto interest expense ratably over the maturity period of the note.  The Borrowers are using the proceeds tofinance the remaining construction costs of the Pipeline Facilities, and tofund the principal and interest payments which were due under the Company’ssubordinated note agreements on March 1, 2003.

 

The Balloon Note is collateralized with letters ofcredit obtained through Allen Drilling Acquisition Company, a Nebraskacorporation (“ADAC”).  Charles A.Holtgraves, a director of the Company, is President and a director of ADAC, andLarry J. Horbach, a director of the Company, is Secretary and a director ofADAC.  Mr. Holtgraves owns directly noshares of ADAC common stock, and owns 14.65% of an entity that owns 55.56% ofthe ADAC senior preferred stock.  Suchpreferred stock has a stated dividend rate equal to two-thirds (66-2/3%) of anyMadisonville payments received by ADAC pursuant to the Agreement discussedbelow.  Mr. Horbach owns no ADAC commonor 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 thirty-three and one-thirdpercent (33-1/3%) ownership interest in the Pipeline Facilities from that dateforward.  The Company is obligated topay the periodic interest payments to the bank during the three-year term ofthe Balloon Note.  Further, the Companygranted liens, subordinate to the Company’s bank liens, on the Company’seconomic interest in the Madisonville project, its Waxahachie pipeline system,and its Fort Cobb subsidiary.  Theagreement contains cross collateral and cross default provisions linking it tothe Madisonville Term Note, described above.

 

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*Term Note– Fort Cobb Vehicles*

 

Effective March 2003, FortCobb borrowed $57,900 from a bank to buy three replacement servicevehicles.  The note requires monthlyprincipal and interest payments of $1,386.50, reflecting interest at 6.99%, andmatures on March 25, 2007.

 

*Letters of Credit*

 

As of March 31, 2003, the Company had outstandingletters of credit totaling $548,595.

 

**(5)**                                 Commitments andContingencies

 

In June 2001 the Company announced that GatewayProcessing Company entered into a long-term agreement with a producer topurchase non-pipeline quality natural gas near Madisonville, Texas.  Concurrently, Gateway Processing enteredinto an agreement with Hanover Compression Limited Partnership (“Hanover”), anaffiliate of The Hanover Company, under which Hanover will treat the gas toremove impurities from the gas to enable the gas to meet pipeline sales qualityspecifications.

 

Of significance toGateway, Hanover will employ the state-of-the-art, patented, absorption basedtechnology developed by Advanced Extraction Technologies, Inc., for whichGateway has the exclusive U.S. license, to remove the nitrogen from the gas.

 

Hanover’s facilities (the“Madisonville Plant”), designed initially to treat 18,000 Mcf per day, and therelated Pipeline Facilities are expected to become fully operational during May2003.  See Note (4) for a description ofthe Company’s financing related to this project.  In connection with securing the Balloon Note, the Company will beobligated at ADAC’s option to either: (i) pay at the end of the term of theBalloon Note a lump-sum, which when added to the payments made, if any, for theprice upside portion, will result in ADAC receiving a 15% pre-tax internal rateof return on the $900,000, or (ii) convey to ADAC a thirty-three and one-thirdpercent (33-1/3%) ownership interest in the Pipeline Facilities in exchange forADAC paying off the Balloon Note on or before the end of the Balloon Note term.  The Company is obligated to pay the periodicinterest payments to the bank during the three-year term of the Balloon Note.

 

The Company and itssubsidiaries are parties to litigation and claims arising in the normal courseof 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.

 

**(6)**                                 Segment Disclosures

 

All of the Company’soperations are in the domestic U.S. and the Gulf of Mexico in Texas and federalwaters.  The Company’s managementreviews and evaluates the operations separately of three main segments—OnshoreOperations, 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 gasgathering, transportation and distribution activities in Texas andOklahoma.  Offshore Operations includenatural gas and liquid hydrocarbon gathering and transportation activities inthe Gulf of Mexico in Texas and federal waters.  The principal markets for the Onshore 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.

 

During 2002 the Companysold 14 of its onshore pipeline systems and its interest in a joint venturethat owned a south Texas natural gas gathering system (the “Sold Properties”),and the operating results of those properties are presented in the accompanyingstatement of operations for the three

 

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months ended March 31,2002 as discontinued operations.  Thefigures for that period presented below have been restated to remove theoperating results of those properties.

