UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





x
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
quarterly period ended March 31, 2009





OR





o
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934


For the
transition period from ________________ to ________________.




Commission
File Number: 000-29463





VELOCITY
ENERGY INC.


(Exact
Name of Registrant as Specified in Its Charter)





Delaware
                  
                  51-0392750(State
      or Other Jurisdiction of
                  
                  (IR.
      Employer Identification No.)Incorporation
      or Organization)





523
N. Sam Houston Pkwy. E.


Suite
175


Houston,
Texas 77060


(Address
of Principal Executive Offices)





Registrant’s
telephone number, including area code: (713) 741-0610





Indicate
by check mark whether the registrant: (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.YES   x    
NO   o





Indicate by check mark whether the
registrant has submitted electronically and posted on its corporate Web site, if
any, every Interactive Data File required to be submitted and posted pursuant to
Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12
months (or fur such shorter period that the registrant was required to submit
and post such files).  YESoNOo





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of "large accelerated filer” and "smaller reporting company” in
Rule 12b-2 of the Exchange Act. (Check one):




Large
      accelerated filer   o
              Accelerated
      filer oNon-accelerated
      filer o
                (Do
      not check if a smaller reporting company)
              Smaller
      reporting company x




Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act). YESoNOx





As of
March 31, 2009 the Registrant had 26,347,359 shares of its common stock, par
value $0.001 per share, issued and outstanding.









PART
I


FINANCIAL
INFORMATION


Item
1. Financial Statements


VELOCITY
ENERGY INC.


Unaudited
Consolidated Balance Sheets




March
      31,
                                        2009
                                      
                                      
                                      December
      31,
                                        2008ASSETSCurrent
      AssetsCash
      and cash equivalents
                                      
                                      $
                                      272,375
                                      
                                      
                                      $
                                      194,826Restricted
      cash
                                      
                                      
                                      2,399,931
                                      
                                      
                                      
                                      3,699,931Accounts
      receivable, net of $119,903 reserved for doubtful accounts
                                      
                                      
                                      47,303
                                      
                                      
                                      
                                      437,281Advances
      to operators
                                      
                                      
                                      174,445
                                      
                                      
                                      
                                      1,077,775Prepaid
      expenses
                                      
                                      
                                      4,826
                                      
                                      
                                      
                                      72,214Total
      current assets
                                      
                                      
                                      2,898,880
                                      
                                      
                                      
                                      5,482,027Property
      and EquipmentOil
      and gas properties, full cost methodUnproved
      properties
                                      
                                      
                                      723,272
                                      
                                      
                                      
                                      675,646Proved
      properties
                                      
                                      
                                      6,618,480
                                      
                                      
                                      
                                      5,199,116Pipelines
      and facilities
                                      
                                      
                                      778,418
                                      
                                      
                                      
                                      778,418Total
      oil and gas properties
                                      
                                      
                                      8,120,170
                                      
                                      
                                      
                                      6,653,180Less
      accumulated depreciation, depletion  and
      amortization
                                      
                                      
                                      (3,906,849
                                      )
                                      
                                      
                                      (2,056,397
                                      )4,213,321
                                      
                                      
                                      
                                      4,596,783Other
      property and equipment, net of accumulated depreciation of $60,945 at
      March 31, 2009 and $19,974 at December 31, 2008.
                                      
                                      
                                      1,883,086
                                      
                                      
                                      
                                      1,925,611Total
      property and equipment, net
                                      
                                      
                                      6,096,407
                                      
                                      
                                      
                                      6,522,394Debt
      issuance costs, net of accumulated amortization of  $124,879 at
      March 31, 2009 and $86,432 at December 31, 2008
                                      
                                      
                                      386,156
                                      
                                      
                                      
                                      461,380Total
      Assets
                                      
                                      $
                                      9,381,443
                                      
                                      
                                      $
                                      12,465,801LIABILITIES
      AND SHAREHOLDERS' DEFICITCurrent
      LiabilitiesAccounts
      payable, trade
                                      
                                      $
                                      795,046
                                      
                                      
                                      $
                                      969,725Other
      payables and accrued liabilities
                                      
                                      
                                      591,198
                                      
                                      
                                      
                                      610,864Participant
      advances
                                      
                                      
                                      966
                                      
                                      
                                      
                                      966Current
      maturities of debt
                                      
                                      
                                      1,735,822
                                      
                                      
                                      
                                      1,735,822Interest
      payable
                                      
                                      
                                      508,654
                                      
                                      
                                      
                                      183,612Total
      current liabilities
                                      
                                      
                                      3,631,686
                                      
                                      
                                      
                                      3,500,989Noncurrent
      LiabilitiesLong-term
      debt, net of discounts of $9,923,615 at December 31, 2008
                                      
                                      
                                      7,562,666
                                      
                                      
                                      
                                      6,888,723Long-term
      debt – related party
                                      
                                      
                                      2,210,551
                                      
                                      
                                      
                                      2,210,551Asset
      retirement obligation
                                      
                                      
                                      129,462
                                      
                                      
                                      
                                      128,443Total
      noncurrent liabilities
                                      
                                      
                                      9,902,679
                                      
                                      
                                      
                                      9,227,717Shareholders'
      DeficitCommon
      stock, par value $0.001 per share, authorized 50,000,000 shares, issued
      and outstanding 26,347,359 and 21,846,559 shares
                                      
                                      
                                      26,351
                                      
                                      
                                      
                                      26,351Treasury
      stock
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Additional
      paid-in capital
                                      
                                      
                                      7,678,585
                                      
                                      
                                      
                                      7,223,851Accumulated
      deficit
                                      
                                      
                                      (11,857,858
                                      )
                                      
                                      
                                      (7,513,107
                                      )Total
      shareholders' deficit
                                      
                                      
                                      (4,152,922
                                      )
                                      
                                      
                                      (262,905
                                      )Total
      Liabilities and Shareholders' Deficit
                                      
                                      $
                                      9,381,443
                                      
                                      
                                      $
                                      12,465,801


See
notes to consolidated financial statements.




1




VELOCITY ENERGY INC.


Consolidated
Statements of Operations





For
      the three months ending,March
      31, 2009
                                          
                                          
                                          March
      31, 2008RevenuesOil
      and gas sales
                                          
                                          $
                                          -
                                          
                                          
                                          $
                                          115,756Contract
      operating income
                                          
                                          
                                          -
                                          
                                          
                                          
                                          54,727Drilling
      rig income
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -Operating
      overhead income
                                          
                                          
                                          -
                                          
                                          
                                          
                                          10,119Gas
      gathering operations
                                          
                                          
                                          75
                                          
                                          
                                          
                                          18,461Total
      revenues
                                          
                                          
                                          75
                                          
                                          
                                          
                                          199,063Costs
      and ExpensesLease
      operating expenses
                                          
                                          
                                          61,698
                                          
                                          
                                          
                                          300,958Production
      taxes
                                          
                                          
                                          -
                                          
                                          
                                          
                                          8,147Drilling
      rig expenses
                                          
                                          
                                          109,900
                                          
                                          
                                          
                                          -Gas
      gathering operations
                                          
                                          
                                          
                                          
                                          
                                          
                                          -Depreciation,
      depletion and amortization
                                          
                                          
                                          50,467
                                          
                                          
                                          
                                          65,784Impairment
      on oil & natural gas properties
                                          
                                          
                                          1,842,510
                                          
                                          
                                          
                                          -Accretion
      on asset retirement obligation
                                          
                                          
                                          1,019
                                          
                                          
                                          
                                          3,740General
      and administrative
                                          
                                          
                                          913,706
                                          
                                          
                                          
                                          982,155Total
      costs and expenses
                                          
                                          
                                          2,979,300
                                          
                                          
                                          
                                          1,360,784(Loss)
      from Operations
                                          
                                          
                                          (2,979,225
                                          )
                                          
                                          
                                          (1,161,721
                                          )Other
      (Expense)Interest
      expense
                                          
                                          
                                          (1,328,749
                                          )
                                          
                                          
                                          (70,593
                                          )Debt
      issuance cost amortization
                                          
                                          
                                          (36,777
                                          )
                                          
                                          
                                          (17,001
                                          )Other
      (expense)
                                          
                                          
                                          (1,365,526
                                          )
                                          
                                          
                                          (87,594
                                          )Net
      (Loss) Before Tax
                                          
                                          $
                                          (4,344,751
                                          )
                                          
                                          $
                                          (1,249,315
                                          )Loss
      Per Common Share:Basic
                                          
                                          $
                                          (0.17
                                          )
                                          
                                          $
                                          (0.05
                                          )Diluted
                                          
                                          $
                                          (0.17
                                          )
                                          
                                          $
                                          (0.05
                                          )Weighted
      average number of common shares outstanding:Basic
                                          
                                          
                                          26,267,359
                                          
                                          
                                          
                                          26,028,323Diluted
                                          
                                          
                                          26,267,359
                                          
                                          
                                          
                                          26,028,323





See
notes to consolidated financial statements.




