UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





Form 10-K





R
            ANNUAL
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the fiscal year ended December 31, 2008OR£
            TRANSITION
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the transition period from ________to _____





Commission
File Number: 000-29463





VELOCITY
ENERGY INC.


(formerly
known as Sonterra Resources, Inc.)


(Exact
Name of Registrant as Specified in Its Charter)





Delaware
                  
                  51-0392750(State
      or Other Jurisdiction of
                  
                  (IR.
      Employer Identification No.)Incorporation
      or Organization) 523
      N. Sam Houston Pkwy. E.
                      Suite
      175
                      Houston,
      Texas 77060
                      (Address
      of Principal Executive Offices)





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





Securities
registered pursuant to Section 12(b) of the Act:


None.





Securities
registered pursuant to Section 12(g) of the Act:


Common
      Stock, $0.001 par value(Title
      of Class)





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  Yes £     No R





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Exchange
Act.  Yes £     No R





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





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the
best of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  £





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





Large
      accelerated filer  ̈
                Accelerated
      filer  ̈Non-accelerated
      filer  ̈
                Smaller
      reporting company  R(Do
      not check if a smaller reporting
company)





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





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





The
aggregate market value of the registrant’s common stock held by non-affiliates
of the registrant (treating all directors, executive officers and 10%
stockholders as if they may be affiliates of the registrant) was $4,310,827 as
of June 30, 2008, based on $2.20 per share, the closing sale price as reported
onthe OTC Bulletin
Board on such date.





The
registrant had 26,347,359 common shares outstanding as of date preceding date of
filing.





DOCUMENTS
INCORPORATED BY REFERENCE: None





TABLE
OF CONTENTS


PagePart
      IItem 1.
                        
                        Business
                        3Item
      2.
                        
                        Properties
                        8Item
      3.
                        
                        Legal
      Proceedings
                        10Item 4.
                        
                        Submission
      of Matters to a Vote of Security Holders
                        10Part
      IIItem
      5.
                        
                        Market
      for Registrant’s Common Equity and Related Stockholder Matters and Issuer
      Purchases of Equity Securities
                        10Item
      6.
                        
                        Selected
      Financial Data
                        11Item 7.
                        
                        Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                        11Item
      8.
                        
                        Financial
      Statements and Supplementary Data
                        19Item
      9.
                        
                        Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                        19Item 9A
      (T).
                        
                        Controls
      and Procedures
                        19Item
      9B.
                        
                        Other
      Information
                        20Part
      IIIItem
      10.
                        
                        Directors,
      Executive Officers and Corporate Governance
                        20Item
      11.
                        
                        Executive
      Compensation
                        23Item
      12.
                        
                        Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                        26Item
      13.
                        
                        Certain
      Relationships and Related Transactions, and Director
      Independence
                        27Item
      14.
                        
                        Principal
      Accountant Fees and Services Exhibits
                        27Part
      IVItem
      15.
                        
                        Exhibits
      and Financial Statement Schedules
                        29Index
      to Financial Statements
                        F-1





Forward-Looking
Statements





This
Annual Report on Form 10-K contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended. This Annual Report on
Form 10-K includes statements regarding our plans, goals, strategies, intent,
beliefs or current expectations. These statements are expressed in good faith
and based upon a reasonable basis when made, but there can be no assurance that
these expectations will be achieved or accomplished. These forward-looking
statements can be identified by the use of terms and phrases such as “believe,”
“plan,” “intend,” “anticipate,” “target,” “estimate,” “expect,” and the like,
and/or future-tense or conditional constructions (“will,” “may,” “could,”
“should,” etc.). Items contemplating or making assumptions about, actual or
potential future sales, market size, collaborations, and trends or operating
results also constitute such forward-looking statements.





Although
forward-looking statements in this report reflect the good faith judgment of
management, forward-looking statements are inherently subject to known and
unknown risks, business, economic and other risks and uncertainties that may
cause actual results to be materially different from those discussed in these
forward-looking statements. Readers are urged not to place undue reliance on
these forward-looking statements, which speak only as of the date of this Annual
Report on Form 10-K. We assume no obligation to update any forward-looking
statements in order to reflect any event or circumstance that may arise after
the date of this report, other than as may be required by applicable law or
regulation. Readers are urged to carefully review and consider the various
disclosures made by us in our reports filed with the SEC which attempt to advise
interested parties of the risks and factors that may affect our business,
financial condition, results of operation and cash flows. If one or more of
these risks or uncertainties materialize, or if the underlying assumptions prove
incorrect, our actual results may vary materially from those expected or
projected.


2


PART
I





Item 1.  Business.





Overview





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





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





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





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


3





Acquisition of Velocity
Partnerships.On July 8, 2008, the Company acquired Velocity
Energy Offshore LP and Velocity Energy Partners LP, both Delaware limited
partnerships. Accordingly, the results of operations of these partnerships are
included in the financial statements of the Company since that date. The Company
paid a total of $10,000 to members of management of the Company, Donald E.
Vandenberg, President and Chief Executive Officer, and Gary L. Lancaster, Vice
President and Chief Legal Officer, in consideration for their partnership
interests in the partnerships. As part of the acquisition, the Company also
assumed a $75,000 promissory note and accrued interest of $11,463 owed to Donald
E. Vandenberg. On November 3, 2008, the Company exercised its option to acquire
Velocity Energy Limited LLC, the general partner of the two Velocity
partnerships, from Messrs. Vandenberg and Lancaster for $10 and other good and
valuable consideration.





Oil and Gas Contracts and Business
Activities.   On April 8, 2008, the Company entered into a
definitive contract operating agreement with South Texas Oil Company (“South
Texas”), to be effective as of April 1, 2008 (“South Texas Contract Operating
Agreement”), pursuant to which the Company began overseeing daily operations,
including both operating services and accounting services, for South Texas’
operated and non-operated properties in Texas and Colorado for a fee of
$75,000 per month. Michael J. Pawelek, who was the Chairman and Chief Executive
Officer of the Company at the time the Company entered into the South Texas
Contract Operating Agreement, was also the Chairman of the Board of
Directors of South Texas Oil Company. Accordingly, our Board of Directors, with
Mr. Pawelek recused from voting as a potentially interested party, reviewed and
evaluated the terms of the South Texas Contract Operating Agreement and
determined that the terms were commercially reasonable. The South Texas Contract
Operating Agreement was terminated effective June 23, 2008, as a result of
the management team changes on that date at both the Company and South Texas Oil
Company whereby (i) the prior management team of the Company, Michael J.
Pawelek, Sherry L. Spurlock, and Wayne Psencik, resigned from their employment
with the Company as Chief Executive Officer and President, Chief Financial
Officer, and Vice President of Operations, respectively (although Michael J.
Pawelek remained as Chairman of the Board of Directors of the Company until
November 3, 2008) and became the management team of South Texas Oil Company and
(ii) Donald E. Vandenberg (Chief Executive Officer and President) and Gary L.
Lancaster (Vice President and Chief Legal Officer), joined by Donald J.
Sebastian (Vice President and Chief Financial Officer) on July 1, 2008, became
the new management team of the Company.





In
connection with the management team transitions, the Company and South Texas Oil
Company entered into another contract operating agreement whereby South
Texas was appointed as the contract operator of all of the Company’s Matagorda
Bay oil and gas assets in the State Waters of Texas located offshore of
Matagorda County and Calhoun County, Texas (“Matagorda Bay Contract Operating
Agreement”), whereupon South Texas began overseeing the daily operations of the
Matagorda Bay 150 Field. Under the Matagorda Bay Contract Operating Agreement,
South Texas is entitled to receive the applicable Council of Petroleum
Accountants Society (COPAS) fees for daily operations and drilling operations
and is entitled to participate in up to 50% (or more by mutual agreement) in all
of the Company’s Matagorda Bay exploratory prospects.





The
descriptions of the above contract operating agreements are qualified in each
case, in their entirety, by reference to the complete texts of such agreements,
which are attached hereto as Exhibits 10.1 and 10.2.





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


4





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





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





Prior to
the transactions set forth above and based on the records of the Company and its
transfer agent, Longview was the owner of approximately 88% of the Company’s
outstanding common Stock and, together with its affiliated funds, Longview
Equity Fund, L.P. and Longview International Fund, L.P., owned approximately 93%
of the Company’s outstanding common stock. Viking Asset Management, LLC
serves as investment adviser to Longview and its affiliated
funds.  Prior to and during the Financial Restructuring, Viking also
served as the investment adviser to Marquis.  Subsequent to the
Financial Restructuring, Summerline Asset Management, LP (“Summerline”) began
serving as the investment adviser to Marquis, which is no longer related to
Longview.





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





In
exchange for the Marquis Warrant and the Marquis Subordinated Note, the Company
acquired from Marquis all of the issued and outstanding shares of common stock,
par value $0.001 per share, of NTDS and that certain Ninth Amended and Restated
Senior Secured Note dated October 3, 2008, in the outstanding principal amount
of $8,575,000, plus accrued and unpaid interest of approximately $865,000, for a
total assumed indebtedness of $9,440,000 owed by NTDS (the “North Texas
Note”). The original North Texas Note was cancelled upon delivery to the
Company.  To induce Marquis and Longview to enter into the Securities
Purchase Agreement, on November 13, 2008, the Company entered into a
Subordination Agreement with Marquis, Longview and Summerline, as Collateral
Agent for Marquis and Longview, pursuant to which the Subordinated Notes are
subordinated to the Senior Secured Note.





An
evaluation of the NTDS assets was prepared by an independent machinery and
equipment appraisal firm.  An independent valuation firm was used to
determine the value of NTDS at $1,137,551.





The
Company issued a subordinated note with a face value of $9,440,000 (The Marquis
Subordinated Note) and 1,000,000 warrants valued at $118,865.  The
excess of the face amount of the Marquis Subordinated Note over the fair value
of NTDS and the warrants was recorded as a discount on the Marquis Subordinated
Note of $8,421,314. The discount will be amortized over the term of the Marquis
Subordinated Note as interest expense.


5





Upon the
Company’s repayment of the Subordinated Notes, the holders of the Subordinated
Notes have the right to convert up to 50% of the Principal (and the accrued and
unpaid interest thereon) to be paid on any Principal Prepayment Date (as each
such capitalized term not otherwise defined herein is defined in the respective
Subordinated Note) into shares of common stock of the Company at a price equal
to $4.00 per share, subject to adjustment.  Pursuant to the Securities
Exchange Agreement, certain subsidiaries of the Company entered into a guaranty
for the Subordinated Notes.





Contemporaneously
with the closing of the New Securities Exchange Agreement, the Company entered
into a second transaction pursuant to a Securities Purchase Agreement (the
“Securities Purchase Agreement”) between the Company and
Marquis.  Under the Securities Purchase Agreement, the Company issued
and sold to Marquis, and Marquis purchased from the Company, for consideration
of $8,075,000, a senior secured promissory note in the principal amount of
$8,875,000, bearing interest at 13% per annum, subject to certain adjustments
(the “Senior Secured Note”), and a warrant to acquire 1,050,000 shares of
Company common stock at an initial exercise price of $0.01 per
share.  As additional consideration under the Securities Purchase
Agreement, the Company also granted Marquis a limited conveyance of overriding
royalty interests (the “Overrides”) of 3% of the Company’s interest in the
hydrocarbon production from all of the Company’s (i) current oil and gas
properties (the “ORRI”) and (ii) oil and gas properties acquired in the future
with $5,000,000 of proceeds (the “Acquisition Funds”) from the sale of the
Senior Secured Note.  The Acquisition Funds were deposited in a
restricted access bank account at Sterling Bank that was set up under the
Deposit Account Control Agreement, dated as of November 13, 2008, among Sonterra
Resources, Inc., Sterling Bank, and Summerline Asset Management, LLC, as
“Collateral Agent” referenced as Exhibit 26 herein (“Acquisition Fund
Account”).  The Acquisition Funds are intended to be used in making
acquisitions of producing oil and gas properties, unless otherwise agreed
between Marquis and the Company. The proceeds from the Securities Purchase
Agreement were used in part to pay $1,000,000 of principal under the existing
indebtedness owed to Longview pursuant to the Old Notes, to fund the Company’s
share of the completion costs of the State Tract 127-1 Unit Well, and for
general corporate purposes.





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





As of
December 4, 2008, the Company, Marquis and Summerline entered into a letter
agreement whereby such parties agreed to release up to $1,300,000 of the
Acquisition Funds from the Acquisition Funds Account for payment directly to STO
Operating Company or another third party for operations related to the wellbore
located at State Tract 150-1 ST #1 Well.  On December 8, 2008,
$927,346 of the Acquisition Funds was released from the Acquisition Funds
Account for drilling costs of the State Tract 150-1 ST #1
Well.  Contemporaneously, the Company delivered an additional
conveyance to Marquis granting to Marquis an overriding royalty interest (the
“New ORRI”) of the Applicable Percentage (as defined in the New ORRI) in the
State Tract 150-1 ST#1 Well. The New ORRI is equal to 7% of the Applicable
Percentage of the oil, gas, and other minerals in, under and that may be
produced from the State Tract 150-1 ST Well.  When Marquis has
received $250,000 from the proceeds of the sale of the production of oil, gas
and other minerals attributable to such 7%, the New ORRI shall be reduced to 3%
of the Applicable Percentage.  The New ORRI is in addition to, and not
in lieu, of the Existing 3% ORRI with respect to the property on which the State
Tract 150-1 ST Well is located.  The balance of $1,300,000 of the
Acquisition Funds authorized to be released from the Acquisition Funds Account,
being $371,654, was released from the Acquisition Funds Account primarily for
completion costs of the State Tract 150-1 ST #1 Well as well as for
miscellaneous costs related to the Financial Restructuring. On March 30,
2009, $700,000 of the Acquisition Funds was released from the Acquisition Funds
Account for payment of interest on the Senior Secured Debt and other corporate
purposes.  On April 1, 2009, $2,000,000 of the Acquisition Funds was
released to prepay part of the Senior Secured Note, in exchange for a reduction
of $2,195,000 of the principal of the Senior Secured Note, leaving a balance in
the Acquisition Funds Account of $399,931.





On April
13, 2009, the Company executed a letter of intent to acquire certain producing
properties in southern West Virginia pursuant to the Company’s Appalachian Basin
acquisition strategy in exchange for approximately $2,702,063 in cash, payable
in three annual installments; the assumption of the balance of a $1,700,541 loan
(estimated to be $1,500,000); and other consideration as detailed in the Letter
of Intent attached hereto as Exhibit 10.33.


6





The
descriptions of the above agreements are qualified in each case, in their
entirety, by reference to the complete texts of such agreements, which are
attached hereto as Exhibits 10.19 through 10.28.





Liquidity
Issues/Going Concern





The
accompanying financial statements to this annual report have been prepared
assuming the Company will continue as a going concern.  As shown in
the accompanying financial statements, the Company experienced a net loss of
approximately $6.3 million for the year ended December 31, 2008, has
approximately $20.8 million in debt as of March 31, 2009, plus associated
interest obligations, and virtually no current source of revenue, which raise
substantial doubt about the Company’s ability to continue as a going concern
unless the Company is able to effectuate its strategy of acquiring producing oil
and gas properties in the Appalachian  Basin as discussed
below.





Business
Strategy





The
Company is actively pursuing potential acquisitions of producing properties in
the Appalachian Basin.   The management team has met with numerous
providers of both debt and equity, is currently evaluating several potential
acquisition targets, and has secured a letter of intent with respect to the
acquisition of producing gas properties in southern West Virginia.  If
successful with its Appalachian Basin acquisition strategy, the Company
anticipates acquiring a steady revenue stream from these long-life Appalachian
properties to service its debt obligations and create shareholder
value.





Competition





The oil
and natural gas industry is highly competitive in all phases. The Company
encounters competition from other oil and natural gas companies in all areas of
operation, including the acquisition of oil and natural gas properties to the
exploration and development of those properties. Our competitors include major
integrated oil and natural gas companies, numerous independent oil and natural
gas companies, individuals and drilling and income programs.  Most of
our competitors are much larger, well-established companies that have
substantially larger operating staffs and substantially greater capital
resources than we do. Such companies may be able to pay more for oil and natural
gas properties and exploratory prospects and to define, evaluate, bid for and
purchase a greater number of properties and prospects than our financial or
human resources permit. Our ability to acquire additional properties and to
discover reserves in the future will depend upon our ability to evaluate and
select suitable properties and to consummate transactions in a highly
competitive environment.





Operating
Hazards and Uninsured Risks





Drilling
activities are subject to many risks, including the risk that no commercially
productive reservoirs will be encountered. There can be no assurance that the
new wells we drill will be productive or that we will recover all or any portion
of our investment. Drilling for oil and natural gas may involve unprofitable
efforts, not only from dry wells, but also from wells that are productive, but
do not produce sufficient net revenues to return a profit after drilling,
operating and other costs. The cost and timing of drilling, completing and
operating wells is often uncertain. Our drilling operations may be curtailed,
delayed or canceled as a result of numerous factors, many of which are beyond
our control, including title problems, weather conditions, gas transportation
problems, delays by project participants, compliance with governmental
requirements, shortages or delays in the delivery of equipment and services and
increases in the cost for such equipment and services. Our future drilling
activities may not be successful and, if unsuccessful, such failure may have a
material adverse effect on our business, financial condition, results of
operations and cash flows.





Our
operations are subject to hazards and risks inherent in drilling for and
producing and transporting oil and natural gas, such as fires, natural
disasters, explosions, encountering formations with abnormal pressures,
blowouts, cratering, pipeline ruptures and spills, any of which can result in
the loss of hydrocarbons, environmental pollution, personal injury claims and
other damage to our properties and those of others. We maintain insurance
against some but not all of the risks described above. Furthermore, in certain
circumstances in which insurance is available, we may not purchase it. The
occurrence of an event that is not covered, or not fully covered, by insurance
could have a material adverse effect on our business, financial condition,
results of operations and cash flows in the period such event may
occur.




7




Regulations





Current Government
Regulation. Exploration for, and production and sale of, crude oil and
natural gas are extensively regulated at the federal, state and local levels.
Crude oil and natural gas development and production activities are subject to
various laws and regulations (and orders of regulatory bodies pursuant thereto)
governing a wide variety of matters, including, among others, allowable rates of
production, prevention of waste and pollution and protection of the environment.
Laws affecting the crude oil and natural gas industry are under constant review
for amendment or expansion and frequently increase the regulatory burden on
companies. Our ability to economically produce and sell crude oil and natural
gas is affected by a number of legal and regulatory factors, including federal,
state and local laws and regulations. Many of these governmental bodies have
issued rules and regulations that are often difficult and costly to comply with,
and that carry substantial penalties for failure to comply. These laws,
regulations and orders may restrict the rate of crude oil and natural gas
production below the rate that would otherwise exist in the absence of such
laws, regulations and orders. The regulatory burden on the crude oil and natural
gas industry increases our costs of doing business and consequently affects our
profitability.





Environmental Matters. As a
developer, owner and occasional operator of crude oil and natural gas
properties, we are subject to various federal, state, and local laws and
regulations relating to the discharge of materials into, and the protection of,
the environment. We must take into account the cost of complying with
environmental regulations in planning, designing, drilling, operating and
abandoning wells. In most instances, the regulatory requirements relate to the
handling and disposal of drilling and production waste products, water and air
pollution control procedures, and the remediation of petroleum-product
contamination. Under state and federal laws, we could be required to remove or
remediate previously disposed wastes, including wastes disposed of or released
by us or prior owners or operators in accordance with current laws or otherwise,
to suspend or cease operations in contaminated areas, or to perform remedial
well-plugging operations or cleanups to prevent future contamination. The U.S.
Environmental Protection Agency and various state agencies have limited the
disposal options for hazardous and non-hazardous wastes. The owner and operator
of a site, and persons that treated, disposed of or arranged for the disposal of
hazardous substances found at a site, may be liable, without regard to fault or
the legality of the original conduct, for the release of a hazardous substance
into the environment. The U.S. Environmental Protection Agency, state
environmental agencies and, in some cases, third parties are authorized to take
actions in response to threats to human health or the environment and to seek to
recover from responsible classes of persons the costs of such action.
Furthermore, certain wastes generated by our crude oil and natural gas
operations that are currently exempt from treatment as hazardous wastes may in
the future be designated as hazardous wastes and, therefore, be subject to
considerably more rigorous and costly operating and disposal requirements. We
have made and will continue to make expenditures in our efforts to comply with
environmental requirements. We do not believe that we have, to date, expended
material amounts in connection with such activities or that compliance with such
requirements will have a material adverse effect upon our capital expenditures,
earnings or competitive position. Although such requirements do have a
substantial impact upon the crude oil and natural gas industry, they do not
appear to affect us to any greater or lesser extent than other companies in the
industry.





Future Government Regulation.Laws affecting the crude oil and natural gas industry are under constant
review for amendment or expansion and frequently increase the regulatory burden
on companies. Future federal, state or local laws or regulations and common law
may impose liabilities in addition to, or restrictions more stringent than,
those described herein. Current federal income tax proposals threaten to
restrict, diminish or eliminate some of the favorable tax benefits and
deductions currently enjoyed by the oil and gas industry, which may have an
adverse impact on our future drilling activities and other
operations.