 

The accounting policiesof the reportable segments are the same as those described in Note 2 to theConsolidated Financial Statements.  TheCompany evaluates the segments based on operating margin, defined as revenuesless cost of purchased gas and operating and maintenance expenses.  Such amounts are before general andadministrative expense, depreciation, interest income or expense or incometaxes.  Inter-segment sales of $483,000and $214,000 were eliminated during consolidation for the three months endedMarch 31, 2003 and 2002.

 

Summarized financialinformation of the Company’s reportable segments,and a reconciliation ofoperating margin to consolidated net loss, is presented below:

 
|                                                                   |   | **Three  Months Ended March 31,** |       |
|------------------------------------------------------------------------|--------|-----------------------------------|------------|
|                                                                   |   | **2003**                          |       | **2002** |   |
| **Onshore Operations**                                                 |   |                              |       |   |   |
| Revenues                                                               |   | $                                 | 1,980,731  |   | $ | 695,599 |   |
| Operating  margin                                                      |   | 217,783                           |       | 108,313 |   |
| Depreciation  and amortization                                         |   | 49,414                            |       | 47,866 |   |
| Total  assets                                                          |   | 5,981,544                         |       | 4,803,228 |   |
|                                                                   |   |                              |       |   |   |
| **Offshore Operations**                                                |   |                              |       |   |   |
| Revenues                                                               |   | 143,265                           |       | 202,033 |   |
| Operating  margin                                                      |   | 77,001                            |       | 136,446 |   |
| Depreciation  and amortization                                         |   | 35,909                            |       | 35,413 |   |
| Total  assets                                                          |   | 1,777,961                         |       | 1,728,250 |   |
|                                                                   |   |                              |       |   |   |
| **Fort Cobb Operations**                                               |   |                              |       |   |   |
| Revenues                                                               |   | 710,095                           |       | 526,282 |   |
| Operating  margin                                                      |   | 202,099                           |       | 177,872 |   |
| Depreciation  and amortization                                         |   | 48,498                            |       | 49,568 |   |
| Total  assets                                                          |   | 2,451,423                         |       | 2,406,851 |   |
|                                                                   |   |                              |       |   |   |
| **Total**                                                              |   |                              |       |   |   |
| Revenues                                                               |   | 2,834,091                         |       | 1,423,914 |   |
| Operating  margin                                                      |   | 496,883                           |       | 422,631 |   |
| Depreciation  and amortization                                         |   | 133,821                           |       | 132,847 |   |
| Total  assets                                                          |   | 10,210,928                        |       | 8,938,329 |   |
|                                                                   |   |                              |       |   |   |
| **Reconciliation to net loss**                                         |   |                              | ** ** |   | ** ** |
| Operating  margin                                                      |   | $                                 | 496,883    |   | $ | 422,631 |   |
| Depreciation  and amortization                                         |   | 133,821                           |       | 132,847 |   |
| General  & administrative                                          |   | 395,358                           |       | 488,426 |   |
| Other  income (loss)                                                   |   | (32,869                           | )          | (9,914 | ) |
| Discontinued  operations - see Note 3                                  |   | —                            |       | (20,575 | ) |
| Cumulative  effect of change in accounting principle – see Note 2 |   | (105,777                          | )          | — |   |
| Net  loss                                                              |   | $                                 | (170,942   | ) | $ | (229,131 | ) |

 

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

 

The followingmanagement’s discussion and analysis contains trend analysis and otherforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended.  Actual results coulddiffer materially from those projected in the forward-looking statementsthroughout this document as a result of the risk factors set forth below in thesection entitled *Factors Affecting Future Results* and elsewhere in thisdocument.

 

**CriticalAccounting Policies**

 

The following accountingpolicies are considered by management to be the most critical to the fairpresentation of the Company’s financial condition, results of operations andcash 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***

 

The Company’s salesrevenues are generated under back-to-back purchase and sales contracts.  Sales revenues are recognized at theredelivery point, which is the point at which title to the gas transfers.  The Company’s transportation revenues aregenerated under contracts which have a stated fee per unit of production (Mcf,MMBtu, or Bbl) gathered or transported. Transportation revenues are recognized at the redelivery point, which isthe point at which another party takes physical custody of the gas or liquidhydrocarbons.