2




VELOCITY
ENERGY INC.


Consolidated
Statements of Cash Flows




For
      the three months ending,March
      31, 2009
                        
                        
                        March
      31, 2008Operating
      ActivitiesNet
      income (loss)
                        
                        $
                        (4,344,751
                        )
                        
                        $
                        (1,249,315
                        )Adjustments
      to reconcile net (loss) to net cash provided by ( used in) operating
      activities:Depreciation,
      depletion and amortization
                        
                        
                        50,467
                        
                        
                        
                        65,784Accretion
      on asset retirement obligation
                        
                        
                        1,019
                        
                        
                        
                        3,740Debt
      issuance costs amortization
                        
                        
                        75,224
                        
                        
                        
                        17,001Non-cash
      compensation expense
                        
                        
                        454,734
                        
                        
                        
                        554,483Accretion
      of discount
                        
                        
                        673,944
                        
                        
                        
                        -Impairment
      on oil & gas properties
                        
                        
                        1,842,510
                        
                        
                        
                        -Changes
      in operating assets and liabilities:Accounts
      receivable
                        
                        
                        389,978
                        
                        
                        
                        2,311,211Prepaid
      expenses
                        
                        
                        970,717
                        
                        
                        
                        (42,313
                        )Accounts
      payable and accrued liabilities
                        
                        
                        (194,345
                        )
                        
                        
                        (2,504,221
                        )Participant
      advances received
                        
                        
                        -
                        
                        
                        
                        29,249Interest
      payable
                        
                        
                        325,042
                        
                        
                        
                        (204,760
                        )Net
      cash provided by (used by) operating activities
                        
                        
                        244,539
                        
                        
                        
                        (1,019,141
                        )Investing
      ActivitiesRestricted
      Cash
                        
                        
                        1,300,000
                        
                        
                        
                        -Purchases
      and development of oil and gas properties
                        
                        
                        (1,466,990
                        )
                        
                        
                        (27,130
                        )Purchases
      of other property and equipment
                        
                        
                        -
                        
                        
                        
                        (1,846
                        )Net
      cash used in investing activities
                        
                        
                        (166,990
                        )
                        
                        
                        (28,976
                        )Net
      Increase (Decrease) in Cash and Equivalents
                        
                        
                        77,549
                        
                        
                        
                        (1,048,117
                        )Cash
      and equivalents at beginning of period
                        
                        
                        194,826
                        
                        
                        
                        2,195,899Cash
      and Equivalents at End of Period
                        
                        $
                        272,375
                        
                        
                        $
                        1,147,782





See
notes to consolidated financial statements.




3




VELOCITY
ENERGY INC.


Notes
to Unaudited Consolidated Financial Statements


Period
Ended March 31, 2009





1.   Basis of
Presentation





The
accompanying unaudited consolidated financial statements report interim
financial information for Velocity Energy Inc., a Delaware corporation formerly
known as Sonterra Resources, Inc. (the “Company”), and its wholly owned
subsidiaries: Sonterra Oil & Gas, Inc., a Delaware corporation (“Sonterra
Oil & Gas”), which was merged into the Company on November 11, 2008;
Sonterra Operating, Inc., a Delaware corporation  (“Sonterra Operating”);
Velocity Energy Inc, a Delaware corporation, which changed its name to Velocity
Energy Operating Inc. on March 4, 2009 (“Velocity Operating”); Velocity Energy
Offshore LP, a Delaware limited partnership (“Velocity Offshore”); Velocity
Energy Partners L.P., a Delaware limited partnership (“Velocity Partners”);
Velocity Energy Limited LLC, a Texas limited liability company (“Velocity
Limited”); North Texas Drilling Services, Inc., a Texas corporation (“NTDS”);
River Capital Holdings Limited, a Barbados corporation (“RCHL”); and River
Reinsurance Limited, a Barbados corporation (“River Re”). Collectively, all of
the subsidiaries are referred to as the “Subsidiaries”.  References to
“the Company” refer to Velocity Energy Inc., formerly known as Sonterra
Resources, Inc., and its Subsidiaries. Additionally, the terms “us,” “our,”
“we,” and “its” are sometimes used as abbreviated references to the
Company.





The
Company was originally incorporated in Florida effective as of June 17, 1997, as
Permastoprust International, Inc. and subsequently changed its name to Greystone
Credit Inc. on June 30, 1999. The current publicly traded entity was
incorporated in Delaware under the name whOOdoo.com, inc. on July 1, 1999. On
August 4, 1999, Greystone Credit Inc. acquired whOOdoo.com, inc. in a share
exchange, resulting in the Company’s state of incorporation being changed to
Delaware and the name of the Company becoming whOOdoo.com, inc.  On
July 17, 2000, the name of the Company was changed to Ballistic Ventures, Inc.
On June 5, 2004, the name of the Company was changed to River Capital Group,
Inc. (“River Capital”). River Capital intended to establish and grow a core
reinsurance business through two entities incorporated in Barbados, RCHL and
River Re, but was unable to raise equity or debt capital and River Capital
abandoned its efforts to establish a reinsurance business. These businesses of
RCHL and River Re are dormant, and the Company intends to divest or dissolve
both RCHL and River Re in the second quarter of 2009. Following the closing of
the Securities Exchange in February 2008 discussed below, the name of the
Company was changed to Sonterra Resources, Inc., and the Company emerged from
shell company status as an oil and gas exploration and production company. On
March 4, 2009, the name of the Company was changed to Velocity Energy
Inc.





On
February 14, 2008, the Company consummated the transactions (the “Securities
Exchange”) contemplated by a Securities Exchange and Additional Note Purchase
Agreement entered into on August 3, 2007 with The Longview Fund, L.P.
(“Longview”), together with an affiliated fund, which collectively owned
approximately 66.6% of the Company’s common stock. The Securities Exchange was
comprised of a series of transactions that occurred as part of the closing
including (i) Sonterra Resources’ 38,552,749 issued and outstanding shares of
common stock being combined into 3,855,275 shares of common stock in a 1-for-10
reverse stock split; (ii) the Company’s name being changed from River Capital
Group, Inc. to Sonterra Resources, Inc.; and (iii) Longview’s exchange of (a)
all of its shares of common stock of Sonterra Oil & Gas, Inc., (b) a
$5,990,010 equity note from Sonterra Oil & Gas, and (c) a warrant to
purchase 50 shares of Sonterra Oil & Gas common stock for 21,846,558 shares
of the Company’s common stock and a warrant to purchase 4,958,678 shares of the
Company’s common stock. Longview also exchanged its $2,000,000 non-equity note
from Sonterra Oil & Gas for a senior secured note from the Company in an
equal principal amount.





As a
result of the Securities Exchange, (i) 100% of the issued and outstanding
capital stock of Sonterra Oil & Gas, which was formerly known as Sonterra
Resources, Inc. prior to the Securities Exchange, was transferred to the
Company (known as River Capital Group, Inc. prior to the Securities Exchange);
(ii) the Company became engaged, through its Subsidiaries, in the operation
and development of oil and gas properties and related assets; and (iii) the
former stockholders of Sonterra Oil & Gas held approximately 95% of the
common stock of the Company. Although the Company was the legal acquirer of
Sonterra Oil & Gas and continues as the publicly traded entity, the
acquisition has been treated for accounting and financial reporting purposes as
a recapitalization of the Company with Sonterra Oil & Gas as the acquirer
(reverse acquisition).  The historical financials prior to February
14, 2008, are those of Sonterra Oil & Gas, which was subsequently merged
into the Company on November 7, 2008, and for SEC reporting purposes, the
Company presents the consolidated historical financial statements of the Company
and the Subsidiaries through the effective date of the Securities Exchange, and
the combined financial results thereafter.




