**U. S. SECURITIES AND EXCHANGECOMMISSION**

**Washington,D. C.  20549**

 

**FORM 10-QSB**

 

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

 

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

 

**o****  TRANSITION REPORT UNDER SECTION 13 OR15(d) OF THE EXCHANGE ACT**

 

**For the transition period from            to          **

 

**Commission File No. 0-6404**

 

**GATEWAY ENERGY CORPORATION**

(Exact name of small business issuer asspecified in its charter)

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

 

**500 DallasStreet, Suite 2615****Houston,TX  77002**

(Address of principal executive offices)

 

**(713) 336-0844**

(Issuer’s telephone number)

 

Check whether the issuer (1) filed all reportsrequired to be filed by Section 13 or 15(d) of the Exchange Act during thepast 12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes  ý   No o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act.)  Yes o   No ý

 

As of November 10, 2004, the Issuer had15,778,349 shares of its common stock outstanding.

 

Transitional Small Business 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 September 30,  2004                                                                                  |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                       |   |
| Unaudited  Consolidated Statements of Operations for  the three months and nine months ended September 30, 2004 and September 30, 2003 |   |
|                                                                                                                                                       |   |
| Unaudited Consolidated  Statements of Cash Flows for  the nine months ended September 30, 2004 and September 30, 2003                  |   |
|                                                                                                                                                       |   |
| Notes to  Unaudited Consolidated Financial Statements                                                                                                      |   |

 

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**GATEWAY ENERGY CORPORATION AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEET**

**September 30, 2004**

**(Unaudited)**

 
| **ASSETS**                                                                                           |   |        |      |
|------------------------------------------------------------------------------------------------------|--------|-------------|-----------|
| Current  Assets                                                                                      |   |        |      |
| Cash and  cash equivalents                                                                           |   | $           | 72,015    |   |
| Trade  accounts receivable                                                                           |   | 1,064,288   |      |
| Inventories,  at average cost                                                                        |   | 47,315      |      |
| Prepaid  expenses and other assets                                                                   |   | 111,066     |      |
| Total  current assets                                                                                |   | 1,294,684   |      |
|                                                                                                 |   |        |      |
| Property and  Equipment, at cost                                                                     |   |        |      |
| Gas  gathering, processing and transportation                                                        |   | 10,329,779  |      |
| Office  furniture and other equipment                                                                |   | 815,566     |      |
|                                                                                                 |   | 11,145,345  |      |
| Less  accumulated depreciation and amortization                                                      |   | (4,126,781  | )         |
|                                                                                                 |   | 7,018,564   |      |
| Other Assets                                                                                         |   |        |      |
| Investment  in AET license, net of accumulated amortization of $142,721                              |   | 278,329     |      |
| Other                                                                                                |   | 202,182     |      |
|                                                                                                 |   | 480,511     |      |
|                                                                                                 |   | $           | 8,793,759 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                       |   |        |      |
| Current  Liabilities                                                                                 |   |        |      |
| Accounts  payable                                                                                    |   | $           | 1,004,115 |   |
| Accrued expenses  and other liabilities                                                              |   | 173,033     |      |
| Notes  payable                                                                                       |   | 247,515     |      |
| Current  maturities of long-term debt                                                                |   | 1,391,753   |      |
| Current  maturities of long-term lease                                                               |   | 10,575      |      |
| Total  current liabilities                                                                           |   | 2,826,991   |      |
|                                                                                                 |   |        |      |
| Noncurrent  Liabilities                                                                              |   |        |      |
| Future asset  retirement obligations                                                                 |   | 315,298     |      |
| Payable to  ADAC                                                                                     |   | 124,415     |      |
| Total  noncurrent liabilities                                                                        |   | 439,713     |      |
|                                                                                                 |   |        |      |
| Long-term  debt, less current maturities                                                             |   | 1,590,263   |      |
| Long-term  capital lease, less current maturities                                                    |   | 77,625      |      |
|                                                                                                 |   |        |      |
| Commitments  and contingencies                                                                       |   | —      |      |
|                                                                                                 |   |        |      |
| Stockholders’  Equity                                                                           |   |        |      |
| Preferred  stock – $1.00 par value; 10,000 shares authorized; no shares issued and  outstanding |   | —      |      |
| Common stock  – $0.25 par value; 35,000,000 shares                                              |   |        |      |
| authorized;  15,778,349 shares issued and outstanding                                                |   | 3,944,585   |      |
| Additional  paid-in capital                                                                          |   | 16,024,591  |      |
| Accumulated  deficit                                                                                 |   | (16,110,009 | )         |
|                                                                                                 |   | 3,859,167   |      |
|                                                                                                 |   | $           | 8,793,759 |   |

 

The accompanying notes are an integral partof these financial statements.

 

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**GATEWAY ENERGY CORPORATION AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                    | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Operating  revenues                                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Natural gas  sales                                                                            |       | $                                          | 5,931,320  |                                      | $          | 4,404,378 |   | $ | 16,840,795 |   | $ | 9,335,958 |   |
| Transportation  of natural gas and liquids                                                    |       | 77,178                                     |       | 139,650                                   |       | 257,338 |   | 380,931 |   |
| Treating and  other                                                                           |       | 35,182                                     |       | 41,486                                    |       | 108,358 |   | 120,212 |   |
|                                                                                          |       | 6,043,680                                  |       | 4,585,514                                 |       | 17,206,491 |   | 9,837,101 |   |
| Operating  costs and expenses                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Cost of  natural gas purchased                                                                |       | 5,324,476                                  |       | 3,808,806                                 |       | 15,126,948 |   | 7,890,339 |   |
| Operation  and maintenance                                                                    |       | 216,251                                    |       | 226,407                                   |       | 679,024 |   | 687,085 |   |
| Depreciation  and amortization                                                                |       | 157,082                                    |       | 158,968                                   |       | 473,249 |   | 435,915 |   |
| Accretion  and changes in estimates                                                           |       | 5,361                                      |       | 94,845                                    |       | 16,080 |   | 102,081 |   |
| General and  administrative                                                                   |       | 384,696                                    |       | 360,838                                   |       | 1,212,845 |   | 1,211,067 |   |
|                                                                                          |       | 6,087,866                                  |       | 4,649,864                                 |       | 17,508,146 |   | 10,326,487 |   |
| Operating  loss                                                                               |       | (44,186                                    | )          | (64,350                                   | )          | (301,655 | ) | (489,386 | ) |
|                                                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Other income  (expense)                                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Interest  income                                                                              |       | 106                                        |       | 1,166                                     |       | 1,267 |   | 13,791 |   |
| Interest  expense                                                                             |       | (108,498                                   | )          | (146,464                                  | )          | (332,357 | ) | (279,974 | ) |
| Interest  capitalized                                                                         |       | —                                     |       | —                                    |       | — |   | 24,466 |   |
| Other income  (expense), net                                                                  |       | 1,513                                      |       | (6,554                                    | )          | 80,067 |   | 8,273 |   |
|                                                                                          |       | (106,879                                   | )          | (151,852                                  | )          | (251,023 | ) | (233,444 | ) |
|                                                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Loss from  continuing operations before income taxes                                          |       | (151,065                                   | )          | (216,202                                  | )          | (552,678 | ) | (722,830 | ) |
| Provision  for income taxes                                                                   |       | —                                     |       | —                                    |       | — |   | — |   |
| Loss from  continuing operations, before cumulative effect of change in accounting  principle |       | (151,065                                   | )          | (216,202                                  | )          | (552,678 | ) | (722,830 | ) |
|                                                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Discontinued  operations                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Gain on sale  of properties                                                                   |       | —                                     |       | —                                    |       | 42,480 |   | — |   |
|                                                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Loss before  cumulative effect of change in accounting principle                              |       | (151,065                                   | )          | (216,202                                  | )          | (510,198 | ) | (722,830 | ) |
| Cumulative  effect of change in accounting principle                                          |       | —                                     |       | —                                    |       | — |   | (105,777 | ) |
| Net loss                                                                                      |       | $                                          | (151,065   | )                                         | $          | (216,202 | ) | $ | (510,198 | ) | $ | (828,607 | ) |
|                                                                                          |       |                                       |       |                                      |       |   |   |   |   |   |   |   |   |
| Basic and  diluted loss per share                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Continuing operations                                                                         |       | $                                          | (0.01      | )                                         | $          | (0.01 | ) | $ | (0.03 | ) | $ | (0.04 | ) |
| Discontinued  operations                                                                      |       | —                                     |       | —                                    |       | — |   | — |   |
| Cumulative  effect of change in accounting principle                                          |       | —                                     |       | —                                    |       | — |   | (0.01 | ) |
| Net loss                                                                                      |       | $                                          | (0.01      | )                                         | $          | (0.01 | ) | $ | (0.03 | ) | $ | (0.05 | ) |
|                                                                                          |       |                                       |       |                                      |       |   |   |   |   |   |   |   |   |
| Weighted  average number of common shares outstanding:                                        |       |                                       |       |                                      |       |   |   |   |   |
| Basic and  diluted                                                                            |       | 15,778,349                                 |       | 15,426,317                                |       | 15,726,615 |   | 15,426,317 |   |

 

The accompanying notes are an integral partof these financial statements.

