**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**x****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For thequarterly period ended September 30, 2007**

 

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

 

**For thetransition period from          to          **

 

**CommissionFile Number 001-32942**

 

**EVOLUTION PETROLEUM CORPORATION**

(Exact name of registrantas specified in its charter)

 

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

 

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

(Address ofprincipal executive offices and zip code)

 

**(713)935-0122**

(Registrant’stelephone number, including area code)

 

Indicate by check mark whether the registrant (1)filed all reports required to be filed by Section 13 or 15(d) of the ExchangeAct during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes:  x  No: o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and large acceleratedfiler” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large acceleratedfiler  o           Acceleratedfiler  o           Non-acceleratedfiler  x

 

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

 

The number of shares outstanding of the registrant’scommon stock, par value $0.001, as of November 1, 2007, was 26,776,234.

 

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**TABLE OFCONTENTS**

** **
|                               |                                                                                                                           | **Page** |
|------------------------------------|--------------------------------------------------------------------------------------------------------------------------------|----------|
|                               |                                                                                                                           |     |
| **PART I.  FINANCIAL INFORMATION** |                                                                                                                           |     |
|                               |                                                                                                                           |
| ITEM  1.                           | FINANCIAL  STATEMENTS                                                                                                          | 3        |
|                               |                                                                                                                           |     |
|                               | Condensed  Consolidated Balance Sheets as of September 30, 2007 (unaudited) and June 30,  2007                                 | 3        |
|                               | Condensed  Consolidated Statements of Operations (unaudited) for the three months ended  September 30, 2007 and 2006 | 4        |
|                               | Condensed  Consolidated Statements of Cash Flows (unaudited) for the three months ended  September 30, 2007 and 2006           | 5        |
|                               | Notes to  Condensed Consolidated Financial Statements (unaudited)                                                              | 6        |
|                               |                                                                                                                           |     |
| ITEM 2.                            | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                                    | 12       |
|                               |                                                                                                                           |     |
| ITEM 3.                            | QUANTITATIVE AND  QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                                    | 17       |
|                               |                                                                                                                           |     |
| ITEM 4.                            | CONTROLS AND PROCEDURES                                                                                                        | 17       |
|                               |                                                                                                                           |
| **PART  II. OTHER INFORMATION**    |                                                                                                                           |     |
|                               |                                                                                                                           |
| ITEM  6.                           | EXHIBITS                                                                                                                       | 17       |
|                               |                                                                                                                           |
| SIGNATURES                         |                                                                                                                           | 18       |
|                                    |                                                                                                                                |          |  |  |

 

2

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**PART I - FINANCIAL INFORMATION**

 

**ITEM 1. CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

 

**Evolution Petroleum Corporationand Subsidiaries**

**CondensedConsolidated Balance Sheets**

** **
| ** **                                                                                                                                    | ** ** | **September 30,** | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                                                                                                    | ** ** | **2007**               | ** ** | **2007**          | ** ** |
| ** **                                                                                                                                    | ** ** | **(unaudited)**        | ** ** | ** **        | ** ** |
| **Assets**                                                                                                                                    |       |                   |       |              |       |
| Current Assets:                                                                                                                               |       |                   |       |              |       |
| Cash and cash  equivalents                                                                                                                    |       | $                      | 25,301,272 |              | $          | 27,746,942 |   |
| Accounts  receivable                                                                                                                          |       | 866,646                |       | 212,585           |       |
| Income tax  receivable                                                                                                                        |       | 707,912                |       | 421,325           |       |
| Inventories                                                                                                                                   |       | 241,085                |       | 274,813           |       |
| Prepaid expenses                                                                                                                              |       | 94,261                 |       | 159,228           |       |
| Retainers and  deposits                                                                                                                       |       | 55,613                 |       | 106,625           |       |
|                                                                                                                                          |       |                   |       |              |       |
| Total current  assets                                                                                                                         |       | 27,266,789             |       | 28,921,518        |       |
|                                                                                                                                          |       |                   |       |              |       |
| Oil & Gas  properties - full cost                                                                                                         |       | 5,448,145              |       | 4,187,440         |       |
| Oil & Gas  properties - not amortized                                                                                                     |       | 2,726,490              |       | 1,924,552         |       |
| Less:  accumulated depletion                                                                                                                  |       | (745,344               | )          | (652,439          | )          |
|                                                                                                                                          |       |                   |       |              |       |
| Net oil &  gas properties                                                                                                                 |       | 7,429,291              |       | 5,459,553         |       |
|                                                                                                                                          |       |                   |       |              |       |
| Furniture,  fixtures and equipment, at cost                                                                                                   |       | 194,429                |       | 173,205           |       |
| Less:  accumulated depreciation                                                                                                               |       | (35,872                | )          | (18,333           | )          |
| Net furniture,  fixtures, and equipment                                                                                                       |       | 158,557                |       | 154,872           |       |
| Other assets,  net                                                                                                                            |       | 369,260                |       | 370,049           |       |
|                                                                                                                                          |       |                   |       |              |       |
| Total assets                                                                                                                                  |       | $                      | 35,223,897 |              | $          | 34,905,992 |   |
|                                                                                                                                          |       |                   |       |              |       |
| **Liabilities and Stockholders’ Equity**                                                                                                 |       |                   |       |              |       |
| Current  liabilities:                                                                                                                         |       |                   |       |              |       |
| Accounts payable                                                                                                                              |       | $                      | 1,107,539  |              | $          | 993,894 |   |
| Accrued  liabilities                                                                                                                          |       | 1,036,693              |       | 595,833           |       |
| Royalties  payable                                                                                                                            |       | 6,951                  |       | 6,831             |       |
|                                                                                                                                          |       |                   |       |              |       |
| Total current  liabilities                                                                                                                    |       | 2,151,183              |       | 1,596,558         |       |
|                                                                                                                                          |       |                   |       |              |       |
| Long term  liabilities:                                                                                                                       |       |                   |       |              |       |
| Deferred tax  liability                                                                                                                       |       | 338,001                |       | 338,001           |       |
| Deferred rent                                                                                                                                 |       | 71,248                 |       | 47,289            |       |
| Asset retirement  obligations                                                                                                                 |       | 145,693                |       | 140,998           |       |
|                                                                                                                                          |       |                   |       |              |       |
| Total  liabilities                                                                                                                            |       | 2,706,125              |       | 2,122,846         |       |
|                                                                                                                                          |       |                   |       |              |       |
| Stockholders’  equity:                                                                                                                   |       |                   |       |              |       |
| Common Stock,  par value $0.001, 100,000,000 shares authorized; 26,776,234 issued and  outstanding as of September 30, 2007 and June 30, 2007 |       | 26,776                 |       | 26,776            |       |
| Additional  paid-in capital                                                                                                                   |       | 12,784,838             |       | 12,443,199        |       |
| Deferred stock  based compensation                                                                                                            |       | (11,458                | )          | (45,826           | )          |
| Retained  earnings                                                                                                                            |       | 19,717,616             |       | 20,358,997        |       |
|                                                                                                                                          |       |                   |       |              |       |
| Total  stockholders’ equity                                                                                                              |       | 32,517,772             |       | 32,783,146        |       |
|                                                                                                                                          |       |                   |       |              |       |
| Total  liabilities and stockholders’ equity                                                                                              |       | $                      | 35,223,897 |              | $          | 34,905,992 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