 

*Property and Equipment*

 

Property and equipment isstated at cost, plus capitalized interest costs on major pipeline projects duringtheir construction period.  Additionsand improvements that add to the productive capacity or extend the useful lifeof 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 gasplant components, 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.

 

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.

 

*Recent Accounting Pronouncements*

 

In June 2001, the FASB issued SFAS No. 143,“Accounting for Asset Retirement Obligations”, which requires that the fairvalue of the liability for asset retirement costs be recognized in an entity’sbalance sheet, as both a liability and an increase in the carrying values ofsuch assets, in the periods in which such liabilities can be reasonablyestimated.  It also requires allocationof such asset retirement cost to expense over its useful life.  The Company has adopted this statement,which is effective for fiscal years beginning after June 15, 2002.

 

The cumulative effect of adopting this statement wasto decrease net income in the three months ended March 31, 2003 by $105,777, or$0.01 per common share.  The presentvalue of the estimated future asset retirement obligation is shown on thebalance sheet as a noncurrent liability, and the same

 

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amount has beencapitalized to gas gathering, processingand transportation equipment.  Infuture periods, until the assets are ultimately sold or retired, the Companywill recognize (i) depreciation expense on the additional capitalized costs;(ii) accretion expense as the present value of the future asset retirementobligation increases with the passage of time, and; (iii) the impact, if any,of changes in estimates of the liability. The pro forma amounts on the income statement have been adjusted to showthe effects of retroactive application of the statement on depreciation andaccretion expense that would have been recognized had the new method been ineffect for the prior period.

 

***Other Assets***

 

The Company’s primaryother asset, its license for a patented process to remove nitrogen from streamsof natural gas, is being amortized to expense over the average 17-year life ofthe underlying patents.

 

*Use of Estimates*

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andthe disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period.  Actual resultscould differ from those estimates.

 

**Results of Operations**

 

***General***

 

The Henry Hub closingindex price for natural gas during the three months ended March 31, 2003averaged $6.58 per MMBtu, compared to $2.34 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.  Because the Company buys and sells gas under“back-to-back” purchase and sale contracts designed to minimize commodity pricerisk, the Company’s net operating margin is relatively insensitive tofluctuations in the market price of gas. Accordingly, the Company evaluates each of its activities based on theoperating margin it produces.  TheCompany defines operating margin as revenues, less the cost of purchased gasand operating and maintenance expenses. Management reviews and evaluates the operations of three mainsegments—Onshore operations, Offshore operations and Fort Cobb operations.

 

During 2002 the Companysold 14 of its onshore pipeline systems and its interest in a joint venturethat owned a south Texas natural gas gathering system (the “Sold Properties”),and the operating results of those properties are presented in the accompanyingstatement of operations for the three months ended March 31, 2002 asdiscontinued operations.  The figuresfor that period presented below have been restated to remove the operatingresults of those properties.

 

# **Three Months Ended March 31, 2003Compared to Three Months Ended March 31, 2002**

 

# *Total Operations*

 
|                           |   | **Three  Months Ended March 31,** |      |
|--------------------------------|--------|-----------------------------------|-----------|
|                           |   | **2003**                          |      | **2002** |   |
| Revenues                       |   | $                                 | 2,834,091 |   | $ | 1,423,914 |   |
| Operating  margin              |   | 496,883                           |      | 422,631 |   |
| Depreciation  and amortization |   | 133,821                           |      | 132,847 |   |
|                                |        |                                   |           |  |  |  |  |

 

Operating margins for thethree months ended March 31, 2003 increased $74,000 compared to the same periodof the prior year.  An increase inOnshore operating margins of $109,000 and Fort Cobb operating margins of$24,000 was partially offset by a decrease in Offshore operating margins of$59,000.  These segments are discussedindividually below in greater detail.

