**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

Washington, D.C. 20549

 

**FORM 10-Q**

 

  o QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended **June 30, 2011**

 

o TRANSITION REPORT UNDER SECTION 13 OR 15 (d) OF THE EXCHANGE ACT

 

For the transition period from _________ to _________

 

Commission File Number: **000-28305**

 

**ENERGY QUEST INC.**

(Name of Small Business Issuer in its charter)

 

| **Nevada**

**91-1880015**

(state or other jurisdiction of incorporation or organization)

(I.R.S. Employer I.D. No.)

 

 

**850 South Boulder Hwy, Suite 169**

**Henderson, Nevada**

**89015-7564**

(Address of principal executive offices)

(Zip Code)

**(702) 568-4131**

(Registrant’s telephone 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 Exchange Act during the past 12 months (or for such shorter period that the registrant was require to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  **Yes  ****þ**   No o 

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

Large accelerated filer o      Accelerated filer o     Non-accelerated filer o     **Smaller reporting company****þ**

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes **  ** o     **No****  ****þ**

 

**APPLICABLE ONLY TO CORPORATE ISSUERS**

 

As of **August 10, 2011** the registrant had **17,933,600 **shares of common stock outstanding.
                 
              
**Table of Contents**

PART I - FINANCIAL INFORMATION

ITEM 2.  MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.  

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS.

ITEM 4.  CONTROL AND PROCEDURES

ITEM 4T.  CONTROL AND PROCEDURES.

PART II – OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS.

ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

ITEM 5.  OTHER INFORMATION.

ITEM 6.  EXHIBITS.

2                 
              
**PART I - FINANCIAL INFORMATION**

 

 

**Energy Quest Inc.**

** **

**(A Development Stage Company)**

 

 

 

 

 

June 30, 2011

 

 

 

 

Index

 

 

Consolidated Balance Sheets (Unaudited)

F-1

 

 

Consolidated Statements of Operations and Other Comprehensive Loss (Unaudited)

F-2

 

 

Consolidated Statements of Cash Flows (Unaudited)

F-3

 

 

Notes to the Unaudited Consolidated Financial Statements

F-4

3                 
              
**Energy Quest Inc.**

**(A Development Stage Company)**

**Consolidated Balance Sheets**

**(Unaudited)**

 

June 30,

2011

December 31,

2010

**Assets**

 

 

 

 

 

**Current Assets**

 

 

 

 

 

Cash

$            163

$           8,246

Deferred financing cost

2,790

2,593

Note receivable – related party

–

8,656

 

 

 

**Total Assets**

2,953

19,495

 

 

 

 

 

 

**Liabilities and Stockholders' Deficit**

 

 

 

 

 

**Current Liabilities**

 

 

 

 

 

Accounts payable and accrued liabilities

53,047

35,871

Amounts due to related parties

855,866

713,055

Notes payable – related parties

86,555

86,002

Convertible notes, net of discount of $38,652, and discount from December 31, 2010 of  $43,223

36,348

10,777

Derivative liabilities

144,445

97,375

 

 

 

**Total Liabilities**

1,176,261

943,080

 

 

 

Stockholders' Deficit

 

 

 

 

 

Preferred Stock

 

 

Authorized: 1,000,000 shares, with a $0.01 par value;

none issued or outstanding

–

–

 

 

 

Common Stock

 

 

Authorized:  200,000,000 shares, with a $0.001 par value;

Issued:  17,983,600 shares and 17,135,604 shares issued and outstanding as of June 30, 2011 and December 31, 2010, respectively

17,984

17,136

 

 

 

Additional paid-in capital

9,011,750

8,956,903

 

 

 

Deficit accumulated during the development stage

(10,203,042)

(9,897,624)

 

** **

** **

**Total Stockholders’ Deficit**

(1,173,308)

(923,585)

 

 

 

**Total Liabilities and Stockholders’ Deficit**

$            2,953

$          19,495

 

 

 

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

F-1                 
              
**Energy Quest Inc.**

**(A Development Stage Company)**

**Consolidated Statements of Operations and Other Comprehensive Loss**

**(Unaudited)**

 

For the

Three Months

Ended

June 30,

2011

For the

Three Months

Ended

June 30,

2010

For the

Six Months

Ended

June 30,

2011

For the

Six Months

Ended

June 30,

2010

Period from

December 14, 2004

(Inception) to

June 30,

2011

**Revenue**

$              –

$              –

$              –

$             –

$             5,164

 

 

 

 

 

 

**Expenses**

 

 

 

 

 

 

 

 

 

 

 

Consulting and management fees

75,000

75,000

150,000

150,000

5,591,394

General and administrative

10,313

20,513

25,543

26,776

549,043

Professional fees

20,760

24,790

25,760

35,175

514,031

Research and development

–

–

–

1,500

266,494

Depreciation and depletion

–

–

–

75,000

398,077

Impairment of intangible assets

–

37,500

–

–

2,632,666

Loss on theft of cash

–

–

–

–

80,000

 