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**EvolutionPetroleum Corporation and Subsidiaries**

**Condensed Consolidated Statements of Operations**

**(unaudited)**

** **
| ** **                                                                                                                              | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                              | ** ** | **September 30,  2007**     | ** ** | **September 30,  2006** | ** ** |
| Revenues:                                                                                                                               | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Oil sales                                                                                                                               |       | $                                | 502,273    |   | $ | 469,024 |   |
| Price risk  management activities                                                                                                       |       | —                           |       | (14 | ) |
|                                                                                                                                    |       |                             |       |   |   |
| Total revenues                                                                                                                          |       | 502,273                          |       | 469,010 |   |
|                                                                                                                                    |       |                             |       |   |   |
| Operating  expenses:                                                                                                                    |       |                             |       |   |   |
| Production  expenses                                                                                                                    |       | 315,005                          |       | 324,119 |   |
| Production taxes                                                                                                                        |       | 17,556                           |       | 34,660 |   |
| Depreciation,  depletion and amortization                                                                                               |       | 110,444                          |       | 61,871 |   |
| General and  administrative (includes stock-based compensation of $376,008 and $489,873,  respectively for September 30, 2007 and 2006) |       | 1,328,317                        |       | 1,039,192 |   |
|                                                                                                                                    |       |                             |       |   |   |
| Total operating  expenses                                                                                                               |       | 1,771,322                        |       | 1,459,842 |   |
|                                                                                                                                    |       |                             |       |   |   |
| Loss from  operations                                                                                                                   |       | (1,269,049                       | )          | (990,832 | ) |
|                                                                                                                                    |       |                             |       |   |   |
| Other income                                                                                                                            |       |                             |       |   |   |
| Interest income                                                                                                                         |       | 341,081                          |       | 530,796 |   |
|                                                                                                                                    |       |                             |       |   |   |
| Total other  income                                                                                                                     |       | 341,081                          |       | 530,796 |   |
|                                                                                                                                    |       |                             |       |   |   |
| Net loss before  income taxes                                                                                                           |       | (927,968                         | )          | (460,036 | ) |
|                                                                                                                                    |       |                             |       |   |   |
| Income tax  benefit - Current                                                                                                           |       | (286,587                         | )          | — |   |
|                                                                                                                                    |       |                             |       |   |   |
| Net loss                                                                                                                                |       | $                                | (641,381   | ) | $ | (460,036 | ) |
|                                                                                                                                    |       |                             |       |   |   |
| Loss per common  share:                                                                                                                 |       |                             |       |   |   |
| Basic and  diluted                                                                                                                      |       | $                                | (0.02      | ) | $ | (0.02 | ) |
|                                                                                                                                    |       |                             |       |   |   |
| Weighted average  number of common shares:                                                                                              |       |                             |       |   |   |
| Basic and  diluted                                                                                                                      |       | 26,776,234                       |       | 26,651,999 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

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**EvolutionPetroleum Corporation and Subsidiaries**

**Condensed Consolidated Statements of Cash Flows**

**(unaudited)**

 
| ** **                                                                  | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                  | ** ** | **September 30,  2007**     | ** ** | **September 30,  2006** | ** ** |
| **Cash  flows from operating activities**                                   | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Net loss                                                                    |       | $                                | (641,381   | ) | $ | (460,036 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities |       |                             |       |   |   |
| Depletion and  depreciation                                                 |       | 110,443                          |       | 61,870 |   |
| Stock-based  compensation                                                   |       | 376,008                          |       | 489,873 |   |
| Accretion of  asset retirement obligations                                  |       | 4,695                            |       | 4,119 |   |
| Deferred rent                                                               |       | 23,959                           |       | — |   |
| Changes in  operating assets and liabilities                                |       |                             |       |   |   |
| Accounts receivable                                                         |       | (654,061                         | )          | (217,996 | ) |
| Inventories                                                                 |       | 33,728                           |       | (27,015 | ) |
| Prepaid expenses                                                            |       | 64,967                           |       | 40,346 |   |
| Accounts payable                                                            |       | (318,869                         | )          | (68,423 | ) |
| Royalties  payable                                                          |       | 120                              |       | (35,962 | ) |
| Accrued  liabilities                                                        |       | 440,860                          |       | (352,592 | ) |
| Income taxes                                                                |       | (286,587                         | )          | (3,000,000 | ) |
| Net cash used in  operating activities                                      |       | (846,118                         | )          | (3,565,816 | ) |
| **Cash  flows from investing activities**                                   |       |                             |       |   |   |
| Development of  oil and gas properties                                      |       | (223,492                         | )          | (74,996 | ) |
| Acquisitions of  oil and gas properties                                     |       | (1,406,637                       | )          | (101,054 | ) |
| Proceeds from asset  sale                                                   |       | —                           |       | 155,378 |   |
| Capital  expenditures for furniture, fixtures and equipment                 |       | (21,224                          | )          | (3,480 | ) |
| Cash in  qualified intermediary account for “like-kind” exchanges |       | —                           |       | (321,220 | ) |
| Retainer and  deposits                                                      |       | 51,012                           |       | 300 |   |
| Other assets                                                                |       | 789                              |       | 1,573 |   |
| Net cash used in  investing activities                                      |       | (1,599,552                       | )          | (343,499 | ) |
| **Cash  flows from financing activities**                                   |       |                             |       |   |   |
| Equity and  transaction costs                                               |       | —                           |       | (7,023 | ) |
| Net cash used in  financing activities                                      |       | —                           |       | (7,023 | ) |
| Net decrease in  cash and cash equivalents                                  |       | (2,445,670                       | )          | (3,916,338 | ) |
| Cash and cash  equivalents, beginning of period                             |       | 27,746,942                       |       | 9,893,547 |   |
| Cash and cash  equivalents, end of period                                   |       | $                                | 25,301,272 |   | $ | 5,977,209 |   |
|                                                                        |       |                             |       |   |   |
| Supplemental  disclosure of cash flow information:                          |       |                             |       |   |   |
| Income taxes  paid                                                          |       | $                                | —     |   | $ | 3,000,000 |   |
| Accounts payable  to acquire oil and gas leasehold interests                |       | $                                | 432,514    |   | $ | — |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

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**EVOLUTIONPETROLEUM CORPORATION AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**(unaudited)**

 

**1. Organization and Basis of Preparation**

 

Headquartered in Houston, Texas, Evolution PetroleumCorporation, formerly Natural Gas Systems, Inc. (the “Company”, “EPM”, “we” or “us”),is a petroleum company incorporated under the laws of the State of Nevada,engaged primarily in the acquisition, exploitation and development ofproperties for the production of crude oil and natural gas. We acquireestablished oil and gas properties and exploit them through the application ofconventional and specialized technology to increase production, ultimaterecoveries, or both.