4




On
November 13, 2008, the Company restructured its financing arrangements
(“Financial Restructuring”) by entering into two transactions with its
lenders.  Under the first transaction, the Company entered into a
Securities Exchange Agreement (the “New Securities Exchange Agreement”) with The
Longview Fund, L.P. (“Longview”) and Longview Marquis Master Fund, L.P.
(“Marquis”) under which Marquis acquired a warrant (the “Marquis Warrant”) to
acquire (a)(i) 1,000,000 shares of the Company’s common stock, par value $0.001
per share, subject to adjustment, at an initial exercise price per share of
$0.01, (ii) and an unsecured subordinated promissory note in the original
aggregate principal amount of $9,440,000 (the “Marquis Subordinated Note”),
bearing interest at 11% per annum; and Longview acquired (b) (i) an unsecured
promissory note in the original aggregate principal amount of $2,210,551 (the
“Longview Subordinated Note”), bearing interest at 11% per annum, and (ii)
$1,000,000 in cash as principal repayment of the Old Notes described
below.





As part
of the consideration to the Company under the New Securities Exchange Agreement,
Longview agreed to surrender to the Company warrants to acquire 3,000,000 shares
of the Company’s common stock at an exercise price of $0.30210709 per share (out
of  that certain Warrant to Purchase Common Stock dated February 14,
2008 to acquire up to 4,958,678 shares of the Company’s common stock that
Longview held prior to such transaction) (the “Old Longview Warrant”), and
Longview surrendered to the Company the following notes payable by the Company
in the aggregate outstanding principal amount of $3,000,000 (collectively, the
“Old Longview Notes”): (i) that certain Amended and Restated Senior Secured note
dated February 14, 2008 (amended and restated May 16, 2008); and (ii) that
certain Senior Secured Note dated May 22, 2008.





In
exchange for the Marquis Warrant and the Marquis Subordinated Note, the Company
acquired from Marquis all of the issued and outstanding shares of common stock,
par value $0.001 per share, of NTDS and that certain Ninth Amended and Restated
Senior Secured Note dated October 3, 2008, in the outstanding principal amount
of $8,575,000, plus accrued and unpaid interest of approximately $865,000,
issued by NTDS (the “North Texas Note”).  The North Texas Note was
cancelled upon delivery to the Company.





Contemporaneously
with the closing of the New Securities Exchange Agreement, the Company entered
into a second transaction pursuant to a Securities Purchase Agreement between
the Company and Marquis (the “Marquis Securities Purchase
Agreement”).  Under the Marquis Securities Purchase Agreement, the
Company issued and sold to Marquis, and Marquis purchased from the Company, for
consideration of $8,075,000, a senior secured promissory note in the principal
amount of $8,875,000, bearing interest at 13% per annum, subject to certain
adjustments (the “Senior Secured Note”), and a warrant to acquire 1,050,000
shares of common stock at an initial exercise price of $0.01 per
share.  As additional consideration under the Securities Purchase
Agreement, the Company also granted Marquis a limited conveyance of overriding
royalty interests (the “Overrides”) of 3% of the Company’s interest in the
hydrocarbon production from all of the Company’s (i) current oil and gas
properties (the “3% ORRI”) and (ii) oil and gas properties acquired in the
future with $5,000,000 of proceeds from the sale of the Senior Secured Note,
which sum has been deposited in the Acquisition Fund Account.  The
proceeds from the Securities Purchase Agreement were used in part to pay
$1,000,000 of principal under the existing indebtedness owed to Longview
pursuant to the Old Notes, to fund the Company’s share of the completion costs
of the State Tract 127-1 Unit, and for general corporate purposes.





Under the
Securities Purchase Agreement, from November 13, 2009 until November 12, 2010,
the Company has the right to purchase from Marquis all (but not less than all)
of the Overrides issued to Marquis prior to November 13, 2009 by delivering to
Marquis, at its election, either Override Warrants (as defined in the Securities
Purchase Agreement) or any combination of Common Override Exchange Shares (as
defined in the Securities Purchase Agreement) and Preferred Override Exchange
Shares (as defined in the Securities Purchase Agreement).  In
connection with the Securities Purchase Agreement, certain subsidiaries of the
Company guaranteed payment of the Senior Secured Note and the Company and
certain of its subsidiaries granted a security interest in substantially all of
their real and personal property to Summerline Asset Management, LLC, as
collateral agent for Marquis, as the secured party, and executed a security
agreement, a mortgage, guarantees and pledges to evidence the same.





These
financial statements have been prepared in accordance with U.S. generally
accepted accounting principles ("GAAP") for interim financial information and
with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by GAAP for complete financial statements. The accounting policies followed by
the Company are described in Note 3 to the audited consolidated financial
statements for the year ended December 31, 2008.





In the
opinion of management, all normal recurring adjustments considered necessary for
the fair statement of the results for the interim period presented have been
included. Certain reclassifications have been made to prior periods’ financial
statements to conform to the current presentation. These reclassifications had
no effect on total assets, total liabilities, stockholders’ equity or net
income.




5




2.Going Concern





The
accompanying financial statements have been prepared assuming the Company will
continue as a going concern.  The Company experienced a net loss of
$6.3 million for the year ended December 31, 2008, a net loss of $4.3 million in
the first quarter of 2009, has $20.8 million in debt, maturity value, plus
associated interest obligations, and virtually no current source of revenue,
which raise substantial doubt about the Company’s ability to continue as a going
concern.




The
Company is pursuing acquisitions of producing properties in the Appalachian
Basin.  The management team has met with numerous providers of both
debt and equity, and is currently evaluating several potential acquisition
targets.  If successful with our Appalachian Basin acquisition
strategy, the Company expects to acquire a steady revenue stream from long-lived
assets.  On April 13, 2009, the Company executed a letter of intent to
acquire certain producing properties in southern West Virginia pursuant to the
Company’s Appalachian Basin acquisition strategy in exchange for approximately
$2,702,063 in cash, payable in three annual installments; the assumption of the
balance of a $1,700,541 loan (estimated to be $1,500,000); and other
consideration detailed in the letter of intent incorporated by reference
hereto.   Funding is subject to assumption of bank loan,
completion of due diligence and execution of purchase and sale
agreement.





3.Restricted Cash





As part
of the Financial Restructuring in November 2008, the Company established a
special controlled access account at Sterling Bank (“Acquisition Funds
Account”), which was intended to be used primarily for acquisitions or as
otherwise agreed by the Company and Summerline, the asset management company
representing Marquis, as Collateral Agent. The balance of the Acquisitions Fund
Account at December 31, 2008 was approximately $3.7 million.  To
access the funds, both the Company and Summerline, the asset management company
representing Marquis, have to agree on the use of such funds and must submit
written authorization to Sterling Bank to release these funds.





On
December 4, 2008, the Company, Marquis, and Summerline entered into a letter
agreement whereby such parties agreed to release up to $1,300,000 of the
Acquisition Funds for payment directly to STO Operating Company (or another
third party) for operations related to the wellbore located at State Tract 150-1
ST #1 Well.  On December 8, 2008, $927,346 of the Acquisition Funds
was released from the Acquisition Funds Account for payment of drilling costs of
the State Tract 150-1 ST #1 Well.  Contemporaneously, the Company
delivered to Marquis an additional conveyance of an overriding royalty interest
of 7% (the “New ORRI”) of the Applicable Percentage (as defined in the New ORRI)
of the oil, gas, and other minerals in, under and that may be produced from the
State Tract 150-1 ST #1 Well.  When Marquis has received $250,000 from
the proceeds of the sale of the production of oil, gas and other minerals
attributable to the New ORRI, the New ORRI shall be reduced to 3% of the
Applicable Percentage.  The New ORRI is in addition to, and not in
lieu, of the 3% ORRI with respect to the oil and gas leases upon which the State
Tract 150-1 ST #1 Well is located.





The
balance of $1,300,000 of the Acquisition Funds, being $371,654, was released
from the Acquisition Funds Account primarily for completion costs of the State
Tract 150-1 ST #1 Well, as well as for miscellaneous costs related to the
Financial Restructuring. On March 30, 2009, $700,000 was released from the
Acquisition Funds Account for payment of interest on the Senior Secured Debt and
other corporate purposes.  On April 1, 2009, $2,000,000 was released
from the Acquisition Funds Account to prepay part of the Senior Secured Note, in
exchange for a reduction of $2,195,000 of the principal of the Senior Secured
Note.  On May 7, 2009, $270,000 was released from the Acquisition
Funds Account to pay for general and administrative costs, leaving a balance in
the Acquisition Funds Account of $129,931.





4.Property and
Equipment





The
Company follows the full cost method of accounting for its investments in oil
and natural gas properties.  Under this method, all costs associated
with acquisition, exploration, and development of oil and gas properties are
capitalized, including general and administrative costs that are directly
related with such acquisition, exploration and development
costs.  Specific capitalized costs include acquisition costs,
geological and geophysical expenditures, lease rentals on undeveloped
properties, and the costs of drilling and equipping productive and
non-productive wells.  Capitalized costs are categorized as either
being subject to amortization or not subject to amortization.