 

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# *Onshore Operations*

 
|                           |   | **Three Months  Ended March 31,** |      |
|--------------------------------|--------|-----------------------------------|-----------|
|                           |   | **2003**                          |      | **2002** |   |
| Revenues                       |   | $                                 | 1,980,731 |   | $ | 695,599 |   |
| Operating  margin              |   | 217,783                           |      | 108,313 |   |
| Depreciation  and amortization |   | 49,414                            |      | 47,866 |   |
|                                |        |                                   |           |  |  |  |  |

 

Operating margins foronshore operations increased in the first quarter by $109,000 from the sameperiod of the prior year.  The increasewas mainly due to higher throughput on the Waxahachie system for the threemonths ended March 31, 2003 than the same period of the prior year andincreased unit margins.  The system hasoperated more profitably since construction of new facilities late in 2002 toallow access to another pipeline and additional supply sources.

 

# *Offshore Operations*

 
|                           |   | **Three  Months Ended March 31,** |    |
|--------------------------------|--------|-----------------------------------|---------|
|                           |   | **2003**                          |    | **2002** |   |
| Revenues                       |   | $                                 | 143,265 |   | $ | 202,033 |   |
| Operating  margin              |   | 77,001                            |    | 136,446 |   |
| Depreciation  and amortization |   | 35,909                            |    | 35,413 |   |
|                                |        |                                   |         |  |  |  |  |

 

Operating margins foroffshore operations decreased in the first quarter by $59,000 from the sameperiod of the prior year, and are directly related to lower throughputvolumes.  A portion of the decline isrelated to the producer shutting in production on its Galveston Block 144Lwell.  This well is unlikely to returnto production.  However, the Companyanticipates an increase in monthly gathering and transporting volumes fromother properties before the end of 2003.

 

# *Fort Cobb Operations*

 
|                           |   | **Three  Months Ended March 31,** |    |
|--------------------------------|--------|-----------------------------------|---------|
|                           |   | **2003**                          |    | **2002** |   |
| Revenues                       |   | $                                 | 710,095 |   | $ | 526,282 |   |
| Operating  margin              |   | 202,099                           |    | 177,872 |   |
| Depreciation  and amortization |   | 48,498                            |    | 49,568 |   |
|                                |        |                                   |         |  |  |  |  |

 

Operating margins forFort Cobb operations increased in the first quarter by $24,000 over the sameperiod of the prior year due to a 12% increase in sales volumes.

 

# *Operations Support*

 
|                                                 |   | **Three  Months Ended March 31,** |    |
|------------------------------------------------------|--------|-----------------------------------|---------|
|                                                 |   | **2003**                          |    | **2002** |   |
| General  and administrative                          |   | $                                 | 395,358 |   | $ | 488,426 |   |
| Interest  income                                     |   | 6,953                             |    | 15,571 |   |
| Interest  expense                                    |   | (58,012                           | )       | (47,924 | ) |
| Interest  capitalized                                |   | 11,226                            |    | 3,079 |   |
| Gain  (loss) on disposal of assets                   |   | 5,807                             |    | 919 |   |
| Other  income (expense), net                         |   | 1,157                             |    | 18,441 |   |
| Discontinued  operations                             |   | —                            |    | (20,575 | ) |
| Cumulative  effect of change in accounting principle |   | (105,777                          | )       | — |   |
|                                                      |        |                                   |         |  |  |  |  |

 

General andadministrative expenses for the quarter are down 19% from the same period oflast year, mainly due to reduced personnel related costs.

 

Interest income variesdirectly with the balance on deposit in the Company’s certificates of depositand short-term money market accounts.

 

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Interest expensefluctuates directly with the amount of outstanding long-term debt and theamount of borrowings under the Company’s bank operating lines of credit.  Interest expense incurred on the debt tofinance the Madisonville project construction was capitalized.

 

The cumulative effect ofchange in accounting principle represents the aggregate difference in retainedearnings that resulted from retroactively applying the provisions of SFAS No.143 to all prior years affected by the new accounting rules.

 

**Liquidity and Capital Resources**

 

Going forward, theCompany’s strategy is to maximize the potential of currently owned properties,to construct new pipeline systems and treating facilities, and to acquireproperties that meet its economic performance hurdles.  The balance sheet as of March 31, 2003 showsan excess of current liabilities over current assets of approximately $960,000,due to accrued Pipeline Facilities construction costs.  However, current assets do not reflectapproximately $1.4 million of untapped loan proceeds available at that date tosatisy the construction costs.

