**UNITED STATESSECURITIES AND EXCHANGE**

**COMMISSION**

 

**Washington,D.C. 20549**

 

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**FORM10-QSB**

 

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

 

**For The Quarterly Period Ended September 30, 2004**

 

**o****TRANSITION REPORT PURSUANTTO SECTION 13 OR 15 (d) OF SECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period                 to                 **

 

**Commission File Number 000-27862**

 

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**NATURALGAS SYSTEMS, INC.** 

(Exactname of registrant as specified in charter)

 
| **Nevada**                                                                   |   | **41-1781991**                  |
|------------------------------------------------------------------------------|--------|---------------------------------|
| (State or other jurisdiction  of incorporation or  Organization)             |   | (I.R.S. employer identification |
|                                                                         |   |                            |
| **820 Gessner, Suite 1340, Houston, Texas 77024**                            |
| (Address  of principal executive offices and zip code)                       |
|                                                                         |   |                            |
| Registrant’s  telephone number, including area code: **(713) 935-0122** |

 

As of November 15, 2004, the number of shares of commonstock outstanding was 23,364,600 shares.

 

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports)and (2) has been subject to such filing requirements for the past 90days.  Yes: ý   No o

 

Transitional Small Business Format(Check One):  Yes o  No: ý

 

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****PART I —FINANCIAL INFORMATION****

 

****ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS****

 

**Natural Gas Systems, Inc.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                  | ** ** | **SEPTEMBER 30,  2004** | ** ** | **JUNE 30,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **(UNAUDITED)**         | ** ** | ** **         | ** ** |
| **ASSETS**                                                                                                                                                                                  |       |                    |       |               |       |
| Current Assets                                                                                                                                                                              |       |                    |       |               |       |
| Cash and short-term investments                                                                                                                                                             |       | $                       | 50,832     |               | $          | 367,831 |   |
| Receivables                                                                                                                                                                                 |       | 164,225                 |       | 24,387             |       |
| Inventories                                                                                                                                                                                 |       | 144,002                 |       | 115,859            |       |
| Prepaid expenses                                                                                                                                                                            |       | 70,096                  |       | 69,067             |       |
| Retainers and deposits                                                                                                                                                                      |       | 5,000                   |       | 5,000              |       |
| Total current assets                                                                                                                                                                        |       | 434,155                 |       | 582,144            |       |
|                                                                                                                                                                                        |       |                    |       |               |       |
| Oil and gas properties being amortized  (full cost method)                                                                                                                                  |       | 3,936,554               |       | 3,075,438          |       |
| Oil and gas properties not being amortized                                                                                                                                                  |       | 49,632                  |       | 105,225            |       |
| Less: accumulated depletion                                                                                                                                                                 |       | (102,615                | )          | (55,509            | )          |
| Net oil and gas properties                                                                                                                                                                  |       | 3,883,571               |       | 3,125,154          |       |
|                                                                                                                                                                                        |       |                    |       |               |       |
| Furniture, fixtures and equipment, at cost                                                                                                                                                  |       | 3,091                   |       | 3,091              |       |
| Less: accumulated depreciation                                                                                                                                                              |       | (1,546                  | )          | (1,159             | )          |
| Net furniture, fixtures and equipment                                                                                                                                                       |       | 1,545                   |       | 1,932              |       |
|                                                                                                                                                                                        |       |                    |       |               |       |
| Other assets (cash balances pledged for  bonding requirements)                                                                                                                              |       | 301,835                 |       | 301,835            |       |
|                                                                                                                                                                                        |       |                    |       |               |       |
| Total assets                                                                                                                                                                                |       | $                       | 4,621,106  |               | $          | 4,011,065 |   |
|                                                                                                                                                                                        |       |                    |       |               |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                               |       |                    |       |               |       |
| Current Liabilities:                                                                                                                                                                        |       |                    |       |               |       |
| Accounts payable                                                                                                                                                                            |       | $                       | 278,694    |               | $          | 139,188 |   |
| Accrued liabilities                                                                                                                                                                         |       | 117,912                 |       | 50,073             |       |
| Notes payable                                                                                                                                                                               |       | 907,115                 |       | 776,235            |       |
| Production taxes payable                                                                                                                                                                    |       | 2,926                   |       | —             |       |
| Total current liabilities                                                                                                                                                                   |       | 1,306,647               |       | 965,496            |       |
|                                                                                                                                                                                        |       |                    |       |               |       |
| Deferred plugging and abandonment  liabilities                                                                                                                                              |       | 314,712                 |       | 311,442            |       |
|                                                                                                                                                                                        |       |                    |       |               |       |
| Stockholders’ equity:                                                                                                                                                                  |       |                    |       |               |       |
| Common stock, par value $0.001 per share;  100,000,000 shares authorized, 23,314,600 and 22,945,400 shares issued and  outstanding as of September 30, 2004 and June 30, 2004, respectively |       | 23,314                  |       | 22,945             |       |
| Additional paid-in capital                                                                                                                                                                  |       | 4,975,500               |       | 4,453,905          |       |
| Deferred stock based compensation                                                                                                                                                           |       | (331,844                | )          | (378,136           | )          |
| Accumulated deficit                                                                                                                                                                         |       | (1,667,223              | )          | (1,364,587         | )          |
| Total stockholders’ equity                                                                                                                                                             |       | 2,999,747               |       | 2,734,127          |       |
|                                                                                                                                                                                        |       |                    |       |               |       |
| Total liabilities and stockholders’ equity                                                                                                                                             |       | $                       | 4,621,106  |               | $          | 4,011,065 |   |