 

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**GATEWAY ENERGY CORPORATION AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                       | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
|                                                                             |       |                                     |       |   |   |
| Cash flows  from operating activities                                            |       |                                     |       |   |   |
| Net loss                                                                         |       | $                                        | (510,198   | ) | $ | (828,607 | ) |
| Adjustments  to reconcile net loss to net cash provided by operating activities: |       |                                     |       |   |   |
| Cumulative  effect of change in accounting principle                             |       | —                                   |       | 105,777 |   |
| Depreciation  and amortization                                                   |       | 473,249                                  |       | 435,915 |   |
| Gain on  disposal of assets                                                      |       | —                                   |       | (5,807 | ) |
| Discontinued  operations – gain on sale of properties                       |       | (42,480                                  | )          | — |   |
| Non-cash  stock option compensation                                              |       | —                                   |       | (15,803 | ) |
| Non-cash  director stock compensation                                            |       | 29,997                                   |       | — |   |
| Accretion  and changes in estimates                                              |       | 16,080                                   |       | 102,081 |   |
| Amortization  of debt discount and debt issuance costs                           |       | 28,409                                   |       | 42,389 |   |
| Payable to  ADAC                                                                 |       | 34,449                                   |       | 67,500 |   |
| Change in operating  assets and liabilities:                                     |       |                                     |       |   |   |
| Trade  accounts receivable                                                       |       | 956,745                                  |       | (614,028 | ) |
| Inventories,  at average cost                                                    |       | (1,070                                   | )          | (14,799 | ) |
| Prepaid  expenses and other current assets                                       |       | (46,957                                  | )          | 7,976 |   |
| Accounts  payable                                                                |       | (942,453                                 | )          | 620,525 |   |
| Accrued  expenses and other liabilities                                          |       | 48,347                                   |       | 221,360 |   |
| Net cash  provided by operating activities                                       |       | 44,118                                   |       | 124,479 |   |
|                                                                             |       |                                     |       |   |   |
| Cash flows  from investing activities                                            |       |                                     |       |   |   |
| Capital  expenditures                                                            |       | (43,005                                  | )          | (1,944,559 | ) |
| Proceeds  from sale of properties                                                |       | —                                   |       | 14,500 |   |
| Proceeds  from contingent payment                                                |       | 42,480                                   |       | — |   |
| Decrease in  certificates of deposit                                             |       | 130,745                                  |       | 522,932 |   |
| Other                                                                            |       | (1,109                                   | )          | 1,915 |   |
| Net cash  provided (used) by investing activities                                |       | 129,111                                  |       | (1,405,212 | ) |
|                                                                             |       |                                     |       |   |   |
| Cash flows  from financing activities                                            |       |                                     |       |   |   |
| Proceeds  from borrowings                                                        |       | 193,127                                  |       | 2,231,401 |   |
| Payments on  borrowings                                                          |       | (396,491                                 | )          | (847,210 | ) |
| Deferred  financing costs                                                        |       | (100,223                                 | )          | (65,433 | ) |
| Net cash  (used) provided by financing activities                                |       | (303,587                                 | )          | 1,318,758 |   |
|                                                                             |       |                                     |       |   |   |
| Net  (decrease) increase in cash and cash equivalents                            |       | (130,358                                 | )          | 38,025 |   |
| Cash and  cash equivalents at beginning of period                                |       | 202,373                                  |       | 80,888 |   |
| Cash and  cash equivalents at end of period                                      |       | $                                        | 72,015     |   | $ | 118,913 |   |
|                                                                             |       |                                     |       |   |   |
| Supplemental  Disclosures of Cash Flow Information:                              |       |                                     |       |   |   |
| Cash paid  for interest (including capitalized interest)                         |       | $                                        | 179,311    |   | $ | 176,593 |   |

 

The accompanying notes are an integral partof these financial statements.

 

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GATEWAY ENERGY CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

**(1)****                                ****Nature of Business**

 

The Company owns and operates natural gas gathering,transportation and distribution systems and related facilities in Texas andOklahoma, and offshore in Texas and federal waters of the Gulf of Mexico. TheCompany also has an exclusive license in the U.S. for a patented technology forthe rejection of nitrogen from natural gas streams.

 

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

 

A summary of the significant accounting policiesconsistently applied in the preparation of the accompanying consolidatedfinancial statements follows.  Certainreclassifications have been made to the prior period statements to beconsistent with the current presentation.

 

### *GoingConcern*

 

Until we are able tosuccessfully raise additional growth capital, our growth strategy throughstrategic alliances in high nitrogen natural gas projects is in question.  Also, any currently owned properties are subjectto sale under the right circumstances (valuation and timing) if the proceedsfrom any such sale could be effectively redeployed into one or more highnitrogen natural gas projects.  We maynot be able to raise outside capital or be able to sell assets on termsfavorable to the Company.  Without theproceeds of a significant financing or some other financial plan, the Companycannot demonstrate that it has sufficient cash reserves and cash flow fromoperations to satisfy its obligations as they come due over the next twelvemonths.  Taken as a whole, the aboveinformation raises substantial doubt that the Company can continue as a goingconcern, without resorting to dispositions of property outside the normal courseof business, restructuring its debt, soliciting additional capital orsubstantially

 

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revising its operations.  TheCompany is taking several steps that it believes may improve the Company’sability to continue as a going concern. First, beginning in the fourth quarter, the Company’s payroll expensehas been significantly reduced due to staff reductions, including thereplacement of Mr. Fadden as President and Chief Executive Officer with Mr.Raasch, who will serve in such position for no compensation.  The staff and office expense savings totalapproximately $9,900 per month and the Company management savings totalapproximately $24,400 per month.  Second,the Company is pursuing a number of projects that it believes may enhancerevenues in the future.  However, suchprojects would require the Company to raise additional capital or enter intojoint ventures with other industry partners before these projects could berealized.  Third, the Company believesthat potential revenues on phase II of the Madisonville project may increase byan estimated $64,800 per month beginning in the second quarter of 2005.  The Company's ability to successfully pursuethese projects depends upon the exclusivity of the license the Company has beengranted from Advanced Extraction Technologies, Inc. ("AET").  See "Other Assets," below.  Finally, the Company is considering raisingadditional capital from existing shareholders. The consolidated financial statements have been prepared withoutadjustments relating to the recoverability and classification of the recordedassets or liabilities that might be necessary should the Company be unable tocontinue as a going concern.

 

***Principles ofConsolidation***

 

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.

 

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

 

***RevenueRecognition Policy***

 

Sales revenues are recognized at the redeliverypoint, 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 is stated at cost, pluscapitalized interest costs on major projects during their constructionperiod.  Additions and improvements thatadd to the productive capacity or extend the useful life of an asset arecapitalized.  Expenditures formaintenance and repairs are charged to expense as incurred.  At September 30, 2004, property andequipment included $88,202 of equipment financed under a capital lease, net of$11,798 of accumulated amortization. Depreciation and amortization is provided using the straight-line methodover estimated useful lives ranging from 6 to 30 years for pipeline systems,gas plant and processing equipment, and from 2 to 10 years for office furnitureand other equipment.  Upon disposition orretirement of pipeline components or gas plant components, any gain or loss ischarged or credited to accumulated depreciation.  When entire pipeline systems, gas plants orother property and equipment are retired or sold, any resulting gain or loss iscredited to or charged against operations.

 

For the nine months ended September 30, 2004and 2003, depreciation expense was $451,719 and $409,732 respectively.

 

Impairment losses are recognized for long-livedassets used in operations when indicators of impairment are present and theundiscounted cash flows are not sufficient to recover the assets’ carryingvalue.  The amount of impairment ismeasured by comparing the fair value of the asset to its carrying amount.

 

The Company provides for the future asset retirementobligations related to the Shipwreck offshore production platform because,eventually, law or regulation will require its abandonment.  The present value of the estimated futureasset retirement obligation, as of the date of acquisition, was capitalized togas gathering,

 

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processingand transportation equipment.  Thepresent value of the estimated future asset retirement obligation, as of thebalance sheet date, is presented as a noncurrent liability.  Until the platform is ultimately sold orretired, the Company will recognize (i) depreciation expense on the additionalcapitalized costs; (ii) accretion expense as the present value of the futureasset retirement obligation increases with the passage of time, and; (iii) theimpact, if any, of changes in estimates of the liability.  The following table sets forth areconciliation of the beginning and ending aggregate carrying amount of assetretirement obligations for the nine months ended September 30, 2004 and2003:

 
| ** **                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------|------------|------------------------------------------|------------|
| ** **                         | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
| Beginning  balance                 |       | $                                        | 299,218    |   | $ | 202,007 |   |
| Accretion                          |       | 16,080                                   |       | 10,854 |   |
| Revisions in  estimated cash flows |       | —                                   |       | 81,356 |   |
| Ending  balance                    |       | $                                        | 315,298    |   | $ | 294,217 |   |

 

**Effective January 1, 2003,the Company adopted Statement of Financial Accounting Standards, or SFAS, No.143, which requires recognition of future asset retirement obligations.  The cumulative effect of adopting thisstatement was to increase net loss for the nine months ended September 30,2003 by $105,777, or $0.01 per common share.**

 

***Other Assets***

 

The Company’s other assets include an exclusivelicense with Advanced Extraction Technologies, Inc. (“AET”) to design,construct, build or license Mehra gas treating units.  The Mehra gas treating units employ apatented process to remove nitrogen from streams of natural gas.  This asset is being amortized to expense overthe life of the underlying patents.  Thelatest of these patents expires in 2022. If on December 31, 2004, the Company has not sold or leased unitsusing the Mehra Process® which produce a target capacity of 20,000 Mcf per day,AET may convert the Company’s license from an exclusive license to anon-exclusive license.  The Company mustadd 4,700 Mcf per day to the existing capacity to meet this targetcapacity.  Under the agreement with AET,the Company may meet this target capacity by licensing the technology to one ormore third parties for the purpose of building a Mehra gas treating unit withthe requisite capacity.  The Company hasentered into an agreement with Advanced Energy Recovery, Inc. (“AER”) andcertain of its subsidiaries for a Mehra treatment unit with at least 5,000 Mcfper day of capacity, at or near the current Madisonville, Texas treatmentplant.  The Board of Directors believesthis agreement will preserve the exclusive license for an additional year.  If the Company does not meet the targetcapacity, the license may still be exploited by the Company as a non-exclusivelicense, but the Company believes that the value of the license would besignificantly diminished.

 

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

 

For purposes of the consolidated statements of cashflows, the Company considers all highly liquid debt instruments purchased withoriginal maturities of three months or less to be cash equivalents.

 

Effective January 1, 2003, the Companyrecognized future asset retirement obligations related to prior periods totaling$202,007 pursuant to SFAS No. 143, discussed above.  A portion of such costs ($112,113) wascapitalized to gas gathering, processing and transportation assets.  The cumulative effect of accounting change of$105,777 is comprised of depreciation of the capitalized future assetretirement obligation of $15,888 and $89,894 of accretion of the relatedliability for the period from the date of acquisition of the platform throughDecember 31, 2002.

 

The Company agreed to pay to Allen DrillingAcquisition Company (“ADAC”) an affiliated Nebraska corporation discussed inNote 4, $24,000 in exchange for its consent to modify the terms of theMadisonville term loan, ratably over a twelve-month period beginning theearlier of the month following maturity of the Balloon Note or the monthfollowing ADAC’s exercise of their option to prepay the Balloon Note asdiscussed in Note 4.  The present valueof this obligation at inception was $18,641, using an imputed interest rate of10%, and is included in

 

8

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theamount payable to ADAC, with a corresponding amount capitalized to deferredloan costs on the accompanying balance sheet. This amount will be amortized to interest expense ratably over the lifeof the term loan.