 

The Company sold 14non-core onshore natural gas gathering systems located in Texas, Oklahoma andLouisiana, effective August 1, 2002. Cash of $839,000 was received at closing, and a contingent payment of upto $260,000 may be due in the fourth quarter of 2003 based on the subsequentperformance of the assets. Additionally, the Company sold its interest in an onshore joint venturethat owned a south Texas natural gas gathering system for $85,000.  The sale of these non-core assets(approximately 58 miles of pipeline) is part of an overall strategy begunseveral years ago to rationalize the Company’s asset base, sell those that arenon-core and focus on and expand those that generate the most cash flow and/orprovide the greatest growth potential.  Whilethe property sales will reduce operating margin in future periods, certainreductions in salaries, employee related and other general and administrativeexpenses are expected to more than offset this reduction.  General and administrative expenses areexpected to be reduced significantly from 2002 due to targeted reductions insuch costs. The Company has cash and cash equivalents and certificates ofdeposit totaling $750,935 at March 31, 2003.

 

The Company has an operatingline of credit with a bank that provides for maximum borrowings of $500,000through June 20, 2003.  Interest ispayable monthly at 5.3% per annum and principal is due on demand, or if nodemand is made, at maturity.  The lineis collateralized by a $500,000 certificate of deposit earning interest at 4.3%per annum.  The Company had $7,486 ofavailable borrowings under the agreement as of March 31, 2003.

 

The Company’s revolvingcredit agreement provides for maximum available borrowings up to $250,000through May 22, 2003.  Principaloutstanding under the agreement accrues interest at a variable rate, based onthe bank’s prime rate index plus 11⁄4%, 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.  Fort Cobb uses the proceeds from time totime for general working capital purposes. The agreement is collateralized withthe assets of Fort Cobb, and guaranteed by the Company.  The Company had $132,150 of availableborrowings under the agreement as of March 31, 2003.

 

Effective June 1, 2001, Fort Cobb borrowed $750,000from a bank.  Principal outstandingunder the note accrues interest at a variable rate, based on the bank’s primerate index plus 11⁄4%, with a minimum rate of 8%.  The note requires monthly payments of approximately $13,000, withthe balance under the note due June 1, 2008. Fort Cobb used the proceeds to refinance its borrowings.

 

Effective February 21, 2002,Gateway Pipeline Company and Gateway Processing Company (the “Borrowers”)entered into a term credit agreement with a bank.  Under the agreement, as amended effective March 31, 2003, theBorrowers may borrow through June 30, 2003 up to $1.5 million in one or moreadvances.  Principal outstanding underthe note accrues interest at a fixed rate of 71⁄4% and the note matures December31, 2005.  The monthly note paymentsthrough June 30, 2003 represent interest only, and thereafter the note requiresmonthly payments of principal and interest ranging from $9,063 to

 

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$54,819 if the maximumavailable under the agreement is borrowed. If less than the maximum amount is borrowed, the monthly payments areproportionately reduced.  The Borrowersare using the proceeds to finance the construction of the PipelineFacilities.  The agreement iscollateralized with the Company’s economic interest in the Madisonville projectand the Waxahachie pipeline system, and the Company has guaranteed the loan andpledged the common stock of the Borrowers. The agreement contains cross collateral and cross default provisionslinking it to the Balloon Note, described below.

 

At March 31, 2003, principal and interest totaling$246,044 which was due under the Company’s subordinated notes on March 1, 2003remained unpaid.  Under the terms of thesubordinated notes, the Company has a sixty-day period in which to make thispayment and prevent acceleration of the remaining outstanding principal.  The Company made the March1, 2003 payments on April 29, 2003.

 

Effective March 31, 2003, the Company entered into aballoon credit agreement (the “Balloon Note”). Under the Balloon Note agreement, the Borrowers may borrow through April26, 2006 up to $900,000 in one or more advances.  Principal outstanding under the Balloon Note will accrue interestat a fixed rate of 71⁄4% and the note will mature after thirty-six months.  The monthly note payments will representinterest only on the total balance outstanding.  The Borrowers are using the proceeds to finance the remainingconstruction costs of the Pipeline Facilities, and to fund the principal andinterest payments which were due under the Company’s subordinated noteagreements on March 1, 2003.

