UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549





FORM 10-Q





(Mark One)





x

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





FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2012





OR





 ̈

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





FOR THE TRANSITION PERIOD FROM ____________ TO ____________





COMMISSION FILE NUMBER: 333-134568





PEGASI ENERGY RESOURCES CORPORATION


(Exact name of registrant as specified in its charter)





Nevada

20-4711443(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification Number)





218 N. Broadway, Suite 204

Tyler, Texas 75702(Address of principal executive offices) (Zip Code)





Registrant’s telephone number, including area code: 903- 595-4139





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





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No  ̈





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 o
Accelerated filer oNon-accelerated filer o
Smaller reporting company x(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 Act. Yes   ̈ No   x





There were 55,214,758 shares of the registrant's common stock outstanding as of August 13, 2012.


1




PEGASI ENERGY RESOURCES CORPORATION


CONSOLIDATED FINANCIAL STATEMENTS


FOR THE QUARTER ENDED JUNE 30, 2012





TABLE OF CONTENTS





PagePART I - FINANCIAL INFORMATIONItem 1. Financial Statements
3Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
18Item 3. Quantitative and Qualitative Disclosures About Market Risk
25Item 4. Controls and Procedures
25PART II - OTHER INFORMATIONItem 1. Legal Proceedings
27Item 1A. Risk Factors
27Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
27Item 3. Defaults Upon Senior Securities
27Item 4. Mine Safety Disclosures
27Item 5. Other Information
27Item 6. Exhibits
28SIGNATURES
29




2




PART I - FINANCIAL INFORMATION





Item 1. Financial Statements.


PEGASI ENERGY RESOURCES CORPORATION


CONSOLIDATED BALANCE SHEETS





June 30,


December 31,2012


2011Assets

(Unaudited)Current assets:Cash and cash equivalents

$
2,071,717


$
6,749,368Accounts receivable, trade


198,726



304,940Accounts receivable, related parties


13,002



11,502Joint interest billing receivable, related parties, net


1,545,288



183,079Joint interest billing receivable, net


361,451



87,512Other current assets


86,105



86,245Total current assets


4,276,289



7,422,646Property and equipment:Equipment


66,855



66,855Pipelines


788,485



728,991Leasehold improvements


7,022



7,022Vehicles


56,174



56,174Office furniture


135,687



137,616Website


15,000



15,000Total property and equipment


1,069,223



1,011,658Less accumulated depreciation


(407,210)



(377,651)Property and equipment, net


662,013



634,007Oil and gas properties:Oil and gas properties, proved


12,716,995



12,188,709Oil and gas properties, unproved


14,724,565



10,351,292Capitalized asset retirement obligations


232,730



232,730Total oil and gas properties


27,674,290



22,772,731Less accumulated depletion and depreciation


(1,317,220)



(1,219,027)Oil and gas properties, net


26,357,070



21,553,704Other assets:Restricted cash – drilling program


301,413



132,353Deferred financing costs


15,550



-Certificates of deposit


78,389



78,285Total other assets


395,352



210,638Total assets

$
31,690,724


$
29,820,995







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





3




PEGASI ENERGY RESOURCES CORPORATION


CONSOLIDATED BALANCE SHEETS (CONTINUED)





June 30,


December 31,2012


2011(Unaudited)Liabilities and Stockholders' EquityCurrent liabilities:Cash overdraft

$
35,428


$
164,360Accounts payable


3,286,566



2,080,390Accounts payable, related parties


2,177,715



1,918,719Revenue payable


327,522



316,646Interest payable, related parties


1,343,178



1,027,020Liquidated damages payable


31,791



207,746Unearned promote


-



121,379Other payables


21,122



33,155Derivative warrant liability


1,398,698



1,949,220Current portion of notes payable and capital leases


7,847



8,743Total current liabilities


8,629,867



7,827,378Drilling prepayments


301,413



132,353Notes payable and capital leases


22,015



19,991Notes payable, related parties


8,160,646



8,160,646Asset retirement obligations


353,828



343,687Total liabilities


17,467,769



16,484,055Commitments and contingencies (Note 12)Stockholders' equity:Preferred stock: $0.001 par value; 5,000,000 shares authorized; none issued and outstanding


-



-Common stock: $0.001 par value; 125,000,000 shares authorized; 55,190,625 and 48,953,679 shares issued and outstanding


55,191



48,954Additional paid-in capital


37,827,162



31,164,705Accumulated deficit


(23,659,398)



(17,876,719)Total stockholders' equity


14,222,955



13,336,940Total liabilities and stockholders' equity

$
31,690,724


$
29,820,995







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


4


PEGASI ENERGY RESOURCES CORPORATION


CONSOLIDATED STATEMENTS OF OPERATIONS


(UNAUDITED)





Three Months

Ended June 30,


Six Months

Ended June 30,2012


2011


2012


2011Revenues:Oil and gas

$
146,723


$
234,468


$
314,731


$
435,634Condensate and skim oil


-



12,472



12,470



21,171Transportation and gathering


35,866



53,242



75,185



200,699Total  revenues


182,589



300,182



402,386



657,504Operating expenses:Lease operating expenses


103,915



108,468



186,148



209,968Pipeline operating expenses


31,456



37,635



71,045



76,667Cost of gas purchased for resale


-



-



-



94,814Depletion and depreciation


69,202



70,742



136,620



132,455General and administrative


2,735,123



474,795



4,150,694



1,062,381Total operating expenses


2,939,696



691,640



4,544,507



1,576,285Loss from operations


(2,757,107
)


(391,458
)


(4,142,121
)


(918,781
)Other income (expenses):Interest income


37



79



105



181Interest expense


(159,267
)


(160,857
)


(317,905
)


(322,035
)Changes in fair value of warrant derivative liability


(436,880
)


2,497,311



(1,240,430
)


1,616,108Warrant modification expense


-



-



(260,554
)


-Changes in liquidated damages


312,965



(8,221
)


175,955



(16,170
)Other income (expense), net


1,644



-



2,271



5,068Total other income (expenses), net


(281,501
)


2,328,312



(1,640,558
)


1,283,152Income (loss) from continuing operations before income tax expense (benefit)


(3,038,608
)


1,936,854



(5,782,679
)


364,371Income tax benefit


-



11,092



-



21,051Income (loss) from continuing operations


(3,038,608
)


1,947,946



(5,782,679
)


385,422Income (loss) from discontinued operations (net of tax expenses of $-0-, $11,092, $-0-, and $21,051, respectively)


-



20,620



-



39,114Net income (loss)

$
(3,038,608
)

$
1,968,566


$
(5,782,679
)

$
424,536Basic and diluted income (loss) per share:Income (loss) from continuing operations

$
(0.06
)

$
0.06


$
(0.11
)

$
0.01Income (loss) from discontinued operations


0.00



0.00



0.00



0.00Basic and diluted income (loss) per share

$
(0.06
)

$
0.06


$
(0.11
)

$
0.01Weighted average shares outstanding-basic and diluted


54,664,712



33,660,801



52,500,887



33,644,503








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


5


PEGASI ENERGY RESOURCES CORPORATION


CONSOLIDATED STATEMENTS OF CASH FLOWS


(UNAUDITED)








Six Months Ended June 30,2012


2011Operating ActivitiesNet income (loss)

$
(5,782,679)


$
424,536Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:Depletion and depreciation


136,620



132,455Accretion of discount on asset retirement obligations


10,141



10,695Stock based compensation


2,195,743



-Common stock issued for consulting services


434,500



20,000Gain on sale of equipment


(276)



(4,872)Change in fair value of warrant derivative liability


1,240,430



(1,616,108)Warrant modification expense


260,554



-Changes in operating assets and liabilities:Accounts receivable, trade


106,214



(261,058)Accounts receivable, related parties


(1,500)



-Joint interest billing receivable, related parties, net


(1,359,327)



120,358Joint interest billing receivable, net


(273,939)



(23,843)Other current assets


140



(4,230)Accounts payable


509,083



428,220Accounts payable, related parties


258,996



321,169Revenue payable


10,876



261,144Interest payable, related parties


316,158



316,158Liquidated damages payable


(175,955)



16,170Other payables


(12,033)



6,687Net cash provided by (used in) operating activities


(2,126,254)



147,481Investing ActivitiesAdditions to certificates of deposit


(104)



(181)Purchases of property and equipment


(64,086)



-Purchases of oil and gas properties


(4,325,846)



(258,964)Proceeds from sale of property and equipment


-



5,000Net cash used in  investing activities


(4,390,036)



(254,145)Financing ActivitiesPayments on notes payable and capital leases


(3,824)



(972)Cash overdraft


(128,932)



320,314Deferred financing costs


(15,550)



-Proceeds from sale of common stock, net of offering costs


1,986,945



(20,000)Net cash provided by financing activities


1,838,639



299,342Net increase (decrease) in cash and cash equivalents


(4,677,651)



192,678Cash and cash equivalents at beginning of period


6,749,368



249,802Cash and cash equivalents at end of period

$
2,071,717


$
442,480





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


6
 PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012 AND 2011


1.  NATURE OF OPERATIONS





Pegasi Energy Resources Corporation (“PERC,” or the “Company”) is engaged in the exploration and production of natural gas and oil through the development of a repeatable, low geological risk, high potential project in the active East Texas oil and gas region.  The Company's business strategy, which it designated as the “Cornerstone Project,” is to identify and exploit resources in and adjacent to existing or indicated producing areas within the Rodessa field area.  PERC’s principals spent over three years and invested over $3.5 million in equity for data harvesting, prospect evaluation and acreage acquisitions for the Cornerstone Project.