All
capitalized costs of oil and gas properties, including the estimated future
costs to develop proved reserves and estimated future costs to plug and abandon
wells and related costs of site restoration, are amortized on the
unit-of-production method using estimates of proved reserves as determined by
independent engineers.  Investments in unproved properties and major
development projects are not amortized until proved reserves associated with the
projects can be determined or until impairment occurs.  If the results
of an assessment indicate that the properties are impaired, the amount of the
impairment is added to the capitalized costs to be amortized.





In
addition, capitalized costs, less accumulated amortization and related deferred
income taxes, shall not exceed an amount (the full cost ceiling) equal to the
sum of:




6




1)
            The present value of estimated
      futures net revenues computed by applying current prices of oil and gas
      reserves to estimated future production of proved oil and gas reserves,
      less estimated future expenditures (based on current costs) to be incurred
      in developing and producing the proved reserves computed using a discount
      factor of ten percent and assuming continuation of existing economic
      conditions;





2)
            plus the cost of properties not
      being amortized;





3)
            plus the lower cost of estimated
      fair value of unproven properties included in the costs being amortized;
      and





4)
            less income tax effects related
      to the differences between the book and tax basis of the
      properties.





We
recognized an impairment expense of $1,842,510 in the first quarter of 2009
because the recorded cost of our oil and gas properties exceeded the full cost
ceiling.





5.Earnings (Loss) Per Common
Share





Basic
(loss) per common share is calculated by dividing net (loss) by the weighted
average number of shares of common stock outstanding during the period. Diluted
earnings per common share considers the dilutive effect of the average number of
common stock equivalents, consisting of the Company’s common stock options and
warrants, that were outstanding during the period.  For the three month
ended March 31, 2009, a net loss of $4,333,751 was incurred. Therefore,
consideration of common stock equivalents in the calculation of the weighted
average number of shares outstanding was not applicable because the effect would
have been anti-dilutive.





For
purposes of calculating the weighted average number of shares of common stock
outstanding and earnings (loss) per share data, the number of common shares
issued by the Company in the Securities Exchange transaction is deemed to be
included in the number of common shares of the Company outstanding during the
interim period.





6.Stock Based
Compensation





Concurrent
with the consummation of the Securities Exchange, the Company adopted the 2007
River Capital Group, Inc. Non-Qualified Stock Option Plan (the “2007 Stock
Option Plan”) to provide for the issuance of stock options as compensation to
key employees, officers and non-employee directors. Immediately upon adoption,
options to purchase 5,140,359 shares of common stock were issued to management
employees of the Company pursuant to the 2007 Stock Option Plan. All of these
options were forfeited on June 23, 2008 as discussed below.





In
accordance with Statement of Financial Accounting Standard No. 123, the Company
determines the value of the stock-based compensation granted to its employees by
use of a Black-Scholes valuation model. That value is recognized as stock
compensation expense over the expected life of the underlying options. Total
stock-based compensation expense recognized for the three months ended March 31,
2009 was $454,734.





Stock Options: 
Stock options issued to employees under the 2007 Stock Option Plan vest
incrementally over a period of three years and have a ten-year life. On February
14, 2008, a total of 5,140,359 common stock options were issued. These options
had exercise prices that ranged from $.332 to $.453 per share, and were
scheduled to expire in February 2018.  These options were forfeited on
June 23, 2008, when the then management team resigned from the Company. A new
management team was employed on June 23, 2008, and a total of 2,459,087 new
common stock options were issued to the initial two members of the management
team with an additional 1,141,719 new common stock options issued to the new
member of the management team whose start date commenced July 1, 2008, who also
received an additional 30,000 new common stock options in exchange for a
four-month deferral of salary.  These options have exercise prices
that range from $1.35 to $2.025 per share and will expire in June
2018.





Number
                                    Outstanding
                                  
                                  
                                  Weighted
                                    Average
                                    Exercise Price
                                  
                                  
                                  Weighted Average
                                    Contractual Term
                                    in Years
                                  
                                  
                                  Aggregate
                                    Intrinsic
                                    ValueOutstanding
      at December 31, 2008
                                  
                                  
                                  3,630,806
                                  
                                  
                                  $
                                  1.707
                                  
                                  
                                  
                                  9.5
                                  
                                  
                                  -Exercised
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  -Outstanding
      at March 31, 2009
                                  
                                  
                                  3,630,806
                                  
                                  
                                  $
                                  1.707
                                  
                                  
                                  
                                  9.5
                                  
                                  
                                  -Exercisable
      at March 31, 2009
                                  
                                  
                                  30,000
                                  
                                  
                                  $
                                  1.35
                                  
                                  
                                  
                                  5.0
                                  
                                  
                                  
                                  -




7




Effective
as of March 31, 2009, the Company adopted the 2008 Sonterra Resources, Inc.
Equity Compensation Plan (“2008 Equity Compensation Plan”). Under the 2008
Equity Compensation Plan, no employee participant may receive options to
purchase more than 400,000 shares of common stock in any given year, the total
number of options awarded to all employee participants shall not exceed
1,300,000 in any given year, and a maximum of 3,000,000 options may be awarded.
The 3,000,000 options available under the 2008 Equity Compensation Plan are in
addition to a maximum of 5,140,165 options available under the 2007 Stock Option
Plan. Equity compensation is intended to qualify as performance-based
compensation under Section 162(m) of the Code. The Corporate Compensation and
Nominating Committee has reviewed and discussed with the Company the 2008 Equity
Compensation Plan as well as the Company’s overall incentive-driven compensation
philosophy.  No options have been awarded under the 2008 Equity
Compensation Plan.





The
following warrants are outstanding as of March 31, 2009:





Number
                        
                        
                        Exercise
      Price
                        
                        Expiration
      DateThe
      Longview Fund, L.P.
                        
                        
                        1,958,678
                        
                        
                        $
                        0.30
                        
                        February
      14, 2013Longview
      Marquis Master Fund, L.P. (1)
                        
                        
                        2,050,000
                        
                        
                        $
                        0.01
                        
                        November 13, 2013





(1)  Notwithstanding
the total of 2,050,000 shares of common stock issuable upon exercise of the
warrants held by Longview Marquis Master Fund, L.P., in no event shall
the total number of shares of common stock of the Company held by Longview
Marquis Master Fund, L.P. immediately following any such exercise exceed 4.99%
of the outstanding shares of the common stock of the Company.





7.Debt




At March
31, 2009 and December 31, 2008, debt consisted of the following:




March
      31, 2009
                        
                        
                        December
      31, 2008Note
      payable to bank, interest rate of 8.75%, interest payable monthly,
      principal due July 2009, secured by trucks and vehicles owned by
      NTDS.
                        
                        $
                        150,000
                        
                        
                        $
                        150,000Senior
      Secured Note, net of unamortized discount of $1,634,835, interest payable
      quarterly, principal amortized monthly over 28 months beginning August 31,
      2009, secured by oil and gas properties.
                        
                        
                        7,240,165
                        
                        
                        
                        7,109,533Marquis
      Subordinated Note, net of unamortized discount of $7,614,837, interest
      payable quarterly, 25% of principal due November 13, 2011 and 75% of
      principal due on November 13, 2012, secured by drilling rigs, owed by
      NTDS
                        
                        
                        1,825,163
                        
                        
                        
                        1,281,852Longview
      Subordinated Note – Related party, interest rate of 11%, interest payable
      quarterly, 25% of principal due November 13, 2011 and 75% of principal due
      on November 13, 2012 secured by oil and gas properties after
      retirement of Senior Secured Note
                        
                        
                        2,210,551
                        
                        
                        
                        2,210,551Subordinated
      note payable to related party, interest rate of 8%, compounded annually,
      all principal and interest payments will be deferred until repayment of
      any senior and subordinated debt
                        
                        
                        83,160
                        
                        
                        
                        83,160Total
      debt
                        
                        
                        11,509,039
                        
                        
                        
                        10,835,096Less:
      current portion
                        
                        
                        (1,735,822
                        )
                        
                        
                        (1,735,822
                        )Long-term
      portion
                        
                        $
                        9,773,217
                        
                        
                        $
                        9,099,274




8.Recent Accounting
Pronouncements




FASB Statement of Accounting
Standards No. 159, "The Fair Value Option for Financial Assets and Financial
Liabilities" ("SFAS 159"): SFAS 159, issued in February 2007, allows
entities the option to measure the eligible financial instruments at fair value
as of specified dates. Such election, which may be applied on an instrument by
instrument basis, is typically irrevocable once elected. SFAS No. 159 is
effective for fiscal years beginning after November 15, 2007, and early
application is allowed under certain circumstances. The Company did not elect
the fair value option for any of its existing financial
instruments.