 

 

 

 

 

 

106,073

157,803

201,303

288,451

10,031,705

 

 

 

 

 

 

**Loss from operations:**

(106,073)

(157,803)

(201,303)

(288,451)

(10,026,541)

 

 

 

 

 

 

Interest expense

(26,913)

(19,633)

(45,573)

(32,428)

(122,040)

Gain on settlement of former shareholder advances

–

–

–

–

310,003

Gain (Loss) on derivative financial instruments

(61,289)

84,478

(51,764)

(5,935)

(163,764)

Loss on write-off of loan receivable

–

–

(6,778)

–

(200,700)

 

 

 

 

 

 

**Net loss**

(194,275)

(92,958)

(305,418)

(326,814)

(10,203,042)

 

 

 

 

 

 

Other comprehensive income

 

 

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustment

–

(839)

–

35

–

 

 

 

 

 

 

Total Comprehensive Loss

$  (194,275)

$  (93,797)

$  (305,418)

$  (326,779)

$  (10,203,042)

 

 

 

 

 

 

Net Loss Per Share – Basic and Diluted

$        (0.01)

$        (0.01)

$        (0.02)

$        (0.02)

 

 

 

 

 

 

 

Weighted Average Shares Outstanding –

Basic and Diluted

17,577,000

14,368,000

17,454,000

14,095,000

 

 

 

 

 

 

 

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

F-2                 
              
**Energy Quest Inc.**

**(A Development Stage Company)**

**Consolidated Statements of Cash Flows**

**(Unaudited)**

 

For the Six Months Ended

June 30, 2011

For the Six Months Ended

June 30, 2010

Accumulated from

December 14, 2004 (Inception) to

June 30, 2011

 

 

 

 

**Cash Flows Used In Operating Activities**

 

 

 

Net loss

$      (305,418)

$    (326,814)

$  (10,203,042)

 

 

 

 

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

Accretion of convertible debt discount

39,572

 27,778

 96,349

Shares issued for services

–

 –

 4,607,306

Loss on shares issued for amounts due related parties

–

 –

 15,976

Loss on theft of cash

–

 –

 80,000

Loss on write-off of loan receivable

6,778

 –

 200,700

Loss on derivative instruments

51,764

 5,935

 163,764

Impairment of intangible assets

–

 –

 2,632,666

Amortization of intangible assets

–

 75,000

 398,077

Gain on settlement of former shareholder advances

–

 –

 (310,003)

Amortization of deferred financing cost

2,303

 1,300

 5,210

 

 

 

 

Changes in operating assets and liabilities:

 

 

 

Accounts payable and accrued liabilities

19,054

 353

 42,460

Due to related parties

142,811

 83,522

 1,170,286

 

 

 

 

**Net Cash Used in Operating Activities**

(43,136)

(132,926)

(1,100,251)

 

 

 

 

**Investing Activities**

 

 

 

Loan receivable

2,000

–

(201,922)

Net cash acquired on business acquisition

–

–

565

Change in restricted cash

–

–

(80,000)

Purchase of intangible assets

–

–

(25,000)

 

 

 

 

Net Cash Provided by (Used In) Investing Activities

2,000

–

(306,357)

 

 

 

 

**Financing Activities**

 

 

 

Proceeds from issuance of common stock

–

100,000

744,307

Payment of deferred financing cost

(2,500)

(2,500)

(8,000)

Proceeds from convertible note

35,000

50,000

135,000

Proceeds from notes payable

–

50,000

568,214

Re-payment of note payable

–

–

(28,005)

 

 

 

 

Net Cash Provided By Financing Activities

32,500

197,500

1,411,516

 

 

 

 

Effect of Exchange Rate Changes on Cash

553

 19

 (4,745)

 

 

 

 

(Decrease) Increase in Cash and Cash Equivalents

(8,083)

64,593

163

 

 

 

 

Cash and Cash Equivalents, beginning

8,246

 816

 –

 

 

 

 

Cash and Cash Equivalents, end

$            163

$     65,409

$               163

 

 

 

 

 

 

 

 

Supplemental Disclosures

 

 

 

 

 

 

 

Cash paid for taxes

$                   –

 $              –

$                   –

Cash paid for interest

–

 –

 –

 

 

 

 

Non-Cash Activities

 

 

 

 

 

 

 

Common stock issued for intangible assets

$                   –

$              –

$     3,000,204

Common stock issued for stock payable

–

–

 161,550

Common stock issued for amounts due to related parties

–

–

 360,954

Conversion of derivative liability

39,694

–

 39,694

Conversion of convertible notes to common stock

16,000

–

 16,000

 

The accompanying notes are an integral part of these unaudited consolidated financial statements.