 

2

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**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                   | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,  2004** | ** ** | **FOR THE  PERIOD FROM  SEPTEMBER 23,  2003  (INCEPTION) TO  SEPTEMBER 30,  2003** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **(unaudited)**                              | ** ** | **(unaudited)**                                                                    | ** ** |
| Revenues:                                                    |       |                                         |       |                                                                               |       |
| Oil sales                                                    |       | $                                            | 164,523    |                                                                               | $          | — |   |
| Gas sales                                                    |       | 66,644                                       |       | —                                                                             |       |
| Total revenues                                               |       | 231,167                                      |       | —                                                                             |       |
|                                                         |       |                                         |       |                                                                               |       |
| Expenses:                                                    |       |                                         |       |                                                                               |       |
| Operating costs                                              |       | 137,748                                      |       | 318                                                                                |       |
| Production taxes                                             |       | 16,024                                       |       | —                                                                             |       |
| Depletion                                                    |       | 47,106                                       |       | —                                                                             |       |
| General and administrative                                   |       | 311,135                                      |       | 8,785                                                                              |       |
| Total expenses                                               |       | 512,013                                      |       | 9,103                                                                              |       |
|                                                         |       |                                         |       |                                                                               |       |
| Loss from operations                                         |       | (280,846                                     | )          | (9,103                                                                             | )          |
|                                                         |       |                                         |       |                                                                               |       |
| Other revenues and expense:                                  |       |                                         |       |                                                                               |       |
| Interest income                                              |       | 3,476                                        |       | —                                                                             |       |
| Interest expense                                             |       | (25,266                                      | )          | (2,394                                                                             | )          |
| Total other revenues and expense                             |       | (21,790                                      | )          | (2,394                                                                             | )          |
|                                                         |       |                                         |       |                                                                               |       |
| Net loss                                                     |       | $                                            | (302,636   | )                                                                                  | $          | (11,497 | ) |
|                                                         |       |                                         |       |                                                                               |       |
| Income (loss) per common share: Basic and  diluted           |       | $                                            | (0.01      | )                                                                                  | $          | (0.00 | ) |
|                                                         |       |                                         |       |                                                                               |       |
| Weighted Average Number of Common Shares,  Basic and Diluted |       | 23,146,313                                   |       | 19,016,250                                                                         |       |

 

3

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***NATURAL GAS SYSTEMS, INC.***