PERC is the successor entity to First Southern Crown Ltd. ("FSC"), a Texas limited partnership formed in December 2002.   In December 2004, FSC sold a thirty percent (30%) interest in all of its production, acreage position, pipeline and a thirty percent (30%) partnership interest in 59 Disposal, Inc. ("59 Disposal") (PERC’s disposal plant) to Marion Energy Limited ("Marion"), an entity publicly traded on the Australian stock exchange ("ASE.ax").  In February 2007, Marion traded its 30% partnership interest in 59 Disposal for a 30% undivided ownership in 59 Disposal’s assets.  Marion later sold its 30% undivided interest in 59 Disposal’s assets, its production interest, acreage position, and its pipeline interest to TR Energy, Inc. (“TR Energy”), a related party.  In 2008, the Company acquired an additional 10% interest in these assets in exchange for 4.2 million shares of the Company’s stock.





PERC conducts its main exploration and production operations through its wholly-owned subsidiary, Pegasi Operating, Inc. ("POI").  It conducts additional operations through another wholly-owned subsidiary: TR Rodessa, Inc. ("TR Rodessa").  Prior to the sale of its assets on July 1, 2011, the Company also conducted additional operations through its wholly-owned subsidiary, 59 Disposal.





TR Rodessa owns an 80% undivided interest in and operates a 40-mile natural gas pipeline and gathering system which is currently being used by PERC to transport its hydrocarbons to market.  Excess capacity on this system is used to transport third-party hydrocarbons.  Prior to its sale, 59 Disposal owned an 80% undivided interest in and operated a saltwater disposal facility which disposed saltwater and flow back waste into subsurface storage.








2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





a)  Basis of Presentation





The accompanying unaudited interim consolidated financial statements of PERC have been prepared in accordance with accounting principles generally accepted (“GAAP”) in the United States of America and the rules of the Securities and Exchange Commission (the “SEC”), and should be read in conjunction with PERC’s audited consolidated financial statements for the year ended December 31, 2011, and notes thereto, which are included in the Company’s annual report on Form 10-K filed with the SEC on March 28, 2012.  In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the Company’s consolidated financial position and the consolidated results of operations for the interim periods presented have been reflected herein.  The consolidated results of operations for interim periods are not necessarily indicative of the results to be expected for the full year.  The notes to consolidated financial statements, which would substantially duplicate the disclosures required in the Company’s 2011 annual consolidated financial statements, have been omitted.





b)  New Accounting Pronouncements





Accounting standards-setting organizations frequently issue new or revised accounting rules. We regularly review all new pronouncements to determine their impact, if any, on our financial statements. We do not believe that pronouncements materially affecting our financial statements have been issued since the filing of our Form 10-K for the year ended December 31, 2011.





c)  Stock-based Compensation





The Company has accounted for stock-based compensation under the provisions of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 718-10, Compensation-Stock Compensation.  The Company recognizes stock-based compensation expense in the consolidated financial statements for equity-classified employee stock-based compensation awards based on the grant date fair value of the awards.  We account for non-employee share-based awards based upon FASB ASC Topic 505-50, Equity-Based Payments to Non-Employees.  During the quarter ended June 30, 2012 and June 30, 2011, the Company recognized $2,195,743 and $0, respectively, of stock-based compensation expense which has been recorded as a general and administrative expense in the consolidated statements of operations.


7
 PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012 AND 2011





d)  Net Loss per Common Share





Basic net loss per common share is calculated using the weighted average number of common shares outstanding during the period. The Company uses the treasury stock method of calculating fully diluted per share amounts whereby any proceeds from the exercise of stock options or other dilutive instruments are assumed to be used to purchase common shares at the average market price during the period. The dilutive effect of convertible securities is reflected in diluted loss per share by application of the if-converted method. Under this method, conversion shall not be assumed for the purposes of computing diluted loss per share if the effect would be anti-dilutive. For the three months and six months ended June 30, 2012 and 2011, the diluted loss per share is the same as the basic loss per share, as the effect of common stock equivalents are anti-dilutive. For the three months ended June 30, 2012 and June 30, 2011, the Company had potentially dilutive shares of 37,522,102 and 30,298,411, respectively. For the six months ended June 30, 2012 and June 30, 2011, the Company had potentially dilutive shares of 37,522,102 and 30,298,411, respectively.





e) Notes Payable, Related Parties





Notes payable, related parties totaling $8,160,646 consisted of the “Teton Renewal Note” in the amount of $6,987,646 dated June 23, 2011 including interest at 8%, with all principal due on the maturity date of June 1, 2015, secured by a stock pledge and security agreement and the “Teton Promissory” note in the amount of $1,173,000 dated October 14, 2009, including interest of 6.25%, with all interest and principal due on the maturity date of June 1, 2015, unsecured.There have been no changes in the note terms since December 31, 2011.





f)  Reclassifications





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





3.  STOCKHOLDER’S EQUITY





Common Stock Issuances





Stock issued for cash, net of share issuance costs:


On March 9, 2012, the Company completed a stock purchase agreement in which it sold 4,444,445 shares of common stock, $.001 par value per share, at a price of $0.45 per share to raise gross proceeds of $2,000,000, before deducting offering expenses of $10,000 and related closing costs of $3,055, resulting in net cash proceeds of $1,986,945.





Stock issued on cashless basis:


On March 5, 2012, the Company issued 776,884 shares of common stock to a placement agent holding 2007 Warrants who exercised their warrants on a cashless basis.  On May 15, 2012, the Company issued 365,617 shares of common stock to a placement agent holding 2007 Warrants who exercised their warrants on a cashless basis. See Note 8 for additional details.





Stock issued for services:


On February 16, 2012, the Company issued 50,000 shares of common stock to consultants valued at $26,500.  On May 22, 2012, the Company issued an additional 600,000 shares of common stock to consultants valued at $408,000. These shares were valued using the closing market price on the date of the grant.





4.     SUPPLEMENTAL CASH FLOW AND NON-CASH INFORMATION





The following non-cash transactions were recorded during the six months ended June 30:




2012


2011Trade in proceeds on equipment

$
2,640


$
-Cashless exercise of warrants classified as a derivative

$
1,117,428


$
-Reclassification of derivative warrant liability to equity due to modification of warrants

$
673,524


$
-Oil and gas assets purchased in account payables

$
697,093


$
210,475Promote liabilities applied against oil and gas assets

$
121,379


$
-Equipment financed through notes payable

$
7,592


$
-


8
 PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012 AND 2011




The following is supplemental cash flow information for the six months ended June 30:




2012



2011Cash paid during the period for interest

$
1,747


$
6,807Cash paid during the period for taxes

$
-


$
-




5.  SEGMENT INFORMATION





The following information is presented in accordance with FASB ASC Topic 280, Segment Reporting.  The Company is engaged in the exploration and production of crude oil and natural gas, and pipeline transportation.  POI, a wholly-owned subsidiary of PERC, conducts the exploration and production operations.  TR Rodessa operates a 40-mile gas pipeline and gathering system which is used to transport hydrocarbons to market to be sold.  59 Disposal operated a saltwater disposal facility which disposed of saltwater and flow-back waste into subsurface storage  and  also  sold the  skim  oil  it  separated from  the  saltwater.  The assets of this company were sold effective July 1, 2011, and we have reported it as a discontinued operation (see Footnote 11).  The Company identified such segments based on management responsibility and the nature of their products, services, and costs.  There are no major distinctions in geographical areas served as all operations are in the United States.  The Company measures segment profit (loss) as income (loss) from operations.  Business segment assets are those assets controlled by each reportable segment.  The following table sets forth certain information about the financial information of each segment as of June 30, 2012 and December 31, 2011 and for the three and six months ended June 30, 2012 and 2011:





Three Months Ended

June 30, 2012


Three Months Ended

June 30, 2011


Six Months

Ended

June 30, 2012


Six Months

Ended

June 30, 2011Business segment revenue:Oil and gas

$
146,723


$
234,468


$
314,731


$
435,634Condensate and skim oil


-



12,472



12,470



21,171Transportation and gathering


35,866



53,242



75,185



200,699Total revenues

$
182,589


$
300,182


$
402,386


$
657,504Business segment profit (loss):Oil and gas

$
(7,941
)