F-3                 
              
**Energy Quest Inc.**

**(A Development Stage Company)**

**Notes to the Unaudited Consolidated Financial Statements**

        1.     Basis of Presentation

The accompanying unaudited interim consolidated financial statements of Energy Quest, Inc. (“Energy Quest” or the “Company”), have been prepared in accordance with accounting principles generally accepted in the United States of America and the rules of the Securities and Exchange Commission, and should be read in conjunction with the audited consolidated financial statements and notes thereto contained in Energy Quest’s Annual Report filed with the SEC on Form 10-K.  In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial position and the results of operations for the interim periods presented have been reflected herein.  The results of operations for interim periods are not necessarily indicative of the results to be expected for future quarters or for the full year.  Notes to the consolidated financial statements which substantially duplicate the disclosure contained in the audited consolidated financial statements for fiscal 2010 as reported in the Form 10-K have been omitted.

*Reclassifications*

Certain reclassifications have been made to the prior period’s financial statements to conform to the current period’s presentation.

 

2.   Going Concern

The Company has incurred losses from operations since December 14, 2004 (inception) to June 30, 2011, has a working capital deficiency and an accumulated deficit that creates substantial doubt about the Company’s ability to continue as a going concern.  These consolidated financial statements have been prepared on the assumption that the Company is a going concern, meaning it will continue in operation for the foreseeable future and will be able to realize assets and discharge liabilities in the ordinary course of operations.  The financial statements do not include any adjustments that might result from the outcome of this uncertainty.  The Company’s continuation as a going concern is dependent upon its ability to attain profitable operations and generate funds there-from, and/or raises equity capital or borrowings sufficient to meet current and future obligations.  Management plans to raise equity financings over the next twelve months to finance operations.  There is no guarantee that the Company will be able to complete any of these objectives.

       3.     Recent Accounting Pronouncements

The Company has implemented all new accounting pronouncements that are in effect and that may impact its financial statements and does not believe that there are any other new accounting pronouncements that have been issued that might have a material impact on its financial position or results of operations.

 

4.      Related Party Transactions

 

The following details note receivable from related parties at June 30, 2011:

During the year ended December 31, 2010, the Company loaned a director $10,000 pursuant to a note receivable.  The Note earns interest at 6% per annum and was due on September 15, 2010 or upon demand by the Company.  This loan was in violation of applicable U.S. law prohibiting loans by public companies to their directors and executive officers.  The director was terminated and the outstanding balance of the note and accrued interest totalling $6,778 was charged to expense during the period ended June 30, 2011.  It is uncertain if fines will be imposed due to this violation.

The following details amounts due to related parties at June 30, 2011:

a.

During the six month period ended June 30, 2011, the Company recorded $75,000 (2010 - $75,000) for management services provided by the President of the Company.  At June 30, 2011, $551,220 (December 31, 2010 - $478,231) is included in due to related parties.

b.

During the six month period ended June 30, 2011, the Company recorded $75,000 (2010 - $75,000) for management services provided by the Secretary of the Company.  At June 30, 2011, $294,272 (December 31, 2010 - $227,084) is included in due to related parties.

The following details Notes payable – related parties:

c.

On March 15, 2009, the Company received $15,555 (CDN$ 15,000) from a related party consultant in exchange for a promissory note payable.  The note bears interest at 6% per annum and is due on demand.  At June 30, 2011, this amount is included in notes payable – related party, and the related accrued interest of $2,140 (December 31, 2010 - $1,618) is included in amounts due to related parties.

d.

On November 5, 2007, the Company received $21,000 from a director in exchange for a promissory note payable.  The note bears interest at 6% per annum, calculated annually, and is due on demand.  At June 30, 2011, accrued interest of $4,602 (December 31, 2010 - $3,977) is included in amounts due to related parties.

e.

On April 14, 2010, the Company received $50,000 from the Secretary of the Company in exchange for a promissory note payable.  The note bears interest at 6% per annum and is due on March 31, 2011.  The Company has secured the note with 1,000,000 shares of common stock to be issued upon default.  During the period, the Secretary of the Company agreed to extend the due date to August 31, 2011.  At June 30, 2011, accrued interest of $3,633 (December 31, 2010 - $2,145) is included in amounts due to related parties.

  
F-4              
              
**Energy Quest Inc.**

**(A Development Stage Company)**

**Notes to the Unaudited Consolidated Financial Statements**

5.      Convertible Debt

a.

On January 29, 2010, the Company borrowed $50,000 from a private investor and issued a convertible note with an 8% interest rate, 22% interest rate upon default and a maturity of nine months.  The Company paid a finders’ fee of $2,500.  The note is convertible into common shares at 55% of the average of the lowest three closing prices for the Company’s common shares during the ten trading day period ending one trading day prior to the date the conversion notice is sent by the investor to the borrower.