 

*Income Taxes*

 

The Company has no current provision for incometaxes because it had net losses in the periods presented, and the related taxbenefits may not be realized in future periods and are therefore fully reservedin the accompanying financial statements. Deferred tax assets and liabilities are recognized for the expectedfuture tax consequences of events that have been included in the financialstatements or income tax returns. Under this method, deferred tax assets andliabilities are determined based on the difference between the financial andtax bases of assets and liabilities as measured using the enacted tax ratesexpected to apply when these differences reverse. Deferred tax assets arereduced by a valuation allowance when it is likely that they will not berealized.  The deferred tax provision isthe result of changes in deferred tax assets and liabilities.

 

*Stock-Based Compensation*

 

The Company accounts for its stock-based employeecompensation plan under the recognition and measurement principles ofAccounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued 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 plans had an exerciseprice equal to the market value of the underlying common stock at the date ofgrant.

 

During May 2004, the Company issued 92,310 shares ofcommon stock to its nonemployee directors as part of their annual compensationfor service to the Company.  A total of$29,997 was charged to general and administrative expense for the nine monthsended September 30, 2004 in connection with these shares.

 

During May 2003 the Company granted 79,998 commonstock options to its nonemployee directors as part of their annual compensationfor service to the Company.  Of the totaloptions granted, 50,000 were granted from the 1998 Outside Directors StockOption Plan (a non-approved plan) and 29,998 were granted from the 1998 StockOption Plan.

 

For pro forma purposes, the estimated value of theCompany’s stock-based awards to employees is amortized over the options’vesting period.  The following tableillustrates the effect on net loss and net loss per share if the Company hadapplied the fair value recognition provisions of SFAS No. 123, “Accounting forStock-Based Compensation,” to its stock-based employee compensation for thethree months and nine months ended September 30, 2004 and 2003:

 
| ** **                                                                                                                                   | ** ** | **Three Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                                                   | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Net loss –  as reported                                                                                                                 |       | $                                          | (151,065   | )                                         | $          | (216,202 | ) | $ | (510,198 | ) | $ | (828,607 | ) |
| Deduct stock  option compensation income recognized on repriced options                                                                      |       | —                                     |       | (37,228                                   | )          | — |   | (15,803 | ) |
| Deduct total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (4,446                                     | )          | (6,817                                    | )          | (14,750 | ) | (15,811 | ) |
| Net loss –  pro forma                                                                                                                   |       | $                                          | (155,511   | )                                         | $          | (260,247 | ) | $ | (524,948 | ) | $ | (860,221 | ) |
|                                                                                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Basic and  diluted net loss per share – as reported                                                                                     |       | $                                          | (0.01      | )                                         | $          | (0.01 | ) | $ | (0.03 | ) | $ | (0.05 | ) |
| Basic and  diluted net loss per share – pro forma                                                                                       |       | $                                          | (0.01      | )                                         | $          | (0.02 | ) | $ | (0.03 | ) | $ | (0.06 | ) |

 

9

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*Earnings Per Share*

 

Basic earnings per share is computed by dividing netearnings or loss by the weighted average number of common shares outstandingduring the period.  Diluted earnings pershare is computed by dividing net earnings or loss by the weighted averagenumber of shares outstanding, after giving effect to potentially dilutivecommon share equivalents outstanding during the period.  Potentially dilutive common share equivalentsare not included in the computation of diluted earnings per share if they areanti-dilutive.  Diluted loss per commonshare is the same as basic for all periods presented because the effect ofpotentially dilutive common shares arising from outstanding stock options andwarrants was anti-dilutive.  For thethree months ended September 30, 2004 and 2003, the potentially dilutivecommon shares were zero and 67,612, respectively.  For the nine months ended September 30,2004 and 2003, the potentially dilutive common shares were 20,571 and 36,624,respectively.

 

*Use of Estimates*

 

The preparation of financial statements inconformity with U.S. generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and the disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

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

 

The Company made total capital expenditures of$1,944,559 in the nine months ended September 30, 2003, primarily toconstruct the pipelines servicing the Madisonville Plant—a four-inch gatheringline, a three-inch injection line and the ten-inch pipeline to transport the pipelinequality gas.

 

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

 

*Notes Payable*

 

The Company’s revolving credit agreement providesfor maximum available borrowings of up to $250,000 through May 22, 2005.  Principal outstanding under the agreementaccrues interest at a variable rate, based on the bank’s prime rate index plus1.25%, with a minimum rate of 8%.  Thebalance under the agreement is due upon demand, or if no demand is made, atmaturity, and is renewable annually.  Costsof obtaining this debt are being charged to interest expense ratably over thematurity period of the note.  Fort Cobbuses the proceeds from time to time for general working capital purposes.  The agreement, along with the Fort Cobb TermNote discussed below, is collateralized with the assets of Fort Cobb andguaranteed by the Company.  The aggregateborrowings under the agreement as of September 30, 2004 were $247,515.

 

*Long-termDebt*

 

Long-term debt at September 30, 2004 consistedof the following:

 
| Subordinated  notes                  |   | $          | 234,327   |   |
|--------------------------------------|--------|------------|-----------|--------|
| Term note –  Fort Cobb          |   | 489,387    |      |
| Term note –  Madisonville       |   | 1,269,458  |      |
| Balloon note  – Madisonville    |   | 900,000    |      |
| Term note –  Fort Cobb vehicles |   | 38,046     |      |
| Trade note  payable                  |   | 50,798     |      |
|                                 |   | 2,982,016  |      |
| Less current  maturities             |   | (1,391,753 | )         |
|                                 |   |       |      |
|                                 |   | $          | 1,590,263 |   |

 

*Subordinated Notes*

 

In connection with the Recapitalization that waseffective March 1, 1997, the Company issued subordinated promissory noteswith a face amount of $1,171,700.  Thestated interest rate is 10% payable quarterly with equal annual principalpayments beginning on March 1, 2000 and continuing through March 1,2004.  The Company calculated the fairmarket value of the notes to be $978,000 at March 1, 1997 and recorded thedifference between

 

10

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fairvalue and the face amount as discount on subordinated notes.  The discount was amortized to interestexpense using the interest method over the term of the subordinated notes.  Such charge to interest expense was $4,611for the nine months ended September 30, 2004 and $20,753 for the ninemonths ended September 30, 2003.  Asa result, the effective interest rate of the subordinated notes is 11.6% forthe nine months ended September 30, 2004, and 15% for the nine monthsended September 30, 2003.

 

At September 30,2004, the final principal payment totaling $234,327, which was due under thesenotes on March 1, 2004, remained unpaid and by their terms are in default.  Due to the subordinatedrights of the note holders, the Company was able to obtain a limited waiverfrom the bank for the violation of a Madisonville term loan agreement covenantnot to allow such a default.  Thesubordinated note holders have been separately notified that they will continueto receive interest at an annual rate of 10% on the final principal installmentoutstanding until such time as it is paid.

 

***Term Note –Fort Cobb***

 

Effective June 1, 2001, Fort Cobb borrowed$750,000 from a bank.  Principaloutstanding under the note accrues interest at a variable rate, based on thebank’s prime rate index plus 11⁄4%, with a minimum rate of 8%.  The interest rate at September 30, 2004was 8%.  The note requires monthlypayments of approximately $13,000, with the balance under the note due June 1,2008.  Costs of obtaining this debt arebeing charged to interest expense ratably over the maturity period of thenote.  Fort Cobb used the proceeds torefinance 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, as theborrowers, entered into a term note agreement with a bank.  Effective November 15, 2003, the termnote agreement was amended to modify provisions governing intercompany debtpayments from the borrowers to Gateway Energy Corporation.  Effective March 31, 2004, the term noteagreement was amended to extend an interest-only period for the months of April throughJuly 2004.  All other terms andconditions of the term note, including the maturity date, remained the same.  The term note agreement was modified toprovide the Company additional working capital during the period thatadditional costs are likely to be incurred to effect the financing described inNote 5.  The Company agreed to pay toADAC $24,000, in exchange for its consent to modify the loan terms, ratablyover a twelve-month period beginning the earlier of the month followingmaturity of the Balloon Note or the month following ADAC’s exercise of theiroption to prepay the Balloon Note as discussed below.  The present value of this obligation atinception was $18,641, using an imputed interest rate of 10%, and is includedin the amount payable to ADAC, with a corresponding amount capitalized todeferred loan costs on the accompanying balance sheet, to be recognized asinterest expense ratably over the term of the agreement.

 

Under the term note, asamended effective March 31, 2004, the borrowers received $1.5 million inmultiple advances.  The January and February 2004payments of principal and interest were each $54,819.  The monthly note payments for March throughJuly 2004 were interest only at a fixed annual rate of 71⁄4%.  Thereafter the note requires 16 monthlypayments of principal and interest of $70,000, with a final payment ofapproximately $204,000, representing unpaid principal and accrued, but unpaid,interest due at the December 31, 2005 maturity date.  Costs of securing this debt are being chargedto interest expense ratably over the maturity period of the note.  The proceeds were used to finance theconstruction of the Madisonville pipeline facilities.  The term note is collateralized with theCompany’s economic interest in the Madisonville project and the Waxahachiepipeline system, and the Company has guaranteed the loan and pledged the commonstock of the borrowers.  The term noteagreement contains cross collateral and cross default provisions linking it tothe Balloon Note, described below.

 

During August 2004,management of the Company initiated discussions with Southwest Bank of Texas,N.A. (as used in this section, the “Bank”) to obtain clearance from the Bank to: (i)incur additional debt in the form of a convertible bridge loan (the “BridgeLoan”) from a third party lender for up to $115,000; (ii) issue new shares ofcommon stock at a per share price of $0.30 to certain directors of the Company(the “Director Stock”) in order to raise $95,000 of additional funds, and;(iii) sell certain ancillary pipeline assets (namely, the 4-inch gatheringpipeline, the 3-inch waste gas pipeline, a 1.5-inch fuel gas pipeline andrelated rights-of-way) in conjunction with a proposed restructuring of theMadisonville agreements under which the Company was to receive substantial

 

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benefits, including a lumpsum of cash, increased guaranteed monthly cash flows and an extended term.  The Company was to retain title to its10-inch Madisonville natural gas sales pipeline.  The Bank approved all of the financingproposals listed above, subject to certain restrictions, and began preparingdocuments reflecting the appropriate amendments to the credit agreement.  Negotiations with the Bank were interruptedby the Company’s management changes. These negotiations have now resumed. With theagreement of the Bank, the Company did not make the Madisonville Term Noteprincipal payments that were due on August 31, September 30 or October 31,2004.  Although the Bank has not demandedpayment of the principal payments, we are in technical default of the originalnote terms.

