**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549**

##### **Form 10-Q**

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| **x**      |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                      |
|------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** |   | ** **                                                                                                                                                                                                                                                                                                        |
| ** ** |   | **For the  quarterly period ended June 30, 2007**                                                                                                                                                                                                                                                                 |
| ** ** |   | ** **                                                                                                                                                                                                                                                                                                        |
| ** ** |   | **or**                                                                                                                                                                                                                                                                                                            |
| ** ** |   | ** **                                                                                                                                                                                                                                                                                                        |
| **o**      |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                     |
| ** ** |   | ** **                                                                                                                                                                                                                                                                                                        |
| ** ** |   | **For the  transition period from                          to                      ** |

 

**Commissionfile number: 001-33457**

**Pinnacle Gas Resources, Inc.**

(Exactname of registrant as specified in its charter)

| **Delaware**                                                    |   | **30-0182582**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **1 E.  Alger Street**                                          |   | ** **                            |
| **Sheridan,  WY**                                               |   | **82801**                             |
| (Address of  principal executive offices)                       |   | (Zip code)                            |

 

**(307) 673-9710**

(Registrant’s telephonenumber, including area code)

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

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Act. (Check one):

Large AcceleratedFiler o       Accelerated Filer o       Non-Accelerated Filer x

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

29,022,301 shares of the registrant’s Common Stockwere outstanding as of August 13, 2007.

 

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**PINNACLEGAS RESOURCES, INC.**

Index to Form 10-Q
| ** **                                                                                           | ** ** | **Page** |
|------------------------------------------------------------------------------------------------------|------------|----------|
| Cautionary Statement  Concerning Forward-Looking Statements                                          |       | 1        |
| Part I. FINANCIAL  INFORMATION                                                                       |       | 3        |
| Item 1. Financial  Statements                                                                        |       | 3        |
| Balance Sheets  as of December 31, 2006 and June 30, 2007                                            |       | 3        |
| Statements of Operations  (unaudited) for the three and six months ended June 30, 2006 and 2007      |       | 4        |
| Statements of  Cash Flows (unaudited) for the six months ended June 30, 2006 and 2007                |       | 5        |
| Statements of  Redeemable Preferred Stock and Stockholders’ Equity at June 30, 2007             |       | 6        |
| Notes to Financial  Statements (unaudited)                                                           |       | 7        |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations |       | 16       |
| Overview                                                                                             |       | 16       |
| Recent Developments                                                                                  |       | 16       |
| Critical Accounting  Policies                                                                        |       | 16       |
| Trends Affecting Our  Business                                                                       |       | 20       |
| Results of Operations                                                                                |       | 21       |
| Liquidity and  Capital Resources                                                                     |       | 24       |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risk                                  |       | 27       |
| Item 4T. Controls  and Procedures                                                                    |       | 28       |
| Part II. OTHER  INFORMATION                                                                          |       | 28       |
| Item 1. Legal Proceedings                                                                            |       | 28       |
| Item  1A. Risk Factors                                                                               |       | 29       |
| Item 2. Unregistered  Sales of Equity Securities and Use of Proceeds                                 |       | 29       |
| Item 3.  Defaults Upon Senior Securities                                                             |       | 29       |
| Item 4. Submission  of Matters to a Vote of Security Holders                                         |       | 29       |
| Item 5. Other Information                                                                            |       | 29       |
| Item  6. Exhibits                                                                                    |       | 30       |

 

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**CAUTIONARYSTATEMENT CONCERNING FORWARD-LOOKING STATEMENTS**

We are including the following discussion to inform youof some of the risks and uncertainties that can affect our company and to takeadvantage of the “safe harbor” protection for forward-looking statements thatapplicable federal securities law affords. Various statements in thisprospectus, including those that express a belief, expectation, or intention,as well as those that are not statements of historical fact, are forward-lookingstatements. These include statements relating to such matters as:

·                  projectionsand estimates concerning the timing and success of specific projects;

·                  our financial position or operatingresults;

·                  our business strategy;

·                  our budgets;

·                  the amount, nature and timing ofcapital expenditures;

·                  the drilling of wells;

·                  the development of recently acquirednatural gas and oil properties;

·                  the timing and amount of futureproduction of natural gas and oil;

·                  our operating costs and otherexpenses;

·                  our estimated future net revenuesfrom natural gas and oil reserves and the present value thereof;

·                  our cash flow and anticipatedliquidity; and 

·                  ourother plans and objectives for future operations.

When we use the words “believe,” “intend,” “expect,” “may,”“should,” “anticipate,” “could,” “estimate,” “plan,” “predict,” “project,”their negatives, or other similar expressions, the statements which includethose words are usually forward-looking statements. When we describestrategy that involves risks or uncertainties, we are making forward-lookingstatements. The forward-looking statements in this quarterly report onForm 10-Q speak only as of the date of this report. We disclaim any obligationto update these statements unless required by securities law, and we cautionyou not to rely on them unduly. We have based these forward-lookingstatements on our current expectations and assumptions about future events.While our management considers these expectations and assumptions to bereasonable, they are inherently subject to significant business, economic,competitive, regulatory and other risks, contingencies and uncertainties, mostof which are difficult to predict and many of which are beyond our control.These risks, contingencies and uncertainties relate to, among other matters,the following:

·                  our ability to implement our businessstrategy;

·                  the extent of our success indiscovering, developing and producing reserves, including the risks inherent inexploration and development drilling, well completion and other developmentactivities;

·                  fluctuations in the commodity pricesfor natural gas and crude oil;

·                  engineering, mechanical ortechnological difficulties with operational equipment, in well completions andworkovers, and in drilling new wells;

·                  the effects of government regulationand permitting and other legal requirements;

·                  labor problems;

1

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·                  environmental-related problems;

·                  the uncertainty inherent inestimating future natural gas and oil production or reserves;

·                  production variances fromexpectations;

·                  the substantial capital expendituresrequired for construction of pipelines and the drilling of wells and therelated need to fund such capital requirements through commercial banks and/orpublic securities markets;

·                  disruptions of, capacity constraints inor other limitations on our or others’ pipeline systems;

·                  our ability to effectively market ourproduction;

·                  land issues and the costs associatedwith perfecting title for natural gas rights in some of our properties;

·                  our ability to develop and replacereserves;

·                  ourdependence upon key personnel;

·                  the lack of liquidity of our equitysecurities;

·                  operating hazards attendant to thenatural gas and oil business, including down-hole drilling and completion risksthat are generally not recoverable from third parties or insurance;

·                  potential mechanical failure or under-performanceof significant wells;

·                  climatic conditions or naturaldisasters;

·                  acts of terrorism;

·                  the availability and cost ofmaterials and equipment;

·                  delays in anticipated start-up dates;

·                  our ability to find and retainskilled personnel;

·                  the availability of capital;

·                  competition from, and the strengthand financial resources of, our competitors; 

·                  generaleconomic conditions; and 

·      regionalprice differentials.

When you consider theseforward-looking statements, you should keep in mind these factors and the otherfactors discussed under “Risk Factors.”

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**PART I. FINANCIAL INFORMATION**