Employees





As of
December 31, 2008, the Company had ten employees, eight of whom were full-time
employees.





Item 2.Properties.





Effective
as of September 1, 2008, we moved our corporate offices from San Antonio,
Texas to our current location of 523 N. Sam Houston Parkway E., Suite 175,
Houston, Texas  77060. We lease this office on a 39-month lease at a
current rental rate of $5,371.98 per month.





The
Company’s oil and gas assets consist of certain oil and gas properties and
related assets that the Company acquired in August 2007 from Cinco Natural
Resources Corporation (“Cinco”) and Flash Gas & Oil Southwest, Inc.
(“Flash”) in two separate transactions for an aggregate amount of approximately
$5.9 million. Our wholly owned subsidiary, Sonterra Operating, Inc., is the
named operator of record with the Texas Railroad Commission for our oil and gas
properties, all of which are located in Matagorda Bay in Texas State Waters
lying offshore of the Texas coastal counties of Calhoun and Matagorda. In the
Cinco acquisition, the Company purchased 60% of the interests held by Cinco in
the Texas State Tract 150 Wells No. 1 and No. 2 located in Matagorda Bay, Texas,
as well as a 320-acre oil and gas lease related to those wells and certain other
leases covering approximately 3,200 additional acres located in Matagorda Bay
for approximately $5.0 million. In the Flash acquisition, the Company purchased
all of the interests held by Flash in the Texas State Tract 150 Wells No. 1 and
No. 2 as well as a seven-mile pipeline connecting the wells to the Keller Bay
onshore facility located in Calhoun County, Texas for approximately $1.2
million.


8




In
December 2007, the Company acquired an additional 1,920 gross (960 net) offset
acres for one of the undrilled Matagorda Bay prospects, giving the Company a
combined total acreage of approximately 5,500 gross (2,100 net) acres. On
December 18, 2007, the Texas State Tract 150 Well No. 2 was shut-in because it
was producing sand. During the first quarter of 2008, the Company worked over
this well in an attempt to clean the sand out of the wellbore. Following the
workover, however, sand accumulation again caused the well to be shut in, and
the well remains shut in pending evaluation for a future
recompletion.





Descriptions
of the business activities with respect to our oil and gas properties are
included in more detail in “Item 1. Business” and in “Item
2. Capital Expenditures and Commitments” and are incorporated herein by
reference.





We
believe that we have satisfactory title to the properties owned and used in our
business, subject to liens for taxes not yet payable, liens incident to minor
encumbrances, liens for credit arrangements and easements and restrictions that
do not materially detract from the value of these properties, our interests in
these properties, or the use of these properties in our business. We believe
that our properties are adequate and suitable for us to conduct business in the
foreseeable future.





Productive
Wells





The
following table sets forth the number of gross and net productive natural gas
and oil wells in which we owned an interest as of December 31,
2008:




Total Productive
                                      Wells
      (1)Gross (2)
                                    
                                    
                                    Net (3)Matagorda
      Bay, Calhoun County, Texas
                                    
                                    
                                    3
                                    
                                    
                                    
                                    0.68Oil
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Total
                                    
                                    
                                    3
                                    
                                    
                                    
                                    0.68







(1)
            Productive
      wells are producing wells, wells capable of production, shut in with
      proven pay behind pipe.(2)
            A
      gross well is a well in which we own an
  interest.


(3)
            The
      number of net wells is the sum of our fractional working interests owned
      in gross wells.





Exploration
and Development Acreage





The
following table indicates our interests in developed and undeveloped acreage as
of December 31, 2008.




Developed
                            Acreage
      (1)
                          
                          Undeveloped
                            Acreage
      (2)Gross (3)
                          
                          
                          Net (4)
                          
                          Gross (3)
                          
                          
                          Net
      (4)Mat  Matagorda
      Bay
                          
                          
                          960
                          
                          
                          
                          239
                          
                          
                          
                          4,480
                          
                          
                          
                          1,358





(1)
            Developed
      acreage consists of acres assignable to productive
  wells.(2)
            Undeveloped
      acreage is considered to be those leased acres on which wells have not
      been drilled or completed to a point that would permit the production of
      commercial quantities of oil and gas, regardless of whether or not such
      acreage contains proved reserves.





(3)
            Gross
      acres refer to the number of acres in which we own a working
      interest.(4)
            Net
      acres represent the number of acres attributable to an owner’s
      proportionate working interest and/or royalty interest in a lease (e.g., a
      50% working interest in a lease covering 320 acres is equivalent to 160
      net acres).





9


Drilling
Activity





The
Company’s drilling program was initiated with the drilling of our first
exploratory well commenced during the second quarter of 2008, which was the
State Tract 127-1 Unit Well in the Matagorda Bay 150 Field as discussed in
detail in “Item 1.Business.”





Present
Activities





As of
March 31, 2009, we have pending field operations in progress of material
significance with respect to the State Tract 127-1 Unit Well and the State Tract
150-1 ST #1 Well, both of which were drilled in the Matagorda Bay 150 Field
during 2008 and both of which are discussed in detail in “Item 1.Business.”





Delivery
Commitments





We are
not obligated under the terms of any existing contract or agreement to provide a
fixed and determinable quantity of oil or gas in the future.





Item
3.  Legal
Proceedings.





None.





Item
4.  Submission of
Matter to a Vote of Security Holders.





The only
matters submitted to a vote of security holders during the fourth quarter of the
fiscal year ended December 31, 2008 were the Financial Restructuring and
approval for the (i) authorization of 50,000,000 million shares of blank check
preferred stock and (ii) change of the Company’s name from Sonterra Resources,
Inc. to Velocity Energy Inc., both of which matters were effectuated in the
first quarter of 2009.





PART
II





Item
5.  Market for
Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of
Equity Securities.





Since May
10, 2006, our common stock has been quoted on the OTC Bulletin
Board.





The
following table sets forth the range of high and low bid quotations for each
period as shown below. These quotations reflect inter-dealer prices without
retail mark-up, markdown, or commissions and may not necessarily represent
actual transactions.





HIGH
                        
                        
                        LOWYear
      2007
                        
                        January
      1 - March 31
                        
                        $
                        0.23
                        
                        
                        $
                        0.13Year
      2007
                        
                        April
      1- June 30
                        
                        $
                        0.40
                        
                        
                        $
                        0.13Year
      2007
                        
                        July
      1- September 30
                        
                        $
                        0.36
                        
                        
                        $
                        0.24Year
      2007
                        
                        October
      1 - December 31
                        
                        $
                        0.57
                        
                        
                        $
                        0.08Year
      2008
                        
                        January
      1 - March 31
                        
                        $
                        2.45
                        
                        
                        $
                        1.70Year
      2008
                        
                        April
      1 - June 30
                        
                        $
                        2.49
                        
                        
                        $
                        1.25Year
      2008
                        
                        July
      1 - September 30
                        
                        $
                        1.75
                        
                        
                        $
                        1.10Year
      2008
                        
                        October
      1-December 31
                        
                        $
                        1.35
                        
                        
                        $
                        0.70





As of
March 31, 2009, there were 576 record holders of our common
stock.





We have
not paid dividends on our stock and do not anticipate paying any dividends
thereon in the foreseeable future. We are restricted from declaring dividends
under the terms of both the Securities Exchange Agreement and the Financial
Restructuring documentation.





As of
December 31, 2008, we had 5,140,000 shares of our common stock authorized for
issuance pursuant to the 2007 River Capital Stock Option
Plan.  Effective as of March 31, 2009, we have 3,000,000 shares of our
common stock authorized for issuance pursuant to the 2008 Sonterra Resources,
Inc. Equity Compensation Plan.  These two plans are our only two
compensation plans.


10




Equity
Compensation Plan Information





The
following table sets forth certain information as of December 31, 2008 with
respect to compensation plans (including individual compensation arrangements)
under which our equity securities are authorized for issuance.




Plan Category
                        
                        Number of
                          Securities to be
                          Issued Upon
                          Exercise of
                          Outstanding
                          Options
                          and Rights (a)
                        
                        
                        Weighted-
                          Average
                          Exercise
                          Price of
                          Outstanding
                          Options
                          and Rights (b)
                        
                        
                        Number of
                          Securities
                          Remaining
                          Available for
                          Future
                          Issuance
                          Under Equity
                          Compensation
                          Plans
                          (Excluding
                          Securities
                          Reflected in
                          Column(a)) (c)Equity
      compensation plans approved by security holders
                        
                        
                        3,630,804
                        
                        
                        $
                        1.707
                        
                        
                        
                        1,509,561Equity
      compensation plans not approved by security holders (1)
                        
                        
                        3,000,000
                        
                        
                        $
                        1.04
                        
                        
                        
                        3,000,000Total
                        
                        
                        6,630,804
                        
                        
                        $
                        1.707
                        
                        
                        
                        4,509,561





(1)
Approved after March 31, 2009; none of these options are
outstanding.









Item
6.  Selected
Financial Data.





Not
applicable to smaller reporting companies.





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





In Note 2
of our Financial Statements for the year ended December 31, 2008, it is noted
that there is substantial doubt about our ability to continue as a going
concern. Our existence is dependent upon management’s ability to raise
sufficient capital for our business plan of acquiring producing oil and gas
properties.





We
incurred a cumulative net loss of $7,513,107 for the period from inception
through December 31, 2008. At December 31, 2008, we had working capital of
$1,981,038.  We have no history of earnings.





The
following discussion provides information with respect to our results of
operations, liquidity, and capital resources on a comparative basis for the
years ended December 31, 2008 and December 31, 2007, respectively, and should be
read in conjunction with the Financial Statements and related notes appearing
elsewhere in this report.





General
Overview of Operations and Current Year Developments





The
Company is an oil and gas exploration and production company.  On
February 14, 2008, we consummated the transactions (the "Securities Exchange")
contemplated by the Securities Exchange and Additional Note Purchase Agreement
entered into on August 3, 2007 with Longview. Longview, together with affiliated
funds, own approximately 95.8% of our common stock.





The
following events occurred prior to or at the closing of the Securities
Exchange:





●
            our
      38,552,749 issued and outstanding shares of common stock were combined
      into 3,855,275 shares of common stock in a 1-for-10 reverse stock
      split;●
            our
      name was changed to “Sonterra Resources, Inc.”;●
            Longview
      exchanged all of its shares of common stock of our now wholly owned
      subsidiary, Sonterra Oil & Gas, Inc., formerly known as Sonterra
      Resources, Inc. (“Sonterra Oil & Gas”), a $5,990,010 equity note from
      Sonterra Oil & Gas and a warrant to purchase 50 shares of Sonterra Oil
      & Gas common stock for 21,846,558 shares of our common stock and a
      warrant to purchase 4,958,678 shares of our common stock;
    and




11




●
            Longview
      exchanged its $2,000,000 non-equity note from Sonterra Oil & Gas for a
      senior secured note made by us in an equal principal
    amount.





As a
result of the Securities Exchange:




●
            we
      own 100% of the issued and outstanding capital stock of Sonterra Oil &
      Gas;●
            we
      are engaged, through Sonterra Oil & Gas, in the operation and
      development of the oil and gas properties and related assets;
      and●
            we
      were the legal acquirer of Sonterra Oil & Gas and continue as a
      publicly traded entity, for accounting purposes, the acquisition has been
      treated as a recapitalization of the Company with Sonterra Oil & Gas
      as the acquirer (reverse acquisition).  The historical
      financials prior to February 14, 2008, are those of Sonterra Oil &
      Gas.





On June
23, 2008, our management team resigned and was replaced by a new management
team, consisting of Donald E. Vandenberg, Chief Executive Officer, and Gary L.
Lancaster, VP and Chief Legal Officer, both of whom were also named as
directors. Doyle Valdez resigned as a director on the same date. Donald J.
Sebastian, VP and Chief Financial Officer joined the Company effective as of
July 1, 2008.





On July
8, 2008 the Company acquired Velocity Partners and Velocity Offshore, previously
owned by certain executive officers of the Company.  Both of these
Velocity entities are recognized in the industry as employing growth strategy
through acquisition of oil and gas properties.  Additionally, Velocity
Offshore is recognized by the Minerals Management Services as a qualified
operator in the Outer Continental Shelf (OCS).  This recognition will
facilitate any potential offshore acquisition targets and streamline assumption
of operations upon closing because we will not have to go through the
time-consuming process of becoming qualified as an OCS operatory.





The
Company’s oil and gas assets consist of certain oil and gas properties and
related assets that we acquired in August 2007 from Cinco Natural Resources
Corporation ("Cinco") and Flash Gas & Oil Southwest, Inc. ("Flash") in two
separate transactions for an aggregate amount of approximately $5.8 million. Our
wholly owned subsidiary, Sonterra Operating, Inc., is the named operator of our
oil and gas properties, which are located in Matagorda Bay in Texas State Waters
lying offshore the Texas coastal counties of Calhoun and Matagorda. In the Cinco
acquisition, for approximately $4.7 million, the Company purchased 60% of the
interests held by Cinco in the Texas State Tract 150 Wells No. 1 and No. 2
located in Matagorda Bay, Texas, as well as a 320-acre oil and gas lease related
to those wells and certain other leases covering approximately 3,200 additional
acres located in Matagorda Bay. In the Flash acquisition, for approximately $1.1
million cash, the Company purchased all of the interests held by Flash in the
Texas State Tract 150 Wells No. 1 and No. 2 as well as a seven-mile pipeline
connecting the wells to the Keller Bay onshore facility located in Calhoun
County, Texas. As discussed below, the Texas State Tract 150 Well No. 2 has been
shut-in as a result of sand production and the State Tract 150 Well No. 1 only
produced marginally in the third quarter.





In
December 2007, we acquired an additional 1,920 gross (960 net) offset acres for
one of the undrilled Matagorda Bay prospects, giving us combined total acreage
of approximately 5,440 gross (1,597 net) acres. On December 18, 2007, the Texas
State Tract 150 Well No. 2 was shut-in because it was producing sand. During the
first quarter of 2008, we worked over this well in an attempt to clean the sand
out of the wellbore. Following the workover, however, sand production again
caused the well to shut-in, and the well remains shut-in pending evaluation for
future utility.





We have
identified four additional drilling locations on our acquired acreage and we
commenced drilling the first well location during the second quarter of
2008.  State Tract 127-1 Unit Well was spud on July 9, 2008 and
reached total depth of 12,494 feet in early September when the well was cased,
logged and temporarily suspended, awaiting completion.  Results of the
logs indicate the well encountered productive pay in the Bol Mex sands and the
Nodasaria #1.  The current status and 2009 plans are discussed in
detail in “Item 1.
Business.”Under
the terms of the contract operating agreement with South Texas Oil Company
described below, South Texas exercised its option to take an undivided 50% of
the Company’s working interest, subject to a 25% reversionary interest after
payout, in the State Tract 127-1 Unit Well.  Additionally, the Company
sold 10.00% working interest to Vinland Energy Capital I LLP on a promoted basis
as to the initial exploratory well only, and Vinland paid its proportionate
share of the leasehold and Geological and Geophysical costs. The proceeds were
recorded as adjustments to oil and gas properties. The net results of the above
transactions resulted in the Company having approximately a 3.56% working
interest before casing point and an 11.36% working interest after well payout
with corresponding net revenue interests of 5.11% and 8.27%,
respectively.


12




On April
8, 2008, the Company entered into a definitive contract operating agreement with
South Texas Oil Company, to be effective as of April 1, 2008, pursuant to which
the Company began overseeing daily operations of both operating services and
accounting services for the operated and non-operated properties of South Texas
Oil Company as an independent contractor acting in the role of contract
operator for a fee of $75,000 per month. Michael J. Pawelek, who was our
Chairman and Chief Executive Officer at the time we entered into the contract
operating agreement with South Texas Oil Company, was also and is currently
the Chairman of South Texas Oil Company. Our Board of Directors, with Mr.
Pawelek recused from voting as a potentially interested party, reviewed and
evaluated the terms of the contract operating agreement and determined that the
terms were commercially reasonable prior to authorizing our entry into and
performance of the South Texas Contract Operating Agreement. The South Texas
Contract Operating Agreement was terminated in July 2008, as a result of
the management team changes at both Sonterra Operating and South Texas Oil
Company.





Immediately
after terminating the South Texas Contract Operating Agreement, the Company
entered into another contract operating agreement with South Texas Oil
Company effective June 23, 2008, pursuant to which South Texas began overseeing
the daily operations of the Matagorda Bay 150 field and commenced the drilling
of the Matagorda Bay State Tract 127-1 Unit Well (“Matagorda Bay Operating
Agreement”).  Pursuant to the contract operating agreement, South
Texas will be entitled to receive the applicable Council of Petroleum
Accountants Society (COPAS) fees for the daily operations and drilling
as well as be entitled to participate in up to 50% in all of the Matagorda
Bay exploratory prospects.





Results
of Operations for the Year Ended December 31, 2008





Revenues.  During
the year ended December 31, 2008, we reported revenues of $285,998 from oil and
gas sales compared to $2,507,176 in 2007.  As described above, only
one of the two productive wells, the Texas State Tract 150 Wells No. 1, was
producing in the year ending December 31, 2008.





Contract
operating income for 2008 and 2007 was $261,234 and $265,718,
respectively.  No contract operating income or operating overhead
income was recorded in the third and fourth quarters of 2008 as a result of the
cancellation of the Contract Operating Agreement with South Texas Oil Company,
which was terminated effective as of June 23, 2008, contemporaneously with the
resignation of our former management team who were simultaneously appointed as
officers of South Texas Oil Company.





Drilling
rig income, recognized after the acquisition of NTDS, was $154,324 in
2008.  The revenue represents drilling services provided after
November 13, 2008.





Lease Operating
Expenses.  During the year ended December 31, 2008, our lease
operating expenses were $722,867 compared to $1,216,796 in 2007.  The
decrease in lease operating costs was a result of having two wells on production
for most of 2007 and only one well producing for a portion of
2008.  Water disposal costs were the most significant expense incurred
in 2008.  No other unusual operating expenses were incurred during the
period.





Drilling
rig expenses were $355,630 in 2008.  Payroll and benefits were the
most significant expense incurred after acquiring NTDS.





Other (Expense).  During
the year ended December 31, 2008, we had interest expense in the amount of
$918,492 and debt issuance costs amortization of $201,943 compared to $428,249
in interest expense and $40,982 in debt issuance cost amortization in 2007. The
interest expense in 2008 relates to the Senior Secured Note, the Longview
Subordinated Note, and the Marquis Subordinated Note.





Impairments.  The
Company recognized an impairment expense of $1,647,288 in 2008.  The
decline in commodity prices and the conveyance of 50% of our share of Matagorda
150 #1 well reduced the pre-tax PV 10 value of proved reserves from $7.1 million
to $4.0 million. There can be no assurance that other impairments will not be
required in the future.




13


General and Administrative
Expense.General and administrative expense for the year ended
December 31, 2008 was $2,974,810 compared to $881,083 in
2007.  Non-cash stock compensation expense for the year ended December
31, 2008 was $1,000,933.  Since all prior non-cash stock compensation
expenses related to the prior management team were reversed in the second
quarter, all 2008 non-cash stock compensation expense relate to the common stock
options of the current management.





Our
corporate structure is to operate with as few employees as feasible; pending
anticipated future acquisitions of producing oil and gas properties, and to
outsource most administrative functions.  The Company has used and is
currently using PetroAcct L.P. for contract accounting services; Akin, Doherty,
Klein and Feuge P.C. and Hein & Associates LLP for audit and tax services;
Thompson & Knight LLP and Duane Morris LLP for legal services; and Sterling
Bank for banking services. Collectively, the combined expenses for accounting,
auditing, and legal services for the year ended December 31, 2008 were
$746,313.





Financial
Condition





Liquidity
and Capital Resources





Our
primary source of liquidity is cash flow from operations; however, neither of
our two wells in the Matagorda Bay 150 Field was producing at December 31, 2008
nor at March 31, 2009.  In addition, all of our NTDS drilling rigs are
currently stacked and have not been utilized in 2009 thus far. While we now
expect to bring both the State Tract 127-1 Unit Well and the State Tract 150-1
ST #1 Well on line to begin producing natural gas in the second quarter of 2009,
there is no assurance that we will not encounter further difficulties with
formation sand accumulation and/or excessive water production that would further
delay production or render further operations to bring production cost
prohibitive at current oil and gas commodity prices.  The
documentation executed in connection with the Financial Restructuring
significantly restricts our ability to incur indebtedness without seeking
subordination from Marquis and Longview. If Marquis is unwilling to waive or
modify such conditions or subordinate the notes to allow us to obtain project
financing for future acquisitions, the Company would likely be unable to
raise the funds required to make acquisitions in the future.




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





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





Our
business plan contemplates that we would make at least one acquisition of
producing properties in the Appalachian Basin within the next six months, which
would require additional funds to be raised. As of December 31, 2008, we did not
have any agreements or commitments to make any such additional acquisitions, and
there is no assurance that we will have available the funds necessary to
complete any acquisition, that Marquis and Longview will agree to subordinate
their notes to allow us to obtain financing for future acquisitions, or that we
will be able to reach an agreement to acquire additional prospects on acceptable
terms, if at all. As indicated above, the Company has entered into a letter of
intent to acquire producing properties in southern West Virginia, which is
scheduled to close on or before May 31, 2009.