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                              | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,  2004** | ** ** | **FOR THE  PERIOD FROM  SEPTEMBER 23,  2003  (INCEPTION) TO  SEPTEMBER 30,  2003** | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **(unaudited)**                              | ** ** | **(undaudited)**                                                                   | ** ** |
| Operating activities:                                                                   |       |                                         |       |                                                                               |       |
| Net loss                                                                                |       | $                                            | (302,636   | )                                                                                  | $          | (11,497 | ) |
| Adjustments to reconcile net loss to net  cash provided (used) by operating activities: |       |                                         |       |                                                                               |       |
| Depletion                                                                               |       | 47,106                                       |       | —                                                                             |       |
| Depreciation                                                                            |       | 386                                          |       | —                                                                             |       |
| Stock-based compensation expense                                                        |       | 46,292                                       |       |                                                                               |       |
| Changes in assets and liabilities:                                                      |       |                                         |       |                                                                               |       |
| Accretion of deferred plugging and  abandonment Liability                               |       | 3,270                                        |       | 254                                                                                |       |
| Accounts receivables                                                                    |       | (139,838                                     | )          | (145                                                                               | )          |
| Inventories                                                                             |       | (28,143                                      | )          | (38,333                                                                            | )          |
| Accounts payable                                                                        |       | 139,506                                      |       | 5,000                                                                              |       |
| Other current liabilities                                                               |       | 70,765                                       |       | 259                                                                                |       |
| Prepaid expenses                                                                        |       | (1,029                                       | )          | —                                                                             |       |
| Net cash provided by operating activities                                               |       | (164,321                                     | )          | (44,462                                                                            | )          |
|                                                                                    |       |                                         |       |                                                                               |       |
| Investing activities:                                                                   |       |                                         |       |                                                                               |       |
| Capital expenditures for oil and gas  properties                                        |       | (805,523                                     | )          | (954,173                                                                           | )          |
| Net cash used in investing activities                                                   |       | (805,523                                     | )          | (954,173                                                                           | )          |
|                                                                                    |       |                                         |       |                                                                               |       |
| Financing activities:                                                                   |       |                                         |       |                                                                               |       |
| Payments on notes payable                                                               |       | (350,716                                     | )          | —                                                                             |       |
| Proceeds from notes payable                                                             |       | 481,597                                      |       |                                                                               |       |
| Proceeds from issuance of common stock                                                  |       | 521,964                                      |       | 1,521,115                                                                          |       |
| Net cash provided by financing activities                                               |       | 652,845                                      |       | 1,521,115                                                                          |       |
|                                                                                    |       |                                         |       |                                                                               |       |
| Net increase (decrease) in cash                                                         |       | (316,999                                     | )          | 522,480                                                                            |       |
|                                                                                    |       |                                         |       |                                                                               |       |
| Cash and cash equivalents, beginning of  period                                         |       | 367,831                                      |       | —                                                                             |       |
| Cash and cash equivalents, end of period                                                |       | $                                            | 50,832     |                                                                               | $          | 522,480 |   |
|                                                                                    |       |                                         |       |                                                                               |       |
| Supplemental Cash Flow Information:                                                     |       |                                         |       |                                                                               |       |
| Interest paid                                                                           |       | 12,082                                       |       | —                                                                             |       |
| Income taxes paid                                                                       |       | —                                       |       | —                                                                             |       |
|                                                                                    |       |                                         |       |                                                                               |       |
| Non-cash transactions:                                                                  |       |                                         |       |                                                                               |       |
| Seller note issued to acquire properties,  net of discount                              |       | —                                       |       | 1,407,049                                                                          |       |
| Assumption of plugging and abandonment  liability                                       |       | $                                            | —     |                                                                               | 301,835    |   |

 

4

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***NATURAL GAS SYSTEMS, INC.***

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS****September 30, 2004

(Unaudited)

 

****NATURALGAS SYSTEMS, INC. AND SUBSIDIARIES****

 

 

**1.****                                      NATUREOF BUSINESS, ORGANIZATION AND BASIS OF PREPARATION AND PRESENTATION**

 

Headquartered in Houston, Texas, Natural Gas Systems, Inc.(the “Company”, “NGS”, “we” or “us”) is incorporated under the laws of thestate of Nevada.  NGS is a petroleumcompany engaged primarily in the acquisition, exploitation and development ofproperties for the production of crude oil and natural gas from undergroundreservoirs.  The Company acquiresestablished oil and gas properties and exploits them through the application ofconventional and specialized technology to increase production, ultimaterecoveries, or both.  At September 30,2004, NGS conducted operations through its 100% working interests in the Delhiand Tullos Urania fields located in Louisiana.

 

The condensed consolidated financial statements for the threemonth period ended September 30, 2004 have been prepared by the Company,without audit, pursuant to the rules and regulations of the Securities andExchange Commission.  Certain informationand footnotes normally prepared in accordance with accounting principlesgenerally accepted in the United States of America have been omitted orcondensed.  However, in management’sopinion, all adjustments, consisting of normal recurring accruals, necessary topresent fairly the financial position and results of operations of the Companyhave been made.

 

The condensed consolidated financial statements providedherein should be read in conjunction with the financial statements and theiraccompanying notes included in the Company’s Form 10-KSB filed for the periodended June 30, 2004.

 

**2.****                                      ACQUISITIONS**

 

On September 2, 2004, we purchased a 100% working interest inapproximately 81 producing oil wells, 8 salt water disposal wells and 54shut-in wells located in La Salle and Winn Parishes, Louisiana.  The purchase included leases covering 386.04gross and net acres, and fee ownership of 2.33 acres around certain of thewells.  Fourteen of the 54 shut-in wellswill require a new lease prior to restoration of production.   The purchase price was $725,000 lessapproximately $20,000 in closing adjustments to reflect an effective date ofJuly 1, 2004, paid in cash, part of which was provided by the Bridge Loandescribed under Note 5.  The acquisitionwas accounted for under the purchase method of accounting.  No goodwill arose from the purchase.  Revenue and expense from the property wasrecognized beginning September 1, 2004.

 

We believe that the acquisition is consistent with ourstrategic business plan to acquire established oil and gas properties in orderto exploit them through the application of conventional and specializedtechnology to increase production, ultimate recoveries, or both.  At the purchase date, the field’s productionaveraged approximately 62 barrels of oil per day.  Since the closing, NGS has initiated aprogram of restoring shut-in wells to production, increasing overall productionper well by addition of incremental water disposal capacity and utilizing gasproduction to replace purchased power for pumps.