 

On November 15, 2004,the Company paid the Madisonville Term Note principal payments that were due onAugust 31, September 30 and October 31, 2004 with the proceedsof the Bridge Loan and Director Stock proceeds discussed in Note 9.

 

*BalloonNote – Madisonville*

 

Effective March 31,2003, the Company entered into a balloon credit agreement (the “Balloon Note”).  Under the Balloon Note agreement, theBorrowers borrowed $900,000 in multiple advances.  Principal outstanding under the Balloon Noteaccrues interest at a fixed rate of 71⁄4% and the note will mature afterthirty-six months.  The monthly notepayments represent interest only on the total balance outstanding.  Costs of securing this debt are being chargedto interest expense ratably over the maturity period of the note.  The Borrowers used the proceeds to financethe remaining construction costs of the Pipeline Facilities, and to fund theprincipal and interest payments which were due under the Company’s subordinatednote agreements on March 1, 2003.

 

The Balloon Note iscollateralized with letters of credit obtained through ADAC.  Charles A. Holtgraves, a director of theCompany, is Chairman of the Board, President and a director of ADAC, and LarryJ. Horbach, a former director of the Company,is Secretary and a director of ADAC.  Mr.Holtgraves owns directly no shares of ADAC common stock, and owns 14.65% of anentity that owns 55.56% of the ADAC senior preferred stock.  Such preferred stock has a stated dividendrate equal to two-thirds (66-2/3%) of any Madisonville payments received byADAC pursuant to the Agreement discussed below. Mr. Horbach does not own, directly or indirectly, any ADAC common orpreferred stock.

 

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

 

*TermNote – Fort Cobb Vehicles*

 

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

 

*TradeNote Payable*

 

Effective October 2003,in connection with the settlement of a dispute mediation, the Company executeda trade note for $100,000, bearing no interest, payable in eighteen monthlyinstallments of $5,200 and one final installment of $6,400.  The note is secured by a lien on the Company’sCrystal Beach terminal facility. Interest

 

12

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expense is beingrecognized over the life of the note at an imputed rate of 10%; accordingly,the obligation was recorded at its present value of $91,290.

 

*Lettersof Credit*

 

As of September 30,2004, the Company had outstanding letters of credit totaling $1,000,000.

 

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

 

Effective March 9,2004, the Company entered into a letter of intent with a subsidiary of TheInvestLinc Group under which InvestLinc was to assist the Company in raisingapproximately $12,000,000 through a combination of a rights/follow-on offeringof its common stock and the formation of a new limited liability company fundedwith capital from the Company and InvestLinc. A description of the material terms of the letter of intent is containedin a Form 8-K filed March 12, 2004.

 

The board of directorsintends to proceed with the registered rights offering to existingstockholders, but will not pursue the follow-on offering.  During August, September and October 2004,no meetings took place between representatives of the Company’s board ofdirectors and Invest Linc Securities, an InvestLinc subsidiary, for the purposeof crafting a new letter of intent between the Company and InvestLincSecurities to fund the Company’s high nitrogen natural gas projects.  There is no guarantee that the parties willmeet in the future, or if such meetings occur, that the parties will be able toagree on essential terms of a new letter of intent.

 

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

 

In connection with securing the Balloon Notedescribed in Note 4 that was used to finance part of the construction costs ofthe Madisonville pipeline facilities, the Company is obligated at ADAC’s optionto either: (i) pay at the end of the term of the Balloon Note a lump-sum, whichwhen added to the payments made, if any, for the price upside portion, willresult in ADAC receiving a 15% pre-tax internal rate of return on the $900,000,or (ii) convey to ADAC a one-third ownership interest in the pipelinefacilities in exchange for ADAC paying off the Balloon Note on or before theend of the Balloon Note term.  TheCompany is obligated to pay the periodic interest payments to the bank duringthe three-year term of the Balloon Note.

 

The Company believes thatit is likely that ADAC will elect to pay off the Balloon Note in exchange foran ownership interest in the pipeline facilities; however, it is beyond theCompany’s control.  Therefore, theminimum return guaranteed to ADAC by the Company is being accrued ratably overthe three-year term of the Balloon Note, and reduced by periodic price upsidepayments, if any, paid to ADAC.  Suchaccruals increased interest expense in the accompanying financial statementsfor the three months and nine months ended September 30, 2004 by $33,750and $101,250, respectively.  In theaccompanying consolidated balance sheet as of September 30, 2004, thepayable to ADAC includes a reserve of $124,415 for such amounts not yetpaid.  If ADAC elects to pay off theBalloon Note at maturity or before, the reserve portion of the ADAC payablewill be credited to income.

 

The Company and its subsidiaries are parties to litigationand claims arising in the normal course of business.  Management, after consultation with legalcounsel, believes that the liabilities, if any, arising from such litigationand claims, will not be material to the consolidated financial statements.

 

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

 

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

 

Under the terms of theADAC agreement, ADAC will receive, during the term of the Balloon Note,one-half of the price upside portion only, if any, of the monthly fee to bereceived by the Company pursuant to the Madisonville project agreements.  Cash price upside payments to ADAC for thethree months and nine months

 

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ended September 30,2004 totaled $30,619 and $94,946, respectively. There were no payments during the corresponding periods of the prioryear, as such price upside payments began during October 2003.

 

Effective November 15, 2004, the Company andcertain of its subsidiaries entered into a License Agreement with AER, ADAC, aNebraska corporation and a wholly owned subsidiary of AER, and Elgin Holdings,LLC, a Texas limited liability company and majority owned subsidiary of ADAC,for the joint participation and development of future high nitrogen natural gasprojects in the Madisonville, Texas area. Charles A. Holtgraves, a director of the Company, is Chairman of theBoard, President and a director of AER, and Chairman of the Board, Presidentand a director of ADAC, and a manager of Elgin Holdings.  Approximately 60% of the stock of AER isowned indirectly by Mr. Holtgraves and his family members.  Mr. Holtgraves owns directly no shares of ADACcommon stock, and owns 14.65% of an entity that owns 55.56% of the ADAC seniorpreferred stock.  Such preferred stockhas a stated dividend rate equal to two-thirds (66-2/3%) of any Madisonvillepayments received by ADAC pursuant to the ADAC Agreement discussed above.

 

Accrued expenses and other liabilities as of September 30,2004 included unpaid directors’ fees of $49,500.

 

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

 

All of the Company’s operations are in Texas andOklahoma, and the Gulf of Mexico in Texas and federal waters.  The Company’s management reviews andevaluates the operations separately of three main segments—onshore operations,offshore operations and Fort Cobb operations. Each segment is an aggregation of operations subject to similar economicand regulatory conditions such that they are likely to have similar long-termprospects for financial performance. Onshore operations include natural gas gathering, transportation anddistribution activities in Texas and Oklahoma. Offshore operations include natural gas and liquid hydrocarbon gatheringand transportation activities in the Gulf of Mexico in Texas and federalwaters.  The principal markets for theonshore segment are industrial customers, and for the offshore segment they areaffiliates of large intrastate and interstate pipeline companies.  Fort Cobb operations are comprised of a localnatural gas distribution company in Oklahoma. This segment supplies natural gas to approximately 2,350 customers,principally for irrigation and crop drying fuel for farming cooperatives, andresidential fuel.

 

The accounting policies of the reportable segmentsare the same as those described in Note 2. The Company evaluates the segments based on operating margin, defined asrevenues less cost of purchased gas and operating and maintenance expenses.  Such amounts are before general and administrativeexpense, depreciation, interest income or expense or income taxes.  Inter-segment sales of $350,000 and $428,000were eliminated during consolidation for the three months ended September 30,2004 and 2003.  Inter-segment sales of$1,047,000 and $1,066,000 were eliminated during consolidation for the ninemonths ended September 30, 2004 and 2003.

 

Summarized financial information of the Company’sreportable segments, and a reconciliation of operating margin to consolidatednet loss, is presented below:

 

| ** **                                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                           | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Onshore  Operations**                              |       |                                       |       |                                      |       |   |   |   |   |
| Revenues                                             |       | $                                          | 5,493,507  |                                      | $          | 3,785,144 |   | $ | 15,561,860 |   | $ | 7,732,972 |   |
| Operating  margin                                    |       | 418,038                                    |       | 301,807                                   |       | 1,122,393 |   | 663,877 |   |
| Depreciation  and amortization                       |       | 69,766                                     |       | 69,927                                    |       | 211,302 |   | 178,025 |   |
| Interest  expense                                    |       | 93,130                                     |       | 131,027                                   |       | 285,472 |   | 227,496 |   |
| Capital  expenditures, net of reimbursements         |       | 1,215                                      |       | (90,351                                   | )          | 32,899 |   | 1,734,208 |   |
| Total assets                                         |       | 5,398,657                                  |       | 5,996,246                                 |       | 5,398,657 |   | 5,996,246 |   |
|                                                 |       |                                       |       |                                      |       |   |   |   |   |
| **Offshore  Operations**                             |       |                                       |       |                                      |       |   |   |   |   |
| Revenues                                             |       | 98,170                                     |       | 170,182                                   |       | 324,145 |   | 478,253 |   |
| Operating  margin                                    |       | 40,881                                     |       | 109,675                                   |       | 141,501 |   | 287,698 |   |
| Depreciation  and amortization                       |       | 37,693                                     |       | 40,540                                    |       | 113,078 |   | 112,390 |   |
| Capital  expenditures                                |       | —                                     |       | 112,610                                   |       | — |   | 112,610 |   |
| Total assets                                         |       | 1,367,993                                  |       | 1,721,543                                 |       | 1,367,993 |   | 1,721,543 |   |
|                                                 |       |                                       |       |                                      |       |   |   |   |   |
| **Fort  Cobb Operations**                            |       |                                       |       |                                      |       |   |   |   |   |
| Revenues                                             |       | 452,003                                    |       | 630,188                                   |       | 1,320,486 |   | 1,625,876 |   |
| Operating  margin                                    |       | 44,034                                     |       | 138,819                                   |       | 136,625 |   | 308,102 |   |
| Depreciation  and amortization                       |       | 49,623                                     |       | 48,501                                    |       | 148,869 |   | 145,500 |   |
| Interest  expense                                    |       | 15,368                                     |       | 15,437                                    |       | 46,885 |   | 52,478 |   |
| Capital  expenditures                                |       | 407                                        |       | 10,706                                    |       | 10,106 |   | 97,741 |   |
| Total assets                                         |       | 2,027,109                                  |       | 2,275,920                                 |       | 2,027,109 |   | 2,275,920 |   |
|                                                 |       |                                       |       |                                      |       |   |   |   |   |
| **Total**                                            |       |                                       |       |                                      |       |   |   |   |   |
| Revenues                                             |       | 6,043,680                                  |       | 4,585,514                                 |       | 17,206,491 |   | 9,837,101 |   |
| Operating  margin                                    |       | 502,953                                    |       | 550,301                                   |       | 1,400,519 |   | 1,259,677 |   |
| Depreciation  and amortization                       |       | 157,082                                    |       | 158,968                                   |       | 473,249 |   | 435,915 |   |
| Interest  expense                                    |       | 108,498                                    |       | 146,464                                   |       | 332,357 |   | 279,974 |   |
| Capital  expenditures                                |       | 1,622                                      |       | 32,965                                    |       | 43,005 |   | 1,944,559 |   |
| Total assets                                         |       | 8,793,759                                  |       | 9,993,709                                 |       | 8,793,759 |   | 9,993,709 |   |
|                                                 |       |                                       |       |                                      |       |   |   |   |   |
| **Reconciliation  to net loss**                      |       |                                       |       |                                      |       |   |   |   |   |
| Operating  margin                                    |       | $                                          | 502,953    |                                      | $          | 550,301 |   | $ | 1,400,519 |   | $ | 1,259,677 |   |
| Depreciation  and amortization                       |       | (157,082                                   | )          | (158,968                                  | )          | (473,249 | ) | (435,915 | ) |
| Accretion  and changes in estimates                  |       | (5,361                                     | )          | (94,845                                   | )          | (16,080 | ) | (102,081 | ) |
| General  & administrative                        |       | (384,696                                   | )          | (360,838                                  | )          | (1,212,845 | ) | (1,211,067 | ) |
| Other income  (expense), net                         |       | (106,879                                   | )          | (151,852                                  | )          | (251,023 | ) | (233,444 | ) |
| Discontinued  operations                             |       | —                                     |       | —                                    |       | 42,480 |   | — |   |
| Cumulative  effect of change in accounting principle |       | —                                     |       | —                                    |       | — |   | (105,777 | ) |
| Net loss                                             |       | $                                          | (151,065   | )                                         | $          | (216,202 | ) | $ | (510,198 | ) | $ | (828,607 | ) |