**ITEM 1. FINANCIAL STATEMENTS**

**PINNACLE GAS RESOURCES, INC.Balance Sheets**
| ** **                                                                                                                                                               | ** ** | **June 30,  2007**                                                        | ** ** | **December 31,  2006** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                               | ** ** | **(unaudited)**                                                                | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                                               | ** ** | **(in thousands, except  share and  per share data)** | ** ** |
| Assets                                                                                                                                                                   |       |                                                                           |       |                        |       |
| Current assets                                                                                                                                                           |       |                                                                           |       |                        |       |
| Cash and cash equivalents                                                                                                                                                |       | $                                                                              | 18,125     |                        | $          | 4,762 |   |
| Receivables                                                                                                                                                              |       |                                                                           |       |                        |       |
| Accrued gas sales                                                                                                                                                        |       | 1,540                                                                          |       | 2,364                       |       |
| Joint interest receivables, net of $100 allowance  for doubtful accounts                                                                                                 |       | 6,038                                                                          |       | 9,237                       |       |
| Derivative instruments                                                                                                                                                   |       | 1,958                                                                          |       | 2,856                       |       |
| Inventory of material for drilling and completion                                                                                                                        |       | 239                                                                            |       | 271                         |       |
| Prepaid expenses                                                                                                                                                         |       | 364                                                                            |       | 394                         |       |
| Total current assets                                                                                                                                                     |       | 28,264                                                                         |       | 19,884                      |       |
| Property and  equipment, at cost, net of accumulated depreciation                                                                                                        |       | 2,142                                                                          |       | 2,107                       |       |
| Oil and gas  properties, using full cost accounting, net of accumulated depletion and  impairment                                                                        |       |                                                                           |       |                        |       |
| Proved                                                                                                                                                                   |       | 29,123                                                                         |       | 39,988                      |       |
| Unproved                                                                                                                                                                 |       | 88,164                                                                         |       | 85,094                      |       |
| Inventory of  material for drilling and completion                                                                                                                       |       | 1,102                                                                          |       | 944                         |       |
| Deposits                                                                                                                                                                 |       | 1,021                                                                          |       | 520                         |       |
| Restricted  certificates of deposit                                                                                                                                      |       | 1,800                                                                          |       | 1,795                       |       |
| Total assets                                                                                                                                                             |       | $                                                                              | 151,616    |                        | $          | 150,332 |   |
| Liabilities and  Stockholders’ Equity                                                                                                                               |       |                                                                           |       |                        |       |
| Current  liabilities                                                                                                                                                     |       |                                                                           |       |                        |       |
| Long term debt-current portion                                                                                                                                           |       | $                                                                              | 22         |                        | $          | 21 |   |
| Trade accounts payable                                                                                                                                                   |       | 8,653                                                                          |       | 17,567                      |       |
| Revenue distribution payable                                                                                                                                             |       | 7,241                                                                          |       | 7,301                       |       |
| Drilling prepayments from joint interest owners                                                                                                                          |       | 154                                                                            |       | 289                         |       |
| Accrued liabilities                                                                                                                                                      |       | 2,515                                                                          |       | 2,375                       |       |
| Total current liabilities                                                                                                                                                |       | 18,585                                                                         |       | 27,553                      |       |
| Asset retirement  obligations                                                                                                                                            |       | 2,533                                                                          |       | 2,321                       |       |
| Derivative  instruments                                                                                                                                                  |       | 313                                                                            |       | —                      |       |
| Production  taxes, non-current                                                                                                                                           |       | 700                                                                            |       | 843                         |       |
| Long term debt-net  of current portion                                                                                                                                   |       | 775                                                                            |       | 786                         |       |
| Total liabilities                                                                                                                                                        |       | 22,906                                                                         |       | 31,503                      |       |
|                                                                                                                                                                     |       |                                                                           |       |                        |       |
| Contingencies                                                                                                                                                            |       |                                                                           |       |                        |       |
|                                                                                                                                                                     |       |                                                                           |       |                        |       |
| Series A  Redeemable Preferred stock, $0.01 par value; 25,000,000 authorized, 0 shares  issued and outstanding at June 30, 2007 and December 31, 2006, respectively      |       | —                                                                         |       | —                      |       |
| Stockholders’  equity                                                                                                                                               |       |                                                                           |       |                        |       |
| Common stock, $0.01 par value; 100,000,000  authorized and 28,928,301 and 25,131,301 shares issued and outstanding at  June 30, 2007 and December 31, 2006, respectively |       | 289                                                                            |       | 251                         |       |
| Additional paid-in capital                                                                                                                                               |       | 149,418                                                                        |       | 119,354                     |       |
| Accumulated deficit                                                                                                                                                      |       | (20,997                                                                        | )          | (776                        | )          |
| Total stockholders’ equity                                                                                                                                          |       | 128,710                                                                        |       | 118,829                     |       |
| Total liabilities and  stockholders’ equity                                                                                                                         |       | $                                                                              | 151,616    |                        | $          | 150,332 |   |

 

See Notes to FinancialStatements (unaudited)

3

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**PINNACLE GAS RESOURCES, INC.**

**Statements ofOperations**

**(unaudited)**
| ** **                                          | ** ** | **Three Months Ended   June 30,**                                 | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                          | ** ** | **2007**                                                                              | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                          | ** ** | **(in thousands except share and per share data)** | ** ** |
| Revenues                                            |       |                                                                                  |       |                                          |       |   |   |   |   |
| Gas sales                                           |       | $                                                                                     | 3,436      |                                          | $          | 2,972 |   | $ | 7,090 |   | $ | 6,599 |   |
| Earn-in joint venture                               |       | —                                                                                |       | —                                        |       | — |   | 379 |   |
| Total revenues                                      |       | 3,436                                                                                 |       | 2,972                                         |       | 7,090 |   | 6,978 |   |
| Cost of revenues  and expenses                      |       |                                                                                  |       |                                          |       |   |   |   |   |
| Lease operating expenses                            |       | 1,219                                                                                 |       | 642                                           |       | 2,136 |   | 1,157 |   |
| Production taxes                                    |       | 357                                                                                   |       | 338                                           |       | 759 |   | 753 |   |
| Marketing and transportation                        |       | 898                                                                                   |       | 454                                           |       | 1,683 |   | 860 |   |
| General and administrative, net                     |       | 1,220                                                                                 |       | 1,716                                         |       | 2,327 |   | 2,486 |   |
| Depreciation, depletion, amortization and accretion |       | 1,612                                                                                 |       | 1,573                                         |       | 3,096 |   | 3,045 |   |
| Impairment of oil and gas properties                |       | 1,151                                                                                 |       | —                                        |       | 18,155 |   | — |   |
| Total cost of revenues and expenses                 |       | 6,457                                                                                 |       | 4,723                                         |       | 28,156 |   | 8,301 |   |
| Operating (loss)                                    |       | (3,021                                                                                | )          | (1,751                                        | )          | (21,066 | ) | (1,323 | ) |
| Other  income(expense)                              |       |                                                                                  |       |                                          |       |   |   |   |   |
| Gain on derivatives                                 |       | 664                                                                                   |       | 1,168                                         |       | 465 |   | 3,054 |   |
| Interest income                                     |       | 251                                                                                   |       | 304                                           |       | 298 |   | 313 |   |
| Other income                                        |       | 113                                                                                   |       | 118                                           |       | 224 |   | 168 |   |
| Unrealized derivative loss                          |       | —                                                                                |       | —                                        |       | — |   | (26 | ) |
| Interest expense                                    |       | (78                                                                                   | )          | (24                                           | )          | (142 | ) | (59 | ) |
| Total other income(expense)                         |       | 950                                                                                   |       | 1,566                                         |       | 845 |   | 3,450 |   |
| Net  (loss)/income before income taxes              |       | (2,071                                                                                | )          | (185                                          | )          | (20,221 | ) | 2,127 |   |
| Income taxes                                        |       | —                                                                                |       | —                                        |       | — |   | — |   |
| Net  (loss)/income                                  |       | (2,071                                                                                | )          | (185                                          | )          | (20,221 | ) | 2,127 |   |
| Preferred  dividends                                |       | —                                                                                |       | (19,719                                       | )          | — |   | (20,964 | ) |
| Net (loss)  attributable to common stockholders     |       | $                                                                                     | (2,071     | )                                             | $          | (19,904 | ) | $ | (20,221 | ) | $ | (18,837 | ) |
| Basic net (loss)  per share                         |       | $                                                                                     | (0.08      | )                                             | $          | (0.87 | ) | $ | (0.79 | ) | $ | (1.31 | ) |
| Diluted net  (loss) per share                       |       | $                                                                                     | (0.08      | )                                             | $          | (0.87 | ) | $ | (0.79 | ) | $ | (1.31 | ) |
| Weighted average  shares outstanding – basic   |       | 27,115,114                                                                            |       | 22,789,692                                    |       | 25,517,025 |   | 14,341,779 |   |
| Weighted average shares  outstanding – diluted |       | 27,115,114                                                                            |       | 22,789,692                                    |       | 25,517,025 |   | 14,341,779 |   |

 

See Notes to FinancialStatements (unaudited)

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**PINNACLE GASRESOURCES, INC.Statements of Cash Flows**