 

As is common with the purchase of producing oil and gasproperties, we assumed an asset retirement obligation.  In accordance with FAS 143, management ismaking an assessment as to the amount of liability to be recorded in theCompany’s financial statements as a resul;t of our assumption of thisobligation.  Due to the current highprice for steel tubular goods and wellhead equipment installed on the wells, webelieve the retirement obligation, net of salvage, will not be significant andwill not materially impact our balance sheet or income statement, prospectivelyor in the future.

 

5

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**3.****                         ****EARNINGS PER SHARE**

 

****Thefollowing table sets forth the computation of basic and diluted earnings (loss)per share:****

 

**** ****
| ** **                                                                                    | ** **     | **THREE MONTHS  ENDED  SEPTEMBER 30, 2004** | ** **     | **FOR THE PERIOD FROM  SEPTEMBER 23, 2003  (INCEPTION) TO  SEPTEMBER 30, 2003** | ** **     |
|-----------------------------------------------------------------------------------------------|----------------|---------------------------------------------|----------------|---------------------------------------------------------------------------------|----------------|
| ****Numerator:****                                                                            |           |                                        |           |                                                                            |           |
| ****Net loss applicable to common stockholders****                                            |           | $                                           | (302,636       | )                                                                               | $              | (11,497 | ) |
| ****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 plus  assumed****** ******Conversions**** |           | (302,636                                    | )              | (11,497                                                                         | )              |
|                                                                                          |           |                                        |           |                                                                            |           |
| ****Denominator:****                                                                          |           | 23,146,313                                  |           | 19,016,250                                                                      |           |
|                                                                                          |           |                                        |           |                                                                            |           |
| ****Affect 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****                |           | **** ****                              |           |                                                                            |           |
| ****Outstanding and assumed conversions****                                                   | **** **** | 23,146,313                                  |           | 19,016,250                                                                      | **** **** |
| **** ****                                                                                | **** **** |                                        |           |                                                                            | **** **** |
| Loss per common share:                                                                        | **** **** | **** ****                              | **** **** | **** ****                                                                  | **** **** |
| Basic and diluted                                                                             | **** **** | ****$****                                   | ****(0.01****  | ****)****                                                                       | ****$****      | ****(0.00**** | ****)**** |

 

 

**4.****                                     ****Liquidity**

 

As of September 30, 2004, we had $50,832 of unrestricted cashand negative working capital of $872,492. We incurred losses for the three months ended September 30, 2004 of$302,636.  Our negative working capitalof $872,492 was adversely impacted by an aggregate $907,115 of short-termmortgage notes we owe on the Delhi Field, the Bridge Loan incurred to fund ourrecent acquisition and the AICCO insurance policy loan, all described in Note5, Notes Payable.  Although our cash flowfrom operations currently approximates our recurring overhead, our cash flowhas been, and continues to be, insufficient to cover our obligations withrespect to our notes payable and capital expenditures necessary to fund ourexisting development plan.  On October29, 2004 our Chairman loaned us an additional $150,000 (added to the previousloan of $475,000) for working capital purposes.

 

6

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Ournegative working capital and cash position, as well as our ongoing operatinglosses, raise significant concerns about our ability to meet future obligationsand fund future operations. In addition, we are currently unable to meet all ofour current obligations as they become due. Although we recently begansatisfying a portion of our obligations through cash flow from operations, wewill need to secure third party financing in the very near term (in the form ofeither debt or equity), in order to meet the remainder of our current andfuture obligations and avoid the possibility of creditors seeking to forecloseon our assets. Management plans to continue to expend considerable time andeffort in attempting to address this issue, as described below.

 

**1.****     Additional Sales of CommonStock:**  From June 30 throughSeptember 30, 2004 we raised $554,723 of gross cash proceeds from the privatesale of 369,200 shares of our common stock, before commissions.  We plan to continue to raise funds throughadditional sales of equity securities in private transactions.  Because there can be no assurance that wewill be able to do so, we plan to continue pursuing borrowing arrangements asdiscussed below.

 

**2.****             ****Borrowing:**  On August 11, 2004, we borrowed $475,000 under a short-termsecured promissory note (the “Bridge Loan”) in favor of Laird Q. Cagan, theCompany’s Chairman and major stockholder, secured by a pledge of all of ourassets.  The loan was earmarked aspartial bridge financing for our purchase of the Tullos Urania Field propertiesfor $725,000 on September 2, 2004, and an additional $150,000 principal amountwas extended to us on October 29, 2004 for working capital purposes.  Terms of the note are described in Note5.  Mr. Cagan is a foundingManaging Partner of Cagan McAfee Capital Partners, the financial advisor to theCompany that is arranging our private equity fundings.

 

Since the beginning of 2004, we have been  attempting to develop relationships withcommercial banks and capital sources that specialize in making loans to, orinvesting in, oil and gas producers.  Webelieve that our Delhi and Tullos properties could provide sufficientcollateral to such investors to enable them to provide us with financingsufficient to repay the remaining Delhi Notes in full, as well as providing uswith additional development capital aimed at increasing our production from ourexisting wells according to our original plan. We currently do not have any arrangements in place with respect to theforegoing, however, and we can not assure you that we will be able to enterinto any such  arrangements on terms thatare acceptable to us, or at all.