$
73,488


$
26,828


$
127,544Condensate and skim oil


-



12,472



12,470



21,171Transportation and gathering


(12,546
)


(1,487
)


(30,917
)


(5,684
)General corporate


(2,736,620
)


(475,931
)


(4,150,502
)


(1,061,812
)Loss from operations

$
(2,757,107
)

$
(391,458
)

$
(4,142,121
)

$
(918,781
)Depreciation and depletion:Oil and gas

$
50,749


$
52,512


$
101,755


$
98,122Transportation and gathering


13,631



13,753



25,232



25,552General corporate


4,822



4,477



9,633



8,781Total depletion and depreciation

$
69,202


$
70,742


$
136,620


$
132,455


9
 PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012 AND 2011




Six Months Ended

June 30, 2012


Six Months Ended

June 30, 2011Capital expenditures:Oil and gas

$
4,901,560


$
258,964Transportation and gathering


64,086



-General corporate


7,592



-Total capital expenditures

$
4,973,238


$
258,964June 30, 2012


December 31, 2011Business segment assets:Oil and gas

$
28,589,474


$
28,362,163Transportation and gathering


628,757



617,129General corporate


2,472,493



841,703Total assets

$
31,690,724


$
29,820,995




6.  FAIR VALUE OF FINANCIAL INSTRUMENTS





FASB ASC Topic 825, Financial Instruments, requires certain disclosures regarding the fair value of financial instruments.  Fair value of financial instruments is made at a specific point in time, based on relevant information about financial markets and specific financial instruments.  As these estimates are subjective in nature, involving uncertainties and matters of significant judgment, they cannot be determined with precision. Changes in assumptions can significantly affect estimated fair values.





FASB ASC Topic 820, Fair Value Measurements, defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required or permitted to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and it considers assumptions that market participants would use when pricing the asset or liability.





FASB ASC Topic 820 establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. FASB ASC Topic 820 establishes three levels of inputs that may be used to measure fair value:





Level 1 - Level 1 applies to assets or liabilities for which there are quoted prices in active markets for identical assets or liabilities.





Level 2 - Level 2 applies to assets or liabilities for which there are inputs other than quoted prices included within Level 1 that are observable for the asset or liability such as quoted prices for similar assets or liabilities in active markets; quoted prices for identicalassets or liabilities in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data.





Level 3 - Level 3 applies to assets or liabilities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the assets or liabilities.


10
 PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012 AND 2011





The following table sets forth our estimate of fair value of our financial instruments that are liabilities as of June 30, 2012:





Quoted Prices in Active Markets for Identical Assets


Significant Other Observable Inputs


Significant Unobservable Inputs(Level 1)


(Level 2)


(Level 3)


Total2007 Warrants

$
-


$
1,398,698


$
-


$
1,398,698





The following table sets forth our estimate of fair value of our financial instruments that are liabilities as of December 31, 2011:





Quoted Prices in Active Markets for Identical Assets


Significant Other Observable Inputs


Significant Unobservable Inputs(Level 1)


(Level 2)


(Level 3)


Total2007 Warrants

$
-


$
1,949,220


$
-


$
1,949,220





The following table sets forth a summary of changes in fair value of our derivative liability for the six months ended June 30, 2012 and 2011:





2012


2011Beginning Balance – December 31,

$
1,949,220


$
3,638,311Derivative warrants exercised


(1,117,428
)


-Reclassification to equity due to modification


(673,524
)


-Change in fair value included in net loss


1,240,430



(1,616,108
)Balance at June 30,

$
1,398,698


$
2,022,203





In accordance with the reporting requirements of FASB ASC Topic 825, the Company calculates the fair value of its assets and liabilities which qualify as financial instruments under this statement and includes this additional information in the notes to consolidated financial statements when the fair value is different than the carrying value of these financial instruments.  The estimated fair values of accounts receivable, accounts payable and other current assets and accrued liabilities approximate their carrying amounts due to the relatively short maturity of these instruments.  The carrying value of long-term debt approximates market value due to the use of market interest rates.





7.  DERIVATIVE WARRANT LIABILITY





Under FASB ASC Topic 815, Derivatives and Hedging, the fair value of certain of our warrants is recorded as a derivative liability.  Each reporting period, the derivative liability related to these warrants is fair valued with the non-cash gain or loss recorded in the period as Other Income/Expense.  Since the exercise price of the warrants can be potentially decreased and the number of shares to settle the warrants increased each time a trigger event occurs that results in a new adjusted exercise price below the adjusted exercise price then in effect, there could be a potentially infinite number of shares required to settle the warrant agreement.  However, the Company has the capability of limiting the occurrence of such events.





As of June 30, 2012, and December 31, 2011, the Company had derivative warrant liabilities of $1,398,698 and $1,949,220, respectively.  We recognized a non-cash loss of $1,240,430 and $436,880 related to the change in the fair value of these warrants during the six months and three months ended June 30, 2012.





In March 2012 a placement agent exercised 407,592 of the 2007 Warrants representing 1,630,368 shares on a cashless basis.  This reduced the derivative liability by $767,740 and increased additional paid-in capital by the same amount.  In May 2012, another placement agent exercised 175,300 of the 2007 Warrants representing 701,200 shares on a cashless basis reducing the derivative liability by $349,688 and increasing additional paid-in capital by the same amount.





Pursuant to the warrant modification agreement discussed in Note 8, we modified certain 2007 Warrant agreements representing 1,760,000 shares to eliminate the ratchet provision contained in the original agreements.  Since these agreements no longer had derivative features as a result of the modification, the amount of derivative warrant liabilities associated with the shares have been reclassified from derivative warrant liabilities to additional paid-in capital. The amount reclassified due to this modification was $673,524.


11
 PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012 AND 2011





The Company used the Black-Scholes valuation model to estimate the fair value of the derivative warrant liability.  Significant assumptions used at June 30, 2012 were as follows:





June 30, 2012Market value of stock on reporting date (1)

$
0.80Risk-free interest rate (2)


0.10
%Dividend yield (3)


0.00
%Volatility factor


80.11
%Expected life (4)

0.46 years




(1)
The market value of the stock on the date of reporting was based reported public market prices.


(2)
The risk-free interest rate was determined by management using the U.S. Treasury zero-coupon yield over the remaining contractual term of the warrant on June 30, 2012.


(3)
Management determined the dividend yield to be 0% based upon its expectation that there will not be earnings available to pay dividends in the near term.


(4)
Expected life is remaining contractual life of the warrants.




8.  WARRANTS OUTSTANDING





In December 2007, the Company issued 8,375,784 warrants to purchase 4,187,901 shares of common stock exercisable until December 31, 2012 in connection with a securities placement agreement.  Also in December 2007, the Company issued warrants to placement agents to purchase 837,850 shares of common stock as part of a securities purchase offering.  On January 24, 2008, the Company issued an additional 9,615 warrants to a placement agent under the same terms as the original warrants.  These warrants had an exercise price of $1.60 per share and could also be exercised on a cashless basis for a reduced number of shares.





The 2007 Warrant Agreement contains anti-dilution protection rights (“ratchet provision”) which require an adjustment to the exercise price of the warrants and a proportional adjustment to the number of shares of common stock issuable upon exercise of the warrants in the event the Company issues common stock, stock options, or securities convertible into or exercisable for common stock, at a price per share lower than such exercise price.




During 2011, the Company offered holders of its 2007 Warrants an option to consider modification of the warrant agreements. The terms of the modification offer would: (1) waive all prior registration rights penalties, (2) remove the cashless exercise feature, (3) change the exercise price from $0.40 to $0.50, (4) extend the exercise term of the warrants by two years, and (5) delete the full-ratchet provisions.  The removal of the cashless exercise feature effectively made the Company liable for a potential registration rights penalty effective sixty days after the agreements were signed.  In March 2012, the Company offered the holders who had signed the 2011 modification agreement two rescission options which would correct the registration rights penalty liability.  Rescission Option A reverted the warrant back to its original 2007 terms with the original expiration date of December 31, 2012. Rescission Option B corrected the cashless exercise feature but retained all other modifications as noted above.  See Note 12, Commitments and Contingencies, for further explanation of the registration rights penalty.  The deletion of the full-ratchet provision resulted in a reclassification of the derivative liability on the signed agreements to additional paid-in capital.  See Note 7, Derivative Warrant Liability, for further explanation.