14


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





Senior
Secured Notes and Subordinated Notes





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





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





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





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





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





The
descriptions of the above agreements are qualified in each case, in their
entirety, by reference to the complete texts of such agreements, which are
attached hereto as Exhibits 10.19 through 10.28.


15




Other
Notes





As part
of the acquisition of the Velocity entities, the Company assumed a $75,000
promissory note, plus accrued interest of $11,463, payable to our President and
Chief Executive Officer, which bears interest at 8%, compounded annually
(“Vandenberg Note”).  The Vandenberg Note has been subordinated to the
Senior Secured Note, the Marquis Subordinated Note, and the Longview
Subordinated Note.





Capital
Expenditures and Commitments





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





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




Critical
Accounting Policies





The
discussion and analysis of our financial condition and results of operations is
based upon our consolidated financial statements, all of which have been
prepared in accordance with U.S. generally accepted accounting principals
(“GAAP”). The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses. Our significant accounting policies are described in
Note 3 to the
Financial Statements. Certain of these policies are of particular
importance to the portrayal of our financial position and results of operations,
and require the application of significant judgment by management. We analyze
our estimates, including those related to reserves, depletion and impairment of
oil and gas properties, and the ultimate utilization of the deferred tax asset,
and base our estimates on historical experience and various other assumptions
that we believe to be reasonable under the circumstances. Actual results may
differ from these estimates under different assumptions or conditions. We
believe the following critical accounting policies affect our more significant
judgments and estimates used in the preparation of our financial statements
subsequent to the Securities Exchange.





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





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


16





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





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





2) plus
the cost of properties not being amortized;





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





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





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





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





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





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





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





In July
2006, the Financial Accounting Standards Board (“FASB”) issued FASB
Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an
interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in a company's financial
statements in accordance with SFAS No. 109, “Accounting for Income Taxes.”
Effective January 1, 2007, we adopted FIN 48. FIN 48 clarified the accounting
for uncertainty in income taxes recognized in the financial statements by
prescribing a recognition threshold and measurement attribute for a tax position
taken or expected to be taken in a tax return. FIN 48 prescribes the procedure
for recognizing, measuring, presenting, and disclosing uncertain tax positions
that the company has taken or expects to take in its income tax returns. FIN 48
requires that only income tax benefits that meet the “more likely than not”
recognition threshold be recognized or continue to be recognized on its
effective date. The adoption of FIN 48 did not have a material effect on our
financial statements.


17




New
Accounting Standards





In
September 2006, FASB issued SFAS No. 157, “Fair Value Measurement” (“SFAS No.
157”). SFAS No. 157 defines fair value, establishes a framework for measuring
fair value, and expands disclosures about fair value measurements. The standard
applies whenever other standards require (or permit) assets or liabilities to be
measured at fair value, but does not expand the use of fair value in any new
circumstances.  In February 2008, FASB granted a one-year deferral of
the effective date of this statement as it applies to non-financial assets and
liabilities that are recognized or disclosed at fair value on a nonrecurring
basis (e.g., those measured at fair value in a business combination and goodwill
impairment).  SFAS No. 157 is effective for all recurring measures of
financial assets and financial liabilities (e.g., derivatives and investment
securities) for financial statements issued for fiscal years beginning after
November 15, 2007, and interim periods within those years. We have completed our
initial evaluation of the impact of SFAS No. 157 as it relates to our financial
assets and liabilities and determined that its adoption is not expected to have
a material impact on our financial position or results of
operations.





In
February 2007, FASB issued SFAS No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities” (“SFAS No. 159”).  SFAS No. 159
allows entities the option to measure eligible financial instruments at fair
value as of specified dates. Such election, which may be applied on an
instrument by instrument basis, is typically irrevocable once elected. SFAS No.
159 is effective for fiscal years beginning after November 15, 2007, and early
application is allowed under certain circumstances. We do not expect the
adoption of SFAS No. 159 to have a significant impact on our consolidated
financial position, results of operations or liquidity.





In
December 2007, FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS
141(R)”), which replaces SFAS 141. SFAS 141(R) establishes principles and
requirements for how an acquirer recognizes and measures in its financial
statements the identifiable assets acquired, the liabilities assumed, any
non-controlling interest in the acquire entity and the goodwill
acquired.  The Statement also establishes disclosure requirements,
which will enable users to evaluate the nature and financial effects of the
business combination. SFAS 141(R) is effective for fiscal years beginning after
December 15, 2008.  The adoption of SFAS 141(R) will have an impact on
accounting for business combinations once adopted, but the effect is dependent
upon acquisitions at that time.





In
December 2007, FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements — an amendment of Accounting Research Bulletin
No. 51” (“SFAS 160”), which establishes accounting and reporting standards for
ownership interests in subsidiaries held by parties other than the parent, the
amount of consolidated net income attributable to the parent and to the
non-controlling interest, changes in a parent's ownership interest and the
valuation of retained non-controlling equity investments when a subsidiary is
deconsolidated. SFAS 160 also establishes reporting requirements that provide
sufficient disclosures that clearly identify and distinguish between the
interests of the parent and the interests of the non-controlling owners. SFAS
160 is effective for fiscal years beginning after December 15, 2008. We do not
currently have non-controlling interests in any of our
subsidiaries.





Off-Balance
Sheet Arrangements





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





Inflation





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





Quantitative
and Qualitative Disclosures about Market Risk.





Interest
Rate Risk





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


18





Commodity
Price Risk





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





Unregistered
Sales of Equity Securities and Use of Proceeds





Not
Applicable.





Default
upon Senior Securities





Not
Applicable.





Item
8.   Financial
Statements and Supplementary Data





The
consolidated financial statements are set forth herein commencing on page
F-1.





Item
9.  Changes in and
Disagreements with Accountants on Accounting and Financial
Disclosure.





Our San
Antonio-based auditing firm, Akin, Doherty, Klein and Feuge P.C., resigned as
auditor on December 30, 2008, but recited no differences with respect to
accounting and financial disclosures. Hein & Associates LLP replaced Akin,
Doherty, Klein and Feuge P.C. for audit and tax services shortly
thereafter.





Item
9A (T).  Controls
and Procedures.





Evaluation
of Disclosure Controls and Procedures





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





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





Management’s
Annual Report on Internal Control Over Financial Reporting





Management
acknowledges its responsibility for establishing and maintaining adequate
internal control over financial reporting in accordance with Rule 13a-15(f)
promulgated under the Securities Exchange Act of 1934. Management has also
evaluated the effectiveness of its internal control over external financial
reporting in accordance with generally accepted accounting principles within the
guidelines of the Committee of Sponsoring Organizations of the Treadway
Commission framework.  Based on the results of this evaluation,
Management has determined that the Company has material weaknesses in our
internal controls over financial reporting.  This assessment is based
on the following:





·
              The
      Company’s financial and accounting organization consists of the Chief
      Financial Officer and an outsourcing company.  Due to the lack
      of financial resources and accounting resources, the financial records,
      prior to audit, did not correctly record certain items which were
      corrected during the audit process.  Because of this lack of
      resources, review procedures were not consistently performed on a timely
      basis to ensure that financial reporting controls were operating in the
      manner designed.
  19
  ·
              The
      Company lacks sufficient knowledge and expertise in financial reporting to
      adequately handle complex or non-routine accounting issues.  The
      Company will consider utilizing third party specialists to assist with
      complex and non-routine accounting issues, which will address both of
      these material weaknesses.





This
annual report does not include an attestation report of our registered public
accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by our
registered public accounting firm pursuant to temporary rules of the Securities
and Exchange Commission that permit us to provide only management’s report in
this annual report.





Changes
in Internal Controls





There
were no changes in our internal control over financial reporting (as defined in
Rule 13a-15(f) of the Securities Exchange Act of 1934) during the quarter ended
December 31, 2008, that have materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting.





Item
9B.   Other
Information.





None.





PART
III





Item
10.  Directors,
Executive Officers, and Corporate Governance.





Directors





DONALD E.
VANDENBERG, age 65, currently serves as the Chief Executive Officer and
President, and has served in such capacities and as a Director, since June 2008.
In November 2008, Mr. Vandenberg became the Chairman of the Board of Directors,
and he currently serves in such capacity.  Mr.Vandenberg is a petroleum
engineer and has held senior management positions throughout his 40-year career
in the exploration and production field. From January 2004 to present,
he co-founded and has served as CEO and President of Velocity Energy
Limited LLC, General Partner of Velocity Energy Offshore LP and Velocity Energy
Partners LP, all of which entities have been acquired by the Company. Mr.
Vandenberg was formerly President of J. M. Corporation’s Energy
Sector.  Prior to that, he was Senior Vice President and General
Manager of Equitable Resources Company, Vice President of Engineering and
Development of Maxus Energy Corp., and held managerial positions at Kilroy
Company of Texas, Union Texas Petroleum, Inc., and Aminoil, Inc. Mr. Vandenberg
has a Professional Degree in Petroleum Engineering from the Colorado School of
Mines.





GARY L.
LANCASTER, age 54, currently serves as the Chief Legal Officer, Vice
President and Secretary, and has served in such capacities as well as a Director
since June 2008. Mr. Lancaster has been a practicing lawyer for 29 years and has
extensive legal and land experience in virtually all facets of the oil industry.
From October 2004 to present, he was a co-founder of and has served as Vice
President of Velocity Energy Limited LLC and its affiliated entities until
joining the Company in June 2008. From February 2004 to October 2004, Mr.
Lancaster was Partner at Duane Morris LLP and from April 2001 until February
2004, he was Of Counsel at Baker & McKenzie. Mr. Lancaster has also held
senior legal and management positions in upstream, midstream, downstream, and
oilfield service companies, including as Vice President of Legal Affairs for J.
M. Corporation’s Energy Sector; Senior Vice President and General Counsel of ICO
Inc.; and Senior Attorney with Scurlock Permian Corporation, a division of
Ashland Oil, Inc. He has a BA Degree in Political Science from West Virginia
University and a JD Degree from the University of Miami.





HERBERT
E. WARNER, age 64, was appointed as a director in November 2008, and has served
in such capacity since that time. From January 1997 to present, Mr. Warner has
been self-employed as an independent contractor, consultant and forensic
accountant providing consulting services to a variety of clients, mainly in the
oil and natural gas industry such as preparing clients’ financial statements and
reviewing financial books and records. Mr. Warner is a licensed certified public
accountant in both Texas and New Mexico.  He received a Master's
of Business Administration Degree from the University of New Mexico and a
Bachelor of Science Degree in Accounting from Bowling Green State
University.


20





JEFFREY
W. TOOTH, age 52, who was appointed as a director in November 2008, and has
served in such capacity since that time. Mr. Tooth is an executive with 25 years
of diverse management, business and technical experience including extensive
hands-on experience leading junior and senior oil and gas companies. From June
2007 to the present, Mr. Tooth has been employed as a consultant performing
geological services in Calgary, Alberta. From November 2005 until the sale of
the Company in June 2007, Mr. Tooth was Vice President of Trigger Resources, a
junior E&P company focused on heavy oil and natural gas in Saskatchewan.
From July 2005 through November 2005, Mr. Tooth traveled and spent time with his
family. From September 2002 through the sale of Canstar in July 2005, Mr. Tooth
was the President and co-founder of Canstar Exploration Ltd., a private
exploration company that was backed by J.M. Huber Corporation and J.R.
Richardson. Prior to Canstar, Mr. Tooth was a Vice President of Exploration for
J. M. Huber Corporation’s Canada subsidiary. Prior to joining J.M. Huber, Mr.
Tooth was Western Canada Exploration Manager for Husky Oil, a senior oil and gas
company ranked among the top 10 producers in Canada. Mr. Tooth received a
Bachelor of Science Degree (Hons.) in Geology in 1978 and a Master of
Science Degree in Petrology in 1980, both from the University of London. He
is a member of A.P.E.G.G.A. and several other professional organizations. He has
served on the boards of Trigger Resources Ltd., Canstar Exploration Ltd. and
Velocity Energy LLC.





Executive
Officers





Donald E.
Vandenberg currently serves as our Chief Executive Officer and President. Gary
L. Lancaster currently serves as the Chief Legal Officer, Vice President and
Secretary. Messrs. Vandenberg and Lancaster have served in such capacities as
well as Directors since June 23, 2008.





DONALD J.
SEBASTIAN, age 56, currently serves as our Chief Financial Officer and Vice
President and has served in such capacities since July 1, 2008.  Mr.
Sebastian has over 34 years of experience in the oil and gas industry including
a unique mix of the financial and accounting expertise traditionally associated
with CFOs plus substantial onshore and offshore operating expertise which he
acquired over the four years from January 2004 through June 2008 where Mr.
Sebastian was Vice President of Onshore Operations and Business Development with
Michael Baker Corporation, a civil engineering and oil and gas service services
with worldwide operations. Prior to that, he was Senior Vice President
responsible for the Gulf Coast Business Unit of the Energy Sector of J. M. Huber
Corporation where he previously had been the Chief Financial Officer and served
in other positions during the course of his 25 year tenure with Huber from 1979
until January 2004. Mr. Sebastian has a BS Degree in Business Administration
from Trinity University in San Antonio, Texas.





Section
16(a) Beneficial Ownership Reporting Compliance





Section
16(a) of the Exchange Act requires our directors, officers and persons who own
more than 10% of our common units to file with the Securities and Exchange
Commission initial reports of ownership and reports of changes in ownership of
common units. Directors, officers and 10% holders of the common units are
required by Securities and Exchange Commission rules and regulations to furnish
us with copies of all Section 16(a) forms they file. To our knowledge, based
solely on a review of the copies of such reports furnished to us, all Section
16(a) filing requirements applicable to our directors, officers and 10% holders
were met.





Corporate
Governance





Our
common stock is quoted on the OTC Bulletin Board. As such, we are not currently
subject to corporate governance standards applicable to companies listed on
national securities exchanges, which require, among other things, that the
majority of the board of directors of a listed company be
independent.





Because
we are not currently subject to corporate governance standards relating to the
independence of our directors, we have chosen to define an “independent”
director in accordance with the American Stock Exchange’s requirements for
independent directors. The American Stock Exchange independence definition
includes a series of objective tests, such as that the director is not an
employee of the company or any of its subsidiaries and has not engaged in
various types of business dealings with the company. We currently have two
directors that we believe are “independent” under the above
definition: Messrs. Warner and Tooth.





Effective
December 31, 2008, the Board established an Audit Committee, a Corporate
Compensation and Nominating Committee, a Select Committee and a Corporate
Governance Committee. The Board of Directors held eight meetings during 2008.
Although a financial expert is not required for smaller reporting companies, we
have an Audit Committee Financial Expert, Herbert E. Warner, who is an
independent director of our Board of Directors. The Corporate Compensation and
Nominating Committee has reviewed and discussed with the Company our most recent
equity compensation plans as well as the Company’s overall incentive-driven
compensation philosophy. The Board of Directors discussed the equity
compensation plans of the Company at its Annual Meeting in February 2009, and
established the foregoing committee as well as a Select Committee to implement
awards under the plans.


21




We will
become subject to the governance rules of any stock exchange on which our common
stock may be listed in the future. However, the rules of many such exchanges,
including the American Stock Exchange and NASDAQ, provide that a controlled
company (i.e., a company more than 50% of whose voting power is held by an
individual, a group or another company) is exempt from certain of such
governance rules, including the requirement that the company’s board consist of
a majority of independent directors and that executive compensation and
nominations of directors be determined by independent directors. We are a
controlled company and we therefore believe that we will be entitled to rely on
these exemptions upon any listing our common stock on a stock exchange providing
such exemptions.





Code
of Business Conduct





We have
adopted a Code of Business Conduct that applies to our principal executive
officer, principal financial officer, and legal officer.  This Code of
Business Conduct is attached as Exhibit 14.1 hereto.


22


Item
11.  Executive
Compensation.




Summary
Compensation Table





The table
below sets forth information regarding compensation for our named executive
officers for periods indicated:




Name
      and Principal Position
                                  
                                  Year
                                  
                                  Salary(1)
                                  
                                  
                                  Bonus(2)
                                  
                                  
                                  Option
                                    Awards(3)
                                  
                                  
                                  All
      Other
                                    Compensation
                                  
                                  
                                  TotalDonald
      E. Vandenberg
                                  
                                  2008
                                  
                                  $
                                  200,000
                                  
                                  
                                  $
                                  70,000
                                  
                                  
                                  $
                                  0
                                  
                                  
                                  $
                                  0
                                  
                                  
                                  $
                                  $270,000Chairman
      of the Board, Chief Executive Officer and PresidentGary
      L. Lancaster
                                  
                                  2008
                                  
                                  $
                                  180,000
                                  
                                  
                                  $
                                  70,000
                                  
                                  
                                  $
                                  0
                                  
                                  
                                  $
                                  0
                                  
                                  
                                  $
                                  250,000Chief
      Legal Officer, Vice President and SecretaryDonald
      J. Sebastian
                                  
                                  2008
                                  
                                  $
                                  180,000
                                  
                                  
                                  $
                                  0
                                  
                                  
                                  $
                                  0
                                  
                                  
                                  $
                                  0
                                  
                                  
                                  $
                                  180,000Chief
      Financial Officer and Vice PresidentMichael
      J. Pawelek(4)
                                  
                                  2008
                                  
                                  $
                                  200,000
                                  
                                  
                                  $
                                  0
                                  
                                  
                                  $
                                  0
                                  
                                  
                                  $
                                  0
                                  
                                  
                                  $
                                  200,000Chief
      Executive Officer and PresidentWayne
      A. Psencik(5)
                                  
                                  2008
                                  
                                  $
                                  180,000
                                  
                                  
                                  $
                                  0
                                  
                                  
                                  $
                                  0
                                  
                                  
                                  $
                                  0
                                  
                                  
                                  $
                                  180,000Vice
      President - Operations







(1)
            Pursuant
      to the employment agreement each named executive officer has with us,
      salaries may be subject to deferral. Please see the discussion below
      accompanying this table.(2)
            Comprised
      of cash sign-on bonus related to our management transition on June 23,
      2008.


(3)
            Represents
      the dollar amount recognized for financial statement reporting purposes
      with respect to the corresponding fiscal year for the fair value of
      30,000 options granted during 2008, as determined in accordance with
      FAS 123(R). These options were granted in relation to our management
      transition on June 23, 2008. Pursuant to SEC rules, the amounts shown
      exclude the impact of estimated forfeitures related to service-based
      vesting conditions. Please see the discussion of the assumptions made in
      the valuation of these awards in Note 3 “Summary of Significant Accounting
      Policies—Stock-Based Compensation” to the audited consolidated financial
      statements included in this report. These amounts reflect our accounting
      expense for these options, and do not correspond to the actual value that
      will be recognized by the named executive officer.(4)
            Michael
      J. Pawelek resigned his position as Chief Executive Officer and President
      pursuant to our management transition on June 23, 2008. Mr. Pawelek
      continues to serve on our board of directors. Mr. Pawelek executed a
      letter agreement, which letter set forth the terms and conditions of the
      termination of his employment agreement with us and the forfeiture of all
      stock options that we previously granted to
him.


(5)
            Wayne
      A. Psencik resigned his position as Vice President - Operations pursuant
      to our management transition on June 23, 2008. Mr. Psencik executed a
      letter agreement, which letter set forth the terms and conditions of the
      termination of his employment agreement with us and the forfeiture of all
      stock options that we previously granted to
him.





The
employment agreements for the members of our executive team dated June 23, 2008,
June 23, 2008, and June 23, 2008 provide for annual salaries of $200,000,
$180,000, and $180,000 for Mr. Vandenberg, Mr. Lancaster and Mr. Sebastian,
respectively. Included as part of their compensation under their respective
employment agreements, Messrs. Vandenberg, Lancaster, and Sebastian have been
awarded options to acquire the common stock of the Company through Option Grants
awarded under the 2007 River Capital Group, Inc. Non-Qualified Stock Option Plan
(“2007 RCGI Plan”).  Messrs. Vandenberg and Lancaster each received a
Sign-On Bonus of $70,000. Mr. Sebastian did not receive a Sign-On Bonus;
however, he did receive options to acquire 30,000 shares of the Company’s Common
Stock upon the commencement of his employment with the Company on July
1, 2008, which options vested on November 1, 2009. Base Salaries for each of
Messrs. Vandenberg, Lancaster, and Sebastian were deferred until November 1,
2008, and salaries accruing from their respective dates of first employment
through October 31, 2008, are deferred until completion of an Acquisition
Completion. As defined in each of the employment agreements, the term
“Acquisition Completion” is defined as an acquisition of oil and gas properties
by virtue of an asset or stock sale that has, individually or in aggregate, a
cash purchase price of $25,000,000.


23




Equity
Awards





2007 RCGI Plan.  A
maximum of 5,140,165 options may be awarded under the 2007 RCGI Plan. Equity
compensation is intended to qualify as performance-based compensation under
Section 162(m) of the Code. A participant may receive more than one equity award
granted under the program. The terms under the 2007 RCGI Plan are set forth in
the chart included under the section entitled Outstanding Equity Awards set
forth below.