 

**3.****             ****Increased Production:**  We continue to work on increasing cash flowfrom operations through our Delhi Field and additional acquisition candidates,thereby spreading our overhead, including significant expenses of being apublic company, over a larger revenue base. During this fiscal quarter:

 

•                  We began production of naturalgas sales in our Delhi Field during July, 2004. Our natural gas revenue has increased each month since startup toapproximately $33,000 for September.  Inmid-September 2004, we began production from our re-completion of the 184-2well that, on a full month basis, would contribute in excess of $60,000 ofrevenue from natural gas sales.

 

•                  On September 2, 2004, we closedthe purchase of producing properties in the Tullos Urania Field, located closeto our Delhi Field operations in Northern Louisiana.  We generated $70,329 of revenue from Tullosin September 2004, producing cash flow from such operations in excess of$30,000 for that month.

 

•                  We are pursuing additionalacquisition candidates meeting our targeted requirements.

 

**5.****                                      NOTESPAYABLE**

 

The followingtable sets forth the Company’s notes payable balances:

 
| **Borrowing**                | ** ** | **September 30, 2004** | ** **  | **June 30, 2004** | ** ** |
|------------------------------|------------|------------------------|-------------|-------------------|------------|
| Delhi Mortgage Notes         |       | $                      | 400,485     |              | $          | 732,807 |   |
| AICCO Insurance Premium Loan |       | 25,033                 |        | 43,428            |       |
| Bridge Loan                  |       | 481,597                |        | —            |       |
|                         |       |                   |        |              |       |
| TOTAL OUTSTANDING            | ** ** | **$**                  | **907,115** | ** **        | **$**      | **776,235** | ** ** |

 

7

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**Delhi Mortgage Notes: **In September 2003, the Companyissued $1,500,000 of notes payable in connection with its acquisition of theDelhi Field.  The notes werecollateralized by a first mortgage on the Company’s Delhi field and are payableto the sellers in twelve equal monthly installments beginning on January 30,2004.  Although the notes bear nointerest, the Company has imputed interest at 8% per annum, thus resulting inan initial recorded principal amount of $1,407,049.

 

**AICCO Loan:**  In May 2004, the Company borrowed $49,490 tofinance 70% of its Director and Officer’s liability insurance premiums.  The note requires eight levelmortgage-amortizing payments in the amount of $6,350 per month, including 7%interest per annum.

 

**Bridge Loan:**OnAugust 11, 2004, we borrowed $475,000under a short-term secured promissory note (the “Bridge Loan”) held by Laird Q.Cagan, the Company’s Chairman and major stockholder, secured by a pledge of allof our assets.  The loan was earmarked aspartial bridge financing for our purchase of the Tullos Urania Field propertiesfor $725,000, prior to post closing adjustments, on September 2, 2004.  On September 21, 2004, the loan wasamended to delay the repayment until the earlier of (a) July 1, 2005, or (b)the date on which the cumulative gross equity funding after August 14, 2004reaches $1 million.  In addition, we mustmake mandatory prepayments of certain revenues and funds from equity raisedafter raising gross equity funding of at least $500,000.  The amended terms of the mandatory prepaymentare fully described in the original documents formerly filed and attached asExhibit 10.1 to this 10-QSB.

 

An additional$150,000 was added to the principal of the Bridge Loan on October 29, 2004, andallocated toward working capital.

 

**6.****                                      COMMONSTOCK AND STOCK OPTIONS**

 

*Common Stock*

 

From July 1, 2004 through September 30, 2004, we raised grossproceeds of $554,723 from the issuance of 369,200 shares of our commonstock.  In connection with theseissuances, we paid placement fees to CMCP, Chadbourn Securities and Laird Q.Cagan in the aggregate amount of $27,500 and issued them warrants to purchaseup to 17,700 shares of our common stock at an exercise price of $1.50 pershare.  We also paid $5,259 to anunrelated third party as a finder’s fee.

 

*Options*

 

Nooptions were issued during the three months ended September 30, 2004.  TheCompany has agreed, however, to issue options to acquire up to 100,000 sharesof our common stock to each of our two independent Board members. The terms ofthese options have not yet been determined.

 

A reconciliation of reported loss as if the Company used thefair value method of accounting for stock-based compensation has not beenprovided as the fair value of options computed under FASB 123 was essentiallythe same as the amount determined in accordance with APB 25.