Pursuant to the 2011 modification agreement, the Company changed the terms of certain 2007 Warrant agreements representing 1,760,000 shares to increase their exercise price from $0.40 to $0.50 per share and to extend the exercise term by two years. These warrants were originally issued in conjunction with equity issues in 2007. The modification resulted in warrant modification expense of $260,554, which was calculated as the difference in the fair value of the warrants immediately before and immediately after the modification using the Black-Scholes option pricing model. The following table details the significant assumptions used to compute the fair market value of the warrant modifications:





Before

AfterRisk free rates
0.11% - 0.14%

0.34%Dividend yield
0%

0%Expected volatility
110.28% - 110.68%

129.35% - 131.00%Remaining term (years)
0.83 years – 0.96 years

2.83 – 2.95 years


12
 PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012 AND 2011




In March 2012, a holder of the 2007 Warrants exercised their 407,592 warrants to acquire 1,630,368 shares on a cashless basis and received 776,884 shares of the Company’s common stock. In May 2012, a holder of the 2007 warrants exercised their 175,300 warrants to acquire 701,200 shares on a cashless basis and received 365,617 shares of the Company’s common stock.





A summary of warrant activity and shares issuable upon exercise of the warrants during the six months ended June 30, 2012 is as follows:





Warrants


Shares Issuable Under Warrants


Weighted Average Exercise PriceOutstanding at December 31, 2011


14,562,930



24,397,812


$
0.52Warrants issued


-



-



-Warrants exercised


(582,892)



(2,331,568)



0.40Warrants cancelled under modification


(880,000)



(1,760,000)



0.40Warrants issued under modification


880,000



1,760,000



0.50Outstanding at June 30, 2012


13,980,038



22,066,244


$
0.54





The intrinsic value of the 13,980,038 warrants outstanding at June 30, 2012 was $3,684,095.  All of the 13,980,038 warrants outstanding at June 30, 2012 are exercisable.





9.  RESTRICTED CASH





Collateral





Certificates of deposit have been posted as collateral supporting a reclamation bond guaranteeing remediation of our oil and gas properties in Texas.  As of June 30, 2012 and December 31, 2011, the balance of the certificates of deposit totaled $78,389 and $78,285, respectively.





2010 Drilling Program





During the last quarter of 2010, the Company executed participation and operating agreements with various independent oil and gas companies regarding the drilling of various wells.   Funds received from these companies are restricted to the drilling programs and are considered released when they are spent in accordance with the agreements.  Since inception, total funds of $2,346,066 were received on these programs and $1,833,490 was spent on drilling activities, and $482,390 was reclassified to promote income, offsetting the Company’s unproved oil & gas properties, leaving a balance of $30,186 in restricted cash and drilling prepayments at June 30, 2012.





2011 Drilling Program





During the last quarter of 2011, the Company executed joint operating agreements with various independent oil and gas companies regarding the drilling of various wells.   Funds received from these companies are restricted to the drilling programs and are considered released when they are spent in accordance with the agreements.  Total funds of $2,825,294 were received on these programs and $2,540,601 was spent on drilling activities, and $13,466 was reclassified to promote income, leaving a balance of $271,227 in restricted cash and drilling prepayments at June 30, 2012.





10.  STOCK-BASED COMPENSATION





The Company has granted stock options to key employees, directors, and consultants as discussed below:





On May 29, 2007, the Company adopted the 2007 Stock Option Plan (the “2007 Plan”) for employees, consultants and such other persons selected by the plan administrator to provide a means to retain the services of such employees and strengthen their incentive to achieve the objectives of the Company and to provide an equity incentive to consultants and other persons to promote the success of the Company.  The 2007 Plan reserves 1,750,000 shares of common stock for issuance by the Company as stock options.


13
 PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012 AND 2011





On October 19, 2010, the Company adopted the 2010 Incentive Stock Option Plan (the “2010 Plan”) for directors, executives, and selected employees and consultants to reward them for making major contributions to the success of the Company by issuing long-term incentive awards under the 2010 Plan thereby providing them with an interest in the growth and performance of the Company.  The 2010 Plan reserves 5,000,000 shares of common stock for issuance by the Company as stock options, stock awards or restricted stock purchase offers.





On February 23, 2012, the Company adopted the 2012 Incentive Stock Option Plan (the “2012 Plan”) for directors, executives, and selected employees and consultants to reward them for making major contributions to the success of the Company by issuing long-term incentive awards under the 2012 Plan thereby providing them with an interest in the growth and performance of the Company.  The 2012 Plan reserves 10,000,000 shares of common stock for issuance by the Company as stock options, stock awards or restricted stock purchase offers.





On January 5, 2012, pursuant to the 2007 Plan, the Company issued stock options for 486,364 shares of common stock at an exercise price of $0.50 per share and 363,636 shares of common stock at an exercise price of $0.55 per share to various executives, selected employees and consultants for their contributions to the success of the Company.   All of the options vested immediately upon issuance at January 5, 2012, and are exercisable at any time, in whole or part, until January 5, 2017.





In addition, on January 5, 2012, pursuant to the 2010 Plan, the Company issued stock options for 880,775 shares of common stock at an exercise price of $0.50 per share to selected employees and consultants for their contributions to the success of the Company.   All of the options vested immediately upon issuance at January 5, 2012, and are exercisable at any time, in whole or part, until January 5, 2017.





On January 5, 2012, pursuant to Board resolution, the Company changed the terms of all options under the 2007 Plan to extend the exercise term for two years from December 31, 2012 to December 31, 2014.  The modification resulted in incremental stock compensation cost of $136,072, which was calculated as the difference in the fair value of the options immediately before and immediately after the modification using the Black-Scholes option pricing model.  The Company used the simplified method to determine the expected term on the options modified due to the lack of historical exercise data.  The following table details the significant assumptions used to compute the fair value of the option modifications:





Before

AfterRisk free rates
0.06%

0.19%Dividend yield
0%

0%Expected volatility
108.47%

127.91%Remaining term (years)
0.5 years

1.5 years








On April 20, 2012, pursuant to Board resolution, the Company changed the terms of the remaining 900,000 options previously granted under the 2007 Plan to decrease the exercise price from $1.20 per share to $0.65 per share.  The modification resulted in incremental stock compensation cost of $93,092, which was calculated as the difference in the fair value of the options immediately before and immediately after the modification using the Black-Scholes option pricing model.  The Company used the simplified method to determine the expected term on the options modified due to the lack of historical exercise data.  The following table details the significant assumptions used to compute the fair value of the option modifications:





Before

AfterRisk free rates
0.23%

0.23%Dividend yield
0%

0%Expected volatility
101.77%

101.77%Remaining term (years)
1.5 years

1.5 years





On April 30, 2012, pursuant to the 2010 Plan, the Company issued stock options for 3,000,000 shares of common stock at an exercise price of $0.55 per share to selected executives for their contributions to the success of the Company. All of the options vested immediately upon issuance at April 30, 2012, and are exercisable at any time, in whole or part, until April 30, 2017. This issuance resulted in stock based compensation expense of $1,371,766, which was calculated using the fair value of the options at grant date.


14
 PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012 AND 2011





A summary of option activity during the six months ended June 30, 2012 is as follows:





Options


Weighted Average

Exercise Price


Weighted Average Grant Date Fair ValueOutstanding at December 31, 2011


1,969,285


$
0.78


$
-Options granted - January


1,730,775



0.51



0.34Options granted - April


3,000,000



0.55



0.46Options exercised


-



-



-Outstanding at June 30, 2012


6,700,060


$
0.53


$
-





The following is a summary of stock options outstanding at June 30, 2012:





Exercise


Options

Remaining Contractual

OptionsPrice


Outstanding

Lives (Years)

Exercisable$
0.65



900,000

2.5


900,000$
0.42



1,059,285

3.5


1,059,285$
0.50



10,000

3.5


10,000$
0.50



486,364

4.5


486,364$
0.55



363,636

4.5


363,636$
0.50



880,775

4.5


880,775$
0.55



3,000,000

5


3,000,000




Based on the Company's stock price of $0.80 at June 30, 2012, the options outstanding had an intrinsic value of $1,419,761.  At June 30, 2011 the Company’s stock price was $0.22 and the options outstanding had no intrinsic value.





Total options exercisable at June 30, 2012 amounted to 6,700,060 shares and had a weighted average exercise price of $0.53.  Upon exercise, the Company issues the full amount of shares exercisable per the term of the options from new shares.  The Company has no plans to repurchase those shares in the future.  The following is a summary of options exercisable at June 30, 2012 and December 31, 2011:





Weighted AverageShares


Exercise PriceJune 30, 2012


6,700,060


$
0.53December 31, 2011


1,969,285


$
0.78





The Company estimates the fair value of stock options using the Black-Scholes option pricing valuation model, consistent with the provisions of FASB ASC Topic 505 and FASB ASC Topic 718.  Key inputs and assumptions used to estimate the fair value of stock options include the grant price of the award, the expected option term, volatility of the Company’s stock, the risk-free rate and the Company’s dividend yield.  Estimates of fair value are not intended to predict actual future events or the value ultimately realized by grantees, and subsequent events are not indicative of the reasonableness of the original estimates of fair value made by the Company.  The Company used the simplified method to determine the expected term on the options issued in the quarter ended June 30, 2012, due to the lack of historical exercise data.