**(unaudited)**
| ** **                                                                                          | ** ** | **Six  Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2007**                                  | ** ** | **2006** | ** ** |
| Cash flows from  operating activities                                                               |       |                                      |       |   |   |
| Net (loss)/income                                                                                   |       | $                                         | (20,221    | ) | $ | 2,127 |   |
| Adjustments to  reconcile net income/(loss) to net cash (used in)/provided by operating  activities |       |                                      |       |   |   |
| Impairment of oil and gas properties                                                                |       | 18,155                                    |       | — |   |
| Depreciation, depletion, amortization and accretion                                                 |       | 3,096                                     |       | 3,045 |   |
| Gain on derivatives                                                                                 |       | (465                                      | )          | (3,028 | ) |
| Allowance for doubtful accounts                                                                     |       | —                                    |       | 100 |   |
| Stock-based compensation                                                                            |       | 362                                       |       | 116 |   |
| Changes in assets and liabilities                                                                   |       |                                      |       |   |   |
| Decrease (increase) in receivables                                                                  |       | 4,023                                     |       | (396 | ) |
| Decrease (increase) in inventory of material for  drilling and completion                           |       | 32                                        |       | (512 | ) |
| Decrease (increase) in prepaid expenses                                                             |       | 30                                        |       | (81 | ) |
| (Decrease) increase in accounts payable and accrued  liabilities                                    |       | (10,283                                   | )          | 2,399 |   |
| Decrease in revenue distribution payable                                                            |       | (60                                       | )          | (1,495 | ) |
| (Decrease) increase in drilling prepayments                                                         |       | (135                                      | )          | 392 |   |
| Net cash (used in)/provided by operating activities                                                 |       | (5,466                                    | )          | 2,667 |   |
| Cash flows from  investing activities                                                               |       |                                      |       |   |   |
| Capital expenditures — exploration and production                                              |       | (11,491                                   | )          | (40,301 | ) |
| Capital expenditures — property and equipment                                                  |       | (421                                      | )          | (681 | ) |
| Purchase of restricted certificate of deposit                                                       |       | (5                                        | )          | (1,606 | ) |
| Increase in inventory held for exploration and  development                                         |       | (158                                      | )          | — |   |
| Deposits                                                                                            |       | (501                                      | )          | (501 | ) |
| Realized gain/(loss) on derivatives                                                                 |       | 1,676                                     |       | (115 | ) |
| Proceeds from the sale of assets held for sale                                                      |       | —                                    |       | 394 |   |
| Net cash used in investing activities                                                               |       | (10,900                                   | )          | (42,810 | ) |
| Cash flows from  financing activities                                                               |       |                                      |       |   |   |
| Proceeds from the issuance of common stock                                                          |       | 33,750                                    |       | 141,187 |   |
| Issuance costs related to common stock                                                              |       | (4,010                                    | )          | (11,252 | ) |
| Dividends paid on preferred stock                                                                   |       | —                                    |       | (1,397 | ) |
| Redemption of preferred stock                                                                       |       | —                                    |       | (52,174 | ) |
| Repurchase and cancellation of common shares                                                        |       | —                                    |       | (16,304 | ) |
| Principal payments on note payable and capital  leases                                              |       | (11                                       | )          | (74 | ) |
| Net cash provided by financing activities                                                           |       | 29,729                                    |       | 59,986 |   |
| Net increase in cash and cash equivalents                                                           |       | 13,363                                    |       | 19,843 |   |
| Cash and cash equivalents at beginning of year                                                      |       | 4,762                                     |       | 2,672 |   |
| Cash and cash equivalents at end of year                                                            |       | $                                         | 18,125     |   | $ | 22,515 |   |
| Noncash  investing and financing activities                                                         |       |                                      |       |   |   |
| Capital expenditures included in trade accounts  payable                                            |       | $                                         | 1,368      |   | $ | 1,854 |   |
| Asset retirement obligation included in oil and gas  properties                                     |       | 113                                       |       | 618 |   |
| Dividend paid in kind with the issuance of  additional preferred stock                              |       | —                                    |       | 1,213 |   |
| Derivative liability related to preferred stock                                                     |       | —                                    |       | 232 |   |
| Cashless exercise of warrants and options                                                           |       | —                                    |       | 15,428 |   |
| Inventory used in oil and gas properties                                                            |       | —                                    |       | 246 |   |
| Supplemental  cash flow information                                                                 |       |                                      |       |   |   |
| Cash payments  for interest, net of amount capitalized                                              |       | $                                         | 142        |   | $ | 59 |   |

 

See Notes to FinancialStatements (unaudited)

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**PINNACLE GAS RESOURCES, INC.Statements of Redeemable Preferred Stock and Stockholders’ Equity**
| ** **                                                      | ** ** | ** **                                                  | ** ** | **Stockholders’ Equity** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                      | ** ** | **Redeemable  Preferred Stock**                        | ** ** | **Common Stock**              | ** ** | **Additional  Paid-In** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                                      | ** ** | **Shares**                                                  | ** ** | **Amount**                         | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| ** **                                                      | ** ** | **(in thousands except share amounts)** | ** ** |
| Balance at  December 31, 2006                                   |       | —                                                      |       | $                                  | —     |   | 25,131,301 |   | $ | 251 |   | $ | 119,354 |   | $ | (776 | ) | $ | 118,829 |   |
| Issuance of  restricted shares                                  |       | —                                                      |       | —                             |       | 47,000 |   | — |   | 126 |   | — |   | 126 |   |
| Sale of common stock  for cash, net of offering costs of $4,010 |       | —                                                      |       | —                             |       | 3,750,000 |   | 38 |   | 29,702 |   | — |   | 29,740 |   |
|                                                            |       |                                                        |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Stock-based  compensation                                       |       | —                                                      |       | —                             |       | — |   | — |   | 236 |   | — |   | 236 |   |
| Net loss                                                        |       | —                                                      |       | —                             |       | — |   | — |   | — |   | (20,221 | ) | (20,221 | ) |
|                                                            |       |                                                        |       |                               |       |   |   |   |   |   |   |   |   |   |   |
| Balance at June 30,  2007 (unaudited)                           |       | —                                                      |       | $                                  | —     |   | 28,928,301 |   | $ | 289 |   | $ | 149,418 |   | $ | (20,997 | ) | $ | 128,710 |   |

 

See Notes to FinancialStatements (unaudited)

6

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**Notes to Financial Statements**

**Unaudited**

**Note 1 — Organization and Nature of Operations**

Pinnacle Gas Resources, Inc., (the “Company”) wasformed as a Delaware corporation in June 2003 through a contribution of cash byfunds affiliated with DLJ Merchant Banking and oil and gas reserves andleasehold interests by subsidiaries of Carrizo Oil & Gas, Inc. and U.S.Energy Corporation.

Pinnacle’s primary business is the exploration for,and the acquisition, development and production of, coalbed methane natural gasin the United States. The Company is also engaged in gas property operationsand the construction of low pressure gas collection systems which providetransportation for the Company’s coalbed methane production.

**Note 2 — Basis of Presentation**

The accompanying unaudited financial statementsinclude the Company’s proportionate share of assets, liabilities, income andexpenses from the properties in which the Company has a participatinginterest.  The Company has nosubsidiaries or affiliates with which intercompany transactions are recorded.

The accompanying financial statements are unaudited,and in the opinion of management, reflect all adjustments that are necessaryfor a fair presentation of the financial position and results of operations forthe periods presented.  All suchadjustments are of a normal and recurring nature. The following notes describeonly the material changes in accounting policies, account details, or financialstatement notes during the first six months of 2007.  The results for the quarterly period endedJune 30, 2007 are not necessarily indicative of the results expected for theentire year.  These financial statementsshould be read in conjunction with the audited financial statements and thesummary of significant accounting policies for prior years contained in theCompany’s Registration Statement on Form S-1/A which was filed April 27, 2007and declared effective May 10, 2007.

*Use of Estimates*

The preparation of the Company’s financial statementsin conformity with accounting principles generally accepted in the UnitedStates of America requires management to make estimates and assumptions thataffect the reported amount of assets and liabilities, disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ from these estimates. Significant estimates with regard to theCompany’s financial statements include the estimated carrying value of unprovedproperties, the estimate of proved oil and gas reserve volumes and the relatedpresent value of estimated future net cash flows and the ceiling test appliedto capitalized oil and gas properties, the estimate of the timing and cost ofthe Company’s future drilling activity, the estimated cost and timing relatedto asset retirement obligations, the estimated fair value of derivative assetsand liabilities, the realizability of deferred tax assets, the estimates ofexpenses and timing of exercise of stock options, accrual of operating costs,capital expenditures and revenue, and estimates for litigation.

*Oil and Gas Properties*

The Company utilizes the full cost method ofaccounting for oil and gas producing activities. Under this method, all costsassociated with property acquisition, exploration and development, includingcosts of unsuccessful exploration, costs of surrendered and abandoned leaseholds,delay lease rentals and the fair value of estimated future costs of siterestoration, dismantlement and abandonment activities are capitalized within acost center. The Company’s oil and gas properties are all located within theUnited States, which constitutes a single cost center. The Company has notcapitalized any overhead costs. No gain or loss is recognized upon the sale orabandonment of undeveloped or producing oil and gas properties unless the salerepresents a significant portion of gas properties and the gain significantlyalters the relationship between capitalized costs and proved gas reserves ofthe cost center. Expenditures for maintenance and repairs are charged to leaseoperating expense in the period incurred.

Depreciation, depletion and amortization of oil andgas properties (“DD&A”) is computed on the unit-of-production method basedon proved reserves. Amortizable costs include estimates of future developmentcosts of proved undeveloped reserves and asset retirement obligations. TheCompany invests in unevaluated oil and gas properties for the purpose of

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exploration for proved reserves. The costs of suchassets, including exploration costs on properties where a determination ofwhether proved oil and gas reserves will be established is still underevaluation, and any capitalized interest are included in unproved oil and gasproperties at the lower of cost or estimated fair market value and are notsubject to amortization. On a quarterly basis, such costs are evaluated forinclusion in the costs to be amortized resulting from the determination ofproved reserves, impairments, or reductions in value. To the extent that theevaluation indicates these properties are impaired, the amount of theimpairment is added to the capitalized costs to be amortized. Abandonment ofunproved properties is accounted for as an adjustment to capitalized costsrelated to proved oil and gas properties, with no losses recognized. TheCompany recorded an impairment of unevaluated properties of $0 and  $740,000 during the three and six months ended June 30, 2007, respectively.Substantially all of the remaining unproved property costs are expected to bedeveloped and included in the amortization base over the next three to fiveyears. Salvage value is taken into account in determining depletion rates andis based on the Company’s estimate of the value of equipment and supplies atthe time the well is abandoned. As of June30, 2007 and December 2006, the estimated salvage value was $6,048,000 and$5,736,000, respectively.