 

The Balloon Note is collateralized with letters ofcredit obtained through Allen Drilling Acquisition Company, a Nebraska corporation(“ADAC”).  Charles A. Holtgraves, adirector of the Company, is President and a director of ADAC, and Larry J.Horbach, a director of 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 anyMadisonville payments received by ADAC pursuant to the Agreement discussedbelow.  Mr. Horbach owns no ADAC commonor 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, ADAChas the option to either: (i) receive at the end of the term of the BalloonNote a lump-sum payment, which when added to the payments received, if any, forthe price upside portion, will result in a 15% pre-tax internal rate of returnon the $900,000, or (ii) pay off the Balloon Note on or before the end of theBalloon Note term in exchange for a thirty-three and one-third percent(33-1/3%) ownership interest in the Pipeline Facilities from that dateforward.  The Company is obligated topay the periodic interest payments to the bank during the three-year term ofthe Balloon Note.  Further, the Companygranted liens, subordinate to the Company’s bank liens, on the Company’seconomic interest in the Madisonville project, its Waxahachie pipeline system,and its Fort Cobb subsidiary.

 

Absent significantacquisitions or development projects, the Company will continue to fund itsoperations through internally generated funds and available cash, thecertificates of deposit and bank borrowings as needed.  The Company believes its cash flows fromsuch sources will be sufficient to fund its ongoing operations for theforeseeable future.  Any significantproperty acquisitions or development projects will require outside projectfinancing.

 

At March 31, 2003, theCompany’s long-term debt to total capitalization was approximately 17%.

 

Natural gas prices asrepresented by the NYMEX Henry Hub index averaged $6.58 and $2.34 for the threemonths ended March 31, 2003 and 2002. The natural gas industry is generally optimistic about long-termprospects based on expected demand, the cost of developing prospects and thesales price of

 

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natural gas.  The Company’s operating margin is notdirectly affected by the price of natural gas since gas gathering andtransportation are generally based on fee arrangements and sales are made under back-to-back purchase andsales arrangements.  However, naturalgas prices can affect exploration and development and result in higher or lowervolumes available for gathering and transportation.

 

**Off-Balance Sheet Arrangements**

 

In connection with thesale of 14 non-core natural gas gathering systems located in Texas, Oklahomaand Louisiana effective August 1, 2002, the Company may be due a contingentpayment of up to $260,000 in the fourth quarter of 2003 based on the subsequentperformance of the assets.

 

In connection withsecuring the Balloon Note, the Company will be obligated at ADAC’s option toeither: (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 (33-1/3%) ownershipinterest in the Pipeline Facilities in exchange for ADAC paying off the BalloonNote on or before the end of the Balloon Note term.

 

**Factors Affecting Future Results**

 

The principal objectiveof the Company is to enhance stockholder value through the execution of certainstrategies. These strategies include, among other things: (i) focusing ongathering, transporting, distributing and treating natural gas; (ii) expandingthe Company’s asset base in core geographic areas; (iii) participating in thedevelopment of sub-quality natural gas reserves to create demand for ourservices, and; (iv) acquiring or constructing properties in one or more newcore areas.

 

The Company is actively pursuing several projects thatwill employ its nitrogen rejection technology. The Company has a technological advantage in this niche, due to itsexclusive U.S. license for the nitrogen rejection process.  The Company’s process competes favorablywith other processes, as it can cost effectively adapt to variable gas flow ratesand variable levels of nitrogen content in the gas.  And, unlike the major competing process, it is unaffected by thepresence of carbon dioxide in the gas. It can therefore economically treat relatively small volumes of gas—aslittle as 5,000 Mcf per day—where variable gas flow and composition iscommon.  Successful completion of theseprojects will depend upon the ability of the Company to market the technologyto the producer community, and to obtain financing on terms satisfactory to theCompany for construction of nitrogen rejection plants and/or acquisition ofworking interests in the high nitrogen properties.