 

Our stock is traded on the American Stock Exchange(AMEX) under the ticker symbol EPM. Prior to July 17, 2006, our stock wasquoted on the OTC Bulletin Board under the symbol NGSY.OB. Prior to May 26,2004, our stock was quoted on the OTC Bulletin Board under the symbol RLYI.OB. Concurrentlywith the listing of our shares on the AMEX during July, 2006, we changed ourname from Natural Gas Systems, Inc. to Evolution Petroleum Corporation to avoidconfusion with similar names traded on the AMEX and to better reflect ourbusiness model.

 

At September 30, 2007, we conducted operations throughour 100% working interests in our Tullos Field Area and our non-operatedinterests in our Delhi Field, all located onshore in Louisiana. Our TullosField Area consists of approximately 156 producing wells out of 260 well boresacross 599 acres of high water cut primary reserve production. Our non-operatedinterests in the 13,636 acre Delhi Field consist of a 7.4% overriding andmineral royalty interest in the Delhi Holt Bryant Unit, a 25% reversionaryworking interest in the Delhi Holt Bryant Unit, and a 25% working interest incertain other depths in the Delhi Field. Our Delhi Holt Bryant Unit isscheduled for redevelopment using CO2 enhanced oil recovery technology.

 

The accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (“GAAP”) with the instructions to Form 10-Q for interim financialinformation. Accordingly, certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with accountingprinciples generally accepted in the United States have been condensed oromitted pursuant to such rules and regulations. All adjustments (consisting ofnormal recurring accruals) which are, in the opinion of management, necessaryfor a fair presentation of the financial position and results of operations forthe interim periods presented have been included. All inter-companytransactions are eliminated upon consolidation. The interim financial informationand notes hereto should be read in conjunction with our 2007 Annual Report onForm 10-KSB for the year ended June 30, 2007, as filed with the Securities andExchange Commission. The results of operations for interim periods are notnecessarily indicative of results to be expected for a full fiscal year.

 

**2. Recent Accounting Pronouncements**

 

In February 2007, theFinancial Accounting Standards Board (“FASB”) issued FASB Statement ofAccounting Standards (“SFAS”) No 159, “The Fair Value Option for FinancialAssets and Financial Liabilities” (“SFAS No. 159”) which permits allentities to choose, at specified election dates, to measure eligible items atfair value. SFAS No. 159 permits entities to choose to measure manyfinancial instruments and certain other items at fair value that are notcurrently required to be measured at fair value, and thereby mitigatevolatility in reported earnings caused by measuring related assets andliabilities differently without having to apply complex hedge accounting provisions.This Statement also establishes presentation and disclosure requirementsdesigned to facilitate comparisons between entities that choose differentmeasurement attributes for similar types of assets and liabilities. SFASNo. 159 is effective as of the beginning of an entity’s first fiscal yearthat begins after November 15, 2007. We are evaluating the impact thatthis Statement will have on our financial statements.

 

In July 2006, theFinancial Accounting Standards Board (“FASB”) issued FASB InterpretationNo. 48 (“FIN 48”),”Accounting for Uncertainty in Income Taxes - anInterpretation of FASB 109.” FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with FASB Statement No. 109, Accounting for IncomeTaxes. FIN 48 prescribes a recognition threshold and measurement attributefor the financial statement recognition and measurement of a tax position takenor expected to be taken in a tax return. FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.

 

We adopted FIN 48effective July 1, 2007. See Note 9.

 

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**3. Net Loss per Share**

 

Basic and diluted lossper share are computed by dividing net loss available to common shareholders bythe weighted average number of common shares outstanding during the period. Forpurposes of computing diluted loss per share, potential common shares have beenexcluded from the computation of weighted average common shares outstanding,because their effect is antidilutive.

 

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

 
| ** **                                                             | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                             | ** ** | **September 30,  2007**     | ** ** | **September 30,  2006** | ** ** |
| Numerator:                                                             |       |                             |       |   |   |
|                                                                   |       |                             |       |   |   |
| Net loss  applicable to common stockholders                            |       | $                                | (641,381   | ) | $ | (460,036 | ) |
| Plus income  impact of assumed conversions:                            |       |                             |       |   |   |
| Preferred stock  dividends                                             |       | N/A                              |       | N/A |   |
| Interest on  convertible subordinated notes                            |       | N/A                              |       | N/A |   |
| Net loss  applicable to common stockholders                            |       | $                                | (641,381   | ) | $ | (460,036 | ) |
|                                                                   |       |                             |       |   |   |
| Denominator:                                                           |       | 26,776,234                       |       | 26,651,999 |   |
|                                                                   |       |                             |       |   |   |
| Effect of  potentially dilutive common shares:                         |       |                             |       |   |   |
| Warrants                                                               |       | N/A                              |       | N/A |   |
| Employee and  director stock options                                   |       | N/A                              |       | N/A |   |
| Convertible  preferred stock                                           |       | N/A                              |       | N/A |   |
| Convertible  subordinated notes                                        |       | N/A                              |       | N/A |   |
| Redeemable  preferred stock                                            |       | N/A                              |       | N/A |   |
| Denominator for  dilutive earnings per share - weighted average shares |       | 26,776,234                       |       | 26,651,999 |   |
|                                                                   |       |                             |       |   |   |
| Loss per common  share:                                                |       |                             |       |   |   |
| Basic and  diluted                                                     |       | $                                | (0.02      | ) | $ | (0.02 | ) |

 

**4. Contingent Liabilities**

 

On August 3, 2007, we were advised of an oil spill inthe Tullos Field near one of our leases. At the request of field agents of theLouisiana Department of Environmental Quality and the EPA, we agreed tocommence a clean-up operation that was completed by the end of August 2007. Adetailed analysis of the oil in the spill compared to our produced oil was conductedby an EPA approved laboratory. We believe that the oil in the spill did notoriginate from our operations, and this is supported by the formal findings ofthe laboratory. We also believe that most of the $700,000 of estimated costsincurred in the cleanup, before adjustment following audit and negotiation ofthe billings, will be covered by insurance or reimbursement from the relevantgovernment oil spill funds, but we can give no assurance that suchreimbursement will occur. Subsequent to September 30, 2007, we received$484,197 from our insurance company. Furthermore, we have accrued insuranceproceeds of $207,000 for cost incurred through September 30, 2007. All clean upcosts, net of any insurance reimbursements, are expensed as incurred.