Underfull cost accounting rules, capitalized costs less accumulated depletion andrelated deferred income taxes may not exceed the sum of (1) the present valuediscounted at ten percent of estimated future net revenue using current pricesand costs, including the effects of derivative instruments designated as cashflow hedges but excluding the future cash outflows associated with settlingasset retirement obligations that have been accrued on the balance sheet, lessany related income tax effects;  plus (2)the cost of properties not being amortized, if any; plus (3) the lower of costsor estimated fair value of unproved properties; less (4) the income tax effectsrelated to differences in the book to tax basis of oil and gas properties. Thisis referred to as the “full cost ceiling limitation.” If capitalized costsexceed the limit, the excess must be charged to expense. The expense may not bereversed in future periods. At the end of each quarter, the Company calculatesthe full cost ceiling limitation.  AtJune 30, 2007, the carrying amount of oil and gas properties exceeded the fullcost ceiling limitation by approximately $1.2 million, based upon anatural gas price of $3.98 per Mcf in effect at that date.  The impairment of the Company’s oil and gasproperties resulted from low commodity prices at June 30, 2007. Based on subsequent price decreases toapproximately $3.30 per Mcf of gas at August 14, 2007, the carrying amount ofthe Company’s oil and gas properties exceeded the full cost ceiling limitationby approximately $9.7 million.  Adecline in gas prices or an increase in operating costs subsequent to themeasurement date or reductions in the economically recoverable quantities couldresult in the recognition of an additional ceiling write-down of theCompany’s oil and gas properties in future periods.

*Per Share Information*

Basic earnings (loss) pershare is computed by dividing net income (loss) from continuing operationsattributable to common stock by the weighted average number of shares of commonstock outstanding during each period. Diluted earnings per share is computed byadjusting the average number of shares of common stock outstanding for thedilutive effect, if any, of common stock equivalents such as stock options andwarrants. Diluted net loss per share was the same as basic loss per share forthe three and six months ended June 30, 2006 and 2007 because potential commonstock equivalents were anti-dilutive.   AtJune 30, 2006 and 2007, common stock equivalents of 1,005,000 and  990,000, respectively, were antidilutive as aresult of the losses incurred and were excluded from the calculation ofearnings per share.

All per share information for common stock has beenretroactively restated for all periods to reflect the 25-for-1stock split which took place on March 31, 2006.

*Income Taxes*

The Company uses the asset and liability method ofaccounting for income taxes, in accordance with Statement of FinancialAccounting Standard (SFAS) No. 109, “Accounting for Income Taxes.”Deferred tax assets and liabilities are recognized for the expected future taxconsequences of temporary differences between the financial statements and taxbases of assets and liabilities. If appropriate, deferred tax assets arereduced by a valuation allowance which reflects expectations of the extent towhich such assets will be realized. As of June 30, 2007 and December 31,2006, the Company had recorded a full valuation allowance for its net deferredtax asset.

On January 1, 2007, the Company adopted FinancialAccounting Standards Board (“FASB”) Interpretation No. 48, “Accounting forUncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN48”).  FIN 48 prescribes a measurementprocess for recording in the financial statements uncertain tax positions takenor expected to be

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taken in a tax return. Additionally, FIN 48 provides guidance regarding uncertain tax positionsrelating to derecognition, classification, interest and penalties, accountingin interim periods, disclosure and transition. At June 30, 2007, the Company had no material uncertain tax positions.

*Recent Accounting Pronouncements*

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements,” which defines fair value, establishes a framework formeasuring fair value in generally accepted accounting principles, and expandsdisclosures about fair value measurements. SFAS No. 157 applies underother accounting pronouncements that require or permit fair value measurements.Accordingly, SFAS No. 157 does not require any new fair valuemeasurements. However, for some entities, the application of SFAS No. 157will change current practice. The provisions of SFAS No. 157 are effectiveas of January 1, 2008. The Company is currently evaluating the impact ofadopting SFAS No. 157 on its financial statements.

In February 2007, the FASB issued SFAS No. 159,“The Fair Value Option for Financial Assets and Financial Liabilities.” SFASNo. 159 permits entities to choose to measure eligible financialinstruments and certain other items at fair value. The objective is to improvefinancial reporting by providing entities with the opportunity to mitigatevolatility in reported earnings caused by measuring related assets andliabilities differently without having to apply complex hedge accountingprovisions. The Statement will be effective as of January 1, 2008 for theCompany. SFAS No. 159 offers various options in electing to apply theprovisions of this Statement, and at this time the Company has not made anydecisions in its application to its financial position or results ofoperations.

**Note 3 — Asset Retirement Obligations**

The Company follows the provisions of SFASNo. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”).  SFAS No. 143 generally applies to legalobligations associated with the retirement of long-lived assets that resultfrom the acquisition, construction, development and/or normal operation of along-lived asset. SFAS No. 143 requires the Company to recognize anestimated liability for costs associated with the abandonment of its oil andgas properties. A liability for the fair value of an asset retirementobligation with a corresponding increase to the carrying value of the relatedlong-lived asset is recorded at the time a well is completed or acquired. Theincreased carrying value is depleted using the units-of-production method, andthe discounted liability is increased through accretion over the remainingeconomic life of the respective oil and gas properties.

The estimated liability is based on historical gasindustry experience in abandoning wells, including estimated economic lives,external estimates as to the cost to abandon the wells in the future andfederal and state regulatory requirements. The Company’s liability isdiscounted using the Company’s best estimate of its credit-adjusted riskfree rate. Revisions to the liability could occur due to changes in estimatedabandonment costs or changes in well economic lives or if federal or stateregulators enact new requirements regarding the abandonment of wells.

The following is a summary of the Company’s assetretirement obligation activity for the three and six months ended June 30, 2007and 2006 (in thousands):
|                                                 | ** ** | **Three  Months Ended  June 30,** | ** ** | **Six  Months Ended  June 30,** | ** ** | **Three  Months Ended  June 30,** | ** ** | **Six  Months Ended  June 30,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                      | ** ** | **2007**                                    | ** ** | **2006**                                  | ** ** |
| ** **                                      | ** ** | **(unaudited)**                             | ** ** | **(unaudited)**                           | ** ** |
| Beginning  balance asset retirement obligations |       | $                                           | 2,438      |                                      | $          | 2,321                                       |       | $                                         | 1,463      |   | $ | 1,277 |   |
| Additional  obligation added during the period  |       | 45                                          |       | 113                                       |       | 462                                         |       | 618                                       |       |
| Obligations  settled during the period          |       | —                                      |       | —                                    |       | —                                      |       | —                                    |       |
| Revisions in  estimates                         |       | —                                      |       | —                                    |       | —                                      |       | —                                    |       |
| Accretion  expense                              |       | 50                                          |       | 99                                        |       | 40                                          |       | 70                                        |       |
| Ending balance  of asset retirement obligations |       | $                                           | 2,533      |                                      | $          | 2,533                                       |       | $                                         | 1,965      |   | $ | 1,965 |   |

 

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**Note 4— Restricted Assets(certificates of deposit) and Deposits**

*Certificates of deposit.*TheCompany holds a certificate of deposit (“CD”), which expired in July 2007,totaling $144,000. The CD is collateral on bonding required by the State ofWyoming, the State of Montana and the Federal Bureau of Land Management.Because the Company renewed the CD for an additional year expiring in July 2008in order to maintain its bonding requirements, the Company has included the CDin other non-current assets as of June 30, 2007.  Additionally, the Company holds another CDfor $627,000 which was issued in February 2006 and expires in February2008.  This CD collateralizes a letter ofcredit in favor of Powder River Energy Corporation, a local rural electricassociation, in order to secure power lines to the Kirby and Deer Creek areas.The Company has included this amount in non-current assets as of June 30, 2007because the Company also intends to renew the CD in order to maintain a powersupply on a long-term basis. In April 2006, the Company issued a $1,029,000letter of credit that expires in April 2008 in favor of Bitter Creek Pipelines,LLC to secure the construction of a high pressure pipeline and relatedcompression facilities to the Company’s Deer Creek and Kirby areas.  The Company has included this amount innon-current assets as of June 30, 2007 because the Company anticipates it willbe required to renew the letter of credit because construction of the pipelineand compression facility is not expected to be completed until the secondquarter of 2009.

*Deposits.* In addition, the Company has prepaid $1.0million to EMIT Technologies, Inc. for the construction of a water treatmentplant near the Cabin Creek drilling area. The Company has also included approximately $20,000 related to royaltypayments in deposits.  These amounts areincluded in Deposits in the accompanying balance sheet at June 30, 2007.