The embedded conversion option contains a reset provision that can cause an adjustment to the conversion price if the Company sells or issues an equity instrument at a price lower than the initial conversion price.  Due to this provision, the embedded conversion option qualifies for derivative accounting under ASC 815-15 .  This fair value of the derivative liability at issuance of $81,995 resulted in a full discount to the note payable and a loss on the fair value of derivatives of $31,995. The carrying value of the convertible note was accreted over the term of the convertible note up to their value of $50,000. (see Note 8)

As at June 30, 2011, the total balance of $50,000 plus $2,000 accrued interest (December 31, 2010 - $46,000), had been converted into 1,059,245 common shares.

The following table summarize the change in convertible debt as of June 30, 2011:

 

June 30,

2011

December 31,

2010

 

 

 

Proceeds from convertible debt

$      50,000

$        50,000

Discount

(50,000)

(50,000)

Converted into 1,059,245 shares of common stock

(50,000)

(46,000)

Accretion of debt discount

50,000

50,000

Carrying value

$              –

$         4,000

As of June 30, 2011, the Company recorded $50,000 as the accretion of interest expense on the convertible note and recorded the cost associated with obtaining the convertible note as deferred financing cost of $2,500 on February 8, 2010.  As of June 30, 2011, the Company recorded $2,500 on amortization of the deferred financing cost.

b.

On November 24, 2010, the Company borrowed $50,000 from a private investor and issued a convertible note with an 8% interest rate, 22% interest rate upon default and a maturity of nine months.  The Company paid a finders’ fee of $3,000.  The note is convertible into common shares at 55% of the average of the lowest three closing prices for the Company’s common shares during the ten trading day period ending one trading day prior to the date the conversion notice is sent by the investor to the borrower.

The embedded conversion option contains a reset provision that can cause an adjustment to the conversion price if the Company sells or issues an equity instrument at a price lower than the initial conversion price.  Due to this provision, the embedded conversion option qualifies for derivative accounting under ASC 815-15 (See Note 9 below).  This fair value of the derivative liability at issuance of $71,911 resulted in a full discount to the note payable and a loss on the fair value of derivatives of $21,911.  The carrying value of the convertible note is to be accreted over the term of the convertible note up to their value of $50,000. (see Note 8)

During the six months ended June 30, 2011, $10,000 was converted into 606,061 shares of common stock.  As at June 30, 2011, the carrying values of the convertible note and accrued convertible interest payable thereon were $31,941, (December 31, 210 - $6,777), and $2,323, (December 31, 2010 - $406), respectively.

The following table summarize the change in convertible debt as of June 30, 2011:

 

June 30,

2011

December 31,

2010

 

 

 

Proceeds from convertible debt

$          50,000

$          50,000

Discount

(50,000)

(50,000)

Converted into 606,061 shares of common stock

(10,000)

–

Accretion of debt discount

41,941

6,777

Carrying value

$           31,941

$           6,777

During the six month period ended June 30, 2011, the Company recorded $35,165 (December 31, 210 - $6,777) as the accretion of interest expense on the convertible note and recorded the cost associated with obtaining the convertible note as deferred financing cost of $3,000 on November 24, 2010.  During the six month period ended June 30, 2011, the Company recorded $1,989, (December 31, 2010 - $593) on amortization of deferred financing cost.

F-5                
               
**Energy Quest Inc.**

**(A Development Stage Company)**

**Notes to the Unaudited Consolidated Financial Statements**

c)

On May 26, 2011, the Company borrowed $35,000 from a private investor and issued a callable convertible note with an 8% interest rate, 22% interest rate upon default and a maturity of nine months.  The Company paid a finders’ fee of $2,500.  The note is convertible into common shares at 50% of the average of the lowest three closing prices for the Company’s common shares during the ten trading day period ending one trading day prior to the date the conversion notice is sent by the investor to the borrower.

The embedded conversion option contains a reset provision that can cause an adjustment to the conversion price if the Company sells or issues an equity instrument at a price lower than the initial conversion price.  Due to this provision, the embedded conversion option qualifies for derivative accounting under ASC 815-15 (See Note 9 below).  This fair value of the derivative liability at issuance of $52,570 resulted in a full discount to the note payable and a loss on the fair value of derivatives of $17,570.  The carrying value of the convertible note is to be accreted over the term of the convertible note up to their value of $35,000.

As at June 30, 2011, the carrying values of the convertible note and accrued convertible interest payable thereon were $4,407 and $268, respectively.