15
 PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012 AND 2011




The following assumptions were used for the Black-Scholes model for options granted in the quarter ended June 30, 2012:





June 30, 2012Risk free rates
0.33%Dividend yield
0%Expected volatility
124.66%Weighted average expected stock options life
2.5 years





The fair value of each stock option is estimated on the date of the grant using the Black-Scholes option pricing model.  No dividends were assumed due to the nature of the Company’s current business strategy.





As of June 30, 2012 and June 30, 2011, the Company had no unrecognized compensation expense related to non-vested stock-based compensation arrangements.  There were 3,000,000 options granted and vested during the quarter ended June 30, 2012.  There were no options granted or vested during the quarter ended June 30, 2011.




11.  DISCONTINUED OPERATIONS





The Company’s wholly-owned subsidiary, 59 Disposal Inc., operated a saltwater disposal facility which disposed of saltwater and flow-back waste into subsurface storage.  The disposal activities had diminished over time and in January 2011, the Company offered for sale certain assets of the subsidiary. A letter of intent signed on March 1, 2011 was closed effective July 1, 2011 at a gross sale price of $1.3 million of which the Company’s portion was $1.04 million.





At July 1, 2011, assets of 59 Disposal included in the sale had a net book value of $300,347 and were previously included in the consolidated balance sheets as assets held for sale.  The Company’s portion of the sales price was their 80% interest which amounted to $1.04 million.  Current assets and liabilities of 59 Disposal at the date of sale, including accounts receivable of $75,648, accounts payable of $68,816, related party payables of $123,290, interest payable of $2,015 and notes payable, related party, of $23,244 as of July 1, 2011, were retained by the Company under the sale provisions.





The following schedule details 59 Disposal’s property and equipment included in the sale as of July 1, 2011:





Cost


Accumulated

Depreciation


July 1, 2011

Net Book ValueLease & well equipment

$
597,740


$
318,916


$
278,824Buildings


19,916



2,353



17,563Office furniture & equipment


6,550



2,590



3,960$
624,206


$
323,859


$
300,347





As a result of the discontinued operations accounting treatment, the Consolidated Statement of Operations reflects 59 Disposal as a discontinued operation for all periods presented. Following is summarized information regarding the discontinued operations:





Revenues of discontinued operations amounted to $-0- and $92,172 for the three months ended June 30, 2012 and 2011.




Three Months EndedJune 30,


June 30,2012


2011Loss from discontinued operations

$
-


$
31,712Income tax expense – discontinued operations


-



(11,092
)Income (loss) from discounted operations, net of tax

$
-


$
20,620


16
 PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE 30, 2012 AND 2011


Revenues of discontinued operations amounted to $-0- and $174,822 for the six months ended June 30, 2012 and 2011.




Six Months EndedJune 30,


June 30,2012


2011Loss from discontinued operations

$
-


$
60,165Income tax expense – discontinued operations


-



(21,051
)Income (loss) from discounted operations, net of tax

$
-


$
39,114





12. COMMITMENTS AND CONTINGENCIES





Along with the Company's counsel, management monitors developments related to legal matters and, when appropriate, makes adjustments to record liabilities to reflect current facts and circumstances.  Management has recorded a liability related to its registration rights agreement with investors that provides for the filing of a registration statement for the registration of the shares issued in the offering in December 2007, as well as the shares issuable upon exercise of related warrants.  The Company failed to meet the deadline for the effectiveness of the registration statement and therefore was required to pay liquidated damages of approximately $100,000 on the first day of effectiveness failure, or July 18, 2008.  An additional $100,000 penalty was required to be paid by the Company every thirty days thereafter, prorated for periods totaling less than thirty days, until the effectiveness failure was cured, up to a maximum of 18% of the aggregate purchase price, or approximately $1,800,000.  The Company’s registration became effective on August 21, 2008.





Pursuant to the warrant modification agreement discussed in Note 8, the Company modified certain 2007 Warrant Agreements representing 10,846,340 shares to waive all prior registration rights and remove the cashless exercise feature.  The removal of the cashless exercise made the Company liable for a potential registration rights penalty effective sixty days after the agreements were signed.  In March 2012, the Company offered two rescission options to the holders who had signed the 2011 modification agreement.  Under Option A the warrant reverted back to the original 2007 terms which would add back the original penalty.  Under Option B the effectiveness date for the registration rights penalty was changed by setting a filing deadline.  As of June 30, 2012, Option A rescission agreements representing 81,668 shares had been received which reverted the warrant to the original 2007 terms.  Also, as of June 30, 2012, Option B rescission agreements representing 12,224,672 shares had been received which continued the waiver of the original penalty and changed the effectiveness date of the modification.





As of March 31, 2012 there had been holders of the 2007 Warrant Agreements representing 10,261,672 shares that signed the 2011 warrant modification agreement and were subject to a registration rights penalty effective sixty days after the agreements were signed.  At that date the penalty was determined to be $314,341.  As of June 30, 2012 all of these warrant holders had signed the 2012 warrant modification agreement which changed the effectiveness date of the modification and reversed the penalty calculated of $314,341 in the prior quarter.  The reversal of the penalty resulted in a decrease to the penalty payable.





At June 30, 2012, management reevaluated the status of the registration statement after the above modifications and rescissions and determined an accrual of $31,791 was sufficient to cover any potential payments for liquidated damages.  The damages are reflected as liquidated damages payable of $31,791 and $207,746 in the accompanying consolidated balance sheets as of June 30, 2012 and December 31, 2011, respectively.   The difference of $175,955 was recorded as changes in liquidated damages  in the Other Income (Expense) section of the consolidated statements of operations.





13.  SUBSEQUENT EVENTS





In July 2012, upon the written consent of the directors and the holders of the majority of the shares issued and outstanding, the Company approved an amendment to the Articles of Incorporation to increase the number of authorized shares of common stock, par value at $0.001 per share to 150,000,000 from 125,000,000.  The Company was also granted the discretion to amend the Articles of Incorporation to effect a reverse split of the Corporation’s common stock, at a ratio not less than one-for-two and not greater than one-for-10 with the exact ratio to be set within such range in the discretion of the Board of Directors, subject to various conditions.




17
  Item2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.





Forward Looking Statements





This Management's Discussion and Analysis of Financial Condition and Results of Operations includes a number of forward-looking statements that reflect management's current views with respect to future events and financial performance. You can identify these statements by forward-looking words such as “may,” “will,” “expect,” “anticipate,” “believe,” “estimate” and “continue,” or similar words.  Those statements include statements regarding the intent, belief or current expectations of us and the management team as well as the assumptions on which such statements are based. Prospective investors are cautioned that any such forward-looking statements are not guarantees of future performance and involve risk and uncertainties, and that actual results may differ materially from those contemplated by such forward-looking statements.





Readers are urged to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the Securities and Exchange Commission.  The following Management’s Discussion and Analysis of Financial Condition and Results of Operations of the Company should be read in conjunction with the Consolidated Financial Statements and notes related thereto included in this Quarterly Report on Form 10-Q. Important  factors not  currently  known  to management  could  cause  actual  results  to differ  materially  from  those in forward-looking  statements.  We undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes in the future operating results over time. We believe that our assumptions are based upon reasonable data derived from and business and operations of the Company.  No assurances are made that actual results of operations or the results of our future activities will not differ materially from our assumptions.  Factors that could cause differences include, but are not limited to, expected market demand for our products, fluctuations in pricing for materials, and competition.





Company Overview





We are an independent energy company engaged in the exploration for, and production of, crude oil and natural gas.  Our focus is on the development of a repeatable, low-geological risk, high-potential project in the active East Texas oil and gas region.  We currently hold interests in properties located in Cass and Marion Counties, Texas, home to the Rodessa oil field.  This field has historically been the domain of small independent operators and is not a legacy field for any major oil company.





Our business strategy in what we have designated the “Cornerstone Project”, is to identify and exploit resources in and adjacent to existing or indicated producing areas within the mature Rodessa field. We believe that we are uniquely familiar with the history and geology of the Cornerstone Project area based on our collective experience in the region as well as through our development and ownership of a large proprietary database which details the drilling history of the Cornerstone Project area since 1980.  Having assembled a substantial acreage position over recent years we intend to quickly develop these resources from 2012 onwards. We plan to develop and produce reserves at low cost and will take an aggressive approach to exploiting our contiguous acreage position through utilization of the latest “best in class” drilling and completion techniques.   We believe that implementing the latest proven drilling and completion techniques to exploit our geological insight in the Cornerstone Project area will enable us to find significant oil and gas.