 

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**(9)****                                 SubsequentEvents**

 

On October 21, 2004, Michael T. Faddenand Scott D. Heflin each notified the Board of his resignation from theBoard.  Mr. Fadden was the President andChief Executive Officer of the Company. Mr. Heflin is the Chief Financial Officer, Treasurer and Secretary ofthe Company.  On October 23, 2004,the Board of Directors of the Company met and accepted the resignations fromthe Board of Messrs. Fadden and Heflin. On October 25, 2004, Mr. Fadden delivered a letter notifying theBoard that his employment with the Company was terminated.  He asserted in that letter that he wasconstructively terminated in violation of his employment agreement.  The Board disagrees with his assertions.  These board resignations and this managementchange were reported in the Company’s Current Report on Form 8-K, dated October 26,2004.  Effective November 1, 2004,John A. Raasch was appointed interim President, Chief Executive Officer andChief Operating Officer of the Company. Mr. Raasch will receive no compensation for his services.  This management change was reported in theCompany’s Current Report on Form 8-K, dated November 4, 2004.

 

EffectiveNovember 1, 2004, certain of the Company’s directors entered into commonstock subscription agreements with the Company for the purchase of 316,667shares of the Company’s common stock for $95,000, reflecting a per share priceof $0.30.

 

Effective November 1, 2004, the Company enteredinto a convertible promissory note agreement (the “Bridge Loan”) with a privateparty for $115,000 accruing interest at a fixed rate of 8%.  The Bridge Loan is unsecured and matures March 31,2005, unless extended by the parties to September 30, 2005.  The Bridge Loan is convertible at any timeuntil maturity into common stock of the Company at a conversion price of thegreater of 85% of the average closing price of the Company’s common stockfor the 90 days prior to conversion, or $0.25 per share, the par value of thecommon stock.  In connection with theBridge Loan, the Company granted a warrant to purchase 100,000 shares of theCompany’s common stock, which was subsequently exercised, at a price of $0.30per share.

 

On November 15, 2004, the Company used theaggregate proceeds of the Bridge Loan and the Director Stock to pay the August,September and October 2004 principal payments due the Bank under theMadisonville Term Note.

 

Effective November 15, 2004, the Company andcertain of its subsidiaries entered into a License Agreement with AER, ADAC, awholly owned subsidiary of AER and a Nebraska corporation, and Elgin Holdings,LLC, a Texas limited liability company, for the joint participation anddevelopment of future high nitrogen natural gas projects in the Madisonville,Texas area.  See Note 7, “Related PartyTransactions.”

 

 

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**Item 2.****                                  ****Management’s Discussion andAnalysis of Financial Condition and Results of Operations.**

 

Statements made in this report, the AnnualReport to Shareholders or other periodic disclosures in which this report ismade a part, other reports and proxy statements filed with the Securities andExchange Commission, communications to shareholders, press releases and oralstatements made by representatives of the Company that are not historical innature, or that state the Company’s or management’s intentions, hopes, beliefs,expectations or predictions of the future, may constitute “forward-lookingstatements” within the meaning of Section 21E of the Securities and ExchangeAct of 1934, as amended (the “Exchange Act”). Forward-looking statements canoften be identified by the use of forward-looking terminology, such as “could,”“should,” “will,” “intended,” “continue,” “believe,” “may,” “expect,” “hope,” “anticipate,”“goal,” “forecast,” “plan,” or “estimate” or the negative of these words,variations thereof or similar expressions. Forward-looking statements are notguarantees of future performance or results. They involve risks, uncertainties and assumptions. It is important tonote that any such performance and actual results, financial condition orbusiness, could differ materially from those expressed in such forward-lookingstatements.  Factors that could cause orcontribute to such differences include, but are not limited to, those discussedbelow as well as those discussed elsewhere herein or in other reports filedwith the Securities and Exchange Commission. Other unforeseen factors not identified herein could also have such aneffect. The Company undertakes no obligation to update or reviseforward-looking statements to reflect changed assumptions, the occurrence ofunanticipated events or changes in future operating results, financialcondition or business over time.

 

**CriticalAccounting Policies**

 

The following accounting policies are considered bymanagement to be the most critical to the fair presentation of the Company’sfinancial condition, results of operations and cash flows.  The policies are consistently applied in thepreparation of the accompanying consolidated financial statements; however,certain reclassifications have been made to the prior period statements to beconsistent with the current presentation.

 

***RevenueRecognition Policy***

 

Sales revenues are recognized at the redeliverypoint, 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 is stated at cost, pluscapitalized interest costs on major pipeline projects during their constructionperiod.  Additions and improvements thatadd to the productive capacity or extend the useful life of an asset arecapitalized.  Expenditures formaintenance and repairs are charged to expense as incurred.  Depreciation is provided using the straight-linemethod over estimated useful lives ranging from 6 to 30 years for pipelinesystems, gas plant and processing equipment, and from 2 to 10 years for officefurniture and other equipment.  Upondisposition or retirement of pipeline components or gas plant components, anygain or loss is charged or credited to accumulated depreciation.  When entire pipeline systems, gas plants orother property and equipment are retired or sold, any resulting gain or loss iscredited to or charged against operations.

 

Impairment losses are recognized for long-livedassets used in operations when indicators of impairment are present and theundiscounted cash flows are not sufficient to recover the assets’ carryingvalue.  The amount of impairment ismeasured by comparing the fair value of the asset to its carrying amount.

 

*Asset Retirement Obligation*

 

The Company provides for the future asset retirementobligations related to the Shipwreck offshore production platform because,eventually, law or regulation will require its abandonment.  The present value of the estimated futureasset retirement obligation, as of the date of acquisition, was capitalized togas gathering, processing and transportation equipment.  The present value of the estimated futureasset retirement obligation, as of the balance sheet date, is presented as anoncurrent liability.  Until the platformis ultimately sold or retired, the Company will recognize (i) depreciationexpense on the additional capitalized costs; (ii) accretion expense as the presentvalue of the future asset retirement obligation increases with the passage oftime, and; (iii) the impact, if any, of changes in estimates of theliability.  The following table setsforth a reconciliation of the beginning and ending aggregate carrying amount ofasset retirement obligations for the nine months ended September 30, 2004and 2003:

 

16

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| ** **                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------|------------|------------------------------------------|------------|
| ** **                         | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
| Beginning  balance                 |       | $                                        | 299,218    |   | $ | 202,007 |   |
| Accretion                          |       | 16,080                                   |       | 10,854 |   |
| Revisions in  estimated cash flows |       | —                                   |       | 81,356 |   |
| Ending  balance                    |       | $                                        | 315,298    |   | $ | 294,217 |   |

 

**Effective January 1, 2003,the Company adopted Statement of Financial Accounting Standards, or SFAS, No.143, which requires recognition of future asset retirement obligations.  The cumulative effect of adopting thisstatement was to increase net loss for the nine months ended September 30,2003 by $105,777, or $0.01 per common share.**

 

***Other Assets***

 

The Company’sother assets include an exclusive license with Advanced ExtractionTechnologies, Inc. (“AET”) to design, construct, build or license Mehra gastreating units.  The Mehra gas treatingunits employ a patented process to remove nitrogen from streams of naturalgas.  This asset is being amortized toexpense over the life of the underlying patents.  The latest of these patents expires in2022.  If on December 31, 2004, theCompany has not sold or leased units using the Mehra Process® which produce atarget capacity of 20,000 Mcf per day, AET may convert the Company’s licensefrom an exclusive license to a non-exclusive license.  The Company must add 4,700 Mcf per day to theexisting capacity to meet this target capacity. Under the agreement with AET, the Company may meet this target capacityby licensing the technology to one or more third parties for the purpose ofbuilding a Mehra gas treating unit with the requisite capacity.  No such contracts are currently in place tomeet the target capacity.  The Company has entered intoan agreement with Advanced Energy Recovery, Inc. (“AER”), and certain of itssubsidiaries, for a Mehra treatment unit with at least 5,000 Mcf per day ofcapacity, at or near the current Madisonville, Texas treatment plant.  The Board of Directors believes thisagreement will preserve the exclusive license for an additional year.  If the Company does not meet the targetcapacity, the license may still be exploited by the Company as a non-exclusivelicense, but the Company believes that the value of the license would besignificantly diminished.

 

*Use of Estimates*

 

The preparation of financial statements inconformity with U.S. generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and the disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.  Actual results could differ from those estimates.