2008 SOTR Plan.  A
maximum of 3,000,000 options may be awarded under the 2008 Sonterra Resources,
Inc. Equity Compensation Plan (“2008 SOTR Plan” or the “Plan”). No employee
participant may receive options to purchase more than 400,000 shares of common
stock under the 2008 SOTR Plan in any given year, the total number of options
awarded to all employee participants shall not exceed 1,300,000 in any given
year under the 2008 SOTR Plan, and any awards under the 2008 SOTR Plan are in
addition to a maximum of 5,140,165 options under the 2007 RCGI Plan. A
participant may receive more than one equity award granted under the program.
Equity compensation is intended to qualify as performance-based compensation
under Section 162(m) of the Code.





Performance Objectives
Necessary for Options to Vest. Vesting of options granted to all
participants in a given year under the 2008 SOTR Plan shall be based upon the
achievement of each performance objective set forth in the following table
(individually or collectively, “Performance Objective”):




Percentage of
                              Options That
                              Vest Each Year
                              for Shares
                              Earned Under
                              the Option
                              Agreement*
                            
                            Compounded
                              Annual Net
                              Reserve
                              Growth
                              Performance
                              Objective**
                            
                            
                            Options that
                              Vest Each
                              Year Based on
                              Achievement
                              of Reserve
                              Growth
                              Performance
                              Objective
                            
                            
                            Options That
                              Vest Each Year
                              Based on
                              Achievement of
                              75% of Reserve
                              Growth
                              Performance
                              Objective
                            
                            
                            Options That
                              Vest Each Year
                              Based on
                              Achievement of
                              50% of Reserve
                              Growth
                              Performance
                              Objective
                            
                            
                            Options That
                              Vest Each Year
                              Based on
                              Achievement of
                              <50% of
                              Reserve
                              Growth
                              Performance
                              Objective33-1/3%
                            
                            
                            36
                            %
                            
                            
                            433,334
                            
                            
                            
                            325,000
                            
                            
                            
                            216,667
                            
                            
                            
                            033-1/3%
                            
                            
                            36
                            %
                            
                            
                            433,333
                            
                            
                            
                            325,000
                            
                            
                            
                            216,666
                            
                            
                            
                            033-1/3%
                            
                            
                            36
                            %
                            
                            
                            433,333
                            
                            
                            
                            325,000
                            
                            
                            
                            216,666
                            
                            
                            
                            0100%
                            
                            
                            
                            
                            
                            
                            1,300,000
                            
                            
                            
                            975,000
                            
                            
                            
                            650,000
                            
                            
                            
                            0





* Once
the applicable compounded Annual Net Reserve Growth Performance Objective Target
has been achieved for a given year at the 100% Target Level (36% or greater),
75% of Target Level (between 24% and 36%), 50% of Target Level (between 18% and
24%), and 0% for 18% or less Compounded Annual Net Reserve Growth, the Options
awarded will vest in full over 3 years at 33-1/3% per annum.





**The
Compounded Annual Net Reserve Growth Performance Objective is based upon the
total proved, probable and possible reserves net to the Company’s interest,
adjusted for production, farmouts, and other dispositions of the underlying oil
and gas assets, as each reserve category is defined under industry standard SPE
reserve definitions.





*** For
every given year during the Plan, the applicable prior period shall commence
April 1, 2008, and shall end as of the end of the calendar quarter ended March
31st
of that given year.





Terms of Options.
Options granted under the Plan shall be subject to the following terms and
conditions and shall be in such form and contain such additional terms and
conditions, not inconsistent with the terms of the Plan, as the board shall
deem desirable:





(a) Option Price. The
options under the Plan shall be priced at $1.04. Notwithstanding the foregoing,
the option price per share of common stock of an option shall never be less than
fair market value on the date of grant.





(b) Option Term. The term
of each option shall be fixed by the Board or Committee thereof, but no option
shall be exercisable more than ten years after the date of
grant.


24





Termination. The
Board shall have the right and the power to terminate the Plan at any time. No
option or other equity compensation shall be granted under the Plan after the
termination of the Plan, but the termination of the Plan shall not have any
other effect, and any option outstanding at the time of the termination of the
Plan may be amended and exercised and may vest after termination of the Plan at
any time prior to the expiration date of such option or other equity
compensation to the same extent such option or other equity compensation could
have been amended and would have been exercisable or would have vested had the
Plan not terminated.





Outstanding
Equity Awards





The
following table sets forth certain summary information regarding outstanding
equity awards as of December 31, 2008 to the Company's Chief Executive Officer,
Chief Legal Officer and Chief Financial Officer during such period.




OUTSTANDING
      EQUITY AWARDS AS OF THE END OF 2008OPTION
      AWARDS
                          
                          STOCK
      AWARDSName
                          
                          Number of
                            Securities
                            Underlying
                            Unexercised
                            Options
                            (#)
                            Exercisable
                          
                          
                          Number of
                            Securities
                            Underlying
                            Unexercised
                            Options
                            (#)
                            Unexercisable
                          
                          
                          Equity
                            Incentive
                            Plan
                            Awards:
                            Number of
                            Securities
                            Underlying
                            Unexercised
                            Unearned
                            Options
                            (#)
                          
                          
                          Option
                            Exercise
                            Price
                            ($)*
                          
                          Option
                            Expiration
                            Date
                          
                          Number
      of
                            Shares
      or
                            Units
      of
                            Stock
      That
                            Have Not
                            Vested
                            (#)
                          
                          
                          Market
                            Value of
                            Shares or
                            Units of
                            Stock That
                            Have Not
                            Vested
                            ($)
                          
                          
                          Equity
                            Incentive
                            Plan
                            Awards:
                            Number of
                            Unearned
                            Shares,
                            Units or
                            Other
                            Rights That
                            Have Not
                            Vested
                            (#)
                          
                          
                          Equity
                            Incentive
                            Plan
                            Awards:
                            Market or
                            Payout
                            Value of
                            Unearned
                            Shares,
                            Units or
                            Other
                            Rights That
                            Have Not
                            Vested
                            (#)D.
      E. Vandenberg
                          
                          
                          0
                          
                          
                          
                          439,122
                          
                          
                          
                          878,246
                          
                          
                          $
                          1.707
                          
                          June
      22, 2018
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          0Gary
      L. Lancaster
                          
                          
                          0
                          
                          
                          
                          380,573
                          
                          
                          
                          761,146
                          
                          
                          $
                          1.707
                          
                          June
      22, 2018
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          0Donald
      J. Sebastian
                          
                          
                          30,000
                          
                          
                          
                          380,573
                          
                          
                          
                          761,146
                          
                          
                          $
                          1.707
                          
                          June
      22, 2018
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          0
                          
                          
                          
                          0





Compensation
of Directors





Directors
serving during the fiscal year ended December 31, 2007, were not compensated.
During the current fiscal year through June 30, 2008, Doyle Valdez and Robert
Terry Gill served as Directors and were paid cash compensation of $1,000 each
for serving as Directors.  Doyle Valdez resigned as a Director of June
23, 2008.  After his resignation as an officer and employee of the
Company on June 23, 2008, Michael J. Pawelek remained as a non-employee Director
and Chairman of the Board until his resignation on November 6, 2008, at which
time he as replaced as Chairman of the Board of Directors by Donald E.
Vandenberg.  Robert Terry Gill resigned as a Director on March 20,
2009.





Name
                      
                      Fees
                        Earned or
                        Paid in
                        Cash
                        ($)
                      
                      
                      Stock
                        Awards ($)
                      
                      
                      Option
                        Awards ($)
                      
                      
                      Non-Equity
                        Incentive
                        Plan
                        Compensation
                        ($)
                      
                      
                      Non-
                        Qualified
                        Deferred
                        Compensation
                        Earnings
                        ($)
                      
                      
                      All
                        Other
                        Compensation
                        ($)
                      
                      
                      Total ($)D.E.
      Vandenberg
                        CEO,
      President
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0Gary
      L. Lancaster
                        CLO,
      VP, Secretary
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0Doyle
      Valdez (1)
                      
                      
                      1,000
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      1,000Robert
      T. Gill (2)
                      
                      
                      1,000
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      1,000Michael
      Pawelek (3)
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0Herbert
      E. Warner (4)
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0Jeffrey
      W. Tooth (5)
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0
                      
                      
                      
                      0





(1)
Resigned effective June 23, 2008.


(2)
Resigned effective November 6, 2008.


(3)
Resigned effective March 20, 2009.


(4)
Appointed effective November 6, 2008.
 (5)
Appointed effective November 6, 2008.


25




Item
12. Security Ownership of
Certain Beneficial Owners and Management and Related Stockholder
Matters.





The
following table sets forth certain information known to the Company with respect
to the beneficial ownership of the Company’s common stock as of April 14, 2009
by (i) each person who is known by the Company to own beneficially more than 5%
of the Company's common stock and (ii) the Company’s directors and executive
officer, and (iii) all officers and directors of the Company as a
group.




Shares beneficially owned (1)Number of
                      shares
                    
                    
                    Percentage of
                      class (2)The
      Longview Fund, L.P. (3)
                      c/o
      Viking Asset Management, L.L.C.
                      600
      Montgomery Street 44th
      Floor
                      San
      Francisco, CA 94111
                    
                    
                    29,346,570
                    
                    
                    
                    93.74
                    %D.
      E. Vandenberg (CEO/P/D) (4)
                    
                    
                    439,122
                    
                    
                    
                    1.64
                    %Gary
      L. Lancaster (CLO/VP/D/S) (4)
                    
                    
                    380,573
                    
                    
                    
                    1.42
                    %Donald
      J. Sebastian (CFO/VP) (4)
                    
                    
                    410,573
                    
                    
                    
                    1.53
                    %Robert
      Terry Gill (D) (5)
                    
                    
                    50,000
                    
                    
                    
                    0.18
                    %Herbert
      E. Warner (D) (6)
                    
                    
                    50,000
                    
                    
                    
                    0.18
                    %Jeffrey
      W. Tooth (D) (7)
                    
                    
                    50,000
                    
                    
                    
                    0.18
                    %Officers
      and Directors as a Group
                    
                    
                    1,380,268
                    
                    
                    
                    5.00
                    %





(1)
Beneficial Ownership is determined in accordance with the rules of the
Securities and Exchange Commission and generally includes voting or investment
power with respect to securities. Shares of common stock subject to options or
warrants currently exercisable or convertible, or exercisable or convertible
within 60 days of March 31, 2008, are deemed outstanding for computing the
percentage of the person holding such option or warrant but are not deemed
outstanding for computing the percentage of any other person. Except as pursuant
to applicable community property laws, the persons named in the table have sole
voting and investment power with respect to all shares of common stock
beneficially owned.





(2)
Percentage based on 26,347,359 shares of common stock outstanding as of March
31, 2009, plus 1,958,678 shares underlying convertible note and
warrants.





(3) The
Longview Fund, L.P. is a private investment fund that is in the business of
investing in publicly-traded securities for their own accounts and is structured
as a California limited partnership whose members are the investors in the fund.
The General Partner of the fund is Viking Asset Management, LLC,
a California limited liability company which manages the operations of the
fund. Peter T. Benz is the managing member of Viking Asset Management,
LLC. As the control person of the shares owned by The Longview Fund, L.P.,
Peter T. Benz may be viewed as the beneficial owner of such shares pursuant to
Rule 13d-3 under the Securities Exchange Act of 1934. The Longview Fund, L.P.,
the major shareholder, holds 23,182,876 shares. The related Longview Equity
Fund, L.P. holds 869,836 shares and the related Longview International Equity
Fund, L.P. holds 335,180 shares for an aggregate of 24,387,892 shares (including
the 23,182,876 shares held by The Longview Fund, L.P.), plus 4,958,678 in
unissued warrants, which totals 29,346,570 share beneficially owned by Peter T.
Benz.


26


(4) The
address of each of Messrs. Vandenberg, Lancaster, and Sebastian is c/o Velocity
Energy Inc., 523 N. Sam Houston Pkwy. E., Suite 175, Houston, TX 77060. 
 The shares of common stock subject to options and corresponding
percentages for Messrs. Vandenberg, Lancaster, and Sebastian are calculated
above upon the assumption that the Company makes an acquisition(s) of producing
oil and gas properties within 60 days of March 31, 2008 totaling, individually
or in aggregate, at least $25,000,000, triggering the vesting of such options
under the 2007 RCGI Plan.  In the absence of acquisition(s) totaling
at least $25,000,000 (“Qualifying Acquisition”) or achievement of a performance
metric tied to the net asset value (“NAV”) of the Company on a per share basis
of a $4 NAV for the first year, $6 NAV for the second year, and $8 NAV for the
third year under the Plan (“Qualifying NAV”); the current share ownership
percentages for each of the officers and directors individually and collectively
as a group would be 0.00%, noting that the only options held by any members of
the Officers and Directors as a Group that are currently vested and exercisable
are options for 30,000 shares of common stock held by Mr. Sebastian, which
vested and became exercisable on November 1, 2008, but his share ownership is
still calculated as 0.00% as rounded.





(5)
Robert Terry Gill resigned as a Director on March 20, 2009. The shares of common
stock subject to options and corresponding percentages for Mr. Gill are
calculated upon the assumption that, within 60 days of March 31, 2008, the
Company makes a Qualifying Acquisition; otherwise, the current share ownership
total and share ownership percentage for Mr. Gill under the 2007 RCGI Plan are 0
options and 0.00%, respectively.





(6) The
shares of common stock subject to options and corresponding percentages for Mr.
Warner are calculated upon the assumption that, within 60 days of March 31,
2008, the Company makes a Qualifying Acquisition; otherwise, the current share
ownership total and share ownership percentage for Mr. Warner under the 2007
RCGI Plan are 0 options and 0.00%, respectively.





(7) The
shares of common stock subject to options and corresponding percentages for Mr.
Tooth are calculated upon the assumption that, within 60 days of March 31, 2008,
the Company makes a Qualifying Acquisition; otherwise, the current share
ownership total and share ownership percentage for Mr. Tooth under the 2007 RCGI
Plan are 0 options and 0.00%, respectively.





Item
13.   Certain
Relationships and Related Transactions, and Director
Independence.





The
Company assumed the $75,000 promissory note, plus $8,160 in accrued interest,
owed by Velocity Energy Partners LP to a related party, Donald E. Vandenberg,
Chief Executive Officer, President, and Director (as well as Chairman of the
Board of Directors as of November 6, 2008) of Sonterra Resources, Inc., on July
8, 2008, as part of the acquisition by the Company of the Velocity
entities.  Interest payments under the promissory note are payable at
a rate of 8%, compounded annually: however, all principal and interest payments
under said note will be deferred (and the underlying debt will be subordinated)
until repayment of any senior and subordinated debt under any current
restructured working capital and project financing credit
facilities.   Director Robert Terry Gill provided certain
drilling muds and other oilfield fluids for a total of approximately $183,000 to
our contract operator, South Texas Oil Company, utilized in the recent drilling
of the two Matagorda Bay Wells discussed herein.





Item 14.Principal Accountant
Fees and Services.





The
following set forth fees billed by Akin, Doherty, Klein and Feuge, P.C.,
(“Akin”) for the audit of our annual financial statements for December 31, 2007,
and for other services provided in 2008 and for Hein and Associates LLP (“Hein”)
for audit services related to 2008.




2008
                    
                    
                    2007Audit
      fees (1)
                    
                    $
                    90,660
                    
                    
                    $
                    47,752Audit
      related fees
                    
                    
                    —
                    
                    
                    
                    —Tax
      fees (2)
                    
                    
                    4,250
                    
                    
                    
                    —Other
      fees
                    
                    
                    —
                    
                    
                    
                    —Total
                    
                    $
                    94,910
                    
                    
                    $
                    47,752





(1)   Audit
fees represent services provided in connection with the fiscal year audit of our
financial statements and review of our quarterly financial statements,
notwithstanding when the fees were billed or when the service was
rendered.





(2)   Tax
fees principally included tax advice, tax planning and tax return preparation,
for services billed from January through December of the fiscal
year.





As
previously reported in a Form 8-K filing on December 31, 2008, Akin resigned as
the independent registered public accounting firm for the
Company.  Akin’s report on the Company’s financial statements for the
period of the Company’s inception, April 17, 2007 through December 31, 2007 as
well as the subsequent interim period through December 29, 2008, did not contain
an adverse opinion or a disclaimer of opinion, and was not qualified as to
uncertainty, audit scope, or accounting principles.  Subsequently, we
engaged Hein & Associates LLP as our independent public accounting
firm.  Any fees for services associated with this report will be paid
in calendar year 2009.


27




Pre-Approval
Policies





The Board
of Directors’ policy is to pre-approve all audit services and all permitted
non-audit services (including the fees and terms thereof) provided by our
independent auditor; provided, however, pre-approval requirements for non-audit
services are not required if all such services (1) do not aggregate to more than
five percent of total revenues paid by us to our independent auditor in the
fiscal year when services are provided; (2) were not recognized as non-audit
services at the time of the engagement; and (3) are promptly brought to the
attention of the Board of Directors and approved prior to the completion of the
audit. The Board pre-approved all fees described above.




28


PART
IV





15.  Exhibits and Financial Statement
Schedules




Exhibit
                    
                    Description3.1
                    
                    Certificate
      of Incorporation (incorporated by reference to Exhibit 2.1 to the
      Registrant’s Registration Statement on Form 10-SB filed February 11,
      2000).3.2
                    
                    Certificate
      of Amendment to the Certificate of Incorporation (incorporated by
      reference to Exhibit 2.1 to the Registrant’s Form 8-K filed June 7,
      2004).3.3
                    
                    Certificate
      of Amendment to the Certificate of Incorporation (incorporated by
      reference to Exhibit 3.1 to the Registrant’s Form 8-K filed February 14,
      2008).3.4
                    
                    Certificate
      of Amendment to the Certificate of Incorporation.3.5
                    
                    Bylaws
      (incorporated by reference to Exhibit 3.2 to the Registrant’s Form 8-K
      filed February 14, 2008).4.1
                    
                    Certificate
      of Designations, Preferences and Rights of Series A Convertible Preferred
      Stock of Velocity Energy Inc.4.2
                    
                    Certificate
      of Correction to the Certificate of Designations, Preferences and Rights
      of Series A Convertible Preferred Stock of Velocity Energy
      Inc.10.1
                    
                    Securities
      Exchange and Additional Note Purchase Agreement, dated August 3, 2007, by
      and between the Registrant and The Longview Fund, L.P. (incorporated by
      reference to Exhibit 10.1 to the Registrant’s Form 8-K filed August 9,
      2007).10.2
                    
                    Schedules
      to Securities Exchange and Additional Note Purchase Agreement
      (incorporated by reference to Exhibit 10.2 to the Registrant’s Form 8-K
      filed August 9, 2007).10.3
                    
                    Security
      Agreement, dated as of July 9, 2007, between Sonterra Resources, Inc.
      (“Sonterra”) and Viking Asset Management, LLC, as Collateral Agent (the
      “Collateral Agent”) (incorporated by reference to Exhibit 10.3 to the
      Registrant’s Form 8-K filed August 9, 2007).10.4
                    
                    First
      Amendment to Security Agreement, dated as of August 3, 2007, between
      Sonterra and the Collateral Agent (incorporated by reference to Exhibit
      10.4 to the Registrant’s Form 8-K filed August 9,
2007).10.5
                    
                    Mortgage,
      Deed of Trust, Assignment of Production, Security Agreement, Fixture
      Filing and Financing Statement, dated August 3, 2007 from Sonterra to the
      Collateral Agent (incorporated by reference to Exhibit 10.5 to the
      Registrant’s Form 8-K filed August 9, 2007).10.6
                    
                    Joinder
      to Security Agreement by Sonterra Resources, Inc. (incorporated by
      reference to Exhibit 10.7 to the Registrant’s Form 10-K filed April 14,
      2008).10.7
                    
                    Guaranty
      dated February 14, 2008 by Sonterra Oil & Gas, Inc. and Sonterra
      Operating, Inc. in favor of Viking Asset Management, LLC (incorporated by
      reference to Exhibit 10.8 to the Registrant’s Form 10-K filed April 14,
      2008).10.8
                    
                    Pledge
      Agreement dated February 14, 2008, between Sonterra Oil & Gas, Inc.
      and Viking Asset Management, LLC (incorporated by reference to Exhibit
      10.9 to the Registrant’s Form 10-K filed April 14,
  2008).10.9
                    
                    First
      Amendment To Mortgage, Deed of Trust, Assignment of Production, Security
      Agreement, Fixture Filing and Financing Statement, dated August 29, 2007,
      by Sonterra Resources, Inc. for the benefit of Viking Asset Management,
      LLC (incorporated by reference to Exhibit 10.10 to the Registrant’s Form
      10-K filed April 14,
2008).