The following table summarize the change in convertible debt as of June 30, 2011:

 

June 30,

2011

December 31,

2010

 

 

 

Proceeds from convertible debt

$          35,000

$             –

Discount

(35,000)

–

Accretion of debt discount

4,407

–

Carrying value

$           4,407

$             –

During the six month period ended June 30, 2011, the Company recorded $4,407 as the accretion of interest expense on the convertible note and recorded the cost associated with obtaining the convertible note as deferred financing cost of $2,500 on May 26, 2011.  During the six month period ended June 30, 2011, the Company recorded $315 on amortization of deferred financing cost.

 

6.

Equity

a)

On January 18, 2011, the Company issued 241,935 shares of common stock upon the partial conversion of the Note dated January 29, 2010.

b)

On May 31, 2011, the Company issued 606,061 shares of common stock upon the partial conversion of the Note dated November 24, 2010.

 

            7.      Fair Value Measurements

ASC 825 defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  In determining fair value for assets and liabilities required or permitted to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and it considers assumptions that market participants would use when pricing the asset or liability.

*Fair Value Hierarchy*

ASC 825 establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement.  ASC 825 establishes three levels of inputs that may be used to measure fair value.

Level 1 applies to assets and liabilities for which there are quoted prices in active markets for identical assets or liabilities.  Valuations are based on quoted prices that are readily and regularly available in an active market and do not entail a significant degree of judgment.

Level 2 applies to assets and liabilities for which there are other than Level 1 observable inputs such as quoted prices for similar assets or liabilities in active markets, quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets), or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data.  Level 2 instruments require more management judgment and subjectivity as compared to Level 1 instruments.  For instance: determining which instruments are most similar to the instrument being priced requires management to identify a sample of similar securities based on the coupon rates, maturity, issuer, credit rating and instrument type, and subjectively select an individual security or multiple securities that are deemed most similar to the security being priced; and determining whether a market is considered active requires management judgment.

F-6                
              
 

**Energy Quest Inc.**

**(A Development Stage Company)**

**Notes to the Unaudited Consolidated Financial Statements**

Level 3 applies to assets and liabilities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the assets or liabilities.  The determination of fair value for Level 3 instruments requires the most management judgment and subjectivity.

Pursuant to ASC 825, the fair value of the cash equivalent is determined based on “Level 1” inputs, which consists of quoted prices in active markets for identical assets.  Convertible notes payable are valued based on “Level 2” inputs, consisting of quoted prices in less active markets.  The Company believes that the recorded values of all of the other financial instruments approximate their current fair values because of their nature and respective relatively short maturity dates or durations.

Assets and liabilities measured at fair value on a recurring basis were presented on the Company’s balance sheet as at June 30, 2011 as follows:

 

Fair Value Measurements Using

 

 

 

Quoted prices in

active markets

for identical

instruments

(Level 1)

Significant other

observable Inputs

(Level 2)

Significant

Unobservable

inputs

(Level 3)

Balance,

March 31,

2011

Balance,

December 31,

2010

 

 

 

 

 

 

Cash and cash equivalents

$       163

$      –

$      –

$      163

$      8,246

Derivative liabilities

–

–

(144,445)

(144,445)

(97,375)

 

 

 

 

 

 

 

$      163

$      –

$(144,445)

$ (144,282)

$   (89,129)

The fair values of other financial instruments, which include amounts receivable, accounts payable, and accrued liabilities approximate their carrying values due to the relatively short-term maturity of these instruments.

8.

Derivative Liability

ASC 815-15 lays out a procedure to determine if an equity-linked financial instrument (or embedded feature) is indexed to its own common stock.

Convertible Debt - The embedded conversion option in the Company’s notes described in Note 5 contain a reset provision that can cause an adjustment to the conversion price if the Company sells or issues an equity instrument at a price lower than the initial conversion price.  The fair value of these liabilities will be re-measured at the end of every reporting period and the change in fair value will be reported in our consolidated statement of operations as a gain or loss on derivative financial instruments.

The following table summarizes the change in derivative liabilities as of June 30, 2011:

Derivative Liabilities at December 31, 2010

$          97,375

Addition of new derivative liabilities

52,570

Conversion of derivative liability

(39,694)

Change in fair value of embedded conversion option

34,194

Derivative Liabilities at June 30, 2011

$          144,445

The following table summarizes the loss on derivatives as of June 30, 2011:

Fair value of derivative liabilities in excess of note proceeds received

$          53,906

Change in fair value of derivative liabilities at December 31, 2010

58,094

Loss on derivative liabilities – December 31, 2010 

$        112,000

Fair value of derivative liabilities in excess of note proceeds received

17,570

Change in fair value of derivative liabilities at June 30, 2011

(77,806)

Loss on derivative liabilities – June 30, 2011

$        51,764

The Company used the Black-Scholes option pricing model to value the embedded conversion feature using the following assumptions: number of options as set forth in the convertible notes agreements; no expected dividend yield; expected volatility ranging from 212% - 534%; risk-free interest rates ranging from 0.01% - 0.28% and expected terms based on the contractual term.