 

**7.****                                      RELATEDPARTY TRANSACTIONS**

 

Laird Q. Cagan, Chairman of the Board of the Company, is aManaging Director of Cagan McAfee Capital Partners, LLC (“CMCP”).  CMCP performs financial advisory services tothe Company pursuant to a written agreement and is paid a monthly retainerof  $15,000.  In addition, Mr. Cagan is a registeredrepresentative of Chadbourn Securities, Inc. (“Chadbourn”), the Company’splacement agent in private equity financings. Pursuant to the Agreement between the Company, Mr. Cagan, and Chadbourn,the Company pays a cash fee equal to 8%

 

8

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of gross equity proceeds and warrants equal to 8% of theshares purchased, net of any similar payments made to third parties.

 

During the three months ended September 30, 2004 the Companyexpensed $45,000 in monthly retainers to CMCP. At September 30, 2004, the amounts due CMCP totaled $105,000 under theagreement.  Also during the three monthperiod, the Company has charged $27,500 to stockholder’s equity as a reductionof the proceeds from common stock sales placed by Chadbourn Securities andLaird Q. Cagan and issued warrants to purchase up to a total of 17,700 sharesof Common Stock to CMCP, Chadbourn Securities and Laird Q. Cagan in connectionwith the placement of our common shares. These warrants have a $1.50 exerciseprice and a seven-year term.

 

John Pimentel, a member of our Board of Directors, is aprincipal at CMCP.

 

Eric McAfee, also a Managing Director of CMCP and asignificant shareholder of the Company, has served as Vice Chairman of the********Boardof Verdisys, Inc., the provider of certain horizontal drilling services to theCompany.  During 2004, Mr. McAfeeresigned from the Board of Directors of Verdisys, but continues to hold sharesin both companies. Mr. McAfee has represented to the Company that he is also a50% owner of Berg McAfee Companies, LLC, which owns approximately 30% of theoutstanding shares of Verdisys, Inc.  NGSpaid $130,000 to Verdisys during 2003 and $25,960 during 2004 for horizontaldrilling services.

 

On August 10, 2004, Laird Cagan, Chairman of the Board of theCompany, loaned us $475,000 as partial bridge financing for the acquisition ofthe Tullos Urania Field.  An additional$150,000 was advanced to us under the loan on October 29, 2004.  See Note 5, Notes Payable, for a furtherexplanation.

 

****ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS****

 

****Liquidity and Capital Resources****

 

As of September 30, 2004, we had $50,832 of unrestricted cashand negative working capital of $872,492. We incurred losses for the three months ended September 30, 2004 of$302,636.  Our negative working capitalof $872,492 was adversely impacted by an aggregate $907,115 of short-termmortgage notes we owe on the Delhi Field, the Bridge Loan incurred to fund ourrecent acquisition and the AICCO insurance policy loan, all described in Note5, Notes Payable.  Although our cash flowfrom operations currently approximates our recurring overhead, our cash flowhas been, and continues to be, insufficient to cover our obligations withrespect to our notes payable and capital expenditures necessary to fund ourexisting development plan.  On October29, 2004 our Chairman loaned us an additional $150,000 (added to the previousloan of $475,000) for working capital purposes.

 

Ournegative working capital and cash position, as well as our ongoing operatinglosses, raise significant concerns about our ability to meet future obligationsand fund future operations. In addition, we are currently unable to meet all ofour current obligations as they become due. Although we recently begansatisfying a portion of our obligations through cash flow from operations, wewill need to secure third party financing in the very near term (in the form ofeither debt or equity), in order to meet the remainder of our current andfuture obligations and avoid the possibility of creditors seeking to forecloseon our assets. Management plans to continue to expend considerable time andeffort in attempting to address this issue, as described below.

 

**1.****     Additional Sales of CommonStock:**  From June 30 throughSeptember 30, 2004 we raised $554,723 of gross cash proceeds from the privatesale of 369,200 shares of our common stock, before commissions.  We plan to continue to raise funds throughadditional sales of equity securities in private transactions.  Because there can be

 

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no assurance that we will be able to do so, we plan tocontinue pursuing borrowing arrangements as discussed below.

 

**2.****             ****Borrowing:**  On August 11, 2004, we borrowed $475,000 under a short-termsecured promissory note (the “Bridge Loan”) in favor of Laird Q. Cagan, theCompany’s Chairman and major stockholder, secured by a pledge of all of ourassets.  The loan was earmarked aspartial bridge financing for our purchase of the Tullos Urania Field propertiesfor $725,000 on September 2, 2004, and an additional $150,000 principal amountwas extended to us on October 29, 2004 for working capital purposes.  Terms of the note are described in Note5.  Mr. Cagan is a founding ManagingPartner of Cagan McAfee Capital Partners, the financial advisor to the Companythat is arranging our private equity fundings.

 

Since the beginning of 2004, we have been  attempting to develop relationships withcommercial banks and capital sources that specialize in making loans to, orinvesting in, oil and gas producers.  Webelieve that our Delhi and Tullos properties could provide sufficientcollateral to such investors to enable them to provide us with financingsufficient to repay the remaining Delhi Notes in full, as well as providing uswith additional development capital aimed at increasing our production from ourexisting wells according to our original plan. We currently do not have any arrangements in place with respect to theforegoing, however, and we can not assure you that we will be able to enterinto any such  arrangements on terms thatare acceptable to us, or at all.