8




FASB Statement of Accounting
Standards No. 160, "Noncontrolling Interests in Consolidated Financial
Statements - an amendment of Accounting Research Bulletin No. 51" ("SFAS
160"): SFAS 160, issued in December 2007, establishes accounting and
reporting standards for ownership interests in subsidiaries held by parties
other than the parent, the amount of consolidated net income attributable to the
parent and to the non-controlling interest, changes in a parent’s ownership
interest and the valuation of retained noncontrolling equity investments when a
subsidiary is deconsolidated. The Statement also establishes reporting
requirements that provide sufficient disclosures that clearly identify and
distinguish between the interests of the parent and the interests of the
non-controlling owners. SFAS 160 is effective for fiscal years beginning after
December 15, 2008. The Company does not currently have any non-controlling
interests in its subsidiaries and thus does not expect the adoption of SFAS 160
to impact its consolidated financial statements.




FASB Statement of Accounting
Standards No. 161, "Disclosures about Derivative Instruments and Hedging
Activities - an amendment of FASB Statement No. 133" ("SFAS 161"): SFAS
161, issued in March 2008, requires new and expanded disclosures regarding
hedging activities. These disclosures include, but are not limited to, a tabular
presentation of derivative data; financial statement presentation of fair values
on a gross basis, including those that currently qualify for netting under FASB
Interpretation No. 39; and, a specific footnote narrative regarding how and
why derivatives are used. The disclosures are required in all interim and annual
reports. SFAS 161 is effective for fiscal and interim periods beginning after
November 15, 2008. The Company is not currently engaged in any hedging
activities and thus does not expect the application of SFAS 161 to impact its
consolidated financial statements.





Item
2. Management's Discussion and Analysis of Financial Condition and Results of
Operations





Forward-Looking
Information





This Form
10-Q quarterly report of the Company for the three months ended March 31, 2009,
may contain certain forward-looking statements within the meaning of Section 27A
of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended, which are intended to be covered by the safe
harbors created thereby.  To the extent that there are statements that are
not recitations of historical fact, such statements constitute forward-looking
statements that, by definition, involve risks and uncertainties.  In any
forward-looking statement, where the Company expresses an expectation or belief
as to future results or events, such expectation or belief is expressed in good
faith and believed to have a reasonable basis, but there can be no assurance
that the statement of expectation or belief will be achieved or
accomplished.





The
following are factors that could cause actual results or events to differ
materially from those anticipated, and include, but are not limited to: general
economic, financial and business conditions; the Company’s ability to minimize
expenses; the Company’s ability to attract and retain key personnel to support
its present and planned operations; the Company’s ability to acquire additional
oil and gas properties and/or operations on acceptable terms, or at all; the
Company’s ability to obtain additional necessary financing from outside
investors and/or bank and mezzanine lenders; and the ability of the Company to
generate sufficient revenues to cover operating expenses and position it to
achieve positive cash flow.





Readers
are cautioned not to place undue reliance on the forward-looking statements
contained herein, which speak only as of the date hereof. The Company believes
the information contained in this Form 10-Q to be accurate as of the date
hereof.  Changes may occur after that date, and the Company will not update
that information except as required by law in the normal course of its public
disclosure practices.





Additionally,
the following discussion regarding the Company’s financial condition and results
of operations should be read in conjunction with the financial statements and
related notes contained in Item 1 of Part 1 of this Form 10-Q, as well as the
financial statements for the fiscal year ended December 31, 2008, as set forth
in the Company’s Form 10-K filed with the U.S. Securities and Exchange
Commission on May 8, 2009.  The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses. Our significant
accounting policies are described in Note 3 to the Financial Statements of
the Company’s Form 10-K. Certain of these policies are of particular importance
to the portrayal of our financial position and results of operations, and
require the application of significant judgment by management. We analyze our
estimates, including those related to reserves, depletion and impairment of oil
and gas properties, and the ultimate utilization of the deferred tax asset, and
base our estimates on historical experience and various other assumptions that
we believe to be reasonable under the circumstances. Actual results may differ
from these estimates under different assumptions or conditions. We believe the
following critical accounting policies affect our more significant judgments and
estimates used in the preparation of our financial statements subsequent to the
Securities Exchange.




9




Critical
Accounting Policies





The
Company’s discussion and analysis of its financial condition and results of
operations are based upon its financial statements, which have been prepared in
accordance with accounting principles generally accepted in the U.S.  The
Company believes certain significant accounting policies affect its more
significant judgments and estimates used in the preparation of its financial
statements.  We believe the following accounting policies to be critical to
our operations:





Full Cost Method of
Accounting.  Oil and gas properties are stated at historical
cost using the full cost method of accounting.  Under this method, all
costs associated with the acquisition, exploration and development of oil and
gas properties are capitalized, including acquisition costs, geological and
geophysical expenditures, lease rentals on undeveloped properties, and the costs
of drilling and equipping productive and non-productive wells. Capitalized costs
are categorized as either being subject to amortization or not being subject to
amortization.





All
capitalized costs of oil and gas properties, including the estimated future
costs to develop proved reserves as well as estimated future costs to plug and
abandon wells and costs of site restoration, are amortized on the
unit-of-production method using estimates of proved reserves as determined by
independent engineers. Investments in unproved properties and major development
projects are not amortized until proved reserves associated with the projects
can be determined or until impairment occurs. If the results of an assessment
indicate that the properties are impaired, the amount of the impairment is added
to the capitalized costs to be amortized.





In
addition, capitalized costs, less accumulated amortization and related deferred
income taxes, shall not exceed an amount (the full cost ceiling) equal to the
sum of:





1) the
present value of estimated future net revenues computed by applying current
prices of oil and gas reserves to estimated future production of proved oil and
gas reserves, less estimated future expenditures (based on current costs) to be
incurred in developing and producing the proved reserves computed using a
discount factor of ten percent and assuming continuation of existing economic
conditions;





2) plus
the cost of properties not being amortized;





3) plus
the lower of cost or estimated fair value of unproven properties included in the
costs being amortized; and





4) less
income tax effects related to the differences between the book and tax basis of
the properties.





Given the
complexities associated with oil and gas reserve estimates and the history of
price volatility in the oil and gas markets, events may arise that would require
us to record an impairment of the recorded book values associated with oil and
gas properties.  We have recognized impairments in both for 2009 and
2008 and there can be no assurance that impairments will not be required in the
future.





Sales of
proved and unproved properties are accounted for as adjustments of capitalized
costs with no gain or loss recognized, unless such adjustments would
significantly alter the relationship between capitalized costs and proved
reserves of oil and gas, in which case the gain or loss is recognized in
income.





Revenue
Recognition.   We recognize oil and gas revenue from our
interest in producing wells as the oil and gas is sold to third parties. Gas
gathering operations revenues are recognized upon delivery of the product to
third parties.





Reserve
Estimates.   Our estimates of oil and gas reserves, by
necessity, are projections based on geologic and engineering data, and there are
uncertainties inherent in the interpretation of such data as well as in the
projection of future rates of production and the timing of development
expenditures. Reserve engineering is a subjective process of estimating
underground accumulations of oil and gas that are difficult to measure. The
accuracy of any reserve estimate is a function of the quality of available data,
engineering and geological interpretation and judgment. Estimates of
economically recoverable oil and gas reserves and future net cash flows depend
upon a number of variable factors and assumptions, all of which may in fact vary
considerably from actual results. These factors and assumptions include
historical production from the area compared with production from other
producing areas, the assumed effects of regulations by governmental agencies and
assumptions governing future oil and gas prices, future operating costs,
severance taxes, development costs and workover costs. The future drilling costs
associated with reserves assigned to proved undeveloped locations may ultimately
increase to an extent that these reserves may be later determined to be
uneconomic. For these reasons, estimates of economically recoverable quantities
of oil and gas attributable to any particular group of properties,
classifications of such reserves based on risk of recovery, and estimates of
future net cash flows expected therefrom, may vary substantially. Any
significant variance in the assumptions could materially affect the estimated
quantity and value of the reserves, which could affect the carrying value of our
oil and gas properties and/or the rate of depletion of the oil and gas
properties. Actual production, revenues and expenditures, with respect to our
reserves, will likely vary from estimates and such variances may be material.
The reserve information contained in this report was developed internally, using
standard guidelines for reserve recognition and reporting.