 

High nitrogen gas is natural gas that containsnitrogen, either alone or in conjunction with other contaminants, in excess ofthe maximum percentage (usually 4%) by volume acceptable to most pipelinecompanies.  About 16% of the domesticnatural gas resource base (approximately 24 Tcf of proven reserves) isestimated by the Gas Technology Institute to be subquality because of thenitrogen content.  Most of the country’scurrent high nitrogen natural gas production is located in southwestern Kansas;however, there are substantial high nitrogen natural gas reserves in otherparts of the country.  The Company’starget projects are located in geographic areas with well known concentrationsof high nitrogen natural gas reserves. Much of this high nitrogen natural gas remains undeveloped or shut-inbecause it cannot meet pipeline quality specifications and it is geographicallyseparated from the large (100,000 Mcf per day or larger) cryogenic nitrogenrejection plants located primarily in Kansas. The Company’s process is well suited to treat these “stranded” reserves.

 

Creation of long-termvalue for the common stockholder depends in part upon successful acquisition orconstruction of additional assets which will add to cash flows and generateattractive returns.  Access toreasonably priced long-term capital will significantly impact the Company’sability to acquire or construct additional properties, enabling overhead coststo be spread over a larger asset base. There are many companies participatingin the midstream segment of the natural gas industry, many with resourcesgreater than the Company. Greater competition for profitable operations canincrease prices

 

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and make it moredifficult to acquire assets at reasonable multiples of cash flow.  However, much of the Company’s focus is onhigh nitrogen natural gas projects where there is limited competition.  Such projects will have to be developed orconstructed using creative financing methods. The Company believes that, with its experienced personnel and its licensednitrogen rejection process, it will be able to compete in this environment andwill be able to find and finance attractive investments which compliment itsexisting properties.

 

Operations aresignificantly affected by factors which are outside the Company’s control.  Gas gathering and processing is dependent onthroughput volume.  Pipeline throughputis dependent on natural gas production which is significantly affected bynatural gas prices as prices affect the willingness of producers to invest therequired capital to obtain geological and geophysical information, to drilldevelopment or exploratory wells, and to rework or maximize production onexisting wells. Natural gas prices are currently at levels which should provideadequate incentive to producers; however, there is no assurance that suchprices will remain at current levels, and that producers will react positivelyto the current prices.

 

Natural gas retail salesare affected by weather. Much of the retail demand is for crop irrigation anddrying.  Above normal precipitation inthe growing season and hot, dry weather in the fall can significantly reducedemand for natural gas on the Fort Cobb distribution system.

 

**Item 3.****  Controlsand Procedures**

 

As required by Rule13a-15 under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”), within the 90 days prior to the filing date of this report, the Companycarried out an evaluation of the effectiveness of the design and operation ofthe Company’s disclosure controls and procedures.  This evaluation was carried out under the supervision and withthe participation of the Company’s management, including the Company’sPresident and Chief Executive Officer along with the Company’s Chief FinancialOfficer.  Based upon that evaluation,the President and Chief Executive Officer along with the Chief FinancialOfficer concluded that the Company’s disclosure controls and procedures areeffective.  There have been nosignificant changes in the Company’s internal controls, or in other factors,which could significantly affect internal controls subsequent to the date theCompany carried out its evaluation.

 

Disclosure controls andprocedures are controls and other procedures that are designed to ensure thatinformation required to be disclosed in Company reports filed or submittedunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in the Securities and Exchange Commission’s rulesand forms.  Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed in Company reports filed underthe Exchange Act is accumulated and communicated to management, including theCompany’s President and Chief Executive Officer and the Chief FinancialOfficer, as appropriate, to allow timely decisions regarding requireddisclosure.

 

###### **Part II**

 

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

 

None

 

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

 

None

 

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

 

None

 

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

 

None

 

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

 

None

 

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| **Item 6.** | **Exhibits and Reports on Form 8-K.** |
|-------------|---------------------------------------|
|        |                                  |   |   |
|        | a)                                    | Exhibits: |   |
|        |                                  | 4(b)(2) | First Amended and Restated Credit Agreement with  Southwest Bank of Texas, dated March 31, 2003, for the Madisonville Term Note |
|        |                                  |   |   |
|        |                                  | 4(b)(3) | Credit Agreement with Southwest Bank of Texas, dated  March 31, 2003, for the Madisonville Balloon Note |
|        |                                  |   |   |
|        |                                  | 11 | Statement Regarding Computation of Per Share  Earnings |
|        |                                  |   |   |
|        |                                  | 99.1 | Officer certification pursuant to Sarbanes-Oxley Act  of 2002, Section 906. |
|        |                                  |   |   |
|        | b)                                    | Reports on Form 8-K: |
|        |                                  | March 31, 2003 –  Selected financial results for the year ended December 31, 2002. |
|        |                                  |   |
|        |                                  | April 23, 2003 –  Update on Status of Borrowings |