 

In November 2005, a multi-plaintiff lawsuit was filedin the Fifth Judicial District Court, Richland Parish, Louisiana, against 18defendants including NGS Sub Corp. and Arkla Petroleum LLC, our wholly ownedsubsidiaries, as working interest owners/operators of various oil and gasleases in the Delhi Field. Plaintiffs claim that the defendants’ oil and gasexploration, development and production activities on their properties havecaused soil and ground water contamination as a result of the release ofhydrocarbons and drilling fluids. Plaintiffs seek damages for testing, clean-upand remediation of the properties as 

 

7

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well as diminution in their value and mental anguishto the individual plaintiffs, unjust enrichment and punitive damages foralleged concealment of ongoing activities.

 

All defendants have filedexceptions to plaintiffs’ suit alleging that it is premature, its allegationsare vague and that administrative review through the Louisiana Office ofConservation rather than legal action in the court is plaintiffs’ properremedy. These exceptions have not yet been heard by the court. Discovery hasbegun and the allegations of plaintiffs’ suit are so vague that the specificsof their claims cannot be determined yet with certainty. Trial is set before ajury in Richland Parish for the first two weeks of September 2008.

 

Management intends tocontest plaintiffs’ claims vigorously. To this point, plaintiffs have notproduced any evidence of specific damage to their lands by defendants’ oil andgas operations. While the Delhi Field has been in production for over fiftyyears, we believe that no contamination of significance occurred during oursubsidiary’s period of ownership of the Delhi operating interests and ArklaPetroleum LLC as operator of said interests, beginning with our acquisitions ofeach in 2003 and ending with our disposition of the Delhi operating interestsin 2006. We believe that our liability exposure results largely through anypotential contractual indemnity of prior working interest owners. Until suchtime as the specifics of plaintiffs’ claims are identified through thediscovery process, and particularly any evidence of actual contamination ofsoil or groundwater, the amount of any judgment that might be rendered cannotbe determined with accuracy.

 

During the quarter endedJune 2006, the Governor of the State of Louisiana signed into law newlegislation addressing complaints similar to and including those filed againstus. Although the intention of the legislation was designed to limit plaintiffcomplaints and remedies by possibly deferring first to administrative expertswithin the Louisiana State Departments of Environmental Quality and NaturalResources, it is unclear at this time the impact of such legislation.

 

**5. Stock-Based Compensation**

 

Effective July 1, 2006, we adopted the fair valuerecognition provisions of Statement of Financial Accounting Standard 123(R) “*Share-Based Payment”* (“SFAS 123(R)”) usingthe modified prospective transition method. Stock-based compensation expense isrecorded as general and administrative expense in the consolidated condensedstatements of operations. We use the Black-Scholes option-pricing model toestimate option fair values. The option-pricing model requires a number ofassumptions, of which the most significant are, expected stock pricevolatility, the expected pre-vesting forfeiture rate and the expected optionterm.

 

The fair values ofoptions and warrants granted during the three months ended September 30, 2007and 2006 were estimated at the date of grant using the Black-Scholes optionspricing model assuming no dividends and with the following weighted averageassumptions for grants in 2007 and 2006:

 
| ** **                   | ** ** | **Three Months Ended** | ** ** |
|------------------------------|------------|----------------------------------|------------|
| ** **                   | ** ** | **September 30**            | ** ** |
| ** **                   | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Weighted average  volatility |       | 93.8                             | %          | N/A |   |
| Expected term  (in years)    |       | 6.25                             |       | N/A |   |
| Risk-free rate               |       | 4.10                             | %          | N/A |   |

 

For options issued duringthe three months ended September 30, 2007, volatilities were based on thehistorical volatility of our closing common stock price and that of a peergroup of three companies (in order to obtain adequate historical volatility). Expectedterm of options and warrants granted represents the period of time that optionsand warrants granted are expected to be outstanding using the “simplified”method provided by Staff Accounting Bulletin 107 (“SAB 107”). The risk-freerate for periods within the contractual life of the options and warrants isbased on the comparable U.S. Treasury rates in effect at the time of eachgrant. The weighted average grant-date fair value of options granted during thethree months ended September 30, 2007 was $1.74. There have been no options orwarrants exercised for the three months ended September 30, 2007 and 2006. Forthe three months ended September 30, 2007, we recognized compensation expenseof $376,008 related to stock option compensation. The following table setsforth the stock option and warrant transactions for the three months endedSeptember 30, 2007:

 

8

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| ** **                                                     | ** ** | **Number of Options  and Warrants** | ** ** | **Weighted Average  Grant Price** | ** ** | **Aggregate  Intrinsic Value   (1)** | ** ** | **Weighted  Average  Remaining  Contractual  Term (in  years)** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------------------------------|------------|
|                                                           |       |                                               |       |                                        |       |                                           |       |                                                                 |       |
| Options and  warrants outstanding at July 1, 2007              |       | 3,948,500                                          |       | $                                           | 1.54       |                                           |       |                                                                 |       |   |
|                                                           |       |                                               |       |                                        |       |                                           |       |                                                                 |       |
| Granted                                                        |       | 1,135,000                                          |       | $                                           | 2.21       |                                           |       |                                                                 |       |   |
| Exercised                                                      |       | 0                                                  |       |                                        |       |                                           |       |                                                                 |       |
| Canceled,  forfeited, or expired                               |       | 0                                                  |       |                                        |       |                                           |       |                                                                 |       |
|                                                           |       |                                               |       |                                        |       |                                           |       |                                                                 |       |
| Options and  warrants outstanding at September 30, 2007        |       | 5,083,500                                          |       | $                                           | 1.69       |                                           | $          | 7,290,470                                                            |       | 8.1 |   |
|                                                           |       |                                               |       |                                        |       |                                           |       |                                                                 |       |
| Vested options  and warrants exercisable at September 30, 2007 |       | 2,569,750                                          |       | $                                           | 1.38       |                                           | $          | 4,477,833                                                            |       | 7.4 |   |

 

----

(1) Based upon thedifference between the market price of our common stock on the last tradingdate of the quarter (or $3.12) and the option or warrant exercise price ofin-the-money options or warrants.

 

A summary of the statusof our unvested options and warrants as of September 30, 2007, and the changesduring the three months ended September 30, 2007, is presented below:

 
| ** **                       | ** ** | **Number of  Options and  Warrants** | ** ** | **Weighted  Average Grant-  Date Fair Value** | ** ** |
|----------------------------------|------------|------------------------------------------------|------------|--------------------------------------------------------------|------------|
|                             |       |                                           |       |                                                         |       |
| Unvested at July  1, 2007        |       | 1,561,875                                      |       | $                                                            | 1.51       |   |
|                             |       |                                           |       |                                                         |       |
| Granted                          |       | 1,135,000                                      |       | $                                                            | 1.74       |   |
|                             |       |                                           |       |                                                         |       |
| Vested                           |       | (183,125                                       | )          |                                                         |       |
|                             |       |                                           |       |                                                         |       |
| Canceled,  forfeited, or expired |       | —                                         |       |                                                         |       |
|                             |       |                                           |       |                                                         |       |
| Unvested at end  of period       |       | 2,513,750                                      |       | $                                                            | 1.65       |   |

 

At September 30, 2007,unrecognized stock based compensation expense related to unvested stock optionand warrant grants totaled approximately $3.8 million. This unrecognizedexpense will be amortized on a straight-line basis per grant over a weightedaverage remaining life of approximately 2.9 years.