 

**Results of Operations**

 

***General***

 

The Henry Hub closing index price for natural gasduring the nine months ended September 30, 2004 averaged $5.81 per MMBtu,compared to $5.79 for the same period of the prior year.  Apart from the Madisonville pipelinefacilities, where the Company receives an additional amount equal to 4.5% ofthe aggregate sales proceeds of gas sold from the Madisonville plant for anaverage price above $3.75 per MMBtu, the Company’s net operating margin isrelatively insensitive to fluctuations in the market price of gas because thesales prices and purchase costs of gas move in tandem, or else revenues aregenerated under contracts which have a stated fee per unit of production (Mcf,MMBtu, or Bbl) gathered or transported. Accordingly, the Company evaluates each of its activities based on theoperating margin it produces.  TheCompany defines operating margin as revenues, less the cost of purchased gasand operating and maintenance expenses.  Managementreviews and evaluates the operations of three main segments—Onshore operations,Offshore operations and Fort Cobb operations.

 

# **Three Months Ended September 30,2004 Compared to September 30, 2003**

#  

# *Total Operations*

#  

The following table sets forth information for thethree months ended September 30, 2004 and 2003:

 
| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Revenues                       |       | $        | 6,043,680  |     | $          | 4,585,514 |   |
| Operating  margin              |       | 502,953  |       | 550,301  |       |
| Depreciation  and amortization |       | 157,082  |       | 158,968  |       |
|                                |            |          |            |          |            |  |  |

 

17

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Operating margin for the three months ended September 30,2004 decreased $47,000 compared to the same period of the prior year.  Onshore operating margin increased $116,000,Offshore operating margin decreased $69,000, and Fort Cobb operating margindecreased $95,000.  Revenues were higherfor the three months ended September 30, 2004 due to higher sale andtransport volumes through the Company’s Madisonville pipeline facilities andslightly stronger natural gas prices. The average Henry Hub index price was $5.75 for the three months ended September 30,2004, compared to $5.65 for the same period of the prior year.  These segments are discussed individuallybelow in greater detail.

 

# *Onshore Operations*

 

The following table sets forth information for thethree months ended September 30, 2004 and 2003:

 
| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Revenues                       |       | $        | 5,493,507  |     | $          | 3,785,144 |   |
| Operating  margin              |       | 418,038  |       | 301,807  |       |
| Depreciation  and amortization |       | 69,766   |       | 69,927   |       |
|                                |            |          |            |          |            |  |  |

 

Operating margin for Onshore operations increased by$116,000 compared to the same period of the prior year, mainly due to theimpact of the Madisonville pipeline facilities which started operations duringsecond quarter 2003.

 

# *Offshore Operations*

 

The following table sets forth information for thethree months ended September 30, 2004 and 2003:

 
| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Revenues                       |       | $        | 98,170     |     | $          | 170,182 |   |
| Operating  margin              |       | 40,881   |       | 109,675  |       |
| Depreciation  and amortization |       | 37,693   |       | 40,540   |       |
|                                |            |          |            |          |            |  |  |

 

Operating margin for Offshore operations decreasedduring the third quarter by $69,000 compared to the same period of the prioryear. The decrease was primarily due to declines in natural gas and liquidsvolumes transported for producers in the areas of Galveston Blocks 190L and213L, and High Island Block 98L.

 

# *Fort Cobb Operations*

 

The following table sets forth information for thethree months ended September 30, 2004 and 2003:

 

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| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Revenues                       |       | $        | 452,003    |     | $          | 630,188 |   |
| Operating  margin              |       | 44,034   |       | 138,819  |       |
| Depreciation  and amortization |       | 49,623   |       | 48,501   |       |
|                                |            |          |            |          |            |  |  |

 

Operating margin for Fort Cobb operations decreased$95,000 during the three months ended September 30, 2004 compared to thesame period of the prior year mainly due to 35% lower delivered volumes as aresult of crop composition and weather patterns.  Fort Cobb’s business normally peaks in thethird and fourth quarters because a significant portion of its load comes fromsupplying natural gas to irrigation and crop-drying customers.

 

# *Reconciliation of OperatingMargin to Net Loss*

 

The following table sets forth information for thethree months ended September 30, 2004 and 2003:

 
| ** **                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|
| Operating  margin                   |       | $        | 502,953    |     | $          | 550,301 |   |
| Depreciation  and amortization      |       | (157,082 | )          | (158,968 | )          |
| Accretion  and changes in estimates |       | (5,361   | )          | (94,845  | )          |
| General and  administrative         |       | (384,696 | )          | (360,838 | )          |
| Interest  income                    |       | 106      |       | 1,166    |       |
| Interest  expense                   |       | (108,498 | )          | (146,464 | )          |
| Other income  (expense), net        |       | 1,513    |       | (6,554   | )          |
| Net loss                            |       | $        | (151,065   | )        | $          | (216,202 | ) |

 

Accretion expense for the three months ended September 30,2003 was $94,845, and included $81,356 recognized in connection with changes inestimated future asset retirement costs.

 

General and administrative expenses for the threemonths ended September 30, 2004 are 7% higher than for the same period ofthe prior year, mainly due to the prior year containing lower board of directorexpenses and stock compensation income of $37,000, which is the non-cash impactof a downward revaluation of employee stock options that were repriced in1999.  Under the Financial AccountingStandards Board Interpretation 44, “Interpretationof APB Opinion 25,” the Company is required to account for these optionsunder variable award accounting, due to the change in the option exerciseprice.  Variable award accountingrequires recognition of compensation expense (or income) under certaincircumstances when the market price of the Company’s stock exceeds the exerciseprice of the stock option.

 

Interest income varies directly with the balance ondeposit in the Company’s certificates of deposit and short-term money marketaccounts.  Interest expense fluctuatesdirectly with the amount of outstanding long-term debt and the amount ofborrowings under the Company’s revolving credit agreement.  Interest expense for the three months ended September 30,2004 and 2003 included $33,750 and $67,500, respectively, recognized inconnection with the reserve for the ADAC guarantee.

 

Other income (expense), net for the prior periodincludes mainly the write-off of uncollectible accounts receivable.

 

# **Nine Months Ended September 30,2004 Compared to September 30, 2003**

 

# *Total Operations*

 

The following table sets forth information for thenine months ended September 30, 2004 and 2003:

 
| ** **                     | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|--------------------------------|------------|-----------|------------|-----------|------------|
| Revenues                       |       | $         | 17,206,491 |      | $          | 9,837,101 |   |
| Operating  margin              |       | 1,400,519 |       | 1,259,677 |       |
| Depreciation  and amortization |       | 473,249   |       | 435,915   |       |
|                                |            |           |            |           |            |  |  |

 

Operating margin for the nine months ended September 30,2004 increased $141,000 compared to the same period of the prior year.  Onshore operating margin increased $459,000,Offshore operating margin decreased $146,000, and Fort Cobb operating margindecreased $171,000.  Revenues were higherfor the period due to higher sale and transport volumes through the Company’sMadisonville pipeline facilities and slightly stronger natural gas prices.  The average Henry Hub index price was $5.81for the nine months, compared to $5.79 for the prior period.  These segments are discussed individuallybelow in greater detail.

 

19

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# *Onshore Operations*

 

The following table sets forth information for thenine months ended September 30, 2004 and 2003:

 
| ** **                     | ** ** | **2004**  | ** ** | **2003** | ** ** |
|--------------------------------|------------|-----------|------------|----------|------------|
| Revenues                       |       | $         | 15,561,860 |     | $          | 7,732,972 |   |
| Operating  margin              |       | 1,122,393 |       | 663,877  |       |
| Depreciation  and amortization |       | 211,302   |       | 178,025  |       |
|                                |            |           |            |          |            |  |  |

 

Operating margin for onshore operations increased $459,000during the nine months ended September 30, 2004 compared to the sameperiod of the prior year, mainly due to the impact of the Madisonville pipelinefacilities which started operations during second quarter 2003.

 

# *Offshore Operations*

#  

The following table sets forth information for thenine months ended September 30, 2004 and 2003:

 
| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Revenues                       |       | $        | 324,145    |     | $          | 478,253 |   |
| Operating  margin              |       | 141,501  |       | 287,698  |       |
| Depreciation  and amortization |       | 113,078  |       | 112,390  |       |
|                                |            |          |            |          |            |  |  |

 

Operating margin for Offshore operations decreased$146,000 during the nine months ended September 30, 2004 compared to thesame period of the prior year.  Thedecrease was primarily due to declines in natural gas and liquids volumestransported for producers in the areas of Galveston Blocks 190L and 213LandHigh Island Block 98L.

 

# *Fort Cobb Operations*

 

The following table sets forth information for thenine months ended September 30, 2004 and 2003:

 
| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Revenues                       |       | $        | 1,320,486  |     | $          | 1,625,876 |   |
| Operating  margin              |       | 136,625  |       | 308,102  |       |
| Depreciation  and amortization |       | 148,869  |       | 145,500  |       |
|                                |            |          |            |          |            |  |  |

 

Operating margin for Fort Cobb operations decreased$171,000 during the nine months ended September 30, 2004 compared to thesame period of the prior year mainly due to 23% lower delivered volumes as aresult of crop composition and weather patterns.  Fort Cobb’s business normally peaks in thethird and fourth quarters because a significant portion of its load comes fromsupplying natural gas to irrigation and crop-drying customers.

 

# *Reconciliation of OperatingMargin to Net Loss*

 

The following table sets forth information for thenine months ended September 30, 2004 and 2003:

 
| ** **                                                 | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|------------------------------------------------------------|------------|------------|------------|------------|------------|
| Operating  margin                                          |       | $          | 1,400,519  |       | $          | 1,259,677 |   |
| Depreciation  and amortization                             |       | (473,249   | )          | (435,915   | )          |
| Accretion  and changes in estimates                        |       | (16,080    | )          | (102,081   | )          |
| General and  administrative                                |       | (1,212,845 | )          | (1,211,067 | )          |
| Interest  income                                           |       | 1,267      |       | 13,791     |       |
| Interest  expense                                          |       | (332,357   | )          | (279,974   | )          |
| Interest  capitalized                                      |       | —     |       | 24,466     |       |
| Other income  (expense), net                               |       | 80,067     |       | 8,273      |       |
| Discontinued  operations – gain on sale of properties |       | 42,480     |       | —     |       |
| Cumulative  effect of change in accounting principle       |       | —     |       | (105,777   | )          |
| Net loss                                                   |       | $          | (510,198   | )          | $          | (828,607 | ) |

 

Accretion and changes in estimates for the ninemonths ended September 30, 2003 was $102,081, and included $81,356recognized in connection with changes in estimated future asset retirementcosts.