29





10.10
                
                Warrant
      to Purchase Common Stock dated February 14, 2008 and issued to The
      Longview Fund, L.P. (incorporated by reference to Exhibit 10.11 to the
      Registrant’s Form 10-K filed April 14, 2008).10.11
                
                Senior
      Secured Note dated February 14, 2008 and issued to The Longview Fund, L.P.
      (incorporated by reference to Exhibit 10.12 to the Registrant’s Form 10-K
      filed April 14, 2008).10.12
                
                Registration
      Rights Agreement, dated February 14, 2008, between Sonterra Resources,
      Inc. and The Longview Fund, L.P. (incorporated by reference to Exhibit
      10.13 to the Registrant’s Form 10-K filed April 14,
  2008).10.13
                
                First
      Amendment to Registration Rights Agreement, dated March 12, 2008
      (incorporated by reference to Exhibit 10.1 to the Registrant’s Form 8-K
      filed March 18, 2008).10.14
                
                February
      2008 Amendment Agreement, dated February 14, 2008, between Sonterra
      Resources, Inc. and The Longview Fund, L.P. (incorporated by reference to
      Exhibit 10.17 to the Registrant’s Form 10-K filed April 14,
      2008).10.15
                
                2007
      Stock Option Plan (incorporated by reference to Exhibit 10.16 to the
      Registrant’s Form 8-K filed August 9, 2007).10.16
                
                Form
      of Stock Option Agreement for Employees under Registrant’s 2007 Stock
      Option Plan (incorporated by reference to Exhibit 10.17 to the
      Registrant’s Form 8-K filed August 9, 2007).10.17
                
                Contract
      Operating Agreement, dated April 8, 2008 to be effective as of April 1,
      2008, among South Texas Oil Company and its subsidiaries and Sonterra
      Operating, Inc. (Incorporated by reference to Exhibit 10.1 of our
      Quarterly Report on Form 10-Q filed on May 15, 2008).10.18
                
                Contract
      Operating Agreement, dated July 21, 2008 to be effective as of June 23,
      3008, among Sonterra Resources and South Texas Oil Company (Incorporated
      by reference to Exhibit 99.2 of our Current Report on Form 8-K filed on
      July 23, 2008).10.19
                
                Securities
      Exchange Agreement and Schedules, dated as of November 13, 2008, among
      Sonterra Resources, Inc., The Longview Fund, L.P., and Longview Marquis
      Master Fund, L.P. (Incorporated by reference to Exhibit 10.1 of our
      Current Report on Form 8-K/A filed on December 10,
  2008).10.20
                
                Securities
      Purchase Agreement and Schedules, dated as of November 13, 2008, among
      Sonterra Resources, Inc., The Longview Fund, L.P., and Longview Marquis
      Master Fund, L.P. (Incorporated by reference to Exhibit 10.2 of our
      Current Report on Form 8-K/A filed on December 10,
  2008).10.21
                
                Security
      Agreement, dated as of November 13, 2008, among Sonterra Resources, Inc.,
      North Texas Drilling Services, Inc, Sonterra Operating, Inc., Velocity
      Energy Limited LLC, Velocity Energy Inc., Velocity Energy Offshore LP,
      Velocity Energy Partners LP, collectively the “Debtors”, and Summerline
      Asset Management, LLC, as “Collateral Agent” (Incorporated by reference to
      Exhibit 10.9 of our Current Report on Form 8-K/A filed on December 10,
      2008).10.22
                
                Subordination
      Agreement, dated as of November 13, 2008, Sonterra Resources, Inc., North
      Texas Drilling Services, Inc., Sonterra Operating, Inc., Velocity Energy
      Limited LLC, Velocity Energy Inc., Velocity Energy Offshore LP, Velocity
      Energy Partners LP, collectively the “Obligors”, The Longview Fund, L.P.
      (“Longview”), Longview Marquis Master Fund, L.P. (“Marquis”), and
      Summerline Asset Management, LLC, as “Collateral Agent” (Incorporated by
      reference to Exhibit 10.13 of our Current Report on Form 8-K/A filed on
      December 10, 2008).10.23
                
                Pledge
      Agreement, dated as of November 13, 2008, among Sonterra Resources, Inc.,
      as “Pledgor”, and  Summerline Asset Management, LLC, as
      “Collateral Agent” (Incorporated by reference to Exhibit 10.14 of our
      Current Report on Form 8-K/A filed on December 10,
  2008).
  30
  10.24
              
              Pledge
      Agreement, dated as of November 13, 2008, among Velocity Energy Limited
      LLC, as “Pledgor”, and  Summerline Asset Management, LLC, as
      “Collateral Agent” (Incorporated by reference to Exhibit 10.15 of our
      Current Report on Form 8-K/A filed on December 10,
  2008).




10.25
              
              Deposit
      Account Control Agreement, dated as of November 13, 2008, among Sonterra
      Operating, Inc., Sterling Bank, and Summerline Asset Management, LLC, as
      “Collateral Agent” (Incorporated by reference to Exhibit 10.16 of our
      Current Report on Form 8-K/A filed on December 10,
  2008).10.26
              
              Deposit
      Account Control Agreement, dated as of November 13, 2008, among Sonterra
      Resources, Inc., Sterling Bank, and Summerline Asset Management, LLC, as
      “Collateral Agent” (Incorporated by reference to Exhibit 10.17 of our
      Current Report on Form 8-K/A filed on December 10,
  2008).10.27
              
              Deposit
      Account Control Agreement, dated as of November 13, 2008, among North
      Texas Drilling Services, Inc., The First National Bank of Weatherford, and
      Summerline Asset Management, LLC, as “Collateral Agent” (Incorporated by
      reference to Exhibit 10.18 of our Current Report on Form 8-K/A filed on
      December 10, 2008).10.28
              
              Letter
      Agreement, dated as of November 13, 2008, among Sonterra Resources, Inc.,
      Longview Marquis Master Fund, L.P., and Summerline Asset Management, LLC,
      as “Collateral Agent” (Incorporated by reference to Exhibit 10.19 of our
      Current Report on Form 8-K/A filed on December 10,
  2008).10.29
              
              2008
      Sonterra Resources, Inc. Equity Compensation Plan, dated effective as of
      March 31, 2009.10.30
              
              Employment
      Agreement, dated as of June 23, 2008, between Sonterra Resources, Inc. and
      Donald E. Vandenberg (Incorporated by reference to Exhibit 99.5 of our
      Current Report on Form 8-K filed on June 27, 2008).10.31
              
              Employment
      Agreement, dated as of June 23, 2008, between Sonterra Resources, Inc. and
      Gary L. Lancaster (Incorporated by reference to Exhibit 99.6 of our
      Current Report on Form 8-K filed on June 27, 2008).10.32
              
              Employment
      Agreement, dated as of June 23, 2008, between Sonterra Resources, Inc. and
      Donald J. Sebastian (Incorporated by reference to Exhibit 99.7 of our
      Current Report on Form 8-K filed on June 27, 2008).10.33
              
              Letter
      of Intent, dated as of April 13, 2008, between and among Velocity Energy
      Partners LP and Classic Oil & Gas Resources, Inc., and its Selling
      Shareholders, William W. Kelly, Jr. and Alvin Kirk (Incorporated by
      reference to Exhibit 99.1 of our Current Report on Form 8-K filed on April
      17, 2009).14.1
              
              Code
      of Business Conduct, dated effective as of December 31,
    2008.21
              
              Subsidiaries
      of the Registrant31.1
              
              Certification
      of Chief Executive Officer pursuant to Securities Exchange Act of 1934
      Rule 13a-14(a) or 15d-14(a).31.2
              
              Certification
      of Chief Financial Officer pursuant to Securities Exchange Act of 1934
      Rule 13a-14(a) or 15d-14(a).32.1
              
              Joint
      Certification of Chief Executive Officer and Chief Financial Officer
      pursuant to Securities Exchange Act of 1934 Rule 13a-14(b) or 15d-14(b)
      and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.




31




SIGNATURES








VELOCITY
      ENERGY INC.By:
                    /s/  Donald
      E. VandenbergName: Donald
      E. VandenbergTitle: PresidentMay
      8, 2009





Pursuant
to the requirements of the Securities Exchange
Act of 1934, this report has been signed below by the following persons on
behalf of the registrant and in the capacity and on the dates
indicated:





Signature
                                      
                                      Title
                                      
                                      Date/s/
      Donald E. Vandenberg
                                      
                                      President
      and Director
                                      
                                      May
      8, 2009Donald
      E. Vandenberg
                                      
                                      (Principal
      Executive Officer)/s/
      Donald J. Sebastian
                                      
                                      Chief
      Financial Officer
                                      
                                      May
      8, 2009Donald
      J. Sebastian
                                      
                                      (Principal
      Financial and Accounting Officer)/s/
      Gary L. Lancaster
                                      
                                      Director
                                      
                                      May
      8, 2009Gary
      L. Lancaster/s/Herbert
      E. Warner
                                      
                                      Director
                                      
                                      May
      8, 2009Herbert
      E. Warner/s/Jeffrey
      W. Tooth
                                      
                                      Director
                                      
                                      May
      8, 2009Jeffrey
      W. Tooth




32


VELOCITY
ENERGY INC. AND SUBSIDIARIES





INDEX
TO FINANCIAL STATEMENTS




PageReports
      of Independent Registered Public Accounting Firm
                  
                  F-2Balance
      Sheets as of December 31, 2008 and 2007
                  
                  F-4Statements
      of Operations for the Year Ended December 31, 2008,  April 17,
      2007 (Inception) to December 31, 2007 and January 1, 2007 to August 3,
      2007
                  
                  F-5Statements
      of Shareholders’ Deficit for the Year Ended December 31, 2008, April 17,
      2007 (Inception) to December 31, 2007 and January 1, 2007 to August 3,
      2007
                  
                  F-6Statements
      of Cash Flows for the Year Ended December 31, 2008, April 17, 2007
      (Inception) to December 31, 2007 and January 1, 2007 to August 3,
      2007
                  
                  F-7Notes
      to Financial Statements
                  
                  F-8




F-1


REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and Shareholders


Velocity
Energy Inc.





We have
audited the accompanying consolidated balance sheet of Velocity Energy Inc. and
subsidiaries as of December 31, 2008, and the related consolidated statements of
operations, shareholders' deficit, and cash flows for the year then
ended.  These financial statements are the responsibility of the
Company's management.  Our responsibility is to express an opinion on
these financial statements based on our audit.





We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements.  An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation.  We believe that our audit provides a reasonable basis
for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Velocity Energy Inc. and
subsidiaries as of December 31, 2008, and the results of their operations and
their cash flows for the year then ended, in conformity with U.S. generally
accepted accounting principles.





We were
not engaged to examine management's assessment of the effectiveness of Velocity
Energy Inc.’s internal control over financial reporting as of December 31, 2008,
included in the accompanying Management’s Annual Report on Internal Control Over
Financial Reporting  and, accordingly, we do not express an opinion
thereon.





The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern. As discussed in Note 2 to the consolidated
financial statements, the Company’s dependence on outside financing, lack of
sufficient working capital, and recurring losses from operations raise
substantial doubt about the Company’s ability to continue as a going concern.
The financial statements do not include any adjustments that might result from
the outcome of these uncertainties.





/s/ Hein
& Associates LLP





Houston,
Texas


May 6,
2009




F-2


REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and Shareholders


Velocity
Energy Inc.


San
Antonio, Texas





We have
audited the consolidated balance sheet of Velocity Energy Inc. and subsidiary
(the “Company”) as of December 31, 2007 and the related consolidated statements
of operations, shareholder’s equity (deficit) and cash flows for the period
April 17, 2007 (date of inception) to December 31, 2007 and the statements of
operations, equity and cash flows for Certain Acquired Oil and Gas Properties
for the period of January 1, 2007 to August 3, 2007. These financial statements
are the responsibility of the Company’s management. Our responsibility is to
express an opinion on these financial statements based on our
audits.





We
conducted our audits in accordance with Standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatements. An audit includes examining, on a
test basis, evidence which supports the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.





In our
opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Velocity Energy Inc.
and subsidiary as of December 31, 2007, and the consolidated results of its
operations and cash flows for the period from April 17, 2007 (date of inception)
to December 31, 2007 and the results of Certain Oil and Gas Properties
operations and cash flows for the period of January 1, 2007 to August 3, 2007,
in conformity with U.S. generally accepted accounting principles.





/s/ Akin,
Doherty, Klein & Feuge, P.C.





Akin,
Doherty, Klein & Feuge, P.C.


San
Antonio, Texas


May 5,
2008




F-3


FINANCIAL
INFORMATION


VELOCITY
ENERGY INC.


Consolidated
Balance Sheets





December
      31,
                                            2008
                                          
                                          
                                          December
      31,
                                            2007ASSETSCurrent
      AssetsCash
      and cash equivalents
                                          
                                          $
                                          194,826
                                          
                                          
                                          $
                                          2,195,899Restricted
      cash
                                          
                                          
                                          3,699,931
                                          
                                          
                                          
                                          -Accounts
      receivable
                                          
                                          
                                          437,281
                                          
                                          
                                          
                                          2,901,502Advances
      to operators
                                          
                                          
                                          1,077,775
                                          
                                          
                                          
                                          -Prepaid
      expenses
                                          
                                          
                                          72,214
                                          
                                          
                                          
                                          151,998Total
      current assets
                                          
                                          
                                          5,482,027
                                          
                                          
                                          
                                          5,249,399Property
      and EquipmentOil
      and gas properties, full cost methodUnproved
      properties
                                          
                                          
                                          674,876
                                          
                                          
                                          
                                          848,894Proved
      properties
                                          
                                          
                                          3,648,627
                                          
                                          
                                          
                                          4,547,578Pipelines
      and facilities
                                          
                                          
                                          778,418
                                          
                                          
                                          
                                          778,418Total
      oil and gas properties
                                          
                                          
                                          5,101,921
                                          
                                          
                                          
                                          6,174,890Less
      accumulated depreciation, depletion  and
      amortization
                                          
                                          
                                          (505,138
                                          )
                                          
                                          
                                          (348,198
                                          )4,596,783
                                          
                                          
                                          
                                          5,826,692Other
      property and equipment, net of accumulated depreciation of $19,974 and $0
      at December 31, 2008 and 2007, respectively
                                          
                                          
                                          1,925,611
                                          
                                          
                                          
                                          30,000Total property and equipment, net
                                          
                                          
                                          6,522,394
                                          
                                          
                                          
                                          5,856,692Other
      AssetsDebt
      issuance costs, net of accumulated amortization of $86,432 and $40,982 at
      December 31, 2008 and 2007, respectively
                                          
                                          
                                          461,380
                                          
                                          
                                          
                                          285,353Total
      other assets
                                          
                                          
                                          461,380
                                          
                                          
                                          
                                          285,353Total
      Assets
                                          
                                          $
                                          12,465,801
                                          
                                          
                                          $
                                          11,391,444LIABILITIES
      AND SHAREHOLDERS' DEFICITCurrent
      LiabilitiesAccounts
      payable, trade
                                          
                                          $
                                          969,725
                                          
                                          
                                          $
                                          2,378,342Other
      payables and accrued liabilities
                                          
                                          
                                          610,864
                                          
                                          
                                          
                                          890,496Participant
      advances
                                          
                                          
                                          966
                                          
                                          
                                          
                                          948,494Current
      maturities of debt
                                          
                                          
                                          1,735,822
                                          
                                          
                                          
                                          -Interest
      payable
                                          
                                          
                                          183,612
                                          
                                          
                                          
                                          268,527Total
      current liabilities
                                          
                                          
                                          3,500,989
                                          
                                          
                                          
                                          4,485,859Noncurrent
      LiabilitiesLong-term
      debt, net of discounts of  $9,923,615 at December 31,
      2008
                                          
                                          
                                          6,888,723
                                          
                                          
                                          
                                          -Long-term
      debt – related party
                                          
                                          
                                          2,210,551
                                          
                                          
                                          
                                          7,990,010Asset
      retirement obligation
                                          
                                          
                                          128,443
                                          
                                          
                                          
                                          116,751Total
      noncurrent liabilities
                                          
                                          
                                          9,227,717
                                          
                                          
                                          
                                          8,106,761Shareholders'
      DeficitCommon
      stock, par value $0.001 per share, authorized 50,000,000 shares,issued and
      outstanding 26,347,359 and 21,846,559 shares
                                          
                                          
                                          26,351
                                          
                                          
                                          
                                          21,847Treasury
      stock
                                          
                                          
                                          -
                                          
                                          
                                          
                                          (900
                                          )Additional
      paid-in capital
                                          
                                          
                                          7,223,851
                                          
                                          
                                          
                                          (10,957
                                          )Accumulated
      deficit
                                          
                                          
                                          (7,513,107
                                          )
                                          
                                          
                                          (1,211,166
                                          )Total
      shareholders' deficit
                                          
                                          
                                          (262,905
                                          )
                                          
                                          
                                          (1,201,176
                                          )Total
      Liabilities and Shareholders' Deficit
                                          
                                          $
                                          12,465,801
                                          
                                          
                                          $
                                          11,391,444


See
notes to consolidated financial statements.


F-4


VELOCITY ENERGY INC.


Consolidated
Statements of Operations




Certain
                                                Acquired Oil
                                                and Gas
                                                PropertiesDecember 31,
                                                2008
                                              
                                              
                                              April 17, 2007
                                                (Inception) to
                                                December 31,
                                                2007
                                              
                                              
                                              January 1,
                                                2007 to
                                                August 3,
                                                2007RevenuesOil
      and gas sales
                                              
                                              $
                                              285,998
                                              
                                              
                                              $
                                              623,276
                                              
                                              
                                              $
                                              1,883,900Contract
      operating income
                                              
                                              
                                              261,234
                                              
                                              
                                              
                                              265,718
                                              
                                              
                                              
                                              -Drilling
      rig income
                                              
                                              
                                              154,324
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Operating
      overhead income
                                              
                                              
                                              14,424
                                              
                                              
                                              
                                              16,347
                                              
                                              
                                              
                                              -Gas
      gathering operations
                                              
                                              
                                              8,623
                                              
                                              
                                              
                                              43,571
                                              
                                              
                                              
                                              88,539Total
      revenues
                                              
                                              
                                              724,603
                                              
                                              
                                              
                                              948,912
                                              
                                              
                                              
                                              1,972,439Costs
      and ExpensesLease
      operating expenses
                                              
                                              
                                              722,867
                                              
                                              
                                              
                                              486,461
                                              
                                              
                                              
                                              730,335Production
      taxes
                                              
                                              
                                              20,029
                                              
                                              
                                              
                                              40,916
                                              
                                              
                                              
                                              123,885Drilling
      rig expenses
                                              
                                              
                                              355,630
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Gas
      gathering operations
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              6,563Depreciation,
      depletion and amortization
                                              
                                              
                                              176,914
                                              
                                              
                                              
                                              348,198
                                              
                                              
                                              
                                              576,184Impairment
      on oil & natural gas properties
                                              
                                              
                                              1,647,288
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -Accretion
      on asset retirement obligation
                                              
                                              
                                              8,572
                                              
                                              
                                              
                                              5,989
                                              
                                              
                                              
                                              7,829General
      and administrative
                                              
                                              
                                              2,974,810
                                              
                                              
                                              
                                              809,283
                                              
                                              
                                              
                                              71,800Total
      costs and expenses
                                              
                                              
                                              5,906,110
                                              
                                              
                                              
                                              1,690,847
                                              
                                              
                                              
                                              1,516,596Income
      (Loss) from Operations
                                              
                                              
                                              (5,181,507
                                              )
                                              
                                              
                                              (741,935
                                              )
                                              
                                              
                                              455,843Other
      (Expense)Interest
      expense
                                              
                                              
                                              (918,492
                                              )
                                              
                                              
                                              (428,249
                                              )
                                              
                                              
                                              -Debt
      issuance costs amortization
                                              
                                              
                                              (201,943
                                              )
                                              
                                              
                                              (40,982
                                              )
                                              
                                              
                                              -Other
      (expense)
                                              
                                              
                                              (1,120,435
                                              )
                                              
                                              
                                              (469,231
                                              )
                                              
                                              
                                              -Net
      Income (Loss) Before Tax
                                              
                                              
                                              (6,301,941
                                              )
                                              
                                              
                                              (1,211,166
                                              )
                                              
                                              
                                              455,843Deferred
      income tax expense
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              173,220Net
      Income (Loss)
                                              
                                              $
                                              (6,301,941
                                              )
                                              
                                              $
                                              (1,211,166
                                              )
                                              
                                              $
                                              282,623Loss
      Per Common Share:Basic
                                              
                                              $
                                              (0.24
                                              )
                                              
                                              $
                                              (.06
                                              )
                                              
                                              $Diluted
                                              
                                              $
                                              (0.24
                                              )
                                              
                                              $
                                              (.06
                                              )Weighted
      average number of common shares outstanding:Basic
                                              
                                              
                                              26,267,359
                                              
                                              
                                              
                                              21,846,559Diluted
                                              
                                              
                                              26,267,359
                                              
                                              
                                              
                                              21,846,559




See
notes to consolidated financial statements.




F-5





VELOCITY ENERGY INC.