F-7                
              
 

**ITEM 2.  Management Discussion and Analysis of Financial Condition and Results of Operations.  **

**Safe Harbor Statement**

This report on Form 10-Q contains certain forward-looking statements.  All statements other than statements of historical fact are “forward-looking statements” for purposes of these provisions, including any projections of earnings, revenues, or other financial items; any statements of the plans, strategies, and objectives of management for future operation; any statements concerning proposed new products, services, or developments; any statements regarding future economic conditions or performance; statements of belief; and any statement of assumptions underlying any of the foregoing. Such forward-looking statements are subject to inherent risks and uncertainties, and actual results could differ materially from those anticipated by the forward-looking statements. 

These forward-looking statements involve significant risks and uncertainties, including, but not limited to, the following: competition, promotional costs, and risk of declining revenues.  Our actual results could differ materially from those anticipated in such forward-looking statements as a result of a number of factors.  These forward-looking statements are made as of the date of this filing, and we assume no obligation to update such forward-looking statements.  The following discusses our financial condition and results of operations based upon our consolidated financial statements which have been prepared in conformity with accounting principles generally accepted in the United States.  It should be read in conjunction with our financial statements and the notes thereto included elsewhere herein. 

The following discussion should be read in conjunction with our consolidated financial statements, including the notes thereto, appearing elsewhere in this Form 10-Q.  The discussions of results, causes and trends should not be construed to imply any conclusion that these results or trends will necessarily continue into the future.

**Overview**

We are engaged in the development and production of hydrogen-enriched alternative fuels.  We plan to employ gasification technologies and catalytic conversion processes to produce clean fuels.  We design, build, lease and in some cases operate the gasification technologies with broad potential application within the energy field.  Our various technologies allow for the use of steam for reformation of coal and other carbonaceous feedstocks, conversion of waste solid fuel sources into gaseous form and allow for incineration of waste in an environmentally friendly manner. 

We have one wholly-owned subsidiary, Syngas Energy Corp., and its principal business involves an integrated gasification production system technology that combines modern gasification with turbine technologies to produce synthetic gas, hydrogen or electricity. 

 

On May 31, 2010, we entered into a Joint Venture Agreement with ZAO Transmashholding, a company registered in Moscow, Russia.  The business purpose of the Joint Venture is to use the knowledge, connections and efforts of both parties to enhance their financial capacities in order to achieve their common business goals.  Transmashholding has set up a bank account with $102,368,000 (Rub 3,200,000,000) to act as collateral for the Joint Venture to acquire lines of credit for financing its business projects.  We are solely responsible for acquiring the lines of credit against the provided collateral, and will assume the main responsibility of finding and arranging investment opportunities for the Joint Venture.  All revenues generated by the Joint Venture will be divided equally between both parties.  Each party will be responsible for their own costs and neither party shall be liable for mistakes made by the other.

 

4                
              
**Liquidity and Capital Resources**

As of June 30, 2011, we had cash and cash equivalents of $163 and a working capital deficiency of $1,173,308.  As of June 30, 2011 our accumulated deficit was $10,203,042.  For the six months ended June 30, 2011 our net loss was $305,418 compared to $326,814 during the same period in 2010.  This decrease was due mostly to lower professional fees and depreciation and depletion expense.

Our loss was funded by proceeds from shareholder loans and from the sale of our common stock.  During the six months ended June 30, 2011, we raised in net proceeds $32,500 through financing activities and our cash position decreased by $8,083.  

We used net cash of $43,136 in operating activities for the six months ended June 30, 2011 compared to net cash of $132,926 in operating activities for the same period in 2010.  We used net cash of $2,000 in investing activities for the six months ended June 30, 2011 compared to $nil during the same period in 2010.  The effect of exchange rates on cash was an increase in cash of $553 for the six months ended June 30, 2011 compared to an increase of $19 during six months ended June 30, 2010.

During the six months ended June 30, 2011 our monthly cash requirement was approximately $7,189, compared to approximately $22,154 for the same period in 2010.  We expect to require a total of approximately $26,585,000 to fully carry out our business plan over the next twelve months beginning September 2011 as set out in this table: 

**Description**  

**Estimated Expense**

Marketing our gasification technologies 

$200,000

Continued improvement of our PyStRTM and other technologies 

$1,200,000

Further commercializing our gasification technologies 

$400,000

Manufacturing of Modular Bio-energy units 

$400,000

Payment of accounts payable and accrued liabilities   

$250,000

General and administrative expenses 

$500,000

Professional fees 

$100,000

Consulting fees 

$200,000

Investor relations expenses 

$100,000

Patent application costs (including legal fees) 

$100,000

Heavy Oil Upgrader Plant (Northern Alberta Oil)

$23,135,000

**Total**  

**$26,585,000**

We intend to meet our cash requirements for the next 12 months through external sources: a combination of debt financing and equity financing through private placements.  We are currently not in good short-term financial standing.  We anticipate that we may not generate any revenues in the near future and we will not have enough positive internal operating cash flow until we can generate substantial revenues, which may take the next few years to fully realize.  There is no assurance we will achieve profitable operations.  We have historically financed our operations primarily by cash flows generated from the sale of our equity securities and through cash infusions from officers and outside investors in exchange for debt and/or common stock.