**Note 5 — Derivatives**

The Company accounts for derivative instruments orhedging activities under the provisions of SFAS No. 133, “Accounting forDerivative Instruments and Hedging Activities.” SFAS No. 133 requires theCompany to record derivative instruments at their fair value. If the derivativeis designated as a fair value hedge, the changes in the fair value of thederivative and of the hedged item attributable to the hedged risk arerecognized in earnings. If the derivative is designated as a cash flow hedge,the effective portions of changes in the fair value of the derivative arerecorded in other comprehensive income (loss) and are recognized in thestatement of operations when the hedged item affects earnings. Ineffectiveportions of changes in the fair value of cash flow hedges, if any, arerecognized in earnings. Changes in the fair value of derivatives that do notqualify for hedge treatment are recognized in earnings.

The Company periodically hedges a portion of its oiland gas production through swap and collar agreements. The purpose of thehedges is to provide a measure of stability to the Company’s cash flows in anenvironment of volatile oil and gas prices and to manage the exposure tocommodity price risk. Management of the Company decided not to use hedgeaccounting for these agreements. Therefore, in accordance with the provisionsof SFAS No. 133, the changes in fair market value are recognized inearnings.

As of June 30, 2007 and 2006, the Company had naturalgas hedges in place as follows:
| **Product and Type of Hedging Contract** | ** ** | **MMbtu Per  Day** | ** ** | **Fixed Price  Range  CIG Index Price** | ** **  | **Time  Period** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------|------------|--------------------------------------------------------|-------------|------------------|------------|
| June 30, 2007  (unaudited)                                        |       |                    |       |                                                   |        |             |       |
| Natural Gas—Collar                                           |       | 1,000                   |       | $                                                      | 5.00-$5.20  |             | 10/04-9/07 |   |
| Natural Gas—Collar                                           |       | 1,000                   |       | $                                                      | 6.50-$10.50 |             | 9/06-12/07 |   |
| Natural Gas—Collar                                           |       | 3,000                   |       | $                                                      | 7.00-$9.05  |             | 1/07-12/07 |   |
| Natural Gas—Collar                                           |       | 3,000                   |       | $                                                      | 6.50-$8.20  |             | 1/08-12/08 |   |
| June 30, 2006  (unaudited)                                        |       |                    |       |                                                   |        |             |       |
| Natural Gas—Collar                                           |       | 1,000                   |       | $                                                      | 5.00-$5.20  |             | 10/04-9/07 |   |
| Natural Gas—Collar                                           |       | 750                     |       | $                                                      | 5.00-$5.50  |             | 10/04-9/06 |   |
| Natural Gas—Collar                                           |       | 1,750                   |       | $                                                      | 6.70-$7.90  |             | 1/06-12/06 |   |
| Natural  Gas—Collar                                          |       | 3,000                   |       | $                                                      | 7.00-$9.05  |             | 1/07-12/07 |   |

 

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The Company realized hedging gains of $1,240,000 and$203,000 during the three months ended June 30, 2007 and 2006, respectively. Asa result of the change in the fair value of the commodity derivatives, the Companyhad an unrealized loss of $576,000 for the three months ended June 30, 2007 andan unrealized gain of $966,000 for the three months ended June 30, 2006.   The aggregate of these contracts resulted ina gain on derivatives of $664,000 and $1,169,000 for the three months endedJune 30, 2007 and 2006, respectively. For the six months ended June 30, 2007,the Company realized a hedging gain of $1,676,000 as compared to a hedging lossof $115,000 for the six months ended June 30, 2006. The Company had anunrealized loss of $1,211,000 for the six months ended June 30, 2007 and anunrealized gain of $3,169,000 for the six months ended June 30, 2006. Theaggregate of these contracts resulted in a gain of derivatives of $465,000 and$3,054,000 for the six months ended June 30, 2007 and 2006, respectively.Unrealized and realized gains and losses are included in gains or losses onderivatives in the accompanying statements of operations. Because the Company’sderivative contracts were not accounted for as cash flow hedges, the Companyclassifies the realized gains and losses in the investing activities in theaccompanying statements of cash flows.

The Company is exposed to credit risk to the extent ofnonperformance by the counterparties in the derivative contracts discussedabove; however, the Company does not anticipate such nonperformance.

**Note 6 — Stock Based Compensation**

*Options under Employee Option Plans*

The Company has adopted a stock incentive plancontaining both incentive and non-statutory stock options. All options allowfor the purchase of common stock at prices not less than the fair market valueof such stock at the date of grant. If the option holder owns more than 10% ofthe total combined voting power of all classes of the Company’s stock, theexercise price cannot be less than 110% of the fair market value of such stockat the date of grant.

Options granted under the plan become vested asdirected by the Company’s Board of Directors and generally expire seven or tenyears after the date of grant, unless the option holder owns more than 10% ofthe total combined voting power of all classes of the Company’s stock, in whichcase the non-statutory stock options must be exercised within five years of thedate of grant. At June 30, 2007, there were options to purchase 990,000 sharesgranted under the plan.

Theoptions granted since formation in June 2003 vest as follows:
| Year 1 |   | 20  | % |
|--------|--------|-----|---|
| Year 2 |   | 30  | % |
| Year 3 |   | 50  | % |
|   |   | 100 | % |

 

*Stock-Based Compensation*

At June 30, 2007, the Company had unvested options topurchase 619,250 shares with a weighted average grant date fair value of $1.3million.  During the three and six monthsended June 30, 2007, the Company granted options to purchase 45,000 and 120,000shares of common stock, respectively, and recognized compensation expense ofapproximately $125,000 and $236,000, respectively. The Company will recognizecompensation expense relating to nonvested options granted after January 1,2006 of approximately $1.3 million ratably over the next 3 years.

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The following table summarizes stock option activityfor the six months ended June 30, 2007:
| ** **                                                        | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price  Per Share** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Aggregate  Intrinsic value** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding,  December 31, 2006                                   |       | 1,035,000                  |       | $                                                              | 6.68       |                                                    |       |                                |       |   |
| Granted                                                           |       | 120,000                    |       | 10.03                                                          |       |                                                    |       |                                |       |
| Canceled or  forfeited                                            |       | (165,000                   | )          | 6.84                                                           |       |                                                    |       |                                |       |
|                                                              |       |                       |       |                                                           |       |                                                    |       |                                |       |
| Outstanding,  June 30, 2007                                       |       | 990,000                    |       | $                                                              | 7.06       |                                                    | 5.22       |                                | $          | 1,859,000 |   |
|                                                              |       |                       |       |                                                           |       |                                                    |       |                                |       |
| Exercisable,  June 30, 2007                                       |       | 370,750                    |       | $                                                              | 5.31       |                                                    | 4.26       |                                | $          | 1,069,014 |   |
| Weighted average fair  value of options granted during the period |       |                       |       | $                                                              | 10.03      |                                                    |       |                                |       |   |

 

The following table summarizes information about stockoptions outstanding at June 30, 2007:

|                          | ** ** | **Options Outstanding**            | ** ** | **Options Exercisable**                            | ** ** | ** **              | ** ** |
|--------------------------|------------|-----------------------------------------|------------|---------------------------------------------------------|------------|-------------------------|------------|
| **Exercise Prices** | ** ** | **Number of  shares  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Fair Value  Determination** | ** ** |
| $4.00                    |       | 137,500                                 |       | 3.3 years                                               |       | 137,500                 |       | $ | 4.00 |   | Black-Scholes |   |
|                          |       |                                    |       |                                                    |       |                    |       |   |   | (minimum  value) |   |
| $4.80                    |       | 350,000                                 |       | 4.8 years                                               |       | 163,750                 |       | $ | 4.80 |   | Black-Scholes |   |
|                     |       |                                    |       |                                                    |       |                    |       |   |   | (minimum  value) |   |
| $5.20                    |       | 112,500                                 |       | 5.5 years                                               |       | 22,500                  |       | $ | 5.20 |   | Black-Scholes |   |
| $8.40                    |       | 45,000                                  |       | 7.0 years                                               |       | —                  |       | $ | 8.40 |   | Black-Scholes |   |
| $11.00                   |       | 345,000                                 |       | 6.1 years                                               |       | 47,000                  |       | $ | 11.00 |   | Black-Scholes |   |
|                     |       | 990,000                                 |       |                                                    |       | 370,750                 |       |   |   |   |   |

 

*Restricted Stock*

The Company has a stock incentive plan whereby grantsof restricted stock have been awarded to members of the Board of Directors andcertain employees.  Restrictions and vesting periods for the awards aredetermined at the discretion of the Board of Directors and are set forth in theaward agreements.

Effective February 12, 2007, the Company granted andissued an aggregate of 12,000 shares of restricted common stock to itsnon-employee directors and 25,000 shares of restricted common stock to certainemployees pursuant to the Company’s stock incentive plan.  In addition, on March 26, 2007, the Companygranted an additional 10,000 shares of restricted common stock to an employeepursuant to the stock incentive plan. The 12,000 restricted shares issued to the non-employee directors willbe fully vested on February 12, 2008.  Theother restricted shares issued to employees will vest according to the optionvesting schedule set forth above.  TheCompany recognized an expense of approximately $77,000 and $126,000 for thequarter and six months ended June 30, 2007, respectively, based on the fairvalue of the vested shares during the period.