 

***RestrictedStock***

 

For the three monthsended September 30, 2007, no new restricted stock awards were granted. Duringthe three months ended September 30, 2007, we recognized compensation expenseof $40,543 related to outstanding restricted stock grants.

 

The following table setsforth the restricted stock transactions for the three months ended September30, 2007:

 

9

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| ** **                       | ** ** | **Number of  Restricted  Shares** | ** ** | **Weighted  Average  Grant-Date  Fair Value** | ** ** |
|----------------------------------|------------|----------------------------------------|------------|----------------------------------------------------|------------|
|                             |       |                                   |       |                                               |       |
| Unvested at July  1, 2007        |       | 23,620                                 |       | $                                                  | 2.83       |   |
|                             |       |                                   |       |                                               |       |
| Granted                          |       | —                                 |       |                                               |       |
|                             |       |                                   |       |                                               |       |
| Vested                           |       | (14,312                                | )          |                                               |       |
|                             |       |                                   |       |                                               |       |
| Canceled,  forfeited, or expired |       | —                                 |       |                                               |       |
|                             |       |                                   |       |                                               |       |
| Unvested at end  of period       |       | 9,308                                  |       | $                                                  | 2.90       |   |

 

At September 30, 2007,unrecognized stock compensation expense related to restricted stock grantstotaled approximately $27,000. Such unrecognized expense will be recognized asvesting occurs over a weighted average period of 0.25 years.

 

**6. Common Stock**

 

During the quarter ended September 2007, the board ofdirectors approved resolutions to issue options to purchase 1,135,000 commonshares to three new employees as part of their initial compensation foremployment, and six current employees as part of their long term annualincentive compensation. The options are excisable at the closing price of thecommon stock on either the date of grant or the first day of employment,whichever is later. Further, the options vest in equal amounts quarterly overfour years and are subject to other standard terms and conditions as providedby the Company.

 

In addition, the Board of Directors has unanimouslyapproved , subject to stockholder approval, amendments to the 2004 Stock Planto increase the number of shares of common stock we are authorized to issuefrom 4,000,000 shares to 5,500,000 shares and to make certain clarifyingchanges and amendments as part of the approval of the Amended and Restated 2004Stock Plan. Stockholders of record, as of October 15, 2007, are scheduledto vote at the 2007 Annual Meeting of Stockholders on December 4, 2007 toapprove these amendments.

 

During the quarter ended September 2006, there were noequity awards issued or granted.

 

**7. Commodity Hedging and Price Risk ManagementActivities**

 

Pursuant to the terms of our previous credit facility,we entered into financial instruments covering approximately 50% of ourexpected oil and gas production from proved developed producing properties on atwo year rolling basis. We used reserve report data prepared by W. D. VonGonten & Co., our independent petroleum engineering firm, to estimate ourfuture production for hedging purposes. As we may elect under FAS 133,Accounting for Derivative Instruments and Hedging Activities, we havedesignated our physical delivery contracts as normal delivery sale contracts. Forthe oil price floors (the “Puts”) we purchased, we have not fulfilled thedocumentation requirements of FAS 133. As a result, the Put contracts are “marked-to-market”,with the unrealized gain or loss reflected in our statement of operations. SinceJune 30, 2006, we had the following financial instruments in place:

 
| (i)    |   | 90 Bbls of oil per day to be delivered from June  2006 through August 2006 to Plains Oil Marketing LLC at a fixed price of  $63.45 per barrel, and extended for six months from September 2006 through  February 2007 at a fixed price of $69.30 per barrel. All fixed prices are  adjusted for basis changes between: (a) the arithmetic daily average of the  prompt month “Light Sweet Crude Oil” contract reported by the New York  Mercantile Exchange, and (b) Louisiana field posted price. This is accounted  for as a normal delivery sales contract. In the case of production  shortfalls, the required barrels are purchased at the current market price  per Plains Oil Marketing price bulletins. |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| (ii)   |   | Purchase of a non-physical Put contract at $38.00  per barrel for 2,000 Bbls of crude oil production from March 2006 through  February 2007. This is accounted for as a “mark-to-market” derivative  investment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |

 

As of February 28, 2007, all of the Company’scommodity hedging and price risk management activities had expired and 

 

10

----

 

were not renewed. Since  March 1, 2007, all of our oil production hasbeen sold to Plains Marketing L.P. under a normal (thirty day “evergreen”)sales contract.

 

**8. Asset Retirement Obligations**

 

SFAS No. 143, “*Accounting for Asset Retirement Obligations*,” (“SFAS 143”)provides accounting requirements for retirement obligations associated withtangible long-lived assets, including: 1) the timing of liability recognition;2) initial measurement of the liability; 3) allocation of asset retirement costto expense; 4) subsequent measurement of the liability; and 5) financialstatement disclosures. SFAS 143 requires that an asset retirement cost shouldbe capitalized as part of the cost of the related long-lived asset andsubsequently allocated to expense using a systematic and rational method.

 

Following is a reconciliation of the beginning andending asset retirement obligation for the period ending September 30 2007 and2006:

 
| ** **                                          | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|
| ** **                                          | ** ** | **September 30,  2007**     | ** ** | **September 30,  2006** | ** ** |
| Asset retirement  obligation at beginning of period |       | $                                | 140,998    |   | $ | 123,679 |   |
| Liabilities  incurred                               |       | —                           |       | — |   |
| Liabilities  settled                                |       | —                           |       | — |   |
|                                                |       |                             |       |   |   |
| Accretion                                           |       | 4,695                            |       | 4,119 |   |
| Asset retirement  obligation at end of period       |       | $                                | 145,693    |   | $ | 127,798 |   |

 

**9. Income Taxes**

 

*UncertainTax Positions*

 

The Company did not haveany unrecognized tax benefits and there was no effect on our financialcondition or results of operations as a result of implementing FIN 48.

 

The amount ofunrecognized tax benefits may change in the next twelve months; however we donot expect the change to have a significant impact on the results of operationsor the financial position of the Company.

 

The Company files aconsolidated federal income tax return in the United States and variouscombined and separate filings in several state and local jurisdictions. With limitedexceptions, the Company is no longer subject to U.S. Federal, state and localincome tax examinations by tax authorities for years before fiscal year endingJune 30, 2004.