 

General and administrative expenses for the ninemonths are approximately the same as for the same period of last year; however,the prior year period included stock compensation income of $16,000, which isthe non-cash

 

20

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impactof a downward revaluation of employee stock options that were repriced in 1999,partially offset by lower legal fees. Under the Financial Accounting Standards Board Interpretation 44, “Interpretation of APB Opinion 25,” theCompany is required to account for these options under variable awardaccounting, due to the change after issuance in the option exercise price.  Variable award accounting requiresrecognition of compensation expense (or income) under certain circumstanceswhen the market price of the Company’s stock exceeds the exercise price of thestock option.

 

Interest income varies directly with the balance ondeposit in the Company’s certificates of deposit and short-term money marketaccounts.  Interest expense fluctuatesdirectly with the amount of outstanding long-term debt and the amount ofborrowings under the Company’s revolving credit agreement.  Interest expense of $24,466 related to theCompany’s Madisonville term loan was capitalized during the nine months ended September 30,2003.  Interest expense for the ninemonths ended September 30, 2004 and 2003 included $101,250 and $67,500,respectively, recognized in connection with the reserve for the ADAC guarantee.

 

**Effective March 31, 2004, the Company factored themajority of its receivable from Enron North America Corp. and received $24,433,representing $0.20 on the dollar for its claim. This amount is reflected in the accompanying statement of operations asother income for the nine months ended September 30, 2004.  Other income for the period also includes theadjustment of approximately $48,000 of amounts previously charged to expense,and late fees and penalties charged its customers by Fort Cobb andmiscellaneous adjustments.**

 

Discontinued operations presented above reflectsadditional cash proceeds received in 2004 related to the Company’s sale of 14non-core natural gas gathering systems located in Texas, Oklahoma andLouisiana, effective August 1, 2002.

 

The cumulative effect of change in accountingprinciple represents the aggregate difference in retained earnings thatresulted from retroactively applying the provisions of SFAS No. 143 to allprior years affected by the new accounting rules, effective January 1,2003.

 

## **Liquidityand Capital Resources**

 

Until we are able to successfully raiseadditional growth capital, our growth strategy through strategic alliances inhigh nitrogen natural gas projects is in question.  Also, any currently owned properties aresubject to sale under the right circumstances (valuation and timing) if theproceeds from any such sale could be effectively redeployed into one or morehigh nitrogen natural gas projects.  Wemay not be able to raise outside capital or be able to sell assets on termsfavorable to the Company.  Without theproceeds of a significant financing or some other financial plan, the Companycannot demonstrate that it has sufficient cash reserves and cash flow fromoperations to satisfy its obligations as they come due over the next twelvemonths.  Taken as a whole, the aboveinformation raises substantial doubt that the Company can continue as a goingconcern, without resorting to dispositions of property outside the normalcourse of business, restructuring its debt, soliciting additional capital orsubstantially revising its operations. The Company is taking several steps that it believes may improve theCompany’s ability to continue as a going concern.  First, beginning in the fourth quarter, theCompany’s payroll expense has been significantly reduced due to staffreductions, including the replacement of Mr. Fadden as President and ChiefExecutive Officer with Mr. Raasch, who will serve in such position for nocompensation.  The staff and officeexpense savings total approximately $9,900 per month and the Company managementsavings total approximately $24,400 per month. Second, the Company is pursuing a number of projects that it believesmay enhance revenues in the future.  Suchprojects would require the Company to raise additional capital or enter intojoint ventures with other industry partners before these projects could berealized.  Third, the Company believesthat potential revenues on phase II of the Madisonville project may increase byan estimated $64,800 per month beginning in the second quarter of 2005.  The Company's ability to successfully pursuethese projects depends upon the exclusivity of the license the Company has beengranted from AET.  Finally, the Companyis considering raising additional capital from existing shareholders.  The consolidated financial statements havebeen prepared without adjustments relating to the recoverability andclassification of the recorded assets or liabilities that might be necessaryshould the Company be unable to continue as a going concern.

 

As described in Note 5,until June 2004, the Company anticipated that substantial reduction of itsdebt would result from, and the growth of its high nitrogen natural gasbusiness would be driven by, financing secured through InvestLinc.  The letter of intent dated March 9, 2004expired by its terms on July 31, 2004. The board of directors intends to proceed with the registered rightsoffering to existing stockholders, but will not pursue the follow-onoffering.  During August, September andOctober 2004, no meetings took place between representatives of theCompany’s board of directors and Invest Linc Securities, an InvestLincsubsidiary, for the purpose of crafting a new letter of intent between theCompany and InvestLinc Securities to fund the Company’s high nitrogen naturalgas projects.  There is no guarantee thatthe parties will meet in the future, or if such meetings occur, that theparties will be able to agree on essential terms of a new letter of intent.

 

21

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Effective November 1, 2004, the Company enteredinto a convertible promissory note agreement (the “Bridge Loan”) with a privateparty for $115,000 accruing interest at a fixed rate of 8%.  The Bridge Loan is unsecured and matures March 31,2005, unless extended by the parties to September 30, 2005.  The Bridge Loan is convertible at any timeuntil maturity into common stock of the Company at a conversion price of thegreater of 85% of the average closing price of the Company’s common stockfor the 90 days prior to conversion, or $0.25 per share, the par value of thecommon stock.  In connection with theBridge Loan, the Company granted a warrant to purchase 100,000 shares of theCompany’s common stock, which was subsequently exercised, at a price of $0.30per share.

 

Effective November 1, 2004, certain of theCompany’s directors entered into common stock subscription agreements with theCompany for the purchase of 316,667 shares of the Company’s common stock for$95,000, reflecting a per share price of $0.30.

 

On November 15, 2004, the Company used theaggregate proceeds of the Bridge Loan and the Director Stock to pay the August,September and October 2004 principal payments due the Bank under theMadisonville Term Note, which were not made timely in accordance with the noteagreement.

 

The board of directors is searching for new capital,the proceeds from which are necessary, in the short term, to repay theremaining $234,327 of subordinated debt plus interest and:

 

•                  fundan estimated $200,000 to $250,000 for construction of a gathering pipeline toconnect a second natural gas well being drilled near the Madisonville plant;

 

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

 

•                  exploitand develop the Company’s high nitrogen natural gas projects.

 

If we are able to increase our involvement in thishigh nitrogen natural gas niche, we expect that a majority of our operatingincome will be derived from our ownership interest in and management fees fromhigh nitrogen natural gas projects.  Overtime, we expect that our fee-based operating income from our current gathering,transportation, distribution and marketing activities will become lesssignificant, except as they support such high nitrogen natural gas projects.

 

At September 30, 2004, the Company’s long-termdebt to total capitalization, including long-term obligations under capitalleases, was approximately 30%.

 

The Company’s revolving credit agreement providesfor maximum available borrowings of up to $250,000 through May 22, 2005, and isrenewable annually.  Principaloutstanding under the agreement accrues interest at a variable rate, based onthe bank’s prime rate index plus 1.25%, with a minimum rate of 8%.  The interest rate at September 30, 2004was 8%.  The balance under the agreementis due upon demand, or if no demand is made, at maturity, and is renewableannually.  Costs of obtaining this debtare being charged to interest expense ratably over the maturity period of thenote.  Fort Cobb uses the proceeds fromtime to time for general working capital purposes.  The agreement, along with the Fort Cobb termnote discussed below, is collateralized with the assets of Fort Cobb andguaranteed by the Company.  The Companyhad $2,485 of available borrowings under the agreement as of September 30,2004.

 

Effective June 1, 2001, Fort Cobb borrowed$750,000 from a bank.  Principaloutstanding under the note accrues interest at a variable rate, based on thebank’s prime rate index plus 11⁄4%, with a minimum rate of 8%.  The interest rate at September 30, 2004was 8%.  The note requires monthlypayments of approximately $13,000, with the balance under the note due June 1,2008.  Costs of obtaining this debt arebeing charged to interest expense ratably over the maturity period of thenote.  Fort Cobb used the proceeds torefinance its previous borrowings from the Company, and then the Company usedthe proceeds for general corporate purposes.

 

The Company, through itssubsidiaries Gateway Pipeline Company and Gateway Processing Company, has aterm note with a bank with a principal balance at September 30, 2004 of$1,269,458.  Monthly note payments for March throughJuly 2004 were interest-only at a fixed annual rate of 71⁄4%.  Thereafter, the note requires 16 monthlypayments of principal and interest of $70,000 with a final payment ofapproximately $204,000 on December 31, 2005.  The term note is collateralized with theCompany’s economic interest in the Madisonville project and the Waxahachiepipeline system.  The Company hasguaranteed the loan and pledged the common stock of itsborrower-subsidiaries.  The term note andagreement contains cross-collateral and cross-default provisions linking it tothe ADAC Balloon Note described below.

 

22

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The Company has a BalloonNote agreement with a bank under which it borrowed $900,000.  Principal accrues interest at a fixed annualrate of 71⁄4%, and the note matures March 31, 2006.  The Balloon Note is collateralized withletters of credit obtained through ADAC.

 

Under the terms of theADAC agreement, ADAC will receive, during the term of the Balloon Note,one-half of the price upside portion only, if any, of the monthly fee to bereceived by the Company pursuant to the Madisonville project agreements.  Under the ADAC agreement, ADAC will have theoption to either: (i) receive at the end of the term of the Balloon Note alump-sum payment, which when added to the payments received, if any, for theprice upside portion, will result in a 15% pre-tax internal rate of return onthe $900,000, or (ii) pay off the Balloon Note on or before the end of theBalloon Note term in exchange for a one-third ownership interest in thepipeline facilities from that date forward. The Company is obligated to pay the periodic interest payments to thebank during the three-year term of the Balloon Note.  Further, the Company granted liens,subordinate to the Company’s bank liens, on the Company’s economic interest inthe Madisonville project, its Waxahachie pipeline system, and its Fort Cobbsubsidiary.  The Agreement contains crosscollateral and cross default provisions linking it to the Madisonville termnote, described above.

 

The Company believes thatit is likely that ADAC will elect to pay off the Balloon Note in exchange foran ownership interest in the pipeline facilities; however, it is beyond theCompany’s control.  Therefore, theminimum return guaranteed to ADAC by the Company is being accrued ratably overthe three-year term of the Balloon Note, and reduced by periodic price upsidepayments, if any, paid to ADAC.  Suchaccruals increased interest expense in the accompanying financial statementsfor the three months and nine months ended September 30, 2004 by $33,750and $101,250, respectively.  Cash priceupside payments to ADAC for the three months and nine months ended September 30,2004 totaled $30,619 and $94,946, respectively. There were no payments during the corresponding periods of the prioryear, as such price upside payments began during October 2003.  If ADAC elects to pay off the Balloon Note atmaturity or before, the reserve for the ADAC guarantee will be credited toincome.