 

**3.*****             *****Increased Production:**  We continue to work on increasing cash flowfrom operations through our Delhi Field and additional acquisition candidates,thereby spreading our overhead, including significant expenses of being apublic company, over a larger revenue base. During this fiscal quarter:

 

•                  We began production of naturalgas sales in our Delhi Field during July, 2004. Our natural gas revenue has increased each month since startup toapproximately $33,000 for September.  Inmid-September 2004, we began production from our re-completion of the 184-2well that, on a full month basis, would contribute in excess of $60,000 ofrevenue from natural gas sales.  Foradditional information, see Results of Operations in the next section.

 

•                  On September 2, 2004, we closedthe purchase of producing properties in the Tullos Urania Field, located closeto our Delhi Field operations in Northern Louisiana.  We generated $70,329 of revenue from Tullosin September 2004, producing cash flow from such operations in excess of$30,000 for that month.

 

•                  We are pursuing additionalacquisition candidates meeting our targeted requirements.

 

****Results of Operations****

 

We did not commence our oil and gas operations until October2003.  Accordingly, quarter-by-quarter comparisons of our results ofoperations would not be meaningful and are therefore not presented. Instead, we provide a brief overview of our operations to date and indicate theprogress we have made with respect to our operations as compared to the lastcalendar calendar quarter of 2003.

 

****During the three months ended September30, 2004, we generated revenues of $231,167, as compared to $24,249 for ourfirst full quarter ended December 31, 2003. Of significance in this fiscal period, we began our first natural gassales from our Delhi Field and we acquired an interest in the Tullos Urania Field,located in close proximity to our Delhi Field.****

 

****Following is a summary of the progress we’vemade in both production and revenue:****

**** ****
| ****Net To NGS:****               | **** **** | ****Three Months Ended********12-31-03**** | **** **** | ****Three Months Ended********9-30-04**** | ***** ***** |
|-----------------------------------|----------------|--------------------------------------------|----------------|-------------------------------------------|------------------|
| **** ****                    | **** **** | **** ****                             | **** **** | **** ****                            | **** ****   |
| ****Oil & Gas Revenue****     | **** **** | ****$****                                  | ****24,249**** | **** ****                            | ****$****        | ****231,167**** | **** **** |
| **** ****                    | **** **** | **** ****                             | **** **** | **** ****                            | **** ****   |
| ****Oil Volumes Sold****          | **** **** | ****857****                                | ****BO****     | ****3,955****                             | ****BO****       |
| ****Gas Volumes Sold****          | **** **** | ****0****                                  | ****MCF****    | ****11,252****                            | ****MCF****      |
| ****Barrels of Oil Equivalent**** | **** **** | ****857****                                | ****BOE****    | ****5,830****                             | ****BOE****      |
| **** ****                    | **** **** | **** ****                             | **** **** | **** ****                            | **** ****   |
| ****Oil Price per Barrel****      | **** **** | ****$****                                  | ****28.29****  | **** ****                            | ****$****        | ****42.66**** | **** **** |
| ****Gas Price per MCF****         | **** **** | ****0****                                  | **** **** | ****$****                                 | ****5.55****     | **** **** |
| **** ****                    | **** **** | **** ****                             | **** **** | **** ****                            | **** ****   |
| ****Operating Cost per BOE****    | **** **** | ****$****                                  | ****92.54****  | **** ****                            | ****$****        | ****26.38**** | **** **** |
| ****DD&A per BOE****          | **** **** | ****$****                                  | ****16.29****  | **** ****                            | ****$****        | ****6.88**** | **** **** |

**** ****

****10****

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**** ****

****Average daily production has increased to63 BOEPD for the three months period ended September 30, 2004 from 9 BOEPDduring the three months period ended December 31, 2003. Three factors were primaryin causing our production to increase.****

 

****•********                 ********The startup of first gas sales fromour Delhi Field, resulting from a six-month capital program to convert anexisting 11-mile field injection line to a gas gathering and sales line.  The conversion also required the design andinstallation of a liquids processing plant in order to condition the high BTUcontent gas for delivery to the sales pipeline.****

 

****•********                 ********The restoration to production ofseveral wells, particularly the 197-2 and 204-2, and the re-completion of wellsto new producing reservoirs, particularly the 184-2 in September 2004.****

 

****•********                 ********The purchase of our interest in theTullos Urania Field added over 62 BOD to September’s production. ****

 

****On a BOE basis, operating expensesdeclined to $24.05 BOE ($153,772) for the three months ended September 30, 2004from $92.54 per BOE ($79,305), for the three months ended December 31,2003.  Operating expenses for bothperiods are still high, but we believe our plan to increase production on themargin is proving successful.****