10




Impairment of Oil & Gas
Properties and Other Property & Equipment.We review our
long-term assets and oil and gas properties for impairment at least annually and
whenever events and circumstances indicate a decline in the recoverability of
their carrying value.  We estimate the expected future cash flows of
our oil and gas properties and compare such future cash flows to the carrying
amount of the properties to determine if the carrying amount is
recoverable.  If the carrying amount exceeds the estimated
undiscounted future cash flows, we will adjust the carrying amount of the oil
and gas properties to their fair value. The factors used to determine fair value
include, but are not limited to, estimates of proved reserves, future commodity
pricing, future production estimates, anticipated capital expenditures, and a
discount rate commensurate with the risk associated with realizing the expected
cash flows projected.





Income
Taxes.   Significant management judgment is required to
determine the provisions for income taxes and to determine whether deferred tax
assets will be realized in full or in part. Deferred income tax assets and
liabilities are measured using enacted tax rates that are expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled. When it is more likely than not that all or some
portion of specific deferred income tax assets will not be realized, a valuation
allowance must be established for the amount of deferred income tax assets that
are determined not to be realizable.





Additionally,
despite our belief that our tax return positions are consistent with applicable
tax law, we believe that certain positions may be challenged by taxing
authorities. Settlement of any challenge can result in no change, a complete
disallowance, or some partial adjustment reached through
negotiations.





In July
2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in
Income Taxes, and Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48
clarifies the accounting for uncertainty in income taxes recognized in a
company’s financial statements in accordance with SFAS No. 109, “Accounting for
Income Taxes.” FIN 48 clarified the accounting for uncertainty in income taxes
recognized in the financial statements by prescribing a recognition threshold
and measurement attributed to a tax position taken or expected to be taken in a
tax return. FIN 48 prescribes how a company should recognize, measure, present,
and disclose uncertain tax positions that the company has taken or expects to
take in its income tax returns.  FIN 48 requires that only income tax
benefits that meet the “more likely than not” recognition threshold be
recognized or continue to be recognized on its effective date.





General
Overview of Operations and Current Developments





Our oil
and gas assets consist of certain oil and gas properties and related assets that
we acquired in August 2007 from Cinco Natural Resources Corporation ("Cinco")
and Flash Gas & Oil Southwest, Inc. ("Flash") in two separate transactions
for an aggregate amount of approximately $5.9 million. Our wholly owned
subsidiary, Sonterra Operating, Inc., is the named operator of our oil and gas
properties, which are located in Matagorda Bay in Texas State Waters lying
offshore of the Texas coastal counties of Calhoun and Matagorda. In the Cinco
acquisition, for approximately $5.0 million, we purchased 60% of the interests
held by Cinco in the Texas State Tract 150 Wells No. 1 and No. 2 located in
Matagorda Bay, Texas, as well as a 320-acre oil and gas lease related to those
wells and certain other leases covering approximately 3,200 additional acres
located in Matagorda Bay. In the Flash acquisition, for approximately $1.2
million cash, we purchased all of the interests held by Flash in the Texas State
Tract 150 Wells No. 1 and No. 2 as well as a seven-mile pipeline connecting the
wells to the Keller Bay onshore facility located in Calhoun County, Texas. As
discussed below, the Texas State Tract 150 Well No. 2 has been shut-in as a
result of sand production and the Texas State Tract 150 Well No. 1 only produced
marginally in the 3rd quarter
of 2008.





In
December 2007, we acquired an additional 1,920 gross (960 net) offset acres for
one of the undrilled Matagorda Bay prospects, giving us combined total acreage
of approximately 5,500 gross (2,100 net) acres. On December 18, 2007, the Texas
State Tract 150 Well No. 2 was shut-in because it was producing sand. During the
first quarter of 2008, we worked over this well in an attempt to clean the sand
out of the wellbore. Following the workover, sand production again caused the
well to shut-in, and the well remains shut-in pending evaluation for future
utility. We have identified four additional drilling locations on our acquired
acreage and commenced drilling the first well location during the second quarter
of 2008.





11





The
Company commenced the drilling of the Matagorda Bay State Tract 127 No. 1 Unit
Well #1 (“State Tract 127-1 Unit Well”) at the end of the second quarter of
2008. The State Tract 127-1 Unit Well is the initial well in the Sydney/150 Deep
Prospect, the first of the four exploratory prospects in the Matagorda Bay 150
Field that have currently been identified as being prospective of oil and gas at
depths of between 8,500 feet and 12,000 feet total vertical depth (TVD). The
Company and South Texas Oil & Gas, (“South Texas”) agreed that South Texas
would acquire 70% of the Company’s working interest, subject to a 25%
reversionary interest after payout, in the State Tract 127-1 Unit
Well.  The Company subsequently sold a 10% working interest to Vinland
Energy Capital I LLP on a promoted basis, including a 10% proportionate share of
the associated leasehold and geological and geophysical costs, and the Company
and South Texas subsequently entered into an amendment to the Matagorda Bay
Contract Operating Agreement to effectuate a 50%/50% split of the 10% working
interest sold to Vinland. The net result of the above transactions resulted in
the Company having approximately a 3.56% working interest before casing point, a
7.03% working interest after casing point, and an 11.36% working interest with
corresponding net revenue interests of 5.11%, 5.11%, and 8.27%, respectively,
after all well payout scenarios occur under various participation agreements and
related documentation. The State Tract 127-1 Unit Well reached total depth of
12,464 feet in late August 2008 and was cased, cemented, logged, and temporarily
suspended. Results of the logs indicate the well encountered productive pay in
the Bol Mex and Nodasaria #1 formations at depths between 8,500 feet and 11,700
feet. The attempted completion in the Nodasaria #2 formation encountered water
with no hydrocarbons.  The Nodasaria #1 formation was tested and found
hydrocarbons, but tests were terminated because formation sand plugged the
wellbore.  During the second quarter of 2009, the Company plans to run
a through-tubing gravel pack to avoid sand accumulation and to commence
production from the Nodasaria #1 formation by laying a gathering line to our
7-mile pipeline.





The State
Tract 150 Well No. 1 produced sporadically a few days a month throughout most of
the first three quarters of 2008, but also produced increasing volumes of water
and was shut-in in 2008.  The State Tract 150-1 ST #1 Well, a side
track development well, was commenced in November 2008. Diagnostic well analysis
indicated multiple gas and condensate pay zones in the Bol Mex Formation at
depths between 9,300 feet and 10,000 feet so we cased, cemented, and tested 785
thousand cubic feet per day (MCF/day) of gas and 120 barrels/day of condensate
at a flowing tubing pressure of 3,600 PSI on an 8/64 inch choke in a late
December 2008 production test at 9,950 feet. The State Tract 150-1 ST #1
subsequently encountered water from an up hole formation so we abandoned the
zone we had tested and then attempted to recomplete up hole, where we again
encountered water and sand along with as much as 563 MCF/day and 2.1 barrels/day
of condensate before this zone was also shut in.  Further testing and
further remedial work is expected to commence in the second or third quarter of
2009.





Revenues. During the three
months ended March 31, 2009 and 2008, we reported total revenues of $75and $199,063,
respectively, primarily from oil and gas sales.  The Matagorda Bay
State Tract 150 #1 well ceased to produce in November 2008.  The well
was subsequently sidetracked, State Tract 150-1 ST #1, but has not returned to
production.  Additional testing and futher remedial work is expected
to commence in the second or third quarter of 2009.





Lease Operating Expenses.
During the three months ended March 31, 2009 and 2008, our lease operating
expenses were $61,697 and $300,958, respectively.  Normal field
monitoring and compliance visits were the most significant expense
incurred.  No other unusual operating expenses were incurred during
the period.





Impairment on Oil & Natural Gas
Properties. During the three months ended March 31, 2009, we
recognized impairment on oil & natural gas properties of $1,842,510 based on
the full cost ceiling tests.  Oil and natural gas prices used in
impairment valuation were $48.10/barrel and $3.84/mcf.  The company
did not recognize an impairment charge in the three months ended March 31,
2008.





General and Administrative
Expense.  General and administrative expenses for the three months
ended March 31, 2009 and 2008 were $913,706 and $982,155,
respectively.  Non-cash stock compensation expenses for the three
months March 31, 2009 and 2008 were $454,734 and $555,000,
respectively.  Stock compensation expenses related to the prior
management team were reversed in the 2nd quarter
of 2008. All non-cash stock compensation expense in 2009 relate to the common
stock options of the current management.





For the
three months ended March 31, 2009, the company recorded a reserve for doubtful
accounts of $119,630, primarily related to two outstanding drilling rig
invoices.  Liens have been filed on the two wells.