 

The Company’s continuingpractice is to recognize estimated interest and penalties related to potentialunderpayment on any unrecognized tax benefits as a component of income taxexpense in the Consolidated Statement of Operations. As of the date ofadoption of FIN 48, the Company did not have any accrued interest or penaltiesassociated with any unrecognized tax benefits, nor was any interest expenserecognized during the quarter. The Company does not anticipate that totalunrecognized tax benefits will significantly change due to the settlement ofaudits and the expiration of statute of limitations prior to September 30,2008.

 

The Company accounts forincome taxes in accordance with SFAS No. 109,*Accounting for Income Taxes* (“SFAS 109”). SFASNo. 109 requires the Company to recognize income tax benefits for losscarry forwards which have not previously been recorded. The tax benefitsrecognized must be reduced by a valuation allowance when it is more likely thannot that the deferred tax asset will not be realized.

 

In determining thecarrying value of a deferred tax asset, SFAS 109 provides for the weighing ofevidence in estimating whether and how much of a deferred tax asset may berecoverable. The Company has put a valuation allowance on certain deferred taxassets primarily inclusive of net operating losses (“NOL’s”) that are limitedby Internal Revenue Code Section 382. Although current conditions appear toindicate a taxable loss in 2007, the Company did have taxable income in 2006and thus paid both federal and state income taxes. A benefit is beingrecognized with the intention of carrying back the current year tax loss. Sufficientincome is available in the prior year to fully utilize the losses created inthe current year. Therefore, management believes no valuation allowance isnecessary on the current year loss.

 

11

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The income tax benefitrate of 31% varies from the U.S. statutory rate primarily due to state incometaxes partially offset by disallowed compensation costs related to incentivestock options.

 

**10. Related Party Transactions**

 

Laird Q. Cagan, Chairman of our Board, is a ManagingDirector and co-owner of Cagan McAfee Capital Partners, LLC (“CMCP”). CMCPperforms financial advisory services to us pursuant to a written agreementamended in November 2005, providing for a retainer of $5,000 per month. Inaddition, Mr. Cagan, as a registered representative of Chadbourn SecuritiesInc. (“Chadbourn”) and a partner of CMCP, has served as the Company’s placementagent in private equity financings. Under the current agreement, CMCP may earncash fees equal to 8% of gross equity proceeds, declining to 4% subject to theamount of equity raised, and a fixed 4% warrant fee. Mr. Cagan receives noadditional compensation for serving as a director or as the Chairman of ourBoard.

 

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

 

During the three months ended September 30, 2007 and2006 respectively, we expensed and paid CMCP $15,000 in quarterly retainers. Therewere no other earned fees by CMCP.

 

**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*This Form 10-Q and theinformation referenced herein contain forward-looking statements. The words “plan,”“expect,” “project,” “estimate,” “assume,” “believe,” “anticipate,” “intend,” “budget,”“forecast,” “predict” and other similar expressions are intended to identifyforward-looking statements. These statements appear in a number of places andinclude statements regarding our plans, beliefs or current expectations,including the plans, beliefs and expectations of our officers and directors.* *When considering any forward-looking statement, you should keep in mindthe risk factors that could cause our actual results to differ materially fromthose contained in any forward-looking statement. Important factors that couldcause actual results to differ materially from those in the forward-lookingstatements herein include the timing and extent of changes in commodity pricesfor oil and gas, operating risks and other risk factors as described in our2007 Annual Report on Form 10-KSB for the year ended June 30, 2007 asfiled with the Securities and Exchange Commission. Furthermore, the assumptionsthat support our forward-looking statements are based upon information that iscurrently available and is subject to change. We specifically disclaim allresponsibility to publicly update any information contained in aforward-looking statement or any forward-looking statement in its entirety andtherefore disclaim any resulting liability for potentially related damages. Allforward-looking statements attributable to Evolution Petroleum Corporation areexpressly qualified in their entirety by this cautionary statement.*

 

*We use the terms, “EPM,” “Company,”“we,” “us” and “our” to refer to Evolution Petroleum Corporation.*

 

**Critical Accounting Policies**

 

Our 2007 Annual Report onForm 10-KSB describes the accounting policies that we believe are critical tothe reporting of our financial position and operating results and that requiremanagement’s most difficult, subjective or complex judgments.

 

This Quarterly Report on Form 10-Q should be read inconjunction with the discussion contained in our 2007 Annual Report on Form10-KSB regarding these critical accounting policies.

 

**Executive Overview**

 

*General*

 

Evolution Petroleum Corporation, formerly Natural GasSystems, Inc., is a petroleum company engaged primarily in the acquisition,exploitation and development of properties for the production of crude oil andnatural gas. We acquire established oil and gas properties and exploit themthrough the application of conventional and specialized technology to increaseproduction, ultimate recoveries, or both.

 

12

----

 

We are focused on an overall strategy of acquiringcontrolling working interests in oil and gas resources within establishedfields and redeveloping those fields through the application of capital andtechnology to convert a portion of the oil and gas resources into profitableproducing reserves. Our strategy is intended to generate scalable developmentopportunities at normally pressured depths, exhibiting relatively lowcompletion risk, generally longer and more predictable production lives, lessexpenditures on infrastructure and lower operational risks.

 

Within this overall strategy, we pursue three specificinitiatives:

 
|   | I      |   | Enhanced oil recovery (EOR), using miscible and  immiscible gas flooding;                        |
|--------|--------|--------|--------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                             |
|   | II     |   | Bypassed primary resource development, within mature  oil and gas fields; and                    |
|   |   |   |                                                                                             |
|   | III    |   | Unconventional gas reservoir development, using  modern stimulation and completion technologies. |

 

Our Inititiative I EOR project at the 13,636 acreDelhi Field, located in northeast Louisiana, is currently our most strategicasset. Our non-operated interests consist of 7.4% in overriding and mineralroyalty interests in the Delhi Field Holt Bryant Unit, a 25% reversionaryworking interest in the Delhi Field Holt Bryant Unit, and a 25% workinginterest in certain other depths in the Delhi Field. Our Holt Bryant Unit isscheduled for redevelopment using CO2 enhanced oil recovery technology, withCO2 injection expected by the operator in calendar 2008, followed by projectedincreases in oil production  beginning incalendar 2009.

 

With the Delhi CO2-EOR project now underway, we arecurrently focused on bringing Inititiative II Bypassed Resource projects andInititiative III Unconventional Gas projects to the forefront. Conceptually,our plan going forward can be illustrated as follows: 

 

**EPM Business Plan**

 

----

* Current cash resources feed Bypassed ResourceProjects for near term revenues

** Cash generated from Bypassed Resource Projects andDelhi then feed pending projects in Unconventional Gas and EOR

 

 

*First Quarter2008 Highlights*

 

Our progress during this quarter includes:

 

•                  Continuedincreases in our intrinsic values per share via additional leaseholdacquisitions of proved undeveloped reserves within our Bypassed ResourceInititiative.

 

13

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•                  Additionalacquisitions of unproved leasehold interests within our Bypassed Resource andour Unconventional Gas Development initiatives.