These consolidated financial statements have been prepared on the assumption that we are a going concern, meaning we will continue in operation for the foreseeable future and will be able to realize assets and discharge liabilities in the ordinary course of operations.  Different bases of measurement may be appropriate when a company is not expected to continue operations for the foreseeable future.  Our continuation as a going concern is dependent upon our ability to attain profitable operations and generate funds there-from, and/or raise equity capital or borrowings sufficient to meet current and future obligations.  Management plans to raise equity financings over the next twelve months to finance operations.  There is no guarantee that we will be able to complete any of these objectives.  We have incurred losses from operations since inception and at June 30, 2011, have a working capital deficiency and an accumulated deficit that creates substantial doubt about our ability to continue as a going concern.

**Results of Operations for the three months ended June 30, 2011 compared to the three months ended June 30, 2010 and from inception to June 30, 2011.**

 

 

5                 
              
*Limited Revenues*

Since our inception on December 14, 2004 to June 30, 2011, we have earned limited revenue of $5,164.  As of June 30, 2011, we have an accumulated deficit of $10,203,042 and we did not earn any revenues during the three months ending on June 30, 2011.  At this time, our ability to generate any significant revenues continues to be uncertain.  Our financial statements contain an additional explanatory paragraph in Note 2, which identifies issues that raise substantial doubt about our ability to continue as a going concern.  Our financial statements do not include any adjustment that might result from the outcome of this uncertainty.

*Net Loss*

We incurred a net loss of $194,275 for the three months ended June 30, 2011, compared to a net loss of $92,958 for the same period in 2010.  This increase in net loss is mostly due to increased interest expense and a loss on derivate financial instruments.  From inception on December 14, 2004 to June 30, 2011, we have incurred a net loss of $10,203,042.  Our basic and diluted loss per share was $0.01 for the three months ended June 30, 2011, and $0.01 for the same period in 2010.  

*Expenses*

Our total operating expenses decreased from $157,803 to $106,073 for the three months ended June 30, 2011 compared to the same period in 2010.  This decrease in expenses is mostly due to lower general and administrative fees and lower impairment of intangible assets.  Since our inception on December 14, 2004 to June 30, 2011, we have incurred total operating expenses of $10,031,705.

Our consulting and management fees remain unchanged at $75,000 for both the three months ended June 30, 2011 and June 30, 2010.  Since our inception on December 14, 2004 until June 30, 2011 we have spent $5,591,394 on consulting and management fees.

Our general and administrative expenses consist of bank charges, travel, meals and entertainment, office maintenance, communication expenses (internet, fax, and telephone), courier, postage costs, office supplies.  Our general and administrative expenses decreased $10,313 from $20,513 to $10,313 for the three months ended June 30, 2011 compared to the same period in 2010.  Since our inception on December 14, 2004 until June 30, 2011 we have spent $549,043 on general and administrative expenses.

We spent $0 on research and development expenses for the three months ended June 30, 2011 and June 30, 2010.  Since our inception on December 14, 2004 until June 30, 2011 we have spent $266,494 on research and development.  Going forward, we anticipate that we will spend approximately $1,600,000 on research and development during the next 12 months.  

Our professional fees, consisting primarily of legal, accounting and auditing fees, decreased by $4,030 to $20,760 for the three months ended June 30, 2011 from $24,790 for the same period in 2010, mainly due to slightly decreased legal and auditing services provided in the three month periods ended June 30, 2011. 

**Results of Operations for the six months ended June 30, 2011 compared to the six months ended June 30, 2010**

*Limited Revenues*

We did not earn any revenues during the six months ending on June 30, 2011, nor did we earn any revenues in the same period in 2010.  At this time, our ability to generate any significant revenues continues to be uncertain.

*Net Loss*

We incurred a net loss of $305,418 for the six months ended June 30, 2011, compared to a net loss of $326,814 for the same period in 2010.  This decrease in net loss is mostly due to lower professional fees and lower depreciation and depletion expense.  Our basic and diluted loss per share was $0.02 for the six months ended June 30, 2011, and $0.02 for the same period in 2010.  