We conduct our main exploration and production operations through our wholly owned subsidiary, POI. As of July 25, 2012, we operated 15 producing wells.  We conduct additional operations through another wholly owned subsidiary, TR Rodessa.


TR Rodessa owns an 80% undivided interest in and operates a 40-mile natural gas pipeline and gathering system which we use to transport our hydrocarbons to market.  Excess capacity on this system is used to transport third-party hydrocarbons.





18





Plan of Operations





We intend to continue to use our competitive strengths to advance our corporate strategy. The following are key elements of that strategy:





·
Continue to lease underdeveloped acreage in the Cornerstone Project area.As of July 25, 2012, our leasehold position is approximately 30,205 gross acres and 20,960 net acres, of which our working interest is approximately 12,115 net acres. During 2011, we completed our lease program with two lease fund partners from which we received $5.2 million.  Our priority is now drilling, and consequently, our leasing program’s primary objective is to support the planned drilling program by securing holdout leases in those units where we plan to drill over the next twelve months and renewing leases that are due to expire in those units where we plan to drill.





We continue to use our extensive proprietary database to optimize additional drilling locations and to acquire additional acreage in the Cornerstone Projectarea.  Most properties in the project area are held by smaller independent companies that lack the resources and expertise to exploit them fully.  We intend to pursue these opportunities to selectively expand our portfolio of properties.  These acreage additions will complement our existing substantial acreage position in the area and provide us with additional drilling opportunities.





·
Develop the resources of the Cornerstone Project through a drilling program.In 2012, our drilling program will be limited to development and will feature two components:





–
Our priority is to drill horizontal wells targeting the Bossier/Cotton Valley Limestone.  We will employ the latest horizontal drilling and dynamic multi-stage fracking techniques that have proven so successful in the Bakken and elsewhere to develop the low permeability oil bearing Bossier and Cotton Valley Limestone formations.  Our first horizontal well, the Morse #1, was drilled with a 2,000 foot horizontal section. This well was recently completed with a five‐stage frack and recorded an average production rate of 281 Bbl/day of high quality crude oil in its first five days of production. We believe that the success of the Morse #1 vindicates our development strategy.  Having proven our development model, we now plan to drill wells with longer laterals involving 15 to 25 frack stages to improve the well economics. We have a 56% working interest in the Morse #1 well;





–
A secondary priority is to drill vertical wells to offset the Norbord #1 discovery of 2010 in the Travis Peak.  We plan to maximize the present value of our vertical wells by utilizing a multi-zone production technique.  We will also implement the latest drilling, fracturing, and completion techniques, including shotgun duals, to develop our properties. The Haggard “B”, which offsets the Norbord #1, was recently hooked up to production.  We have a 32% working interest in the Haggard “B”; and


–
We have no current plans to drill any further test wells. The Swamp Fox #1 test well was recompleted in November 2011 and a complete evaluation of the well and discussion of how to proceed is still in progress with our drilling partners. We have a 28% working interest in the well.


·
Maintain a conservative and flexible financial strategy.We will continue to maintain a low level of corporate overhead expense and utilize outsourcing, where appropriate, to maximize cash flow.  We believe that internally generated cash flow, coupled with reserve-based debt financing when appropriate, will provide the optimal capital structure to fund our future drilling activity.





19





Results of Operations





Three Months Ended June 30, 2012 Compared to Three Months Ended June 30, 2011.





Summarized Results of Operations





2012


2011


Increase (Decrease)Total revenues

$
182,589


$
300,182


$
(117,593
)Total operating expenses


2,939,696



691,640



2,248,056Loss from operations


(2,757,107
)


(391,458
)


(2,365,649
)Total other expenses


(281,501
)


2,328,312



(2,609,813
)Income (loss) from continuing operations before income tax benefit


(3,038,608
)


1,936,854



(4,975,462
)Income tax benefit


-



11,092



(11,092
)Income (loss) from continuing operations


(3,038,608
)


1,947,946



(4,986,554
)Income from discontinued operations, net of tax


-



20,620



(20,620
)Net income (loss)

$
(3,038,608
)

$
1,968,566


$
(5,007,174
)





Revenues:  Total revenues for the quarter ended June 30, 2012 totaled $182,589, compared to $300,182 for the quarter ended June 30, 2011.  Oil revenue for the three months ended June 30, 2012 was $84,735, compared to $106,565 for the three months ended June 30, 2011.  Average production for the three months ended June 30, 2012 decreased 16% compared to June 30, 2011, which along with a 4% decrease in price, resulted in a decrease of $21,830 in oil revenue. Gas revenue for the three months ended June 30, 2012 was $61,988, compared to $127,903 for the three months ended June 30, 2011, resulting in a decrease of $65,915.  The decrease in gas revenue was due to a decrease in the average price of gas of approximately 50%.  Transportation and gathering revenue decreased $17,376 to $35,866 for the three months ended June 30, 2012 from $53,242 for the three months ended June 30, 2011, mainly due to the decrease in overall production by the Childers #2 and Huntington #1 wells. Condensate and skim oil was $0 and $12,472 for the three months ended June 30, 2012 and June 30, 2011, respectively.




Expenses:  Total operating expenses for the three months ended June 30, 2012 were $2,939,696, compared to $691,640 for the three months ended June 30, 2011, resulting in a total increase of $2,248,056.  This change is comprised primarily of increases in general and administrative expenses.





●
General and AdministrativeExpenses:  There was a $2,260,328 increase in general and administrative expenses to $2,735,123 for the three months ended June 30, 2012 from $474,795 for the three months ended June 30, 2011.   The primary reason for the increase was stock-based compensation of $1,591,631 incurred during the three months ended June 30, 2012, whereas there was no stock-based compensation incurred in the three months ended June 30, 2011. Consulting fees increased $678,020 during the three month period due to consulting contracts of $635,333 with companies assisting in our search for financing and contracts of $42,687 for management consulting.





Other Income (Expenses):Total other expenses for the three months ended June 30, 2012 was $281,501 compared to other income of $2,328,312 for the three months ended June 30, 2011, resulting in a decrease of $2,609,813.  The primary reason for the decrease was due to a $2,497,311 non-cash gain for the three months ended June 30, 2011 resulting from the change in fair value of our warrant derivative liability.  The change was caused by a decrease in the stock price between March 31, 2011 and June 30, 2011.  A non-cash loss from the change in fair value of the derivative liability of $436,880 was recognized in the three months ended June 30, 2012 due to the increase in our stock price between March 31, 2012 and June 30, 2012. This caused an overall decrease of $2,934,191 in the non-cash change in fair value of our warrant derivative liability.





20




This decrease was offset by an increase of $321,186 in liquidated damages due to the reversal of a penalty of $314,341 during the three months ended June 30, 2012 which had been originally recorded as of March 31, 2012. See footnotes 8 – Warrants Outstanding, and 12 – Commitments and Contingencies, for additional details. There were no warrant modifications in the quarter ended June 30, 2011.





Income Tax Expense:During the three months ended June 30, 2012, we recognized a net income tax expense of $0.  The three months ended June 30, 2011 income tax benefit of $11,092 related to discontinued operations.
 
 Net Loss:As a result of the above described revenues and expenses, we incurred a net loss of $3,038,608 for the three months ended June 30, 2012, as compared to a net income of $1,968,566 for the three months ended June 30, 2011.





Six Months Ended June 30, 2012 Compared to Six Months Ended June 30, 2011.





Summarized Results of Operations





2012


2011


Increase (Decrease)Total revenues

$
402,386


$
657,504


$
(255,118
)Total operating expenses


4,544,507



1,576,285



2,968,222Loss from operations


(4,142,121
)


(918,781
)


(3,223,340
)Total other expenses


(1,640,558
)


1,283,152



(2,923,710
)Income (loss) from continuing operations before income tax benefit


(5,782,679
)


364,371



(6,147,050
)Income tax benefit


-



21,051



(21,051
)Income (loss) from continuing operations


(5,782,679
)


385,422



(6,168,101
)Income from discontinued operations, net of tax


-



39,114



(39,114
)Net income (loss)

$
(5,782,679
)

$
424,536


$
(6,207,215
)





Revenues:  Total revenues for the six months ended June 30, 2012 totaled $402,386, compared to $657,504 for the six months ended June 30, 2011.  Oil revenue for the six months ended June 30, 2012 was $185,366, compared to $194,782 for the six months ended June 30, 2011.  The decrease of $9,416 in oil revenue was due to a small decrease in production.  Gas revenue for the six months ended June 30, 2012 was $129,365, compared to $240,852 for the six months ended June 30, 2011, resulting in a decrease of $111,487.  The decrease in gas revenue was due to a decrease in the average price of gas of approximately 44%.  Transportation and gathering revenue decreased $125,514 to $75,185 for the six months ended June 30, 2012, compared to $200,699 for the six months ended June 30, 2011.  The decrease was due to a third party operator who began handling the income from gas being carried through our pipeline in February of 2011. Condensate and skim oil was $12,470 and $21,171 for the six months ended June 30, 2012 and June 30, 2011, respectively.