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A summary of the status and activity of the restrictedstock for the six months ended June 30, 2007 is presented below.
|                                  | ** ** | **Shares** | ** ** | **Weighted-Average  Grant-Date  Fair Value** | ** ** |
|----------------------------------|------------|------------|------------|---------------------------------------------------|------------|
| Non-vested at  December 31, 2006 |       | 36,360     |       | $                                                 | 11.00      |   |
| Granted                          |       | 47,000     |       | $                                                 | 11.00      |   |
| Forfeited                        |       | (9,090     | )          | $                                                 | 11.00      |   |
| Vested                           |       | (9,090     | )          | $                                                 | 11.00      |   |
| Non-vested at June 30,  2007     |       | 65,180     |       | $                                                 | 11.00      |   |

 

As of June 30, 2007, theCompany had approximately $717,000 of unrecognized share-based compensationexpense related to non-vested stock awards, which is expected to be amortizedover the remaining vesting period of 3 years.

**Note 7 — Long-Term Debt**

*Credit Facility*

Effective February 12, 2007, the Company enteredinto a new $100 million credit facility (the “Credit Agreement”) with The RoyalBank of Scotland (“RBS”), with an initial commitment of $27 million whichpermits borrowings up to the borrowing base as designated by the administrativeagent.  As of June 30, 2007, theborrowing base under the Credit Agreement was $22 million although theborrowing availability is less than the initial borrowing base due to covenantlimitations. As of June 30, 2007, the borrowing availability was $16.7 million.The borrowing base is determined on a semi-annual basis and at such other timesas may be requested by the borrower or administrative agent.  Borrowing under the Credit Agreement bearsinterest either: (i) at a domestic bank rate plus an applicable margin between0.25% and 1.25% per annum based on utilization or (ii) on a sliding scale fromthe one, two, three, or six month LIBOR rate plus 1.25% to 2.25% per annumbased on utilization. The Credit Agreement matures February 12, 2011 andreplaced the Company’s previous credit facility.  The Credit Agreement with RBS iscollateralized by substantially all of the Company’s producing assets.  At June 30, 2007, the Company had nodebt outstanding under the Credit Agreement. The Company used a portion of the net proceeds from its initial publicoffering in May 2007 to pay down all of the outstanding indebtedness under the CreditAgreement.

The Credit Agreementcontains covenants that, among other things, restrict the Company’s ability,subject to certain exceptions, to do the following:

·      incur liens;

·      incur debt;

·      make investments in otherpersons;

·      declare dividends or redeemor repurchase stock;

·      engage in mergers,acquisitions, consolidations and asset sales or amend the Company’sorganizational documents;

·      enter into certain hedgingarrangements;

·      amend material contracts;and

·      enter into related partytransactions.

With regard to hedgingarrangements, the Credit Agreement provides that acceptable commodity hedgingarrangements cannot be greater than 80 to 85%, depending on the measurementdate, of the Company’s monthly production

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from its hydrocarbonproperties that are used in the borrowing base determination and that the fixedor floor price of the Company’s hedging arrangements must be equal to orgreater than the gas price used by the lenders in determining the borrowingbase.

The Credit Agreement alsorequires that the Company satisfy certain affirmative covenants, meet certainfinancial tests, maintain certain financial ratios and make certain customaryindemnifications to lenders and the administrative agent. The financialcovenants include requirements to maintain: (i) earnings before income taxes,depreciation, depletion, amortization and accretions (“EBITDA”) to cashinterest expense of not less than 3.00 to 1.00, (ii) current ratio of not lessthan 1.00 to 1.00, (iii) total debt to annualized EBITDA of not more than 3.0to 1.0, (iv) quarterly total senior debt to annualized EBITDA equal to or lessthan 3.0 to 1.0 until June 30, 2007 and 2.00 to 1.0 thereafter, and (v) totalproved PV-10 value of reserves to total debt of at least 1.50 to 1.00.  The Credit Agreement contains customaryevents of default, including, without limitation, payment defaults, covenantdefaults, certain events of bankruptcy and insolvency, defaults in the paymentof other material debt, judgment defaults, breaches of representations andwarranties, loss of material permits and licenses and a change in control. Inaddition, the Credit Agreement required us to cure specified title defectswithin certain time periods. Except for the title defect covenant thecompliance with which was waived, the Company was in compliance with thecovenants under the Credit Agreement as of June 30, 2007*.*

*OfficeBuilding Loan*

On November 15,2005, the Company entered into a mortgage loan secured by its office buildingin Sheridan, Wyoming in the aggregate principal amount of $829,000. Thepromissory note provides for monthly payments of principal and interest in theinitial amount of $6,400, and unpaid principal bears interest at 6.875% duringthe first three years, at a variable base rate thereafter and at 18% upon adefault. The variable base rate is based on the lender’s base rate. Thematurity date of this mortgage is November 15, 2015, at which time a principaland interest payment of $615,400 will become due. As of June 30, 2007, theCompany had $797,000 outstanding in principal and interest on this mortgage.

**Note 8 — Equity**

*Common Stock*. In April 2006, theCompany completed a private placement of 12,835,230 shares of common stock at aprice of $11.00 per share.  The Companyreceived net proceeds of approximately $129.9 million, before offeringcosts,  which were used as follows: (i)approximately $53.6 million to redeem all of the outstanding shares of Series ARedeemable Preferred Stock, including the payment of all accrued and unpaiddividends and a redemption premium, (ii) approximately $27.0 million forthe acquisition of the Green River Basin assets, (iii) approximately$16.3 million to repurchase an aggregate of 1,593,783 shares of commonstock at a price of $10.23 per share from certain stockholders, and (iv)approximately $33.0 million to fund the Company’s development drillingprogram, additional out of pocket offering costs and for general corporatepurposes.

In May 2007, the Company completed an initial publicoffering of an aggregate of 3,750,000 shares of common stock at a price pershare of $9.00, or $8.37 net of underwriters’ discounts and commissions.  In June 2007, the underwriters partiallyexercised their over-allotment option to purchase 258,614 shares of the Company’scommon stock from certain selling stockholders. The Company received netproceeds of approximately $31.4 million from its initial public offering,before out of pocket offering costs of approximately $1.1 million, which wereused to pay down the $7.0 million outstanding under the Credit Agreement andwill be used to fund the Company’s drilling program and for general corporatepurposes.

*Preferred Stock.*As of June 30,2007, there were no shares of preferred stock issued and outstanding. InApril 2006, following the initial closing of the Company’s private placementdiscussed above, the Company redeemed all of the outstanding shares of Series ARedeemable Preferred Stock with a portion of the proceeds from the privateplacement including the payment of accrued and unpaid dividends of $1.4million.  The difference between theredemption price and the carrying value of the Series A Redeemable PreferredStock resulted in a $19.6 million redemption premium that was recorded as adividend expense in the accompanying statements of operations for the three andsix months ended June 30, 2006.

*Warrants.*As of December 31,2005, there were Series A warrants outstanding to purchase an aggregate 10,530,725shares of common stock with an exercise price of $4.00 per share. However,immediately prior to the initial closing of the private placement, alloutstanding warrants and 1,168,204 escalating options were exchanged in acashless transaction into an aggregate of 8,062,584 shares of common stock.  As of June 30, 2007, there were nooutstanding warrants to purchase shares of the Company’s common stock.

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**Note 9 — Contingencies**

From time to time, the Company may be involved inlitigation that arises in the ordinary course of business operations. As of thedate of this report, the Company is not a party to any litigation that itbelieves could reasonably be expected to have a material adverse effect on itsfinancial position, results of operations or cash flows.

The Company is currentlya defendant in two lawsuits whereby the plaintiff, among other things, isseeking to permanently enjoin the State of Montana and its administrativebodies from issuing licenses or permits to drill on, or from authorizing theremoval of ground water from under, the plaintiff’s property. Based on theinformation available to date, the Company believes the claims are withoutmerit and intends to defend the cases vigorously. Additionally, the Company’soil and gas operations are subject to various Federal, state and local laws andregulations. The Company could incur significant expense to comply with the newor existing laws and non-compliance could have a material adverse effect on theCompany’s operations.

**Note 10 — Subsequent Events**

Effective July 1, 2007, the Company granted 54,000shares of restricted  common stock tocertain employees. These restricted shares will vest equally in one-thirdincrements over the three years from the date of grant.

On July 20, 2007, the Company entered into employmentagreements with certain of its executive officers. In conjunction with theemployment agreements, these executive officers were granted  an aggregate of 50,000 shares of restrictedcommon stock.  These restricted shareswill vest equally in one-third increments on the third, fourth and fifthanniversary of the grant date.