 

**SIGNATURES**

Pursuant to the requirements of Section 13 or 15 (d)of the Securities Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 
|         |   | GATEWAY ENERGY  CORPORATION              |   |
|--------------|--------|------------------------------------------|--------|
|         |   |                                     |   |
|         |   | /s/ Michael T.  Fadden                   |   |
|         |   | President and  Chief Executive Officer   |   |
|         |   |                                     |   |
|         |   | /s/ Scott D.  Heflin                     |   |
|         |   | Chief Financial  Officer & Treasurer |   |
|         |   |                                     |   |
| May 15, 2003 |   |                                     |   |
| (Date)       |   |                                     |   |

 

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**GATEWAYENERGY CORPORATION AND SUBSIDIARIES**

 

**OFFICER CERTIFICATION**

 

I, Michael T. Fadden,certify that:

 

1.  I have reviewed this quarterly report onForm 10-QSB of Gateway Energy Corporation;

 

2.  Based on my knowledge, this quarterly reportdoes not contain any untrue statement of a material fact or omit to state amaterial fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this quarterly report;

 

3.  Based on my knowledge, the financialstatements, and other financial information included in this quarterly report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periodspresented in this quarterly report;

 

4.  The registrant’s other certifying officersand I are responsible for establishing and maintaining disclosure controls andprocedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for theregistrant and have:

 

a)  designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this quarterly reportis being prepared;

 

b)  evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this quarterly report (the “Evaluation Date”); and

 

c)  presented in this quarterly report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.  The registrant’s other certifying officersand I have disclosed, based on our most recent evaluation, to the registrant’sauditors and the audit committee of registrant’s board of directors (or personsperforming the equivalent functions):

 

a)  all significant deficiencies in the designor operation of internal controls which could adversely affect the registrant’sability to record, process, summarize and report financial data and haveidentified for the registrant’s auditors any material weaknesses in internalcontrols; and

 

 b) any fraud, whether or not material, that involves management or otheremployees who have a significant role in the registrant’s internal controls;and

 

6.  The registrant’s other certifying officersand I have indicated in this quarterly report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Date:  May 15, 2003 | /s/ Michael T.  Fadden                 |   |
|--------------------------|----------------------------------------|--------|
|                     | Michael T. Fadden                      |   |
|                     | President and Chief  Executive Officer |   |

 

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**GATEWAYENERGY CORPORATION AND SUBSIDIARIES**

#  

# **OFFICER CERTIFICATION**

 

I, Scott D. Heflin,certify that:

 

1.  I have reviewed this quarterly report onForm 10-QSB of Gateway Energy Corporation;

 

2.  Based on my knowledge, this quarterly reportdoes not contain any untrue statement of a material fact or omit to state amaterial fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this quarterly report;

 

3.  Based on my knowledge, the financialstatements, and other financial information included in this quarterly report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periodspresented in this quarterly report;

 

4.  The registrant’s other certifying officersand I are responsible for establishing and maintaining disclosure controls andprocedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for theregistrant and have:

 

a)  designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this quarterly reportis being prepared;

 

b)  evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this quarterly report (the “Evaluation Date”); and

 

c)  presented in this quarterly report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

 

5.  The registrant’s other certifying officersand I have disclosed, based on our most recent evaluation, to the registrant’sauditors and the audit committee of registrant’s board of directors (or personsperforming the equivalent functions):

 

a)  all significant deficiencies in the designor operation of internal controls which could adversely affect the registrant’sability to record, process, summarize and report financial data and haveidentified for the registrant’s auditors any material weaknesses in internalcontrols; and

 

b)  any fraud, whether or not material, thatinvolves management or other employees who have a significant role in theregistrant’s internal controls; and

 

6.  The registrant’s other certifying officersand I have indicated in this quarterly report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Date:  May 15, 2003 | /s/ Scott D.  Heflin                   |   |
|--------------------------|----------------------------------------|--------|
|                     | Scott D. Heflin                        |   |
|                     | Chief Financial Officer  and Treasurer |   |

 

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