Expenses:  Total operating expenses for the six months ended June 30, 2012 were $4,544,507, compared to $1,576,285 for the six months ended June 30, 2011, resulting in a total increase of $2,968,222.  This change is comprised primarily of increases in general and administrative expenses offset by a decrease in cost of gas purchased for resale.





●
General and AdministrativeExpenses:  There was a $3,088,313 increase in general and administrative expenses to $4,150,694 for the six months ended June 30, 2012 from $1,062,381 for the six months ended June 30, 2011.   The primary reason for the increase was stock-based compensation of $2,195,743 incurred during the six months ended June 30, 2012, whereas there was no stock-based compensation incurred in the six months ended June 30, 2011.  Consulting fees increased $750,760 during the six months ended June 30, 2012, due to contracts with companies assisting us in the search for financing. In addition, advertising and marketing costs increased $102,161 during the six month period due to various contracts with companies for investor relations




21




●
Cost of Gas Purchased for Resale:  Total cost of gas purchased for resale for the six months ended June 30, 2012 was $-0- compared to $94,814 for the six months ended June 30, 2011.  In February 2011, a third party operator began collecting the revenue from other companies’ gas that went through our pipelines, which eliminated our need to record cost of gas purchased for resale.





Other Income (Expenses):Total other expenses for the six months ended June 30, 2012 was $1,640,558, compared to other income of $1,283,152 for the six months ended June 30, 2011, resulting in a decrease of $2,923,710.   The primary reason for the decrease was due to a $1,616,108 non-cash gain for the six months ended June 30, 2011 resulting from the change in fair value of our warrant derivative liability.  The change was caused by a decrease in the stock price between December 31, 2010 and June 30, 2011.  A non-cash loss from the change in fair value of the derivative liability of $1,240,430 was recognized in the six months ended June 30, 2012 due to the increase in our stock price between December 31, 2011 and June 30, 2012. This caused an overall decrease of $2,856,538 in the non-cash change in fair value of our warrant derivative liability.


In addition, modifications to certain warrants in the six months ended June 30, 2012, resulted in warrant modification expense of $260,554.  This was offset by an increase to other income of $175,955 in the six months ended June 30, 2012 for the removal of the original penalty on the modified warrants for a net decrease of $84,599. See footnotes 8 – Warrants Outstanding, and 12 – Commitments and Contingencies, for additional details. There were no warrant modifications in the quarter ended June 30, 2011.





Income Tax Expense:During the six months ended June 30, 2012 we recognized a net income tax expense of $-0-.  The six months ended June 30, 2011 income tax benefit of $21,051 related to discontinued operations.





Net Loss:As a result of the above described revenues and expenses, we incurred a net loss of $5,782,679 for the six months ended June 30, 2012 as compared to net income of $424,536 for the six months ended June 30, 2011.





Liquidity and Capital Resources





We held $2,071,717 in cash at June 30, 2012, made up of a majority of our cash accounts.  However, at June 30, 2012, several cash accounts had an overdraft that totaled $35,428, resulting in net cash of $2,036,289. We held $6,749,368 in cash at December 31, 2011, which when netted against the overdrafts of $164,360, resulted in net cash of $6,585,008.  The decrease in cash is related to purchases of leases and well equipment, the increase in our drilling activities, and the use of cash to cover operating expenses. The decrease was partially offset by an influx of cash from the sale of common stock during the six months ended June 30, 2012.


Cash Flows





The following table summarizes our cash flows for the six months ended June 30, 2012 and 2011:





2012


2011Total cash provided by (used in):Operating activities

$
(2,126,254)


$
147,481Investing activities


(4,390,036)



(254,145)Financing activities


1,838,639



299,342Increase (decrease) in cash and cash equivalents

$
(4,677,651)


$
192,678





The net amount of cash used in operating activities during the six months ended June 30, 2012 was $2,126,254.  This was a result of the net loss of $5,782,679 being offset by non-cash income and expense items totaling $4,277,711 as well as increases in various payables and other liabilities totaling $907,125.  These were offset by an increase of $1,359,327 in receivables from working interest investors to reimburse us for the substantial amount of drilling and completion work expenses on the Morse well during the quarter ended June 30, 2012.  Approximately $1 million of this receivables increase was from a related party investor.  The remaining change in cash of $169,085 was from changes in various operating assets.  Non-cash income and expense items included a $1,240,430 change in the fair value of the warrant derivative liability, $260,554 warrant modification expense, stock based compensation to various executives, employees and consultants of $2,195,743, and stock issued to consultants for $434,500 in fees.


22





The net amount of cash provided by operating activities during the six months ended June 30, 2011 was $147,481.  This was a result of the net income of $424,536 being offset by non-cash income and expense items totaling $1,457,830 as well as increases in various payables totaling $1,349,548.  The remaining change in cash of $168,773 was from changes in various operating assets.





Cash used in investing activities for the six months ended June 30, 2012 was $4,390,036, compared to $254,145 used in investing activities for the six months ended June 30, 2011, resulting in an increase of $4,135,891.  There was $4,325,846 spent on lease and well equipment, and intangible drilling and completion costs for work done on the Haggard A#1, Haggard B#1 and Morse wells in the first six months of 2012.  There was only $258,964 spent in the first six months of 2011, resulting in an increase of $4,066,881.  In addition, there was $64,086 spent on purchases of property and equipment in the first six months of 2012 compared to no purchases in the first six months of 2011.  There was also $5,000 in proceeds from the sale of property and equipment in the first six months of 2011 and $-0- in proceeds received during the six months ended June 30, 2012.
 
 Cash provided by financing activities for the six months ended June 30, 2012 totaled $1,838,639, compared to $299,342 for the six months ended June 30, 2011, resulting in an increase in cash of $1,539,297.  In the first six months of 2012, we received $2,000,000 in gross proceeds from the sale of common stock, which was offset by $13,055 in offering and closing costs, compared to no proceeds from sales of common stock in the first six months of 2011.  The $299,342 of cash provided by financing activities for the six months ended June 30, 2011 was primarily a result of changes in the cash overdraft. There was a $128,932 decrease in our cash overdraft for the first six months of 2012, compared to an increase in our cash overdraft of $320,314 for the first six months of 2011, resulting in an increase of $449,246. There were also deferred financing costs of $15,550 in the first six months of 2012, whereas we had no deferred financing costs in the first six months of 2011.


Sources of Liquidity





Production revenues have not been sufficient to finance our operating expenses; therefore, we have had to raise capital in recent years to fund our activities.Planned lease acquisitions and exploration, development, production and marketing activities, as well as administrative requirements (such as salaries, insurance expenses, general overhead expenses, legal compliance costs and accounting expenses) will require a substantial amount of additional capital and cash flow.
 
 We recently completed our first horizontal well, the Morse #1.  This well recorded an average production rate of 281 bbl/day of high quality crude oil in its first five days of production.  Management expects that the production from the Morse well will significantly increase our revenues in the forthcoming quarters as we have a 56% working interest in this well.  We expect that additional funds raised from future financing activities will be needed, together with production revenue,to finance our operations for the next twelve months.  The extent of our drilling program in the second half of 2012 is dependent on our ability to raise additional capital.  There are no guarantees that we will be able to raise additional funds on terms acceptable to us, if at all.  We may also consider farm-out agreements, whereby we would lease parts of our properties to other operators for drilling purposes and we would receive payment based on the production.


We are pursuing sources of additional capital through various financing transactions or arrangements, including joint venturing of projects, debt financing, equity financing and other means.




March 2012 Financing
 
 In March 2012, we sold 4,444,445 shares of common stock at $0.45 per share to one non-affiliated non-U.S. person, for a purchase price of $2,000,000. We incurred legal and escrow fees of $13,055.


23





Off Balance Sheet Arrangements





We do not have any off balance sheet arrangements that are reasonably likely to have a current or future effect on our consolidated financial condition, revenues, results of operations, liquidity or capital expenditures.





Critical Accounting Policies





Our critical accounting policies, including the assumptions and judgments underlying them, are disclosed in the notes to consolidated financial statements which accompany the consolidated financial statements included in our annual report on Form 10-K filed with the SEC on March 28, 2012.  These policies have been consistently applied in all material respects and address such matters as revenue recognition and depreciation methods.  The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that 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 recorded amounts of revenues and expenses during the reporting period.  Actual results could differ from these estimates.