Total
payroll for the period ending March 31, 2009 was $161,235. The Company’s
corporate structure is to maintain as few employees as needed and to outsource
all administrative functions.  Currently, we used PetroAcct L.P. for
contract accounting services; Hein & Associates LLP for audit and tax
services; and Thompson and Knight LLP and Duane Morris LLP for legal
services.  Collectively, the combined expenses for the quarter were
$97,988.




Other (Expense).  During
the three months ended March 31, 2009, we had other expenses of $1,365,526,
consisting of interest expense, including accretion of debt discounts, in the
amount of $1,328,749 and debt issuance costs amortization of $36,777. During the
three months ended March 31, 2008, we had other expenses of $87,594 consisting
of interest expense in the amount of $70,593 and debt issuance costs
amortization of $17,001.




12




Financial
Condition





Liquidity and Capital
Resources





Our
primary source of liquidity is cash flow from operations; however, neither of
our two wells in the Matagorda Bay 150 Field was producing at December 31, 2008
or as of March 31, 2009.  In addition, all of our NTDS drilling rigs
are currently stacked and have not been utilized in 2009 thus far. While we now
expect to bring both the State Tract 127-1 Unit Well and the State Tract 150-1
ST #1 Well on line to begin producing natural gas in the third quarter of 2009,
there is no assurance that we will not encounter further difficulties with
formation sand accumulation and/or excessive water production that would further
delay production or render further operations to bring production cost
prohibitive at current oil and gas commodity prices.  The
documentation executed in connection with the Financial Restructuring
significantly restricts our ability to incur indebtedness without seeking
subordination from Marquis and Longview. If Marquis is unwilling to waive or
modify such conditions or subordinate the notes to allow us to obtain project
financing for future acquisitions, the Company would likely be unable to
raise the funds required to make acquisitions in the future.




The
Company believes that we will have sufficient sources of capital through access
to fund our operations for the next twelve months if we are able to commence
production at the expected rates from the aforementioned wells in the Matagorda
Bay 150 Field, generate revenue from our NTDS subsidiary, and/or consummate an
acquisition of producing properties, including but not limited to the
acquisition of producing properties in the Appalachian Basin contemplated in the
letter of intent we signed on April 13, 2009. Our future funding requirements
will depend on numerous factors, including ongoing costs associated with
investigating and acquiring potential oil and gas prospects, exploration and
other development costs of acquired oil and gas leases, and general
administrative and operating expenses.





The
current financial crisis and recession has negatively impacted the prices for
our oil and natural gas production, limited access to the credit and equity
markets, increased the cost of capital, and may have other negative consequences
that we cannot predict.The
continued credit crisis and related turmoil in the global financial system and
economicrecession
in the U.S. create financial challenges that will grow if conditions do not
improve. Our cash flow from operations and cash onhand
historically have not been sufficient to fund all of our expenditures, and we
have relied on Longview and Marquis to provide us with additional capital. Our
ability to access the capital markets has beenrestricted
as a result of these crises and may continue to be restricted at a time when we
would like, orneed,
to raise capital. If our cash flow from operations is less than anticipated and
our access to capitalis
restricted, we may be required to reduce our operating and capital budget, which
could havea
material adverse effect on our results and future operations. The financial
crisis may also limit thenumber
of participants or reduce the values we are able to realize in asset sales or
other transactionswe
may engage in to raise capital, thus making these transactions more difficult to
consummate andless
economic. Additionally, the current economic situation has affected the demand
for natural gas andoil
and has resulted in lower prices for natural gas and oil, which could have a
negative impact on ourrevenues.





Our
business model is based on growing the company by completing one or more
acquisitions of producing properties with upside proven locations to be drilled
and by participating in drilling prospects generated in-house and by third
parties. As discussed above, acquisitions and access to capital may be difficult
in the current economic environment. Acquisitions will have associated
production equipment. We currently have three senior management team members
focused on acquisitions. The number of acquisitions we complete and number of
prospects in which we participate, if any, will determine whether we will hire
additional consultants and/or employees. There is the potential for a
significant increase in the number of consultants and/or employees in the event
that we acquire or develop additional oil and gas properties and related
assets.





On March
30, 2009, $700,000 of the Acquisition Funds was released from the Acquisition
Funds Account for payment of interest on the Senior Secured Debt and other
corporate purposes.  On April 1, 2009, $2,000,000 of the Acquisition
Funds were released to prepay part of the Senior Secured Note, in exchange for a
reduction of $2,195,000 of the principal of the Senior Secured
Note.  On May 7, 2009, $270,000 of the Acquisition Funds were released
to pay for general and administrative costs, leaving a balance in the
Acquisition Funds Account of $129,931.





On April
13, 2009, the Company executed a letter of intent to acquire certain producing
properties in southern West Virginia pursuant to the Company’s Appalachian Basin
acquisition strategy in exchange for approximately $2,702,063 in cash, payable
in three annual installments; the assumption of the balance of a $1,700,541 loan
(estimated to be $1,500,000); and other consideration as detailed in the letter
of intent incorporated by reference hereto.




13




Senior
Secured Notes and Subordinated Notes





On
November 13, 2008, the Company restructured its financing arrangements
(“Financial Restructuring”) by entering into two transactions, as more fully
discussed in “Item 1. Financial Statements—Note 1.Basis
of Presentation”.  Under the first transaction, the Company entered
into a Securities Exchange Agreement (the “New Securities Exchange Agreement”)
with The Longview Fund, L.P. (“Longview”) and Longview Marquis Master Fund, L.P.
(“Marquis”) under which Marquis acquired a warrant (the “Marquis Warrant”) to
acquire (a)(i) 1,000,000 shares of the Company’s common stock, par value $0.001
per share (“Common Stock”), subject to adjustment, at an initial exercise price
per share of $0.01, (ii) and an unsecured subordinated promissory note in the
original aggregate principal amount of $9,440,000 (the “Marquis Subordinated
Note”), bearing interest at 11% per annum; and Longview acquired (b)(i) an
unsecured promissory note in the original aggregate principal amount of
$2,210,551 (the “Longview Subordinated Note”), bearing interest at 11% per
annum, and (ii) $1,000,000 in cash as principal repayment of the Old Notes
described below.





As part
of the consideration to the Company under the New Securities Exchange Agreement,
Longview agreed to surrender to the Company warrants to acquire 3,000,000 shares
of the Company’s Common Stock at an exercise price of $0.30210709 per share (out
of  that certain Warrant to Purchase Common Stock dated February 14,
2008 to acquire up to 4,958,678 shares of the Company’s Common Stock that
Longview held prior to such transaction) (the “Old Longview Warrant”), and
Longview surrendered to the Company the following notes payable by the Company
in the aggregate outstanding principal amount of $3,000,000 (collectively, the
“Old Longview Notes”): (i) that certain Amended and Restated Senior Secured note
dated February 14, 2008 (amended and restated May 16, 2008); and (ii) that
certain Senior Secured Note dated May 22, 2008.





In
exchange for the Marquis Warrant and the Marquis Subordinated Note, the Company
acquired from Marquis all of the issued and outstanding shares of common stock,
par value $0.001 per share, of NTDS and that certain Ninth Amended and Restated
Senior Secured Note dated October 3, 2008, in the outstanding principal amount
of $8,575,000, plus accrued and unpaid interest of approximately $865,000,
issued by NTDS (the “North Texas Note”).  The North Texas Note was
cancelled upon delivery to the Company.





Contemporaneously
with the closing of the New Securities Exchange Agreement, the Company entered
into a second transaction pursuant to a Securities Purchase Agreement (the
“Securities Purchase Agreement”) between the Company and
Marquis.  Under the Securities Purchase Agreement, the Company issued
and sold to Marquis, and Marquis purchased from the Company, for consideration
of $8,075,000, a senior secured promissory note in the principal amount of
$8,875,000, bearing interest at 13% per annum, subject to certain adjustments
(the “Senior Secured Note”), and a warrant to acquire 1,050,000 shares of Common
Stock at an initial exercise price of $0.01 per share.  As additional
consideration under the Securities Purchase Agreement, the Company also granted
Marquis a limited conveyance of overriding royalty interests (the “Overrides”)
of 3% of the Company’s interest in the hydrocarbon production from all of the
Company’s (i) current oil and gas properties (the “ORRI”) and (ii) oil and gas
properties acquired in the future with $5,000,000 of proceeds (the “Acquisition
Funds”) from the sale of the Senior Secured Note, which sum has been deposited
in the Acquisition Fund Account.  The proceeds from the Securities
Purchase Agreement were used in part to pay $1,000,000 of principal under the
existing indebtedness owed to Longview pursuant to the Old Notes, to fund the
Company’s share of the completion costs of the State Tract 127-1 Unit, and for
general corporate purposes.