*Expenses*

Our total operating expenses decreased from $288,451 to $201,303 for the six months ended June 30, 2011 compared to the same period in 2010.  This decrease in expenses is mostly due to lower professional fees and lower depreciation and depletion expense.  

Our consulting and management fees remain unchanged at $150,000 for the six months ended June 30, 2011 and June 30, 2010.  

Our general and administrative expenses consist of bank charges, travel, meals and entertainment, office maintenance, communication expenses (internet, fax, and telephone), courier, postage costs, office supplies.  Our general and administrative expenses decreased $1,233 from $26,776 to $25,543 for the six months ended June 30, 2011 compared to the same period in 2010.

We spent $0 on research and development expenses for the six months ended June 30, 2011 compared to $1,500 spent on research and development during the six months ended June 30, 2010.  

Our professional fees, consisting primarily of legal, accounting and auditing fees, decreased by $9,415 to $25,760 for the six months ended June 30, 2011 from $35,175 for the same period in 2010, mainly due to decreased legal and auditing services provided in the six month period ended June 30, 2011.

 

6                
              
 

**Inflation**

The amounts presented in the financial statements do not provide for the effect of inflation on our operations or financial position.  The net operating losses shown would be greater than reported if the effects of inflation were reflected either by charging operations with amounts that represent replacement costs or by using other inflation adjustments.

**Off-Balance Sheet Arrangements**

As of June 30, 2011, we had no off-balance sheet transactions that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. 

**ITEM 3.  Quantitative and Qualitative Disclosure About Market Risks.**

Not applicable. 

**ITEM 4.  Control and Procedures**

Not applicable

**ITEM 4T.  Control and Procedures.**

Disclosure controls and procedures have been designed to ensure that information required to be disclosed by the Company is collected and communicated to management to allow timely decisions regarding required disclosures.  The Chief Executive Officer and the Chief Financial Officer have concluded, based on their evaluation as of June 30, 2011 that, as a result of the following material weaknesses in internal control over financial reporting as described further in our Annual Report on Form 10-K/A filed with the SEC on July 16, 2011, disclosure controls and procedures were not effective in providing reasonable assurance that material information is made known to them by others within the Company:

a)    We did not maintain sufficient personnel with an appropriate level of technical accounting knowledge, experience, and training in the application of generally accepted accounting principles commensurate with our complexity and our financial accounting and reporting requirements.  We have limited experience in the areas of financial reporting and disclosure controls and procedures.  Also, we do not have an independent audit committee.  As a result, there is a lack of monitoring of the financial reporting process and there is a reasonable possibility that material misstatements of the consolidated financial statements, including disclosures, will not be prevented or detected on a timely basis; and

b)    Due to our small size, we do not have a proper segregation of duties in certain areas of our financial reporting process.  The areas where we have a lack of segregation of duties include cash receipts and disbursements, approval of purchases and approval of accounts payable invoices for payment.  This control deficiency, which is pervasive in nature, results in a reasonable possibility that material misstatements of the financial statements will not be prevented or detected on a timely basis.

 

**7                 
              
 

**Changes in Internal Control Over Financial Reporting**  

There were no changes in our internal control over financial reporting during the fiscal quarter ended June 30, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 

 

**Limitations On The Effectiveness Of Internal Controls**

Our management, including the CEO and CFO, does not expect that our disclosure controls and procedures or our internal control over financial reporting will necessarily prevent all fraud and material error.  An internal control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.  Further, the design of the control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs.  Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.  These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake.  Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the internal control.  The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.  Over time, control may become inadequate because of changes in conditions, and/or the degree of compliance with the policies or procedures may deteriorate. 

**PART II – OTHER INFORMATION**

**ITEM 1.  Legal Proceedings.**

As of August 8, 2011 there are no material pending legal proceedings, other than ordinary routine litigation incidental to our business, to which we or any of our subsidiaries are a party or of which any of our properties is the subject.  Also, our management is not aware of any legal proceedings contemplated by any governmental authority against us.

**ITEM 2.  Unregistered Sales of Equity Securities.**

On May 31, 2011 we issued 606,061 shares of common stock upon partial conversion of a convertible note.

**ITEM 3.  Defaults Upon Senior Securities.**

None.

**ITEM 4.  Submission of Matters to a Vote of Security Holders.**

None.

**ITEM 5.  Other Information.**

None.

8                 
              
 
 

**ITEM 6.  Exhibits.**

**Number**

 

**Description**

 

 

 

31.1

 

Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

 

 

32.1

 

Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

 

 

 
**SIGNATURES**

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

  

**ENERGY QUEST INC.**

 

 

(REGISTRANT)

  

 

Date:  August 10, 2011

/s/ *Ronald Foster*

 

 

Ronald Foster

  

 

President, Chief Executive Officer, Secretary, Treasurer, Chief Financial Officer and Director

 

 

(Authorized Officer for Registrant)

 

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