Consolidated
Statements of Shareholders Equity (Deficit)


For
the period from April 1, 2007 (inception) to December 31, 2008




Shares
                      
                      
                      Common
                        Stock
      Par
                        Value
                      
                      
                      Additional
                        Paid
      In
                        Capital
                      
                      
                      Treasury
                        Stock
                      
                      
                      Accumulated
                        Deficit
                      
                      
                      Total
                        Shareholder’s
                        Equity
                        (Deficit)Balance,
      April 1, 2007 (Inception)Issuance
      of stock
                      
                      
                      23,814,717
                      
                      
                      $
                      23,815
                      
                      
                      $
                      (12,925
                      )
                      
                      $
                      
                      
                      
                      $
                      
                      
                      
                      $
                      10,890Repurchase
      of shares
                      
                      
                      (1,968,158
                      )
                      
                      
                      (1,968
                      )
                      
                      
                      1,968
                      
                      
                      
                      (900
                      )
                      
                      
                      
                      
                      
                      
                      (900
                      )Net
      loss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (1,211,166
                      )
                      
                      
                      (1,211,166
                      )Balance,
      December 31, 2007
                      
                      
                      21,846,559
                      
                      
                      
                      21,847
                      
                      
                      
                      (10,957
                      )
                      
                      
                      (900
                      )
                      
                      
                      (1,211,166
                      )
                      
                      
                      (1,201,176
                      )Reverse
      merger
                      
                      
                      4,500,800
                      
                      
                      
                      4,504
                      
                      
                      
                      (587,476
                      )
                      
                      
                      900
                      
                      
                      
                      
                      
                      
                      
                      (582,072
                      )Convert
      note from debt to equity
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      5,786,279
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      5,786,279Issuance
      of warrants with senior debt
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      916,207
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      916,207Issuance
      of warrants – NTDS
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      118,865
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      118,865Stock
      Compensation
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      1,000,933
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      1,000,933Net
      Loss
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (6,301,941
                      )
                      
                      
                      (6,301,941
                      )Balance,
      December 31, 2008
                      
                      
                      26,347,359
                      
                      
                      $
                      26,351
                      
                      
                      $
                      7,223,851
                      
                      
                      $
                      -
                      
                      
                      $
                      (7,513,107
                      )
                      
                      $
                      (262,905
                      )




See
notes to consolidated financial statements.




F-6


VELOCITY
ENERGY INC.


Consolidated
Statements of Cash Flows




Certain
                    Acquired Oil
                    and Gas
                    PropertiesDecember 31,
                    2008
                  
                  
                  April 17, 2007
                    (Inception) to
                    December 31,
                    2007
                  
                  
                  January 1,
                    2007 to
                    August 3,
                    2007Operating
      ActivitiesNet
      income (loss)
                  
                  $
                  (6,301,941
                  )
                  
                  $
                  (1,211,166
                  )
                  
                  $
                  282,623Adjustments
      to reconcile net income (loss) to net cash provided by ( used in)
      operating activities:Depreciation,
      depletion and amortization
                  
                  
                  176,914
                  
                  
                  
                  348,198
                  
                  
                  
                  576,184Accretion
      on asset retirement obligation
                  
                  
                  8,572
                  
                  
                  
                  5,989
                  
                  
                  
                  7,829Non-cash
      compensation expense
                  
                  
                  1,000,933
                  
                  
                  
                  -
                  
                  
                  
                  -Debt
      issuance costs amortization
                  
                  
                  201,943
                  
                  
                  
                  -
                  
                  
                  
                  -Non-cash
      interest added to debt
                  
                  
                  210,551
                  
                  
                  
                  -
                  
                  
                  
                  -Accretion
      of discount
                  
                  
                  339,925
                  
                  
                  
                  -
                  
                  
                  
                  -Impairment
      on oil & gas properties
                  
                  
                  1,647,288
                  
                  
                  
                  -
                  
                  
                  
                  -Changes
      in operating assets and liabilities:Accounts
      receivable
                  
                  
                  2,666,881
                  
                  
                  
                  (2,901,502
                  
                  
                  
                  -Prepaid
      expenses
                  
                  
                  (997,991
                  )
                  
                  
                  (151,998
                  )
                  
                  
                  -Accounts
      payable and accrued liabilities
                  
                  
                  (4,113,037
                  )
                  
                  
                  3,268,838
                  
                  
                  
                  -Participant
      advances received
                  
                  
                  -
                  
                  
                  
                  948,494
                  
                  
                  
                  -Interest
      payable
                  
                  
                  (84,915
                  )
                  
                  
                  268,527
                  
                  
                  
                  -Net
      cash provided by (used by) operating activities
                  
                  
                  (5,244,877
                  )
                  
                  
                  575,380
                  
                  
                  
                  866,636Investing
      ActivitiesRestricted
      Cash
                  
                  
                  (3,699,931
                  )
                  
                  
                  -
                  
                  
                  
                  -Purchases
      and development of oil and gas properties
                  
                  
                  (813,188
                  )
                  
                  
                  (6,064,128
                  )
                  
                  
                  (230,435
                  )Proceeds
      from sale of oil and gas properties
                  
                  
                  212,000
                  
                  
                  
                  -
                  
                  
                  
                  -Purchases
      of other property and equipment
                  
                  
                  (6,655
                  )
                  
                  
                  (30,000
                  )
                  
                  
                  -Acquisition
      of Velocity Energy Offshore LP and Velocity Energy Partners
    LP
                  
                  
                  (12,870
                  )
                  
                  
                  -
                  
                  
                  
                  -Acquisition
      of North Texas Drilling Services, Inc.
                  
                  
                  71,149
                  
                  
                  
                  -
                  
                  
                  
                  -Net
      cash used in investing activities
                  
                  
                  (4,249,495
                  )
                  
                  
                  (6,094,128
                  )
                  
                  
                  (230,435
                  )Financing
      ActivitiesProceeds
      from issuance of long term debt, net of debt issuance
costs
                  
                  
                  1,000,000
                  
                  
                  
                  8,027,157
                  
                  
                  
                  -Repayment
      of long-term debt
                  
                  
                  (1,000,000
                  )
                  
                  
                  (322,500
                  )
                  
                  
                  -Proceeds
      from issuance of common stock
                  
                  
                  -
                  
                  
                  
                  10,890
                  
                  
                  
                  -Purchase
      of treasury stock
                  
                  
                  -
                  
                  
                  
                  (900
                  )
                  
                  
                  -Debt
      costs
                  
                  
                  (581,701
                  )
                  
                  
                  -
                  
                  
                  
                  -Proceeds
      from Senior Debt
                  
                  
                  8,075,000
                  
                  
                  
                  -
                  
                  
                  
                  -Distributed
      equity
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (636,201
                  )Net
      cash provided by (used in) financing activities
                  
                  
                  7,493,299
                  
                  
                  
                  7,714,647
                  
                  
                  
                  (636,201
                  )Net
      Increase (Decrease) in Cash and Equivalents
                  
                  
                  (2,001,073
                  )
                  
                  
                  2,195,899
                  
                  
                  
                  -Cash
      and equivalents at beginning of period
                  
                  
                  2,195,899
                  
                  
                  
                  -
                  
                  
                  
                  -Cash
      and Equivalents at End of Period
                  
                  $
                  194,826
                  
                  
                  $
                  2,195,899
                  
                  
                  $
                  -Non-Cash
      Investing & Financing ActivitiesConversion of debt
      to equity, net of costs
                  
                  $
                  5,786,279
                  
                  
                  $
                  -
                  
                  
                  $
                  -Acquisition
      of Velocity entities and assumption of note
                  
                  $
                  83,160
                  
                  
                  $
                  -
                  
                  
                  $
                  -Liabilities
      assumed in reverse merger
                  
                  $
                  582,072
                  
                  
                  $
                  -
                  
                  
                  $
                  -Supplementary
      Disclosure of Cash Flow InformationInterest
      Paid
                  
                  $
                  420,253
                  
                  
                  $
                  157,722
                  
                  
                  $
                  -




See
notes to consolidated financial statements.


F-7


VELOCITY
ENERGY INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





1.  NATURE
OF OPERATIONS





Velocity
Energy Inc., (formerly Sonterra Resources, Inc.) a Delaware corporation
(“Velocity” or the “Company”) is an independent energy company engaged in the
acquisition, development, exploration and production of natural gas and
oil.  Our current operations are located in Matagorda Bay, Calhoun
County, Texas, where we have currently drilled and cased two wells, the State
Tract 127 #1 and the State Tract 150 #1 ST #1.  These wells in various
stages of completion and were not on production at the end of 2008. ST 150 #2 is
shut-in waiting on a workover to the next zone.





Our core
business strategy is based on growing the company by completing one or more
acquisitions of producing properties with upside proven locations to be drilled
and by participating in drilling prospects generated in-house and by third
parties. Acquisitions will have associated production equipment and a current
production stream. Although we did not complete any acquisition of producing oil
and natural gas properties by year-end, we are actively engaged in several
potential acquisition targets in the Appalachian Basin.





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




As a
result of the Securities Exchange (i) 100% of the issued and outstanding capital
stock of the Company is owned by New Sonterra; (ii) New Sonterra is engaged,
through the Company, in the operation and development of oil and gas properties
and related assets; (iii) the Company’s management comprises the management of
New Sonterra; and (iv) the former shareholders of the Company now hold 95.8% of
the common stock of New Sonterra.  The acquisition has been treated as
a recapitalization of the Company with Sonterra Oil & Gas as the acquirer
(reverse acquisition).  The historical financials prior to February
14, 2008 are those of Sonterra Oil & Gas.





In
November of 2008, the Company acquired North Texas Drilling Services Inc.,
(“NTDS”).  NTDS owns two drilling rigs, each of which is capable of
drilling wells to approximately 4,000 feet.  Our intent is to utilize
these rigs in developing drilling locations on future acquisitions in the
Appalachian Basin and/or on a day rate or footage contract work with third
parties in the Appalachian Basin or elsewhere depending upon our internal need
for such rigs.





In the
first quarter of 2009, the Company filed a definitive Form 14C, changing its
name from Sonterra Resources, Inc. to Velocity Energy Inc. and is currently
operating under the new name.





2.  GOING
CONCERN





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





The
Company is pursuing acquisitions of producing properties in the Appalachian
Basin.  The management team has met with numerous providers of both
debt and equity, and is currently evaluating several potential acquisition
targets.  If successful with our Appalachian Basin acquisition
strategy, the Company will acquire a steady revenue stream from long-lived
assets.


F-8





3.  SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES





Principles
of Consolidation





The
consolidated financial statements are presented in accordance with U. S.
generally accepted accounting principles.  The consolidated financial
statements include the accounts of the Company and its wholly-owned
subsidiaries, Sonterra Operating, Inc., Velocity Energy Offshore LP, Velocity
Energy Partners LP, and North Texas Drilling Services, Inc., after elimination
of all significant intercompany transactions and balances.





The
financial statements also include the statements of operations, equity and cash
flows for the period of January 1, 2007 to August 3, 2007 of the Certain
Acquired Oil and Gas Properties acquired by the Company in August, 2007. See
Note 5. The statements of operations include the revenues and direct expense
(lease operating, production taxes and pipeline operations) based on historical
data for each respective property. Depreciation, depletion and amortization
(DD&A) was computed based on the historical DD&A rates of each seller,
and applied to the properties acquired. General and administrative expenses
attributable to the Certain Acquired Oil and Gas Properties on the statements of
operations are determined based on the pro-rata allocation of the sellers’ total
general and administrative expenses to the capitalized oil and gas property
costs acquired by the Company as a percentage of the sellers’ total capitalized
oil and gas property costs. Management believes the costs and operations of the
acquired properties are reasonable and appropriate





Property
and Equipment





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





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





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





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





2)
            plus
      the cost of properties not being
amortized;





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





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





We
recognized an impairment expense of $1,647,288 in 2008 because the recorded cost
of our oil and gas properties exceeded the full cost ceiling.





Capitalized
costs of proved oil and gas properties are depleted on a unit of production
basis using proved oil and gas reserves.  Costs depleted include net
capitalized costs subject to depletion and estimated future dismantlement,
restoration, and plugging & abandonment expenses.


F-9




The
following costs of unproved properties are capitalized as part of the Company’s
full cost pool. These costs are excluded from the calculation of full cost pool
amortization until such time the related drilling programs are completed and the
costs can be evaluated as proved, or until the costs are determined to be
impaired, which is expected to occur in 2010.





December
      31,
                        
                        
                        December
      31,2008
                        
                        
                        2007Unproved
      properties:Oil
      and gas leasehold acreage acquisition costs
                        
                        $
                        675,647
                        
                        
                        $
                        843,345Geological
      and geophysical costs
                        
                        
                        -
                        
                        
                        
                        5,549Drilling
      in progress
                        
                        
                        772,526
                        
                        
                        
                        -$
                        1,448,173
                        
                        
                        $
                        848,894




Other
property and equipment, which includes drilling rigs, vehicles, computer
hardware, software, and other computer equipment, office fixtures, furniture,
and other office equipment, is recorded at cost and is generally depreciated on
a straight-line basis over the estimated useful lives of the assets, which range
in periods of three to seven years. Repairs and maintenance are charged to
expense as incurred.





Proceeds
from the sale of oil and gas properties are credited to the full cost pool,
except with respect to transactions involving a significant quantity of reserves
or where the proceeds from such sale would significantly alter the relationship
between capitalized costs and proved reserves, in which a gain or loss is
recognized.





Revenue
Recognition





We
recognize oil and gas revenue from our interest in producing wells as the oil
and gas is sold to third parties.  Gas gathering revenues are
recognized upon delivery of the product to third parties.  Drilling
revenues are recognized at the completion of the services provided and the
generation of the invoice to the customer.





Accounts
Receivable





Accounts
receivable are reported at outstanding principal net of allowance for doubtful
account of $0 at December 31, 2008 and 2007.  The allowance for
doubtful accounts is determined based on the Company’s historical losses, as
well as review of specific accounts.  Accounts are charged off when
collection efforts have failed and the account is deemed
uncollectible.  The Company does not charge interest on accounts
receivable.





Reclassifications





Certain
reclassifications have been made to prior periods’ financial statements to
conform to the current presentation.  These reclassifications had no
effect on total assets, total liabilities, shareholders’ equity or net
income.





Use
of Estimates





The
preparation of financial statements in conformity with U. S. generally accepted
accounting principles requires management to make estimates and assumptions the
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the consolidated financial
statements and the reported amounts of revenues and expenses during the periods
reported.  Actual results could differ from these
estimates.





Significant
estimates include volumes of oil and natural gas reserves used in calculating
depletion of proved oil and natural gas properties, future net revenues and
abandonment obligations, impairment of undeveloped properties, future income
taxes and related assets/liabilities, the collectability of outstanding accounts
receivables, stock-based compensation expense, contingencies and the results of
current and future litigation.  Oil and natural gas reserve estimates,
which are the basis for unit-of-production depletion and the ceiling test, have
numerous inherent uncertainties.  The accuracy of any reserve estimate
is a function of the quality of relevant engineering, seismic, and other
data as well as appropriate engineering, geological, and geophysical
interpretation and judgment.  Subsequent drilling results, testing and
production may justify revision of such reserve estimates and, accordingly,
reserve estimates are often different from the quantities of oil and natural gas
that are ultimately recovered.  In addition, reserve estimates are
vulnerable to changes in wellhead prices of crude oil and natural
gas.  Such prices have been volatile in the past and can be expected
to be volatile in the future.


F-10




The
significant estimates are based on current assumptions that may be materially
effected by changes to future economic conditions, such as the market prices
received for sales of volumes of oil and natural gas, interest rates, the market
value of the Company’s common stock, volatility as to oil and gas commodity
prices, and the Company’s ability to generate future taxable
income.  Future changes in these assumptions may affect these
significant estimates materially in the near term.





Oil
and Natural Gas Reserve Estimates





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





Cash
and Cash Equivalents





The
Company considers all highly liquid investments with an original maturity of
three months or less to be cash equivalents.





Restricted
Cash





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





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





The
balance of $1,300,000 of the Acquisition Funds, being $371,654, was released
from the Acquisition Funds Account primarily for completion costs of the State
Tract 150-1 ST #1 Well, as well as for miscellaneous costs related to the
Financial Restructuring. On March 30, 2009, $700,000 of the Acquisition
Funds was released from the Acquisition Funds Account for payment of interest on
the Senior Secured Debt and other corporate purposes.  On April 1,
2009, $2,000,000 of the Acquisition Funds was released to prepay part of the
Senior Secured Note, in exchange for a reduction of $2,195,000 of the principal
of the Senior Secured Note, leaving a balance in the Acquisition Funds Account
of $399,931.


F-11




On April
13, 2009, the Company executed a letter of intent to acquire certain producing
properties in southern West Virginia pursuant to the Company’s Appalachian Basin
acquisition strategy in exchange for approximately $2,702,063 in cash, payable
in three annual installments; the assumption of the balance of a $1,700,541 loan
(estimated to be $1,500,000); and other consideration as detailed in the Letter
of Intent attached hereto as Exhibit 10.33.





Financial
Instruments





The
Company’s financial instruments consist of cash, receivables, payables and
long-term debt. The carrying amount of cash, receivables and payables
approximates fair value because of the short-term nature of these items. The
carrying amounts of long-term debt under the Senior Note and the Subordinated
Note approximate fair value as these borrowings bear interest at variable
interest rates.





Debt
Issuance Costs, Net





Net
long-term debt issuance costs were capitalized as of December 31, 2008, and are
being amortized over the thirty-six month life of our Marquis Senior Secured
Loan, which runs through October 2011, and over the forty-eight month life of
our Marquis Subordinated Note and our Longview Subordinated Note, each of which
run through October 2012.





Income
Taxes





The
Company accounts for deferred income taxes in accordance with the asset
and liability method, whereby deferred income taxes are recognized for the
tax consequences of temporary differences by applying enacted statutory tax
rates applicable to future years to differences between the financial
statement carrying amounts and the respective tax basis of its assets and
liabilities. Valuation allowances are provided for deferred tax
assets when their recovery is doubtful.





In June
2006, FASB Interpretation (FIN) No. 48, "Accounting for Uncertainty in Income
Taxes", an interpretation of FASB Statement 109 Accounting for Income Taxes, was
issued. FIN No. 48 describes accounting for uncertainty in income taxes, and
includes a recognition threshold and measurement attribute for recognizing the
effect of a tax position taken or expected to be taken in a tax return. FIN No.
48 is effective for fiscal years beginning after December 15, 2006. The Company
adopted FIN No. 48 in April 2007, and it did not have a material effect on the
Company's financial condition, results of operations, or cash
flows.





Loss
Per Common Share





Basic
loss per common share is computed on the basis of the weighted average number of
common shares outstanding during each year.  Diluted earnings per
share are computed on the basis of the weighted average number of common shares
and dilutive securities outstanding.  Dilutive securities have an
anti-dilutive effect on diluted share loss are excluded from the
calculation.





Contingencies





Liabilities
and other contingencies are recognized upon determination of an exposure, which
is determined when it is both probable that an asset has been impaired or that a
liability has been incurred, and the amount of which is reasonably capable of
estimation.





Stock-Based
Compensation





Effective
January 1, 2006, the Company adopted the provisions of SFAS No. 123R,
“Shared-Based Payment,” (“SFAS 123R”) using the modified prospective method.
SFAS 123R addresses the accounting for share-based payment transactions in which
an enterprise received services in exchange for (a) equity instruments of the
enterprise or (b) liabilities that are based on the fair value of the
enterprise’s equity instruments or that may be settled by the issuance of such
equity instruments.  Compensation expense is recorded for stock
options and other equity awards over the requisite vesting periods based upon
the fair value on the date of the grant.


F-12





Recent
Accounting Pronouncements




FASB Statement of Accounting
Standard No. 157, "Fair Value Measurement"("SFAS 157"): SFAS 157, issued
in September 2006, defines fair value, establishes a framework for measuring
fair value, and expands disclosures about fair value measurements. The standard
applies whenever other standards require (or permit) assets or liabilities to be
measured at fair value, but does not expand the use of fair value in any new
circumstances. In February 2008, the FASB granted a one-year deferral of the
effective date of this statement as it applies to non-financial assets and
liabilities that are recognized or disclosed at fair value on a nonrecurring
basis (e.g., those measured at fair value in a business combination and goodwill
impairment). SFAS No. 157 is effective for all recurring measures of financial
assets and liabilities (e.g., derivatives and investment securities) for
financial statements issued for fiscal years beginning after November 15, 2007,
and interim periods within those years. The adoption of SFAS No. 157 did not
have a material impact on the Company’s consolidated financial
statements.





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




FASB Statement of Accounting
Standards No. 141 (R), "Business Combinations" ("SFAS 141 (R)"): SFAS No.
141(R) was issued in December 2007 to replace SFAS 141. SFAS 141 (R) establishes
principles and requirements for how an acquirer recognizes and measures in its
financial statements the identifiable assets acquired, the liabilities assumed,
any non-controlling interest in the assets and goodwill acquired. The Statement
also establishes disclosure requirements that enable users to evaluate the
nature and financial effects of the business combination. SFAS 141 (R) is
effective for fiscal years beginning after December 15, 2008. The adoption of
SFAS 141 (R) will have an impact on accounting for business combinations once
adopted, but the effect is dependent upon acquisitions at that
time.




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





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





4.  ACQUISITION
OF NORTH TEXAS DRILLING SERVICES, INC.





As part
of the Financial Restructuring consummated on November 13, 2008, the Company
acquired North Texas Drilling Services, Inc, a company previously owned by
Marquis.  NTDS is engaged in providing drilling services for
exploration and development companies in the continental U. S. under either day
work or footage contracts.  Assets acquired and liabilities assumed by
the Company have been recorded on the Company’s Consolidated Balance Sheet as of
the acquisition date based upon their estimated fair values at such
date.  The results of operations of NTDS have been included in the
Company’s Consolidated Statement of Operations since November 13,
2008.