Accounts Receivable





We perform ongoing credit evaluations of our customers’ financial condition and extend credit to virtually all of our customers.  Collateral is generally not required, nor is interest charged on past due balances.  Credit losses to date have not been significant and have been within management’s expectations.  In the event of complete non-performance by our customers, our maximum exposure is the outstanding accounts receivable balance at the date of non-performance.





Property and Equipment





Property and equipment are stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets, which range from five to thirty-nine years.  Expenditures for major renewals and betterments that extend the useful lives are capitalized.  Expenditures for normal maintenance and repairs are expensed as incurred.  Upon the sale or abandonment, the cost of the equipment and related accumulated depreciation are removed from the accounts and any gains or losses thereon are recognized in the operating results of the respective period.





Oil and Gas Properties





We use the full-cost method of accounting for our oil and gas producing activities, which are all located in Texas.  Accordingly, all costs associated with the acquisition, exploration, and development of oil and gas reserves, including directly-related overhead costs, are capitalized.





All capitalized costs of oil and gas properties, including the estimated future costs to develop proved reserves, are amortized on the units-of-production method using estimates of proved reserves.  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 will be added to the capitalized costs to be amortized.





In addition, the capitalized costs are subject to a “ceiling test,” which limits such costs to the aggregate of the “estimated present value,” discounted at a ten percent interest rate, of future net revenues from proved reserves, based on current economic and operating conditions, plus the lower of cost or fair market value of unproved properties and less the income tax effects related to 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 the operating results of the respective period.





24





Derivative Instruments





For derivative instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in fair value recognized in earnings each reporting period. For warrant derivative instruments, the Company uses the Black-Scholes model to value the derivative instruments at inception and subsequent valuation dates. The classification of derivative instruments, including whether such instruments should be recorded as a liability or as equity, is re-assessed at the end of each reporting period, in accordance with FASB ASC Topic 815, Derivatives and Hedging. Derivative instrument liabilities are classified in the balance sheet as current or non-current based on whether or not the net-cash settlement of the derivative instrument could be required within 12 months of the balance sheet date.





Fair Value of our Debt and Equity Instruments





Many of our various debt and equity transactions require us to determine the fair value of a debt or equity instrument in order to properly record the transaction in our consolidated financial statements.  Fair value is generally determined by applying widely acceptable valuation models, (e.g. the Black Scholes model) using the trading price of the underlying instrument or by comparison to instruments with comparable maturities and terms.





Revenue Recognition





We utilize the accrual method of accounting for crude oil and natural gas revenues, whereby revenues are recognized based on our net revenue interest in the wells.  Crude oil inventories are immaterial and are not recorded.





Gas imbalances are accounted for using the entitlement method.  Under this method, revenues are recognized only to the extent of our proportionate share of the gas sold.  However, we have no history of significant gas imbalances.





Income Taxes





Deferred income taxes are determined using the “liability method” in accordance with FASB ASC Topic No. 740, Income Taxes.Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.





Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which such temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the operating results of the period that includes the enactment date.  In addition, a valuation allowance is established to reduce any deferred tax asset for which it is determined that it is more likely than not that some portion of the deferred tax asset will not be realized.





Item 3.   Quantitative and Qualitative Disclosures about Market Risk





Not required under Regulation S-K for “smaller reporting companies.”





Item 4.  Controls and Procedures.





(a) Evaluation of disclosure controls and procedures.





Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934 as of the end of the period covered by this Quarterly Report on Form 10-Q. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.


25





Based on our evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as a result of the material weaknesses described below, as of June 30, 2012, our disclosure controls and procedures are not designed at a reasonable assurance level and are ineffective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. The material weaknesses, which relate to internal control over financial reporting, that were identified are:





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





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





We are committed to improving our financial organization.  We will look to increase our personnel resources and technical accounting expertise within the accounting function to resolve non-routine or complex accounting matters. In addition, when funds are available, we will take the following action to enhance our internal controls: Hiring additional knowledgeable personnel with technical accounting expertise to further support our current accounting personnel, which management estimates will cost approximately $100,000 per annum.  As our operations are relatively small and we continue to have net cash losses each quarter, we do not anticipate being able to hire additional internal personnel until such time as our operations are profitable on a cash basis or until our operations are large enough to justify the hiring of additional accounting personnel.  We currently engage an outside accounting firm to assist us in the preparation of our consolidated financial statements and anticipate doing so until we have a sufficient number of internal accounting personnel to achieve compliance. As necessary, we will engage consultants in the future in order to ensure proper accounting for our consolidated financial statements.





Management believes that hiring additional knowledgeable personnel with technical accounting expertise will remedy the following material weakness: insufficient personnel with an appropriate level of technical accounting knowledge, experience, and training in the application of GAAP commensurate with our complexity and our financial accounting and reporting requirements.





Management believes that the hiring of additional personnel who have the technical expertise and knowledge with the non-routine or technical issues we have encountered in the past will result in both proper recording of these transactions and a much more knowledgeable finance department as a whole. Due to the fact that our internal accounting staff consists solely of a Chief Financial Officer, additional personnel will also ensure the proper segregation of duties and provide more checks and balances within the department. Additional personnel will also provide the cross training needed to support us if personnel turn over issues within the department occur. We believe this will greatly decrease any control and procedure issues we may encounter in the future.





(b) Changes in internal control over financial reporting.





There were no changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.




26




PART II - OTHER INFORMATION





Item 1. Legal Proceedings.





From time to time, we may become involved in various lawsuits and legal proceedings which arise in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business. Except as described below, we are currently not aware of any such legal proceedings or claims that we believe will have, individually or in the aggregate, a material adverse effect on our business, consolidated financial condition, or operating results.





On or about January 27, 2012, purported shareholders of Prodigy Oil and Gas, LLC (“Prodigy”), a minority working interest partner on one of our projects, filed a lawsuit in District Court, Dallas, Texas against Prodigy, us and others, by filing a Petition. The case is William Hall, et al. v. Prodigy Oil & Gas, LLC, et al., Cause No. DC-12-01065. In this action, the plaintiffs seek the return of investments made in Prodigy, and believe that some of those funds were given to us. The plaintiffs have not accused us of wrongdoing, and only that they believe we hold money and profits that they are entitled to as constructive trustees. On March 22, 2012, we filed our answer, in which we denied all allegations, requested that the lawsuit be dismissed against us, and requested that Plaintiff pay our attorneys’ fees for defending the frivolous lawsuit. After the filing of our answer, it was established that the Plaintiff’s did not provide notice to potential defendants sixty days before filing suit. On April 5, 2012 the Plaintiff’s gave the required notice and the trial date has been set for July 22, 2013





Item 1A. Risk Factors.





Not required under Regulation S-K for “smaller reporting companies.”





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





On May 15, 2012, we issued 365,617 shares of common stock, $0.001 par value per share, upon the exercise of 701,200 warrants on a cashless basis.
 
 On May 22, 2012, the Company issued an additional 600,000 shares of common stock to consultants valued at $408,000. These shares were valued using the closing market price on the date of the grant.
 
 * All of the above offerings and sales were deemed to be exempt under either rule 506 of Regulation D and Section 4(2) or Rule 902 of Regulation S of the Securities Act of 1933, as amended. No advertising or general solicitation was employed in offering the securities. The offerings and sales were made to a limited number of persons, all of whom were accredited investors, business associates of Pegasi Energy Resources Corporation or executive officers of Pegasi Energy Resources Corporation and transfer was restricted by Pegasi Energy Resources Corporation in accordance with the requirements of the Securities Act of 1933. In addition to representations by the above-referenced persons, we have made independent determinations that all of the above-referenced persons were accredited or sophisticated investors, and that they were capable of analyzing the merits and risks of their investment, and that they understood the speculative nature of their investment. Except as expressly set forth above, the individuals and entities to whom we issued securities as indicated in this section are unaffiliated with us.


Item 3. Defaults Upon Senior Securities.





None.





Item 4. Mine Safety Disclosures





None.





Item 5. Other Information.





None.




27





Item 6. Exhibits.





31.01
Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.





31.02
Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.





32.01
Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.





101 INS
XBRL Instance Document*





101 SCH
XBRL Schema Document*





101 CAL
XBRL Calculation Linkbase Document*





101 LAB
XBRL Labels Linkbase Document*





101 PRE
XBRL Presentation Linkbase Document*





101 DEF
XBRL Definition Linkbase Document*





*
Pursuant to Rule 405(a)(2) of Regulation S-T, the Company will furnish the XBRL Interactive Data Files with detailed footnote tagging as Exhibit 101 in an amendment to this Form 10-Q within the permitted 30-day grace period granted for the first quarterly period in which detailed footnote tagging is required.


28





SIGNATURES





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





PEGASI ENERGY RESOURCES CORPORATIONDate:  August 14, 2012
By:
/s/ MICHAEL NEUFELDMichael NeufeldChief Executive Officer and Interim Chief Financial Officer