 

•                  Continueddevelopment of our operational infrastructure, acquisitions of drilling permitsand completion of contract service negotiations required to begin our 10 wellBypassed Resource development drilling program by the end of calendar 2007.

 

**Liquidity and Capital Resources**

 

At September 30, 2007,our working capital, predominately cash and cash equivalents, was approximately$25.1 million, and we continued to be debt free. This compares to workingcapital of approximately $27.3 million at June 30, 2007. Approximately $2.1million of investments in oil and gas leasehold interests accounted for the$2.2 million decrease in working capital since June 30, 2007.

 

For the three monthsended September 30, 2007, approximately $846,000 was used in operations. Thiscompares to approximately $3.6 million used in operations for the three monthsended in 2006, including $3 million used to extinguish income taxes payable.

 

Cash flows used ininvesting activities totaled approximately $1.6 million during the three monthsended September 30, 2007 (in addition to approximately $433,000 of oil and gasexpenditures charged to Accounts Payable at period end,  not yet paid in cash, as noted in theSupplemental Note to our Statement of Cash Flows). This compared toapproximately $343,000 used in investing activities for the comparable threemonths of 2006. Virtually all investments in both periods were used to acquireoil and gas property interests.

 

There were no cash flowsfrom financing activities in the three months ended September 30, 2007 and$7,000 was used in the comparable 2006 three month period.

 

We expect our capitalexpenditures will increase substantially during fiscal year 2008, due tocontinued leasing and the execution of a development drilling program withinour Bypassed Resource Initiative, and continued leasing in our UnconventionalGas Initiative. Based on our current plans, we expect capital expenditures toexceed $15 million during fiscal 2008, with half or more dedicated todevelopment drilling. Our working capital is sufficient to fund this drillingprogram.

 

**Results of Operations**

 

***Three months ended September 30,2007 compared to three months ended September 30, 2006***

 

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

 

14

----

 
| ** **                                         | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** | ** **   | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|------------|------------|--------------|------------|
| ** **                                         | ** ** | **September 30**            | ** ** | ** ** | ** ** | **%**        | ** ** |
| ** **                                         | ** ** | **2007**                         | ** ** | **2006**   | ** ** | **Variance** | ** ** | **change** | ** ** |
|                                               |       |                             |       |       |       |         |       |   |   |
| **Sales  Volumes, net to Evolution:**              |       |                             |       |       |       |         |       |   |   |
|                                               |       |                             |       |       |       |         |       |   |   |
| Oil (Bbl)                                          |       | 7,034                            |       | 7,694      |       | (660         | )          | -9 | % |
|                                               |       |                             |       |       |       |         |       |   |   |
| Gas (Mcf)                                          |       | —                           |       | —     |       | —       |       |   |   |
|                                               |       |                             |       |       |       |         |       |   |   |
| Oil and Gas  (Boe)                                 |       | 7,034                            |       | 7,694      |       | (660         | )          | -9 | % |
|                                               |       |                             |       |       |       |         |       |   |   |
| **Revenue  data (a):**                             |       |                             |       |       |       |         |       |   |   |
|                                               |       |                             |       |       |       |         |       |   |   |
| Oil revenues                                       |       | $                                | 502,273    |       | $          | 469,010      |       | $ | 33,263 |   | 7 | % |
|                                               |       |                             |       |       |       |         |       |   |   |
| Gas revenues                                       |       | —                           |       | —     |       | —       |       | — |   |
| Total oil and  gas revenues                        |       | $                                | 502,273    |       | $          | 469,010      |       | $ | 33,263 |   | 7 | % |
|                                               |       |                             |       |       |       |         |       |   |   |
| **Average  prices (a):**                           |       |                             |       |       |       |         |       |   |   |
| Oil (per Bbl)                                      |       | $                                | 71.41      |       | $          | 60.96        |       | $ | 10.45 |   | 17 | % |
| Gas (per Mcf)                                      |       | —                           |       | —     |       | —       |       | — |   |
| Oil and Gas (per  Boe)                             |       | $                                | 71.41      |       | $          | 60.96        |       | $ | 10.45 |   | 17 | % |
|                                               |       |                             |       |       |       |         |       |   |   |
| **Expenses  (per Boe)**                            |       |                             |       |       |       |         |       |   |   |
| Lease operating  expenses and production taxes (b) |       | $                                | 47.28      |       | $          | 46.63        |       | $ | 0.65 |   | 1 | % |
| Depletion  expense on oil and gas properties       |       | $                                | 13.15      |       | $          | 7.87         |       | $ | 5.28 |   | 67 | % |

 

----

(a)          Includes the cash settlement of hedgingcontracts in the prior year

 

(b)         Excludes non-recurring oil spill expenses inthe current year

 

Net Loss. For the three months endedSeptember 30, 2007, we reported a net loss of approximately $641,000, or $0.02loss per share, on total oil and gas revenues of approximately $502,000, ascompared to a net loss of $460,000, or $0.02 loss per share, on total oil andgas revenues of $469,000 for the three months ended September 30, 2006. Theincrease to our net loss is primarily attributable to increases to General andAdministrative expenses of approximately $289,000 and a decrease in interestincome earned of approximately $190,000, offset by an income tax benefit ofapproximately $287,000 in the quarter ended September 30, 2007 as compared tozero in the 2006 quarter. Additional details of the components of net loss areexplained in greater detail below.

 

Sales Volumes. Oil sales volumes,net to our interest, for the three months ended September 30, 2007 decreased 9%to 7,034 Bbls, compared to 7,694 Bbls for the three months ended September 30,2006. The decrease in oil sales volumes is due to a decrease of production fromthe Tullos Field area by approximately 6%.

 

Production. Oil production variesfrom oil sales volumes by changes in crude oil inventories, which are notcarried on our balance sheet. Net working interest oil production for the threemonths ended September 30, 2007 decreased 6% to 7,145 Bbls, compared to 7,602Bbls for the three months ended September 30, 2006. This was due to variouswells being offline due to repairs to tank batteries and casing leaks, offsetby wells returned to production which were previously idle. Further, productionwas adversely impacted due to the diversion of oilfield service equipment andservices to assist the vendor hired to clean up the oil spill.

 

Oil and Gas Revenues. Revenuespresented in the table above and discussed herein represent revenue from salesof our oil and natural gas production volumes, net to our interest. Productionsold under fixed price delivery contracts, which have been designated for thenormal purchase and sale exemption under SFAS 133, are also included in theseamounts. Realized prices may differ from market prices in effect during theperiods, depending on when the fixed delivery contract was executed.

 

Oil revenues increased 7% for the three months endedSeptember 30, 2007, compared to the same period in 2006, as a result of a 17%increase in oil prices, from $61 per barrel to $71per barrel. As describedabove, a 9% decrease in sales volumes offset this increase in oil revenues.