F-13




An
independent valuation firm was used to determine the value of NTDS as
follows:





Cash
                      
                      $
                      71,149Accounts
      receivable
                      
                      
                      202,659Property,
      plant and equipment
                      
                      
                      1,908,930Accounts
      payable
                      
                      
                      (567,346
                      )Accrued
      liabilities
                      
                      
                      (327,841
                      )Bank
      note
                      
                      
                      (150,000
                      )Value
      of NTDS
                      
                      $
                      1,137,551




The
Company issued a subordinated note with a face value of $9,440,000 (The Marquis
Subordinated Note) and 1,000,000 warrants valued at $118,865.  The
excess of the face amount of the Marquis Subordinated Note over the fair value
of NTDS and the warrants was recorded as a discount on the Marquis Subordinated
Note of $8,421,314. The discount will be amortized over the term of the Marquis
Subordinated Note as interest expense.




The
acquisition of NTDS was part of the Financial Restructuring and the issuance of
the Senior Secured Note. Therefore, the excess of the face amount of the note
over the fair value of the net assets acquired was treated as a discount on the
subordinated note rather than recorded as goodwill.




Unaudited
pro forma consolidated results of operations for the years ended December 31,
2008 and 2007, as though NTDS had been acquired as of January 1, 2007,
follow:





2008
                    
                    
                    2007Sales
                    
                    $
                    984,470
                    
                    
                    $
                    3,988,560Net
      loss
                    
                    
                    (6,748,908
                    )
                    
                    
                    (2,904,693
                    )Loss
      per common share
                    
                    $
                    (0.26
                    )
                    
                    $
                    (0.13
                    )




5.  ACQUISITION
OF OIL AND GAS PROPERTIES




The
Company acquired certain oil and gas properties, as follows:




Purchased
for $4.7 million on August 3, 2007 from Cinco Natural Resources Corporation
(“Cinco”):


a.
            60%
      of Cinco’s interest (63.00% working interest and 49.77% net revenue
      interest) in the Matagorda Bay 150 #1 producing gas well and the related
      320 acre tract leased from the State of Texas.b.
            60%
      of Cinco’s interest (50.50% working interest and 39.26% net revenue
      interest) in the Matagorda Bay 150 #2 producing gas well and the related
      320 acre tract leased from the State of
Texas.


c.
            Certain
      other tracts leased from the State of Texas, none of which currently have
      any production.





Purchased for $1.1 million on August
29, 2007 from Flash Gas & Oil, Southwest, Inc.
(“Flash”):


a.
            100%
      of Flash’s interest (35.99% working interest and 27.65% net revenue
      interest) in the Matagorda Bay 150 #1 producing gas
  well.b.
            100%
      interest in the 7.3 mile pipeline connecting the Matagorda Bay 150 #1 and
      150 #2 to the Keller Bay Facility onshore, located in Calhoun County,
      Texas.





6.  ASSET
RETIREMENT OBLIGATION





In
June 2001, FASB issued SFAS No. 143, “Accounting for Asset Retirement
Obligations”(“SFAS No. 143”). SFAS No. 143 requires that an
asset retirement obligation (“ARO”) associated with the retirement of a
tangible long-lived asset be recognized as a liability in the period in which a
legal obligation is incurred and becomes determinable, with an offsetting
increase in the carrying amount of the associated asset. The ARO is recorded at
fair value, excluding salvage values, and accretion expense will be recognized
over time as the discounted liability is accreted to its expected settlement
value. The fair value of the ARO is measured using expected future cash outflows
discounted at the Company’s credit-adjusted risk-free interest rate. The cost of
the tangible asset, including the initially recognized ARO, is depleted such
that the cost of the ARO is recognized over the useful life of the
asset.


F-14




Inherent
in the fair value calculation of ARO are numerous assumptions and judgments
including the ultimate settlement amounts, inflation factors, credit adjusted
discount rates, timing of settlement, and changes in the legal, regulatory,
environmental and political environments. To the extent future revisions to
these assumptions impact the fair value of the existing ARO liability, a
corresponding adjustment is made to the oil and natural gas property
balance.




The
following table is a reconciliation of the asset retirement obligation liability
for the years ended December 31:





2008
                    
                    
                    2007Asset
      retirement obligation at beginning of year
                    
                    $
                    116,751
                    
                    
                    $
                    -Liabilities
      incurred
                    
                    
                    3,120
                    
                    
                    
                    110,762Liabilities
      settled
                    
                    
                    -
                    
                    
                    
                    -Accretion
      expense
                    
                    
                    8,572
                    
                    
                    
                    5,989Asset
      retirement obligation at end of year
                    
                    $
                    128,443
                    
                    
                    $
                    116,751





7.  INCOME
TAXES





Income
tax benefit as reported is reconciled to the federal statutory rate (34%)
as follows:





For the year ended
                      December 31, 2008
                    
                    
                    For the period from
                      April 17, 2007 to
                      December 31, 2007Income
      tax benefit computed at statutory rate
                    
                    $
                    (2,142,660
                    )
                    
                    $
                    (411,796
                    )Nondeductible
      costs
                    
                    
                    115,575
                    
                    
                    
                    -Change
      in valuation allowance
                    
                    
                    2,066,000
                    
                    
                    
                    420,000Other
                    
                    
                    (38,915
                    )
                    
                    
                    (8,204
                    )Income
      tax benefit
                    
                    $
                    -
                    
                    
                    $
                    -





Deferred
income taxes reflect the net tax effects of net operating losses, depletion
carryovers, and temporary differences between the carrying amounts of assets and
liabilities for financial reporting purposes and the amounts used for income tax
purposes. Significant components of the Company’s deferred tax assets and
liabilities are as follows:




Dec. 31, 2008
                    
                    
                    Dec. 31, 2007Deferred
      tax assets:Net  operating
      tax loss carry forward
                    
                    $
                    2,397,000
                    
                    
                    $
                    421,000Deferred
      compensation
                    
                    
                    347,000
                    
                    
                    
                    -Tax
      basis in excess of book basis in property and equipment
                    
                    
                    218,000
                    
                    
                    
                    (1,000
                    )Valuation
      allowance
                    
                    
                    (3,076,000
                    )
                    
                    
                    (420,000
                    )Other
                    
                    
                    114,000
                    
                    
                    
                    -Net
      deferred tax assets
                    
                    $
                    -
                    
                    
                    $
                    -





The
Company recorded a valuation allowance of $590,000 during 2008 at the time NTDS
was acquired, related to the acquired operating loss carryforwards.





As of
December 31, 2008, the Company had approximately $6.9 million of tax
net operating loss carryforwards, which will begin to expire in 2027. The net
operating loss carryforwards assume that certain items, primarily intangible
drilling costs, have been capitalized and are being amortized under the tax laws
for the current year. However, the Company has not made a final determination if
an election will be made to capitalize all or part of these items for tax
purposes.  A portion of the net operating loss carry forward is
subject to change in ownership limitations that could restrict the Company’s
ability to utilize such losses in the future.





Generally
Accepted Accounting Principles require a valuation allowance to be recognized
if, based on the weight of available evidence, it is more likely than not that
some portion or all of the deferred tax asset will not be realized. The Company
does not expect to fully realize its deferred tax assets, and therefore recorded
a valuation allowance in 2008 and 2007 to the full extent of all net deferred
tax assets.


F-15




8.  DEBT




At
December 31, 2008 and 2007, debt consisted of the following:




December
      31,2008
                        
                        
                        2007Note
      payable to bank, interest rate of 8.75%, interest payable monthly,
      principal due July 2009, secured by trucks and vehicles owned by
      NTDS.
                        
                        $
                        150,000
                        
                        
                        $
                        -Senior
      Secured Note, net of unamortized discount of $1,765,467, interest payable
      quarterly, principal amortized monthly over 28 months beginning August 31,
      2009, secured by oil and gas properties.
                        
                        
                        7,109,533
                        
                        
                        
                        -Marquis
      Subordinated Note, net of unamortized discount of $8,158,148, interest
      payable quarterly, 25% of principal due November 13, 2011 and 75% of
      principal due on November 13, 2012, secured by drilling rigs, owed by
      NTDS
                        
                        
                        1,281,852
                        
                        
                        
                        -Longview
      Subordinated Note – Related party, interest rate of 11%, interest payable
      quarterly, 25% of principal due November 13, 2011 and 75% of principal due
      on November 13, 2012 secured by oil and gas properties after
      retirement of Senior Secured Note
                        
                        
                        2,210,551
                        
                        
                        
                        2,000,000Longview
      Equity Note – Related party, interest rate of three-month LIBOR plus
      8.25%, interest payable quarterly, secured by certain oil and gas
      properties, restructured in February 2008 (See below and Note
      1)
                        
                        
                        -
                        
                        
                        
                        5,990,010Subordinated
      note payable to related party, interest rate of 8%, compounded annually,
      all principal and interest payments will be deferred until repayment of
      any senior and subordinated debt
                        
                        
                        83,160
                        
                        
                        
                        -Total
      debt
                        
                        
                        10,835,096
                        
                        
                        
                        7,990,010Less:
      current portion
                        
                        
                        (1,735,822
                        )
                        
                        
                        -Long-term
      portion
                        
                        $
                        9,099,274
                        
                        
                        $
                        7,990,010




The
following is a payment schedule of principal, excluding interest, as of December
31, 2008:




Due
      in calendar year:2009
                  
                  $
                  1,735,8222010
                  
                  
                  3,803,5722011
                  
                  
                  6,399,2442012
                  
                  
                  8,821,073Total
                  
                  $
                  20,758,711





On August
3, 2007, in connection with the closing of an oil and gas property acquisition
and pursuant to a securities purchase agreement with Longview, the Company
received an advance of $5,990,010 in exchange for a senior secured note (the
"Equity Note") payable to Longview. The Equity Note was issued with a maturity
date of August 31, 2010, with the principal balance being due in full at
maturity. Interest payments under the Equity Note were due quarterly at a rate
equal to a three-month LIBOR plus 8.25%, redetermined for each calendar quarter.
Concurrent with the issuance of the Equity Note, Sonterra issued Longview a
warrant to purchase 50 shares of the Sonterra Oil & Gas common stock. As
part of the Securities Exchange, on February 14, 2008, Longview exchanged all
its shares of Sonterra Oil & Gas common stock and the Equity Note for common
shares of the Company. Also as part of the Securities Exchange, Longview
exchanged the warrant to purchase 50 shares of the Sonterra Oil & Gas common
stock for a warrant to purchase 4,958,678 common shares of the Company at an
exercised price of $.3021709 per share..




F-16


On August
29, 2007, the Company received $2,000,000 in exchange for a senior secured note
(the "Non-Equity Note") payable to Longview. A portion of these proceeds were
used to provide funds for the acquisition of certain oil and gas properties. The
Non-Equity note was issued with a maturity date of August 31, 2010, with the
principal balance being due in full at maturity. Interest payments are due
quarterly at a rate equal to a three-month LIBOR plus 8.25%, redetermined for
each calendar quarter. On November 13, 2008, the Old Notes and the accrued and
unpaid interest of $210,551 were restructured as an unsecured promissory note
for $2,210,551 (the Longview Subordinated Note).  The Longview
Subordinated note bears interest at 11%.  As part of the
restructuring, Longview agreed to surrender warrants to acquire 3,000,000 shares
of the Company’s Common Stock issue in the Securities Exchange on February 14,
2008.





In July
2008, the Company assumed a $75,000 promissory note, and $8,160 in accrued
interest, owed to Donald E. Vandenberg, who is a related party as previously
discussed.  Interest payments under the promissory note are payable at
a rate of 8%, compounded annually; however, all principal and interest payments
under said note will be deferred (and the underlying debt will be subordinated)
until repayment of any senior and subordinated debt under any current
restructured working capital and project financing credit
facilities.





On
November 13, 2008, the Company restructured its financing arrangements
(“Financial Restructuring”) by entering into two transactions.  Under
the first transaction, the Company entered into a Securities Exchange Agreement
(the “New Securities Exchange Agreement”) with The Longview Fund, L.P.
(“Longview”) and Longview Marquis Master Fund, L.P. (“Marquis”) under which
Marquis acquired a warrant (the “Marquis Warrant”) to acquire 1,000,000 shares
of the Company’s common stock, par value $0.001 per share (“Common Stock”),
subject to adjustment, at an initial exercise price per share of $0.01; and an
unsecured subordinated promissory note in the original aggregate principal
amount of $9,440,000 (the “Marquis Subordinated Note”), bearing interest at 11%
per annum; and Longview acquired an unsecured promissory note in the original
aggregate principal amount of $2,210,551 (the “Longview Subordinated Note”),
bearing interest at 11% per annum; and $1,000,000 in cash as repayment of 1/3 of
the principal of the Old Notes described below.





Prior to
the transactions set forth above and based on the records of the Company and
transfer agent, Longview was the owner of approximately 88% of the Company’s
outstanding Common Stock and, together with its affiliated funds, Longview
Equity Fund, L.P. and Longview International Fund, L.P., owned approximately 93%
of the Company’s outstanding Common Stock.  Viking Asset Management,
LLC serves as investment adviser to Longview and its affiliated
funds.  Prior to and during the Financial Restructuring, Viking also
served as the investment adviser to Marquis.   Subsequent to the
Financial Restructuring, Summerline now serves as the investment adviser to
Marquis, and Marquis and Longview are no longer related parties.





Upon the
Company’s repayment of the Subordinated Notes, the holders of the Subordinated
Notes have the right to convert up to 50% of the Principal (and the accrued and
unpaid interest thereon) to be paid on any Principal Prepayment Date (as each
such capitalized term not otherwise defined herein is defined in the respective
Subordinated Note) into shares of Common Stock of the Company at a price equal
to $4.00 per share, subject to adjustment.  Pursuant to the Securities
Exchange Agreement, certain subsidiaries of the Company entered into a guaranty
of the Subordinated Notes.




Under the
second transaction, the Company entered into a Securities Purchase Agreement,
(the Securities Purchase Agreement) whereby the Company issued and sold to
Marquis, and Marquis purchased from the Company, for consideration of
$8,075,000, a senior secured promissory note in the principal amount of
$8,875,000, bearing interest at 13% per annum, subject to certain adjustments
(the “Senior Secured Note”), and a warrant to acquire 1,050,000 shares of Common
Stock at an initial exercise price of $0.01 per share.  As additional
consideration under the Securities Purchase Agreement, the Company also granted
Marquis a limited conveyance of overriding royalty interests (the “Overrides”)
of 3% of the Company’s interest in the hydrocarbon production from all of the
Company’s (i) current oil and gas properties (the “ORRI”) and (ii) oil and gas
properties acquired in the future with $5,000,000 of proceeds (the “Acquisition
Funds”) from the sale of the Senior Secured Note, which sum has been deposited
in an Acquisition Funds Account.  Under the Securities Purchase
Agreement, from November 13, 2009 until November 12, 2010, the Company has the
right to purchase from Marquis all (but not less than all) of the Overrides
issued to Marquis prior to November 13, 2009 by delivering to Marquis, at its
election, either Override Warrants (as defined in the Securities Purchase
Agreement) or any combination of Common Override Exchange Shares (as defined in
the Securities Purchase Agreement) and Preferred Override Exchange Shares (as
defined in the Securities Purchase Agreement).  In connection with the
Securities Purchase Agreement, certain subsidiaries of the Company guaranteed
payment of the Senior Secured Note and the Company and certain of its
subsidiaries granted a security interest in substantially all of their real and
personal property to Summerline, as collateral agent for Marquis, as the secured
party, and executed a security agreement, a mortgage, guarantees and pledges to
evidence the same.  The proceeds of $8,075,000 received at Closing
were allocated as follows: $7,032,774 to the Senior Secured Note, $916,207 to
the Marquis Warrants, and $126,019 to the Marquis overriding royalty
interest.  The discount on the Senior Secured Note is being amortized
to interest expense, using the effective interest method over the term of the
Senior Secured Note.


F-17





To induce
Marquis and Longview to enter into the Securities Purchase Agreement, on
November 13, 2008, the Company entered into a Subordination Agreement between
and among North Texas, Sonterra Operating, Inc., a Delaware corporation,
Velocity Energy Limited LLC, a Texas limited liability company, Velocity Energy
Inc., a Delaware corporation, Velocity Energy Offshore LP, a Delaware limited
partnership, and Velocity Energy Partners, LP, a Delaware limited partnership,
each of which is a subsidiary of the Company, Marquis, Longview and Summerline,
as collateral agent, pursuant to which the Subordinated Notes are subordinated
to the Senior Secured Note.





9.  COMMITMENTS
AND CONTINGENCIES





From time
to time, the Company is party to certain legal actions and claims arising in the
ordinary course of business. While the outcome of these events cannot be
predicted with certainty, management does not expect these matters to have a
materially adverse effect on the financial position or results of operations of
the Company.





The
operations and financial position of the Company continue to be affected from
time to time in varying degrees by domestic and foreign political developments
as well as legislation and regulations pertaining to restrictions on oil and
natural gas production, imports and exports, natural gas regulation, tax
increases, environmental regulations and cancellation of contract rights. Both
the likelihood and overall effect of such occurrences on the Company vary
greatly and are not predictable.





The
Company has a long-term operating lease agreement for its corporate office that
expires in November 2011.  Annual lease commitments are as
follows:





Amount2009
                      
                      $
                      64,4642010
                      
                      
                      64,4642011
                      
                      
                      59,092Total
                      
                      $
                      188,020





Rent
expense for the years ended December 31, 2007 and December 31, 2008, was
$15,273 and $75,049, respectively.





10.  RELATED
PARTY TRANSACTIONS





As
discussed in Note 1, the company acquired Velocity Offshore and Velocity
Partners from Messrs. Vandenberg and Lancaster, two of the Company’s senior
executives.  In July 2008, the Company assumed a $75,000 promissory
note, together with $8,160 in accrued interest, owed by Velocity Partners to
Donald E. Vandenberg, who is a related party as previously
discussed.  Interest payments under the promissory note are payable at
a rate of 8%, compounded annually: however, all principal and interest payments
under said note will be deferred (and the underlying debt will be subordinated)
until repayment of any senior and subordinated debt under any current
restructured working capital and project financing credit
facilities.





The
operation of Velocity Partners and Velocity Offshore are included in the
accompanying consolidate financial statements from date of
acquisition.  Pro forma information is not included because results of
operations of the acquired entities would not have a material effect on the
Company’s financial statements.  The purchase price was allocated on
the fair values of the assets at the date of acquisition as
follows:





Allocation
      of Purchase PriceOil
      and gas properties
                                    
                                    $
                                    96,030Note
      payable and accrued interest
                                    
                                    
                                    (83,160
                                    )Net
      Cash
                                    
                                    $
                                    12,870





The oil
and gas properties of $96,030 were impaired at year-end and
expensed.





11.  SHAREHOLDER
EQUITY AND STOCK INCENTIVE PLANS





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


F-18




Stock
options issued to employees under the 2007 Non-Qualified Stock Option Plan vest
incrementally over a period of three years and have a ten-year life. On February
14, 2008, a total of 5,140,359 common stock options were issued. These options
had exercise prices that ranged from $.332 to $.453 per share, and were
scheduled to expire in February 2018.  These options were forfeited on
June 23, 2008, when the then management team resigned from the
Company.  Messrs. Vandenberg and Lancaster were retained as part of
the Company’s new management team on June 23, 2008, and a total of 2,459,087 new
common stock options were issued to them. An additional 1,141,719 new common
stock options were issued to Mr. Sebastian, the third member of the Company’s
new management team, under his employment agreement dated June 23, 2008, along
with an additional 30,000 options in exchange for a four month deferral of
salary from July 1, 2008 to November 1, 2008.  These options have
exercise prices ranging from $1.35 in the first year, $1.755 in the second year,
and $2.04 in the third year, and all of these options will expire in June 2018.
A participant may receive more than one equity award granted under the
program.  Equity compensation is intended to qualify as
performance-based compensation under Section 162(m) of the Code.  The
following table summarizes the status of issued and outstanding options under
the 2007 Non-Qualified Stock Option Plan:




Number
                      Outstanding
                    
                    
                    Weighted
                      Average
                      Exercise Price
                    
                    
                    Weighted Average
                      Contractual Term
                      in Years
                    
                    
                    Aggregate
                      Intrinsic
                      ValueOutstanding
      at December 31,2007
                    
                    
                    -
                    
                    
                    $
                    -
                    
                    
                    
                    -Issued
                    
                    
                    8,771,165
                    
                    
                    $
                    0.709
                    
                    
                    
                    10.0Forfeited
                    
                    
                    (5,140,359
                    )
                    
                    $
                    0.393
                    
                    
                    
                    9.9Exercised
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Outstanding
      at December 31, 2008
                    
                    
                    3,630,806
                    
                    
                    $
                    1.707
                    
                    
                    
                    9.5
                    
                    
                    $
                    -Exercisable
      at December 31, 2008
                    
                    
                    30,000
                    
                    
                    $
                    1.35
                    
                    
                    
                    5.0
                    
                    
                    
                    -





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





The
weighted average grant date fair value of options granted during 2008 was
$0.84.  The fair value of the options was estimated, as of the grant
date, using the Black Sholes option-pricing model with the following
assumptions:  (i) expected volatility of 57%; (ii) a risk-free
interest rate of 4.3%; and (iii) a six year expected life.  Due to the
Company not having an active market, the Company used the historical stock price
fluctuations of a comparable public entity in computing expected
volatility.  The Company recorded $1,000,933 in non-cash stock
compensation related to these options during 2008. As of December 31, 2008,
there was approximately $2,100,388 of total unrecognized compensation costs
related to outstanding stock options and warrants.  That cost is
expected to be recognized over the next three years as stock options
vest.