 

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

 

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

 

As of September 30,2004, the Company had outstanding letters of credit totaling $1,000,000.

 

Natural gas prices as represented by the NYMEX HenryHub index averaged $5.81 and $5.79 for the nine months ended September 30,2004 and 2003, respectively.  The naturalgas industry is generally optimistic about long-term prospects based onexpected demand, the cost of developing prospects and the sales price ofnatural gas.  Apart from the Madisonvillepipeline facilities, where the Company receives an additional amount equal to4.5% of the aggregate sales proceeds of gas sold from the Madisonville plantfor an average price above $3.75 per MMBtu, the Company’s operating margin isnot significantly affected by the price of natural gas since gas gathering andtransportation are generally based on fee arrangements and sales prices andpurchase costs of natural gas move in tandem. However, natural gas prices can affect exploration and development and resultin higher or lower volumes available for gathering and transportation.

 

**Off-Balance Sheet Arrangements**

 

In connection with securing the Balloon Note, theCompany will be obligated at ADAC’s option to either: (i) pay at the end of theterm of the Balloon Note a lump-sum, which when added to the payments made, ifany, for the price upside portion, will result in ADAC receiving a 15% pre-taxinternal rate of return on the $900,000, or (ii) convey to ADAC a one-third(33-1/3%) ownership interest in the Pipeline Facilities in exchange for ADACpaying off the Balloon Note on or before the end of the Balloon Note term.

 

**Factors Affecting Future Results**

 

Going forward, the Company’s strategy is to:maximize the potential of currently owned pipeline properties; construct, ownand operate new treating plants to remove nitrogen from natural gas and relatedpipeline systems; and acquire and produce high nitrogen natural gasreserves.  The exclusive license for thepatented process to reject nitrogen from natural gas streams comprises theprimary vehicle for the growth of our high nitrogen natural gas business, andwill require significant additional capital to exploit.  For approximately the past three years, we

 

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havebeen attempting to obtain capital funding for projects utilizing our nitrogenrejection technology.  During that time,one project, the Madisonville plant, has been developed by otheres using ourlicensed technology.

 

High nitrogen gas isnatural gas that contains nitrogen in excess of the maximum percentage, usually4%, by volume acceptable to most pipeline companies.  About 16% of the domestic natural gasresource base (approximately 24 Tcf of proven reserves) is estimated by the GasTechnology Institute to be subquality because of the nitrogen content.  Most of the country’s current high nitrogennatural gas production is located in southwestern Kansas; however, there aresubstantial high nitrogen natural gas reserves in other parts of thecountry.  The Company’s target projectsare located in geographic areas with well known concentrations of high nitrogennatural gas reserves.  Much of this highnitrogen natural gas remains undeveloped or shut-in because it cannot meet pipelinequality specifications and it is geographically separated from the large(100,000 Mcf per day or larger) cryogenic nitrogen rejection plants locatedprimarily in Kansas.  The Company’sprocess is well suited to treat these “stranded” reserves.

 

We have a technological advantage in thisniche due to our exclusive license in the U.S. from AET for the nitrogenrejection process.  The Mehra Process®competes favorably with other processes, as it can cost effectively adapt tovariable gas flow rates and variable levels of nitrogen content in thegas.  And, unlike the major competingprocess, it is unaffected by the presence of carbon dioxide and certain liquidsin the gas.  It can thereforeeconomically treat relatively small volumes of gas—as little as 1,000 Mcf perday—where variable gas flow and composition is common.  Successful completion of these projects willdepend upon the ability of the Company to market the technology to the producercommunity, and to obtain financing on terms satisfactory to the Company forconstruction of nitrogen rejection plants and/or acquisition of workinginterests in the high nitrogen natural gas properties.

 

The Mehra gas treating units employ a patentedprocess to remove nitrogen from streams of natural gas.  This asset is being amortized to expense overthe life of the underlying patents.  Thelatest of these patents expires in 2022. If on December 31, 2004, the Company has not sold or leased unitsusing the Mehra Process® which produce a target capacity of 20,000 Mcf per day,AET may convert the Company’s license from an exclusive license to anon-exclusive license.  The Company mustadd 4,700 Mcf per day to the existing capacity to meet this targetcapacity.  Under the agreement with AET,the Company may meet this target capacity by licensing the technology to one ormore third parties for the purpose of building a Mehra gas treating unit withthe requisite capacity.  No such executedcontracts are currently in place to meet the target capacity.  The Company has entered into an agreementwith AER and certain of its subsidiaries for a Mehra treatment unit with atleast 5,000 Mcf per day of capacity, at or near the current Madisonville, Texastreatment plant.  The Board of Directorsbelieves this agreement will preserve the exclusive license for an additionalyear.  If the Company does not meet thetarget capacity, the license may still be exploited by the Company as anon-exclusive license, but the Company believes that the value of the licensewould be significantly diminished.

 

Execution of our strategies discussed above dependsin part on our success raising capital as discussed above in “Liquidity andCapital Resources.”  If we cannot find acapital source to replace the financing previously anticipated with InvestLinc,we will be dependent upon capital from other sources including possible fundsfrom the rights offering, costly project-by-project financing withmiddle-market capital providers or strategic affiliations, any of which wouldrequire us to assign the majority of the economic benefits in the high nitrogennatural gas projects to others.  We couldalso sell selected properties, which might have an adverse effect upon ourlong-term financial position and cash flows.

 

Our operations are significantly affected by factorsthat are outside the Company’s control. Gas gathering and processing is dependent on throughput volume.  Pipeline throughput is dependent on naturalgas production that is significantly affected by natural gas prices as pricesaffect the willingness of producers to invest the required capital to obtaingeological and geophysical information, to drill development or exploratorywells, and to rework or maximize production on existing wells. Natural gasprices are currently at levels that should provide adequate incentive to producers;however, there is no assurance that such prices will remain at current levels,and that producers will react positively to the current prices.

 

Natural gas retail sales are affected byweather.  Much of the retail demand isfor crop irrigation and drying. Above-normal precipitation in the growing season and hot, dry weather inthe fall can significantly reduce demand for natural gas on the Fort Cobbdistribution system.

 

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**Item 3.  Controlsand Procedures**

 

As of October 25, 2004, under thesupervision and with the participation of the Company’s Chief Executive Officerand the Chief Financial Officer, prior management evaluated the effectivenessof the design and operation of the Company’s disclosure controls andprocedures.  Based upon that evaluation,the former Chief Executive Officer and the Chief Financial Officer concludedthat the Company’s disclosure controls and procedures were effective as of thatdate.  There were no significant changesin the Company’s internal controls during the fiscal quarter covered by thisreport that have materially affected, or are reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

On October 21, 2004, Michael T. Fadden andScott D. Heflin each notified the Board of his resignation from the Board.  Mr. Fadden was the President and ChiefExecutive Officer of the Company. Mr. Heflin is the Chief Financial Officer, Treasurer and Secretaryof the Company.  On October 23, 2004,the Board of Directors of the Company met and accepted the resignations fromthe Board of Messrs. Fadden and Heflin. On October 25, 2004, Mr. Fadden delivered a letter notifying theBoard that his employment with the Company was terminated.  He asserted in that letter that he wasconstructively terminated in violation of his employment agreement.  The Board disagrees with his assertions.  These board resignations and managementchange were reported in the Company’s Current Report on Form 8-K, dated October 26,2004.  Effective November 1, 2004,John A. Raasch was appointed interim President, Chief Executive Officer andChief Operating Officer of the Company. Mr. Raasch will receive no compensation for his services.  This management change was reported in theCompany’s Current Report on Form 8-K, dated November 4, 2004.

 

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

 

**Item 1.****                                                          ****Legal Proceedings**

 

None

 

**Item 2.****                                                          ****Changes in Securities**

 

None

 

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

 

None

 

**Item 4.****                                                          ****Submission of Matters to aVote of Security Holders**

 

None

 

**Item 5.****                                                          ****Other Information**

 

None

 

**Item 6.****                                                          ****Exhibits and Reports on Form8-K.**

 

a)              Exhibits:

 

4(c)(1)              Convertible Promissory Note Agreement betweenGateway Energy Corporation and Josh H. Buterin for $115,000, dated November 1,2004.

 

4(c)(2)              Common Stock Purchase Warrant granted to JoshH. Buterin for 100,000 shares of Gateway Energy Corporation common stock, datedNovember 1, 2004.

 

4(d)(1)             Subscription Agreement between Gateway EnergyCorporation and Philip A. Wilson for the purchase of 116,667 shares of commonstock, dated November 1, 2004.

 

4(d)(2)             Subscription Agreement between Gateway EnergyCorporation and John A. Raasch for the purchase of 150,000 shares of commonstock, dated November 1, 2004.

 

4(d)(3)             Subscription Agreement between Gateway EnergyCorporation and Charles A. Holtgraves for the purchase of 50,000 shares ofcommon stock, dated November 1, 2004.

 

10(h)                     License Agreement among Gateway EnergyCorporation, Gateway Processing Company, Advanced Energy Recovery, Inc, AllenDrilling Acquisition Company and Elgin Holdings, LLC.

 

11                                    Statement Regarding Computation of Per ShareEarnings

 

31.1                           Section 302 Certification of ChiefExecutive Officer

 

31.2                           Section 302 Certification of ChiefFinancial Officer

 

32.1                           Section 906 Certification of ChiefExecutive Officer

 

32.2                           Section 906 Certification of ChiefFinancial Officer

 

b)             Reports on Form 8-K:

 

July 27, 2004 – Other Events (Status ofInvestLinc Financing).

 

August 27, 2004 – Resignation of Director(Horbach)

 

**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15 (d) of the Securities Exchange Act of1934, the Registrant has duly caused this report to be signed on its behalf bythe undersigned thereunto duly authorized.

 

 
|   | /s/ John A. Raasch                                               |   | /s/ Scott D. Heflin                   |   |
|--------|------------------------------------------------------------------|--------|---------------------------------------|--------|
|   | President, Chief Executive  Officer and  Chief Operating Officer |   | Chief Financial Officer and Treasurer |   |

 
| November 16, 2004 |   |
|------------------------|--------|
| (Date)                 |

 

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