 

15

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Lease Operating Expenses (including productionseverance taxes). Lease operating expenses for the threemonths ended September 30, 2007 decreased approximately 7% from the comparable2006 period. The overall decrease in operating expenses in 2007 is primarilyattributable to lower severance taxes and lower field expenses in our TullosField. On a BOE basis, lease operating expenses increased by 1% over thecomparable 2006 quarter, primarily due to a 9% decrease in volumes.

 

General and Administrative Expenses (G&A).G&A expenses increased 28% to approximately $1.3 million for the threemonths ended September 30, 2007, compared to approximately $1 million for thethree months ended September 30, 2006. Higher overall compensation expenses forestimated accrued bonuses and new hires accounted for the majority of theincrease, in addition to increases to Franchise taxes owed for the State ofTexas. New hires are associated with building up our infrastructure to executethe planned drilling program. Non-cash stock compensation expense wasapproximately $376,000 and $490,000 for the 2007 and 2006 three month periods,respectively.

 

Depreciation, Depletion & Amortization Expense(DD&A). DD&A expense increased approximately $48,000to approximately $110,000 for the three months ended September 30, 2007 from$62,000 for the same period in 2006. The increase is primarily due to a higherDD&A rate ($13 vs. $8) per barrel that went into effect on July 1, 2007,the date of our reserve report. Slightly offsetting depletion expense is adecrease in sales volumes of 9%, described above.

 

Interest Income. Interest income forthe three months ended September 30, 2007 decreased approximately $190,000 toapproximately $341,000, compared to approximately $531,000 for the three monthsended September 30, 2006. The decrease in interest income is primarily due tolower available cash balances averaging approximately $27 million during mostof the current quarter, as compared to cash balances averaging approximately$44 million in the comparable prior year quarter. The lower cash balance is dueto cash used to relieve income taxes payable arising from the $50 million wereceived from the Delhi Farmout and for additions to our oil and gasproperties.

 

**Off Balance Sheet Arrangements**

 

Pursuant to the terms of our previous credit facility,we entered into financial instruments covering approximately 50% of ourexpected oil and gas production from proved developed producing properties on atwo year rolling basis. We used reserve report data prepared by W. D. VonGonten & Co., our independent petroleum engineering firm, to estimate ourfuture production for hedging purposes. As we may elect under FAS 133,Accounting for Derivative Instruments and Hedging Activities, we havedesignated our physical delivery contracts as normal delivery sale contracts. Forthe oil price floors (the “Puts”) we purchased, we have not fulfilled thedocumentation requirements of FAS 133. As a result, the Put contracts are “marked-to-market”,with the unrealized gain or loss reflected in our statement of operations. SinceJune 30, 2006, we had the following financial instruments in place:

 
| (i)    |   | 90 Bbls of oil per day  to be delivered from June 2006 through August 2006 to Plains Oil Marketing  LLC at a fixed price of $63.45 per barrel, and extended for six months from  September 2006 through February 2007 at a fixed price of $69.30 per barrel.  All fixed prices are adjusted for basis changes between: (a) the arithmetic  daily average of the prompt month “Light Sweet Crude Oil” contract reported  by the New York Mercantile Exchange, and (b) Louisiana field posted price.  This is accounted for as a normal delivery sales contract. In the case of  production shortfalls, the required barrels are purchased at the current  market price per Plains Oil Marketing price bulletins. |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| (ii)   |   | Purchase of a  non-physical Put contract at $38.00 per barrel for 2,000 Bbls of crude oil  production from March 2006 through February 2007. This is accounted for as a  “mark-to-market” derivative investment. As of February 28, 2007, the market  value of the Put contract was zero.                                                                                                                                                                                                                                                                                                                                                                                                                       |

 

As of February 28, 2007, all of the Company’scommodity hedging and price risk management activities have expired and havenot been renewed. As of March 1, 2007, all of our oil production has been soldto Plains Marketing L.P. under a normal (thirty day “evergreen”) salescontract.

 

16

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**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISKS**

 

*InterestRate Risk*

 

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

 

*CommodityPrice Risk*

 

Our revenues,profitability and future growth depend substantially on prevailing prices foroil and gas. Prices also affect the amount of cash flow available for capitalexpenditures and our ability to borrow and raise additional capital. Lower pricesmay also reduce the amount of oil and gas that we can economically produce. Wemay periodically use derivative instruments to hedge our commodity price risk.We may hedge a portion of our projected oil and gas production through avariety of financial and physical arrangements intended to support oil and gasprices at targeted levels and to manage our exposure to price fluctuations. Wemay use futures contracts, swaps and fixed price physical contracts to hedgeour commodity prices. Realized gains and losses from our price risk managementactivities are recognized in oil and gas sales when the associated productionoccurs. We do not hold or issue derivative instruments for speculativepurposes.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in ourExchange Act reports is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’s rules andforms and that such information is accumulated and communicated to this Company’smanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate to allow for timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management is required to apply its judgment inevaluating the cost-benefit relationship of possible controls and procedures.

 

As required by Securities and Exchange Commission Rule13a-15(b), we carried out an evaluation, under the supervision and with theparticipation of the Company’s management, including our Chief ExecutiveOfficer and the Company’s Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures as of the end ofthe quarter covered by this report. Based on the foregoing, our Chief ExecutiveOfficer and Chief Financial Officer concluded that our disclosure controls andprocedures are effective in ensuring that the information required to bedisclosed in our reports filed or submitted under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission rules and forms.

 

There has been no change in our internal control overfinancial reporting during our most recent fiscal quarter that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

**PART II - OTHER INFORMATION**

 

**ITEM 6. EXHIBITS**

 

A.           Exhibits

 
|   |   | 31.1   |   | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934,  as amended.                         |
|--------|--------|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |   |                                                                                                                                                                   |
|   |   | 31.2   |   | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934,  as amended.                         |
|   |   |   |   |                                                                                                                                                                   |
|   |   | 32.1   |   | Certification of Chief Executive Officer pursuant  Rule 13a-14(b) or Rule 15d-14(b) under the Securities Exchange Act of 1934,  as amended and 18 U.S.C. Section 1350. |
|   |   |   |   |                                                                                                                                                                   |
|   |   | 32.2   |   | Certification of Chief Financial Officer pursuant  Rule 13a-14(b) or Rule 15d-14(b) under the Securities Exchange Act of 1934,  as amended and 18 U.S.C. Section 1350. |

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

**EVOLUTIONPETROLEUM CORPORATION**

(Registrant)

 

 
|   |   | Date: November 14, 2007 | By:    |                                       | /s/ STERLING H. MCDONALD |   |
|--------|--------|-------------------------|--------|--------------------------------------------|--------------------------|--------|
|   |   |                    |   | Sterling H. McDonald                       |                     |
|   |   |                    |   | Vice-President and Chief Financial Officer |                     |
|   |   |                    |   | Principal Financial and  Accounting        |                     |
|   |   |                    |   | Officer                                    |                     |

 

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