The
following warrants are outstanding as of December 31, 2008;





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





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


F-19




12.
EARNINGS PER SHARE





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




Year Ended
                        December 31,
                        2008
                      
                      
                      April 17, 2007
                        (Inception)
                        to
                        December 31,
                        2007Numerator:Net
      loss applicable to common stockholders
                      
                      $
                      (6,301,941
                      )
                      
                      $
                      (1,211,166
                      )Denominator:Denominator
      for basic loss per share — weighted-average shares
    outstanding
                      
                      
                      26,267,359
                      
                      
                      
                      21,846,559Effect
      of potentially dilutive common shares:Warrants
      (a)
                      
                      NA
                      
                      
                      
                      -Denominator
      for diluted loss per share — weighted-average shares outstanding and
      assumed conversions
                      
                      $
                      26,267,359
                      
                      
                      $
                      21,846,559Basic
      loss per share
                      
                      $
                      (0.24
                      )
                      
                      $
                      (0.06
                      )Diluted
      loss per share
                      
                      $
                      (0.24
                      )
                      
                      $
                      (0.06
                      )




Warrants
and stock options for which the exercise prices were greater than the average
market price of the Company’s common stock are excluded from the computation of
diluted earnings per share. All potentially dilutive shares, whether from
options or warrants, are excluded in the event of an operating loss because
inclusion of such shares would be anti-dilutive.





(a)             The
number of warrants excluded totaled 4,008,678 in 2008.





13.   
SUPPLEMENTAL INFORMATION ON OIL AND NATURAL GAS EXPLORATION, DEVELOPMENT NAD
PRODUCITON ACTIVITIES (UNAUDITED)





STANDARDIZED
MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATING TO PROVED OIL AND GAS
RESERVES





The
following table presents the standardized measure of future net cash flows from
proved oil reserves in accordance with SFAS No. 69. All components of the
standardized measure are from proved reserves, all of which are located within
the continental United States.  As prescribed by this statement,
amounts shown are based on prices and costs as of December 31, 2008 and 2007,
and assume the continuation of then existing economic conditions. All future
income taxes are based on year-end statutory rates, adjusted for tax credits. A
discount factor of ten percent was used to reflect the timing of the Company’s
future net cash flows. Extensive judgments are involved in estimating the timing
of production and the costs that will be incurred through the remaining lives of
the fields.  Accordingly, the estimates of future net revenues from
proved reserves and the present value thereof may not be materially correct when
judged against actual subsequent results. Further, since prices and costs do not
remain static, and no price or cost changes have been considered, and all future
production and development costs are estimated to be incurred in developing and
producing the estimated proved oil reserves, the results are not necessarily
indicative of the fair market value of estimate proved reserves, and the results
may not be comparable to estimates by other oil and gas producers.




F-20




Costs
Incurred
 
 The costs
incurred in oil and gas acquisition, exploration and development activities are
as follows:




Years
      Ended December 31,2008
                        
                        
                        2007Property
      acquisition costs, proved
                        
                        
                        
                        
                        $
                        4,542,924Property
      acquisition costs, unproved
                        
                        $
                        36,728
                        
                        
                        
                        848,894Exploration
      costs
                        
                        
                        10,342
                        
                        
                        
                        4,654Development
      costs
                        
                        
                        777,712
                        
                        
                        
                        -Total
      costs incurred
                        
                        $
                        824,782
                        
                        
                        $
                        5,396,472




The
following costs of unproved properties are capitalized as part of the Company’s
full cost pool. These costs are excluded from the calculation of full cost pool
amortization until such time the related drilling programs are completed and the
costs can be evaluated as proved, or until the costs are determined to be
impaired, which is expected to occur in 2010.





December
      31,
                            
                            
                            December
      31,2008
                            
                            
                            2007Unproved
      properties:Oil
      and gas leasehold acreage acquisition costs
                            
                            $
                            675,647
                            
                            
                            $
                            843,345Geological
      and geophysical costs
                            
                            
                            -
                            
                            
                            
                            5,549Drilling
      in progress
                            
                            
                            772,526
                            
                            
                            
                            -$
                            1,448,173
                            
                            
                            $
                            848,894




Proved
Reserves





The
following reserve schedule summarizes the Company's net ownership interests in
estimated quantities of proved oil and gas reserves and changes in its proved
reserves, all of which are located in the continental United States. All reserve
estimates for crude oil contained below were internally prepared by the
Company.  The Company emphasizes that reserve estimates are inherently
imprecise and that estimates of new discoveries are more imprecise than those of
currently producing oil and gas properties. Accordingly, we anticipate that
these oil and gas reserve estimates will change as future information becomes
available. All of our reserves are located in Texas State Waters in the Gulf of
Mexico.




Crude Oil
                                      (Bbls)
                                    
                                    
                                    Natural Gas
                                      (Mcf)PROVED
      DEVELOPED AND UNDEVELOPED RESERVES:December
      31, 2006
                                    
                                    
                                    90,959
                                    
                                    
                                    
                                    2,271,837Revision
      of previous estimates
                                    
                                    
                                    (37,865
                                    )
                                    
                                    
                                    (926,046
                                    )Purchase
      of reserves
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Extensions,
      discoveries, and other additions
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Sale
      of reserves
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Production
                                    
                                    
                                    (2,404
                                    )
                                    
                                    
                                    (68,881
                                    )December
      31, 2007
                                    
                                    
                                    50,690
                                    
                                    
                                    
                                    1,276,910Revision
      of previous estimates
                                    
                                    
                                    (5,708
                                    )
                                    
                                    
                                    (153,590
                                    )Purchase
      of reserves
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Extensions,
      discoveries, and other additions
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Sale
      of reserves
                                    
                                    
                                    (11,160
                                    )
                                    
                                    
                                    (266,120
                                    )Production
                                    
                                    
                                    (522
                                    )
                                    
                                    
                                    (24,560
                                    )December
      31, 2008
                                    
                                    
                                    33,300
                                    
                                    
                                    
                                    832,640PROVED
      DEVELOPED RESERVESDecember
      31, 2006
                                    
                                    
                                    14,102
                                    
                                    
                                    
                                    424,698December
      31, 2007
                                    
                                    
                                    310
                                    
                                    
                                    
                                    17,533December
      31, 2008
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -




F-21




Standardized
Measure





The
standardized measure of discounted future net cash flows relating to proved oil
and natural gas reserves is as follows (in thousands):





Years
      Ended December 31,2008
                                
                                
                                2007Future
      cash inflows
                                
                                $
                                5,663
                                
                                
                                $
                                13,533Future
      production costs
                                
                                
                                (1,641
                                )
                                
                                
                                (2,413
                                )Future
      development costs
                                
                                
                                (647
                                )
                                
                                
                                (2,880
                                )Future
      income tax expense
                                
                                
                                -
                                
                                
                                
                                (1,123
                                )Future
      net cash flows
                                
                                
                                3,375
                                
                                
                                
                                7,11710%
      annual discount for estimated timing of cash flows
                                
                                
                                (795
                                )
                                
                                
                                (2,715
                                )Standardized
      measure of discounted future net cash flow related to proved
      reserves
                                
                                $
                                2,580
                                
                                
                                $
                                4,402





Change
in Standardized Measure





A summary
of the changes in the standardized measure of discounted future new cash flow
applicable to proved oil and natural reserves is as follows (in
thousands):





Years
      Ended December 31,2008
                        
                        
                        2007Balance,
      beginning of period
                        
                        $
                        4,402
                        
                        
                        $
                        -Sales
      of oil and gas, net
                        
                        
                        454
                        
                        
                        
                        (96
                        )Net
      change in prices and production costs
                        
                        
                        (1,950
                        )
                        
                        
                        -Net
      change in future development costs
                        
                        
                        (2,283
                        )
                        
                        
                        -Extensions
      and discoveries
                        
                        
                        -
                        
                        
                        
                        -Revisions
      of previous quantity estimates
                        
                        
                        (589
                        )Previously
      estimated development costs incurred
                        
                        
                        778
                        
                        
                        
                        -Net
      change in income taxes
                        
                        
                        1,229
                        
                        
                        
                        (1,553
                        )Accretion
      of discount
                        
                        
                        814
                        
                        
                        
                        -Purchase
      of minerals in place
                        
                        
                        -
                        
                        
                        
                        5.444Sales
      of reserves
                        
                        
                        (1,044
                        )
                        
                        
                        -Other
                        
                        
                        769
                        
                        
                        
                        607Balance,
      end of period
                        
                        $
                        2,580
                        
                        
                        $
                        4,402




The
standardized measure of discounted future net cash flows as of December 31, 2008
and 2007 was calculated using the following average prices in effect as of the
end of each year:





2008
                    
                    
                    2007Average
      crude oil price per barrel
                    
                    $
                    44.30
                    
                    
                    $
                    91.45Average
      gas price per MCF
                    
                    $
                    5.03
                    
                    
                    $
                    6.19




F-22


INDEX
TO EXHIBITS





Exhibit
                  
                  Description3.1
                  
                  Certificate
      of Incorporation (incorporated by reference to Exhibit 2.1 to the
      Registrant’s Registration Statement on Form 10-SB filed February 11,
      2000).3.2
                  
                  Certificate
      of Amendment to the Certificate of Incorporation (incorporated by
      reference to Exhibit 2.1 to the Registrant’s Form 8-K filed June 7,
      2004).3.3
                  
                  Certificate
      of Amendment to the Certificate of Incorporation (incorporated by
      reference to Exhibit 3.1 to the Registrant’s Form 8-K filed February 14,
      2008).3.4
                  
                  Certificate
      of Amendment to the Certificate of Incorporation.3.5
                  
                  Bylaws
      (incorporated by reference to Exhibit 3.2 to the Registrant’s Form 8-K
      filed February 14, 2008).4.1
                  
                  Certificate
      of Designations, Preferences and Rights of Series A Convertible Preferred
      Stock of Velocity Energy Inc.4.2
                  
                  Certificate
      of Correction to the Certificate of Designations, Preferences and Rights
      of Series A Convertible Preferred Stock of Velocity Energy
      Inc.10.1
                  
                  Securities
      Exchange and Additional Note Purchase Agreement, dated August 3, 2007, by
      and between the Registrant and The Longview Fund, L.P. (incorporated by
      reference to Exhibit 10.1 to the Registrant’s Form 8-K filed August 9,
      2007).10.2
                  
                  Schedules
      to Securities Exchange and Additional Note Purchase Agreement
      (incorporated by reference to Exhibit 10.2 to the Registrant’s Form 8-K
      filed August 9, 2007).10.3
                  
                  Security
      Agreement, dated as of July 9, 2007, between Sonterra Resources, Inc.
      (“Sonterra”) and Viking Asset Management, LLC, as Collateral Agent (the
      “Collateral Agent”) (incorporated by reference to Exhibit 10.3 to the
      Registrant’s Form 8-K filed August 9, 2007).10.4
                  
                  First
      Amendment to Security Agreement, dated as of August 3, 2007, between
      Sonterra and the Collateral Agent (incorporated by reference to Exhibit
      10.4 to the Registrant’s Form 8-K filed August 9,
2007).10.5
                  
                  Mortgage,
      Deed of Trust, Assignment of Production, Security Agreement, Fixture
      Filing and Financing Statement, dated August 3, 2007 from Sonterra to the
      Collateral Agent (incorporated by reference to Exhibit 10.5 to the
      Registrant’s Form 8-K filed August 9,
2007).





10.6
                      
                      Joinder
      to Security Agreement by Sonterra Resources, Inc. (incorporated by
      reference to Exhibit 10.7 to the Registrant’s Form 10-K filed April 14,
      2008).10.7
                      
                      Guaranty
      dated February 14, 2008 by Sonterra Oil & Gas, Inc. and Sonterra
      Operating, Inc. in favor of Viking Asset Management, LLC (incorporated by
      reference to Exhibit 10.8 to the Registrant’s Form 10-K filed April 14,
      2008).10.8
                      
                      Pledge
      Agreement dated February 14, 2008, between Sonterra Oil & Gas, Inc.
      and Viking Asset Management, LLC (incorporated by reference to Exhibit
      10.9 to the Registrant’s Form 10-K filed April 14,
  2008).10.9
                      
                      First
      Amendment To Mortgage, Deed of Trust, Assignment of Production, Security
      Agreement, Fixture Filing and Financing Statement, dated August 29, 2007,
      by Sonterra Resources, Inc. for the benefit of Viking Asset Management,
      LLC (incorporated by reference to Exhibit 10.10 to the Registrant’s Form
      10-K filed April 14,
2008).




33




10.10
                                        
                                        Warrant
      to Purchase Common Stock dated February 14, 2008 and issued to The
      Longview Fund, L.P. (incorporated by reference to Exhibit 10.11 to the
      Registrant’s Form 10-K filed April 14, 2008).10.11
                                        
                                        Senior
      Secured Note dated February 14, 2008 and issued to The Longview Fund, L.P.
      (incorporated by reference to Exhibit 10.12 to the Registrant’s Form 10-K
      filed April 14, 2008).10.12
                                        
                                        Registration
      Rights Agreement, dated February 14, 2008, between Sonterra Resources,
      Inc. and The Longview Fund, L.P. (incorporated by reference to Exhibit
      10.13 to the Registrant’s Form 10-K filed April 14,
  2008).10.13
                                        
                                        First
      Amendment to Registration Rights Agreement, dated March 12, 2008
      (incorporated by reference to Exhibit 10.1 to the Registrant’s Form 8-K
      filed March 18, 2008).10.14
                                        
                                        February
      2008 Amendment Agreement, dated February 14, 2008, between Sonterra
      Resources, Inc. and The Longview Fund, L.P. (incorporated by reference to
      Exhibit 10.17 to the Registrant’s Form 10-K filed April 14,
      2008).10.15
                                        
                                        2007
      Stock Option Plan (incorporated by reference to Exhibit 10.16 to the
      Registrant’s Form 8-K filed August 9, 2007).10.16
                                        
                                        Form
      of Stock Option Agreement for Employees under Registrant’s 2007 Stock
      Option Plan (incorporated by reference to Exhibit 10.17 to the
      Registrant’s Form 8-K filed August 9, 2007).10.17
                                        
                                        Contract
      Operating Agreement, dated April 8, 2008 to be effective as of April 1,
      2008, among South Texas Oil Company and its subsidiaries and Sonterra
      Operating, Inc. (Incorporated by reference to Exhibit 10.1 of our
      Quarterly Report on Form 10-Q filed on May 15, 2008).10.18
                                        
                                        Contract
      Operating Agreement, dated July 21, 2008 to be effective as of June 23,
      3008, among Sonterra Resources and South Texas Oil Company (Incorporated
      by reference to Exhibit 99.2 of our Current Report on Form 8-K filed on
      July 23, 2008).10.19
                                        
                                        Securities
      Exchange Agreement and Schedules, dated as of November 13, 2008, among
      Sonterra Resources, Inc., The Longview Fund, L.P., and Longview Marquis
      Master Fund, L.P. (Incorporated by reference to Exhibit 10.1 of our
      Current Report on Form 8-K/A filed on December 10,
  2008).10.20
                                        
                                        Securities
      Purchase Agreement and Schedules, dated as of November 13, 2008, among
      Sonterra Resources, Inc., The Longview Fund, L.P., and Longview Marquis
      Master Fund, L.P. (Incorporated by reference to Exhibit 10.2 of our
      Current Report on Form 8-K/A filed on December 10,
  2008).10.21
                                        
                                        Security
      Agreement, dated as of November 13, 2008, among Sonterra Resources, Inc.,
      North Texas Drilling Services, Inc, Sonterra Operating, Inc., Velocity
      Energy Limited LLC, Velocity Energy Inc., Velocity Energy Offshore LP,
      Velocity Energy Partners LP, collectively the “Debtors”, and Summerline
      Asset Management, LLC, as “Collateral Agent” (Incorporated by reference to
      Exhibit 10.9 of our Current Report on Form 8-K/A filed on December 10,
      2008).10.22
                                        
                                        Subordination
      Agreement, dated as of November 13, 2008, Sonterra Resources, Inc., North
      Texas Drilling Services, Inc., Sonterra Operating, Inc., Velocity Energy
      Limited LLC, Velocity Energy Inc., Velocity Energy Offshore LP, Velocity
      Energy Partners LP, collectively the “Obligors”, The Longview Fund, L.P.
      (“Longview”), Longview Marquis Master Fund, L.P. (“Marquis”), and
      Summerline Asset Management, LLC, as “Collateral Agent” (Incorporated by
      reference to Exhibit 10.13 of our Current Report on Form 8-K/A filed on
      December 10,
2008).




34




10.23
                                  
                                  Pledge
      Agreement, dated as of November 13, 2008, among Sonterra Resources, Inc.,
      as “Pledgor”, and  Summerline Asset Management, LLC, as
      “Collateral Agent” (Incorporated by reference to Exhibit 10.14 of our
      Current Report on Form 8-K/A filed on December 10,
  2008).10.24
                                  
                                  Pledge
      Agreement, dated as of November 13, 2008, among Velocity Energy Limited
      LLC, as “Pledgor”, and  Summerline Asset Management, LLC, as
      “Collateral Agent” (Incorporated by reference to Exhibit 10.15 of our
      Current Report on Form 8-K/A filed on December 10,
      2008).10.25
                                  
                                  Deposit
      Account Control Agreement, dated as of November 13, 2008, among Sonterra
      Operating, Inc., Sterling Bank, and Summerline Asset Management, LLC, as
      “Collateral Agent” (Incorporated by reference to Exhibit 10.16 of our
      Current Report on Form 8-K/A filed on December 10,
  2008).10.26
                                  
                                  Deposit
      Account Control Agreement, dated as of November 13, 2008, among Sonterra
      Resources, Inc., Sterling Bank, and Summerline Asset Management, LLC, as
      “Collateral Agent” (Incorporated by reference to Exhibit 10.17 of our
      Current Report on Form 8-K/A filed on December 10,
  2008).10.27
                                  
                                  Deposit
      Account Control Agreement, dated as of November 13, 2008, among North
      Texas Drilling Services, Inc., The First National Bank of Weatherford, and
      Summerline Asset Management, LLC, as “Collateral Agent” (Incorporated by
      reference to Exhibit 10.18 of our Current Report on Form 8-K/A filed on
      December 10, 2008).10.28
                                  
                                  Letter
      Agreement, dated as of November 13, 2008, among Sonterra Resources, Inc.,
      Longview Marquis Master Fund, L.P., and Summerline Asset Management, LLC,
      as “Collateral Agent” (Incorporated by reference to Exhibit 10.19 of our
      Current Report on Form 8-K/A filed on December 10,
  2008).10.29
                                  
                                  2008
      Sonterra Resources, Inc. Equity Compensation Plan, dated effective as of
      March 31, 2009.10.30
                                  
                                  Employment
      Agreement, dated as of June 23, 2008, between Sonterra Resources, Inc. and
      Donald E. Vandenberg (Incorporated by reference to Exhibit 99.5 of our
      Current Report on Form 8-K filed on June 27, 2008).10.31
                                  
                                  Employment
      Agreement, dated as of June 23, 2008, between Sonterra Resources, Inc. and
      Gary L. Lancaster (Incorporated by reference to Exhibit 99.6 of our
      Current Report on Form 8-K filed on June 27, 2008).10.32
                                  
                                  Employment
      Agreement, dated as of June 23, 2008, between Sonterra Resources, Inc. and
      Donald J. Sebastian (Incorporated by reference to Exhibit 99.7 of our
      Current Report on Form 8-K filed on June 27, 2008).10.33
                                  
                                  Letter
      of Intent, dated as of April 13, 2008, between and among Velocity Energy
      Partners LP and Classic Oil & Gas Resources, Inc., and its Selling
      Shareholders, William W. Kelly, Jr. and Alvin Kirk (Incorporated by
      reference to Exhibit 99.1 of our Current Report on Form 8-K filed on April
      17, 2009).14.1
                                  
                                  Code
      of Business Conduct, dated effective as of December 31,
    2008.21
                                  
                                  Subsidiaries
      of the Registrant31.1
                                  
                                  Certification
      of Chief Executive Officer pursuant to Securities Exchange Act of 1934
      Rule 13a-14(a) or 15d-14(a).31.2
                                  
                                  Certification
      of Chief Financial Officer pursuant to Securities Exchange Act of 1934
      Rule 13a-14(a) or 15d-14(a).32.1
                                  
                                  Joint
      Certification of Chief Executive Officer and Chief Financial Officer
      pursuant to Securities Exchange Act of 1934 Rule 13a-14(b) or 15d-14(b)
      and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of
2002.




35