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**ITEM2. MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS****OF OPERATIONS**

*The discussion and analysis thatfollows should be read together with the accompanying financial statements andnotes related thereto that are included elsewhere in this quarterly report onForm 10-Q. It includes forward-looking statements that may reflect ourestimates, beliefs, plans and expected performance. The forward-lookingstatements are based upon events, risks and uncertainties that may be outsideour control. Our actual results could differ significantly from those discussedin these forward-looking statements. Factors that could cause orcontribute to these differences include, but are not limited to, market pricesfor natural gas and oil, regulatory changes, estimates of proved reserves,economic conditions, competitive conditions, development success rates, capitalexpenditures and other uncertainties, as well as those factors discussed belowand elsewhere in this quarterly report on Form 10-Q, including in “Risk Factors”and “Cautionary Statement Concerning Forward-Looking Statements,” all ofwhich are difficult to predict. As a result of these assumptions, risks anduncertainties, the forward-looking matters discussed may not occur.*

**Overview**

We are an independent energy company engaged in theacquisition, exploration and development of domestic onshore natural gasreserves. We were formed in June 2003 as a Delaware corporation by fundsaffiliated with DLJ Merchant Banking III, Inc., which we refer to collectivelyas DLJ Merchant Banking, and subsidiaries of Carrizo Oil & Gas, Inc., orCarrizo, and U.S. Energy Corporation, or U.S. Energy.  We primarily focus our efforts on thedevelopment of CBM properties located in the Powder River Basin in northeasternWyoming and southern Montana. In addition, in April 2006, we acquiredproperties located in the Green River Basin in southern Wyoming. As of June 30,2007, we owned natural gas and oil leasehold interests in approximately 478,000gross (332,000 net) acres, approximately 94% of which are undeveloped. As of February28, 2007, we had estimated net proved reserves of approximately 25.9 Bcf basedon the CIG index price of $6.28, with a pre-tax PV-10 value of $54.8 million.  We drilled 41 gross (25 net) wells andcompleted 72 gross (45 net) wells during the six months ended June 30, 2007,and we operated 100% of those wells. We incurred capital expenditures of$11.5 million during the six months ended June 30, 2007 related todrilling, completion and infrastructure costs on our undeveloped acreage in ourKirby, Deer Creek, Cabin Creek and Green River Basin areas.

**Recent Developments**

InMay 2007, we completed an initial public offering of an aggregate of 3,750,000shares of our common stock at a price per share of $9.00, or $8.37 net of theunderwriters’ discounts and commissions, and received approximately $30.3million of net proceeds after offering expenses.  In June 2007, the underwriters partiallyexercised their over-allotment option to purchase 258,614 shares of our commonstock from certain selling stockholders.

As of June 30, 2007, we had no outstanding debt under ourcredit facility.  As of May 30, 2007, wehad $7.0 million of outstanding borrowings under our credit facility.  We used a portion of the net proceeds fromour initial public offering in May 2007 to pay down all of the outstandingindebtedness under our credit facility. Please see “—Liquidity and Capital Resources—Credit Facility” forfurther information regarding our credit facility.

**Critical Accounting Policies**

The most subjective and complex judgments used in thepreparation of our financial statements are:

·                  Reserveevaluation and determination.

·                  Estimatesof the timing and cost of our future drilling activity.

·                  Estimatesof the fair valuation of hedges in place.

·                  Estimatesof timing and cost of asset retirement obligations.

·                  Estimatesof the expense and timing of exercise of stock options.

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·                  Accrualsof operating costs, capital expenditures and revenue.

***Oiland Gas Properties***

We use the full cost method of accounting for oil and gasproducing activities. Under this method, all costs associated with propertyacquisition, exploration and development, including costs of unsuccessfulexploration, costs of surrendered and abandoned leaseholds, delay lease rentalsand the fair value of estimated future costs of site restoration, dismantlementand abandonment activities, are capitalized within a cost center. Our oil andgas properties are all located within the United States, which constitutes asingle cost center. We have not capitalized any overhead costs. No gain or lossis recognized upon the sale or abandonment of undeveloped or producing oil andgas properties unless the sale represents a significant portion of gasproperties and the gain significantly alters the relationship betweencapitalized costs and proved gas reserves of the cost center. Expenditures formaintenance and repairs are charged to lease operating expense in the periodincurred.

Depreciation, depletion and amortization of oil and gasproperties is computed on the unit-of-production method based on provedreserves. Amortizable costs include estimates of future development costs ofproved undeveloped reserves and asset retirement obligations. We invest inunevaluated oil and gas properties for the purpose of exploration for provedreserves. The costs of such assets, including exploration costs on propertieswhere a determination of whether proved oil and gas reserves will beestablished is still under evaluation, and any capitalized interest, areincluded in unproved oil and gas properties at the lower of cost or estimatedfair market value and are not subject to amortization. On a quarterly basis,such costs are evaluated for inclusion in the costs to be amortized resultingfrom the determination of proved reserves, impairments, or reductions in value.To the extent that the evaluation indicates these properties are impaired, theamount of the impairment is added to the capitalized costs to be amortized. Werecorded an impairment of unevaluated properties of $0 and $740,000,respectively,  during the three and sixmonths ended June 30, 2007. Abandonment ofunproved properties are accounted for as an adjustment to capitalized costsrelated to proved oil and gas properties, with no losses recognized.

Substantially all remaining unproved property costs areexpected to be developed and included in the amortization base ratably over thenext three to five years. Salvage value is taken into account in determiningdepletion rates and is based on our estimate of the value of equipment andsupplies at the time the well is abandoned. As of June 30, 2007 and December 31,2006, the estimated salvage value was $6,048,000 and $5,736,000, respectively.

Underfull cost accounting rules, capitalized costs less accumulated depletion andrelated deferred income taxes may not exceed the sum of (1) the present valuediscounted at ten percent of estimated future net revenue using current pricesand costs, including the effects of derivative instruments designated as cashflow hedges but excluding the future cash outflows associated with settlingasset retirement obligations that have been accrued on the balance sheet, lessany related income tax effects;  plus (2)the cost of properties not being amortized, if any; plus (3) the lower of costsor estimated fair value of unproved properties; less (4) the income tax effectsrelated to differences in the book to tax basis of oil and gas properties. Thisis referred to as the “full cost ceiling limitation.” If capitalized costsexceed the limit, the excess must be charged to expense. The expense may not bereversed in future periods. At the end of each quarter, we calculate the fullcost ceiling limitation.  At June 30,2007, the carrying amount of oil and gas properties exceeded the full costceiling limitation by approximately $1.2 million, based upon a natural gasprice of $3.98 per Mcf in effect at that date. The impairment of the our oil and gas properties resulted from lowcommodity prices at June 30, 2007. Based onsubsequent price decreases to approximately $3.30 per Mcf of gas at August 14,2007, the carrying amount of our oil and gas properties exceeded the full costceiling limitation by approximately $9.7 million.  A decline in gas prices or an increase inoperating costs subsequent to the measurement date or reductions in theeconomically recoverable quantities could result in the recognition of anadditional ceiling write-down of our oil and gas properties in futureperiods.

***GasSales***

We use the sales method for recording natural gas sales.Sales of gas applicable to our interest in producing natural gas and oil leasesare recorded as revenues when the gas is metered and title transferred pursuantto the gas sales contracts covering our interest in gas reserves. During suchtimes as our sales of gas exceed our pro rata ownership in a well, such salesare recorded as revenues unless total sales from the well have exceeded ourshare of estimated total gas reserves underlying the property at which timesuch excess is recorded as a gas imbalance liability. At June 30, 2007 andDecember 31, 2006, there was no such liability recorded. Although therewas no such liability recorded for prior periods, gas reserves are an estimateand are updated on an annual and interim basis. Gas pricing, expenses andproduction may impact future gas reserves remaining which in turn, could impactthe recording of liabilities in the future. Gas sales accrual at June 30, 2007and December 31, 2006 were based on the

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actual volume statements from our purchasers and distribution process.If accruals were to change by 10% at June 30, 2007 and December 31, 2006, theimpact would have been a $478,000 and $319,000 change, respectively.

***AssetRetirement Obligations***

We follow the provisions of Statement of FinancialAccounting Standards (SFAS) No. 143, “Accounting for the Asset RetirementObligations.” SFAS No. 143 generally applies to legal obligationsassociated with the retirement of long-lived assets that result from theacquisition, construction, development and/or the normal operation of along-lived asset. SFAS No. 143 requires us to recognize an estimatedliability for costs associated with the abandonment of our oil and gasproperties.

A liability for the fair value of an asset retirementobligation with a corresponding increase to the carrying value of the relatedlong-lived asset is recorded at the time a well is completed or acquired. Theincreased carrying value is depleted using the units-of-productionmethod, and the discounted liability is increased through accretion over theremaining life of the respective oil and gas properties.

The estimated liability is based on historical gasindustry experience in abandoning wells, including estimated economic lives,external estimates as to the cost to abandon the wells in the future andfederal and state regulatory requirements. Our liability is discounted usingour best estimate of our credit-adjusted risk-free rate. Revisions to theliability could occur due to changes in estimated abandonment costs, changes inwell economic lives or if federal or state regulators enact new requirementsregarding the abandonment of wells. For example, a 10% change in our estimatedretirement costs would have a $254,000 effect on our asset retirementobligation liability.