Under the
Securities Purchase Agreement, from November 13, 2009 until November 12, 2010,
the Company has the right to purchase from Marquis all (but not less than all)
of the Overrides issued to Marquis prior to November 13, 2009 by delivering to
Marquis, at its election, either Override Warrants (as defined in the Securities
Purchase Agreement) or any combination of Common Override Exchange Shares (as
defined in the Securities Purchase Agreement) and Preferred Override Exchange
Shares (as defined in the Securities Purchase Agreement).  In
connection with the Securities Purchase Agreement, certain subsidiaries of the
Company guaranteed payment of the Senior Secured Note and the Company and
certain of its subsidiaries granted a security interest in substantially all of
their real and personal property to Summerline, as collateral agent for Marquis,
as the secured party, and executed a security agreement, a mortgage, guarantees
and pledges to evidence the same.





The
descriptions of the above agreements are qualified in each case, in their
entirety, by reference to the complete texts of such agreements, which have
previously been filed with the SEC.





Other
Notes





As part
of the acquisition of the Velocity entities, the Company assumed a $75,000
promissory note, plus accrued interest of $8,160, payable to our President and
Chief Executive Officer, which bears interest at 8%, compounded annually
(“Vandenberg Note”).  The Vandenberg Note has been subordinated to the
Senior Secured Note, the Marquis Subordinated Note, and the Longview
Subordinated Note.




14




Capital
Expenditures and Commitments





Our
commitment to drill an additional well in one of our Matagorda Bay prospects by
July 1, 2008, was met by the commencement of drilling operations of the State
Tract 127-1 Unit Well in late June 2008.  The well was drilled, cased
and temporarily suspended, awaiting completion.  Completion operations
commenced on November 1, 2008, and the well was expected to be on production by
year-end 2008. However, due to sand accumulation, it will be necessary to
perform a through tubing gravel pack in order to produce said well and, if
successful, then tie the well into our 7-mile pipeline in order to commence
production from the State Tract 127-1 Unit Well, both of which tasks are
expected to be completed some time in the second or third quarter of
2009.  The future capital required for both tasks is estimated to be
$45,000, net to our working interest.





The State
Tract 150-1 ST #1 Well, a side track development well, was commenced in November
2008. Diagnostic well analysis indicated multiple gas and condensate pay zones
in the Bol Mex Formation at depths between 9,300 feet and 10,000 feet so we
cased, cemented, and tested 785 thousand cubic feet per day (MCF/day) of gas and
120 barrels/day of condensate at a flowing tubing pressure of 3,600 PSI on an
8/64 inch choke in a late December 2008 production test at 9,950 feet. The State
Tract 150-1 ST #1 subsequently encountered water from an up hole formation so we
abandoned the zone we had tested and then attempted to recomplete up hole, where
we again encountered water and sand along with as much as 563 MCF/day and 2.1
barrels/day of condensate before this zone was also shut in.  Further
testing and wire line work to determine any future remedial work is expected to
commence in the second or third quarter of 2009.  The capital required
for this evaluation work is estimated to be $10,000, net to our
interest.





Off-Balance
Sheet Arrangements





We did
not have any off-balance sheet arrangements as of December 31, 2008, nor as of
March 31, 2009.





Inflation





We do not
believe that inflation has had a significant impact on our operations since
inception.





Item
3. Quantitative and Qualitative Disclosures about Market Risk.





Interest
Rate Risk





Our notes
have fixed interest rates so we are not exposed to changes in interest
rates.





Commodity
Price Risk





Our
revenues, profitability and future growth depend substantially on prevailing
prices for oil and natural gas. Prices also affect the amount of cash flow
available for capital expenditures and our ability to borrow and raise
additional capital, as, if and when needed. Lower prices may also reduce the
amount of oil and natural gas that we can economically produce. We may
periodically use derivative instruments to hedge our commodity price risk,
although we do not currently have any derivative instruments in
place.





Item
4T. Controls and Procedures.





Evaluation of Disclosure Controls
and Procedures





We
maintain disclosure controls and procedures that are designed to ensure that
information required to be disclosed in our filings with the Securities and
Exchange Commission are recorded, processed, summarized and reported within the
time period specified in the Securities and Exchange Commission’s rules and
forms, and that such information is accumulated and communicated to management,
including our chief executive and chief financial officer, as appropriate,
to allow timely decisions regarding required disclosure based on the definition
of “disclosure controls and procedures” as defined in Rule 13a-15(e) promulgated
under the Securities Exchange Act of 1934.





An
evaluation was carried out under the supervision and with the participation of
our management, including our chief executive officer and chief financial
officer, of the effectiveness of our disclosure controls and procedures as of
the end of the period covered by this report. Based on that evaluation, the
chief executive officer and the chief financial officer concluded that our
disclosure controls and procedures were not effective as of December 31,
2008, due to a material weakness regarding timely filing as reported in
Management’s Annual Report on Internal Control Over Financial Reporting, as of
December 31, 2008.




Changes in Internal Control Over
Financial Reporting





There
have been no significant changes in our internal control over financial
reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under
the Exchange Act) during the fiscal quarter to which this report relates that
have materially affected, or are reasonably likely to materially affect, the
Company’s internal control over financial reporting.




15




Part
II


OTHER
INFORMATION





Item
1. Legal Proceedings





We
currently are not aware of, or a party to, any legal proceedings. Additionally,
our officers and directors, in their capacity as such, are not a part to any
legal proceedings.




Item
1A. Risk Factors





Because
we are a smaller reporting company, we need not provide the information required
by this Item.




Item 2. Unregistered Sales of
Equity Securities and Use of Proceeds




Not
Applicable.




Item
3. Default upon Senior Securities





Not
Applicable.





Item
4. Submission of Matters to a Vote of Securities Holders





Not
Applicable.





Item
5. Other Information





Not
Applicable


.


Item
6. Exhibits




Exhibit
              
              Description10.1
              
              Letter
      of Intent, dated as of April 13, 2008, between and among Velocity Energy
      Partners LP and Classic Oil & Gas Resources, Inc., and its Selling
      Shareholders, William W. Kelly, Jr. and Alvin Kirk (Incorporated by
      reference to Exhibit 99.1 of our Current Report on Form 8-K filed on April
      17, 2009).10.2
              
              2008
      Sonterra Resources, Inc. Equity Compensation Plan, dated effective as of
      March 31, 2009 (Incorporated by reference to Exhibit 10.29 of our Annual
      Report on Form 10-K filed on May 8, 2009).31.1
              
              Certification
      of Chief Executive Officer pursuant to Securities Exchange Act of 1934
      Rule 13a-14(a) or 15d-14(a).31.2
              
              Certification
      of Chief Financial Officer pursuant to Securities Exchange Act of 1934
      Rule 13a-14(a) or 15d-14(a).32.1
              
              Joint
      Certification of Chief Executive Officer and Chief Financial Officer
      pursuant to Securities Exchange Act of 1934 Rule 13a-14(b) or 15d-14(b)
      and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.




16




SIGNATURES




Pursuant to the requirements of the
Securities Exchange Act of 1934, the registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly
authorized.




Dated:
  May 20, 2009




VELOCITY
      ENERGY INC.By:
                /s/
      Donald J. SebastianDonald
      J. SebastianChief
      Financial Officer
                  (Principal
      Financial and Accounting
Officer)





17




EXHIBIT
INDEX
 
 Exhibit
                
                Description10.1
                
                Letter
      of Intent, dated as of April 13, 2008, between and among Velocity Energy
      Partners LP and Classic Oil & Gas Resources, Inc., and its Selling
      Shareholders, William W. Kelly, Jr. and Alvin Kirk (Incorporated by
      reference to Exhibit 99.1 of our Current Report on Form 8-K filed on April
      17, 2009).10.2
                
                2008
      Sonterra Resources, Inc. Equity Compensation Plan, dated effective as of
      March 31, 2009 (Incorporated by reference to Exhibit 10.29 of our Annual
      Report on Form 10-K filed on May 8, 2009).31.1
                
                Certification
      of Chief Executive Officer pursuant to Securities Exchange Act of 1934
      Rule 13a-14(a) or 15d-14(a).31.2
                
                Certification
      of Chief Financial Officer pursuant to Securities Exchange Act of 1934
      Rule 13a-14(a) or 15d-14(a).32.1
                
                Joint
      Certification of Chief Executive Officer and Chief Financial Officer
      pursuant to Securities Exchange Act of 1934 Rule 13a-14(b) or 15d-14(b)
      and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.
  18