 

****General and Administrative expensesincreased for the three months ended September 30, 2004 to $311,135, from$239,093 for the three months ended December 31, 2003.  At least $64,000 of the increase was due tocosts related to being a public company, including approximately $37,000 inaudit fees, $12,500 in independent board member fees and over $14,000 in otherrelated expenses.****

 

****ITEM 3.  CONTROLS AND PROCEDURES****

 

Our management evaluated, withthe participation of our Chief Executive Officer and Chief Financial Officer,the effectiveness of our disclosure controls and procedures, as of the end ofthe period covered by this report.  Basedon this evaluation, the Chief Executive Officer and Chief Financial Officerconcluded that the Company’s disclosure controls and procedures are effectiveto ensure that information required to be disclosed by the Company in thereports that it files or submits under the Securities Exchange Act of 1934 isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms.

 

During the fiscal quarter, webegan performing under an agreement entered into with Petroleum Financial, Inc.(“PFI”), whereby we outsource certain financial processing and reporting functionsthrough PFI’s staff, software and hardware systems.  PFI is a subsidiary of P2 Energy Solutions,Inc., the owner of the Excalibur software for oil and gas that PFI uses toprocess and control its client’s financial records.  P2 Energy Solutions is a subsidiary ofPetroleum Place. Although we are not currently subject to Section 404 ofSarbanes-Oxley, we believe this arrangement could improve our internal controlover financial reporting, and provide a foundation for eventual 404compliance.   PFI has informed us thatthey regularly undergo a SAS 70 audit performed by a Big 4 accountingfirm.  The auditor’s report assessed PFI’sinternal controls over transaction processing and financial reporting relativeto Internal Controls, Computer Controls and Application Transaction Processing.

 

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The conclusion of the reportdated October 31, 2003, was that there were no relevant exceptions, but for afew isolated errors, found by the auditors in their assessment and testing ofthe above referenced areas of control. Due to PFI’s reputation and the results of their SAS 70 reports, webelieve that our financial and reporting process control is strengthened withrespect to that portion of workflow provided to us by PFI.

 

**PART II – OTHER INFORMATION**

 

**ITEM 1.****    ****LEGAL PROCEEDINGS**

 

None.

 

**ITEM 2.****      CHANGES IN SECURITIESAND  SMALL BUSINESS ISSUER PURCHASES OFEQUITY SECURITIES**

 

(c) As reported on our Current Report on Form8-K, filed October 26, 2004.

 

****ITEM 3.********    ********DEFAULTS UPONSENIOR SECURITIES****

 

****None.****

 

****ITEM 4.********    ********SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS****

 

****None.****

 

****ITEM 5.********    ********OTHER INFORMATION****

 

****None********.****

 

****ITEM 6. EXHIBITS AND REPORTSON FORM 8K****

 

****(a) Exhibits****

 
| 10.1   | Amendment to Secured  Promissory Note – Laird Q. Cagan, dated September 20, 2004.                                                                |   | Included |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|
|   |                                                                                                                                                  |   |     |
| 31.1   | Certification of Chief  Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002                                                       |   | Included |
|   |                                                                                                                                                  |   |     |
| 31.2   | Certification of Chief  Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002                                                       |   | Included |
|   |                                                                                                                                                  |   |     |
| 32.1   | Certification of  Chief Executive Officer pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |   | Included |
|   |                                                                                                                                                  |   |     |
| 32.2   | Certification of  Chief Financial Officer pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |   | Included |

 

****(b) Reports on Form 8K****

 

****Amendedcurrent report on Form 8-K/A filed on August 9, 2004****

 

****Currentreport on Form 8-K filed on September 9, 2004****

 

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**SIGNATURES**

 

In accordance with therequirements of the Securities Exchange Act of 1934, the registrant caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
|                          | **NATURAL GAS SYSTEMS, INC.** |
|-------------------------------|-------------------------------|
|                          | *By:*                         | */s/ Sterling  H. McDonald* | * * |
|                          | * *                      | *Sterling  H. McDonald* |
|                          | * *                      | * * |
|                          | * *                      | *Chief  Financial Officer* |
|                          | * *                      | *(Principal  Financial and* |
|                          | * *                      | *Accounting  Officer)* |
|                          | * *                      | * * |
| Date:  November 16, 2004 |                          |

 

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**Exhibit Index**

 
| 10.1   |   | Amendment to  Secured Promissory Note — Laird Q. Cagan, dated September 20, 2004.                                                               |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                 |
| 31.1   |   | Certification  of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of  2002                                                     |
|   |   |                                                                                                                                                 |
| 31.2   |   | Certification  of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of  2002                                                     |
|   |   |                                                                                                                                                 |
| 32.1   |   | Certification  of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|   |   |                                                                                                                                                 |
| 32.2   |   | Certification  of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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