Thefollowing is a summary of our asset retirement obligation activity for the threeand six months ended June 30, 2007 (in thousands):
|                                                 | ** ** | **Three  Months Ended  June 30,** | ** ** | **Six  Months Ended  June 30,** | ** ** | **Three  Months Ended  June 30,** | ** ** | **Six  Months Ended  June 30** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|---------------------------------------------|------------|------------------------------------------|------------|
| ** **                                      | ** ** | **2007**                                    | ** ** | **2006**                                  | ** ** |
| ** **                                      | ** ** | **(unaudited)**                             | ** ** | **(unaudited)**                           | ** ** |
| Beginning  balance asset retirement obligations |       | $                                           | 2,438      |                                      | $          | 2,321                                       |       | $                                        | 1,463      |   | $ | 1,277 |   |
| Additional  obligation added during the period  |       | 45                                          |       | 113                                       |       | 462                                         |       | 618                                      |       |
| Obligations  settled during the period          |       | —                                      |       | —                                    |       | —                                      |       | —                                   |       |
| Revisions in  estimates                         |       | —                                      |       | —                                    |       | —                                      |       | —                                   |       |
| Accretion  expense                              |       | 50                                          |       | 99                                        |       | 40                                          |       | 70                                       |       |
| Ending balance of asset  retirement obligations |       | $                                           | 2,533      |                                      | $          | 2,533                                       |       | $                                        | 1,965      |   | $ | 1,965 |   |

 

***Inventory***

We acquired inventory of oil and gas equipment, primarilytubulars, in 2007 and 2006, to take advantage of quantity pricing and to securea readily available supply. Inventory is valued at the lower of average cost ormarket. Inventory is used in the development of gas properties and to theextent it is estimated that it will be billed to other working interest ownersduring the next year, it is included in current assets. Otherwise, it isrecorded in other assets. The price of steel is a primary factor in valuing ourinventory. Under the valuation method of lower of average cost or market, a 10%reduction in the price of steel would cause a $113,000 reduction in ourinventory valuation as of June 30, 2007. The market price of steel is evaluatedeach quarter using prices quoted by authorized vendors in the area.

***Propertyand Equipment***

Property and equipment is comprised primarily of abuilding, computer hardware and software, vehicles and equipment, and isrecorded at cost. Renewals and betterments that substantially extend the usefullives of the assets are capitalized. Maintenance and repairs are expensed whenincurred. Depreciation and amortization are provided using the straight-linemethod over the estimated useful lives of the assets, ranging as follows:buildings—30 years, computer hardware and software—3 to 5 years,machinery, equipment and vehicles—5 years, and office furniture and equipment—3to 5 years.

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***Long-LivedAssets***

Long-lived assets to be held and used in our business arereviewed for impairment whenever events or changes in circumstances indicatethat the related carrying amount may not be recoverable. When the carryingamounts of long-lived assets exceed the fair value, which is generally based ondiscounted expected future cash flows, we record an impairment. No impairmentswere recorded during the year ended December 31, 2006 or the six monthsended June 30, 2007.

***Generaland Administrative Expenses***

General and administrative expenses are reported net ofamounts allocated and billed to working interest owners of gas propertiesoperated by us. The administrative expenses billed to working interest ownersmay change in accordance with the terms of the joint operating agreements.Administrative expenses are charged to working interest owners based onproductive well counts. A 10% change in well counts for the three and sixmonths ended June 30, 2007 would have increased or decreased our expenses billedto working interest owners by approximately $49,000 and $75,000, respectively.As we operate and drill additional wells in the future, additionaladministrative expenses will be charged to the working interest owners when thewells become productive.

***IncomeTaxes***

We use the asset and liability method of accounting forincome taxes, in accordance with SFAS No. 109, “Accounting for IncomeTaxes.” Deferred tax assets and liabilities are recognized for the expectedfuture tax consequences of temporary differences between the financialstatement and tax bases of assets and liabilities. If appropriate, deferred taxassets are reduced by a valuation allowance which reflects expectations of theextent to which such assets will be realized. As of June 30, 2007 andDecember 31, 2006 we had recorded a full valuation allowance for our netdeferred tax asset.

On January 1, 2007, we adopted the Financial AccountingStandards Board Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes – an interpretation of FASB Statement No. 109.”  FIN 48 prescribes a measurement process forrecording in the financial statements uncertain tax positions taken or expectedto be taken in a tax return. Additionally, FIN 48 provides guidance regarding uncertain tax positionsrelating to derecognition, classification, interest and penalties, accountingin interim periods, disclosure and transition. At June 30, 2007, we had no material uncertain tax positions.

***Derivatives***

We use derivative instruments to manage our exposure to fluctuatingnatural gas prices through the use of natural gas swap and option contracts. Weaccount for derivative instruments or hedging activities under the provisionsof SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities.” SFAS No. 133 requires us to record derivative instruments attheir fair value. If the derivative is designated as a fair value hedge, thechanges in the fair value of the derivative and of the hedged item attributableto the hedged risk are recognized in earnings. If the derivative is designatedas a cash flow hedge, the effective portions of changes in the fair value ofthe derivative are recorded in other comprehensive income (loss) and arerecognized in the statement of operations when the hedged item affects earnings.Ineffective portions of changes in the fair value of cash flow hedges, if any,are recognized in earnings. Changes in the fair value of derivatives that donot qualify for hedge treatment are recognized in earnings. Please seenote 5 included in the accompanying unaudited Notes to FinancialStatements for additional discussions of derivatives.

We periodically hedge a portion of our oil and gasproduction through swap and collar agreements. The purpose of the hedges is toprovide a measure of stability to our cash flows in an environment of volatileoil and gas prices and to manage the exposure to commodity price risk. Ourmanagement decided not to use hedge accounting for these agreements. Therefore,in accordance with the provisions of SFAS No. 133, the changes in fairmarket value are recognized in earnings.

***Stock-BasedCompensation***

Effective January 1, 2006, we adopted SFASNo. 123(R), “Share-Based Payments,” which requires companies torecognize compensation expense for share-based payments based on theestimated fair value of the awards.

SFAS No. 123(R) also requires that the benefits oftax deductions in excess of compensation cost recognized for stock awards andoptions (“excess tax benefits”) be presented as financing cash inflows in theStatement of Cash Flows. Prior to January 1, 2006, we accounted for share-basedpayments under the recognition and measurement provisions of APB Opinion 

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No. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations, as permitted by SFAS No. 123, “Accounting for Stock-BasedCompensation.” In accordance with APB No. 25, no compensation cost wasrequired to be recognized for options granted that had an exercise price equalto or greater than the market value of the underlying common stock on the dateof the grant.

***AccountsReceivable***

Our revenue producing activities are conducted primarilyin Wyoming. We grant credit to qualified customers, which potentially subjectsus to credit risk resulting from, among other factors, adverse changes in the industryin which we operate and the financial condition of our customers. Wecontinuously monitor collections and payments from our customers and, ifnecessary, record an allowance for doubtful accounts based upon historicalexperience and any specific customer collection issues identified. We recorded$100,000 at June 30, 2007 and December 31, 2006, respectively.

***TransportationCosts***

We account for transportation costs under Emerging IssuesTask Force Issues 00-10, “Accounting for Shipping and Handling Fees and Costs,”whereby amounts paid for transportation are classified as operating expenses.

***PerShare Information***

Basic earnings (loss) per share is computed by dividingnet income (loss) from continuing operations attributable to common stock by theweighted average number of shares of common stock outstanding during eachperiod. Diluted earnings per share is computed by adjusting the average numberof shares of common stock outstanding for the dilutive effect, if any, ofcommon stock equivalents such as stock options and warrants. Diluted netloss per share was the same as basic loss per share for the six months endedJune 30, 2006 as potential common stock equivalents were anti-dilutive.   Commonstock equivalents of 990,000 and 1,005,000 at June 30, 2007 and 2006, respectively, were excluded because they were anti-dilutive due to the lossesincurred in the periods.

***NewAccounting Pronouncements***

For information regarding new accounting pronouncements,please see note 2 included in the accompanying unaudited Notes to FinancialStatements.

**Trends Affecting Our Business**

We have experienced increasing costs since our inceptionin 2003 due to increased demand for oilfield products and services. Thecyclical nature of the natural gas industry causes fluctuations in demand forgoods and services from oilfield companies, suppliers and others associatedwith the industry, which in turn affects the prices for those goods andservices. Typically, as prices for natural gas increase, so do all the costsassociated with natural gas production. Recently, we have seen increases in the cost of tubulars, drilling rigsand cement in particular. We expect that increased demand for the goods andservices we use in our business will continue to put pressure on prices in thenear to medium term.

Historically, natural gas prices have been extremelyvolatile, and we expect that volatility to continue. For example, during thethree months ended June 30, 2007, the NYMEX natural gas index price ranged froma high of $8.19 per MMBtu to a low of $6.66 per MMBtu, while the CIG natural gas index price ranged from ahigh of $6.96 per MMBtu to a low of $0.78 per MMBtu.  During the six months ended June 30, 2007,the NYMEX natural gas index price ranged from a high of $8.19 per MMBtu toa low of $6.16 per MMBtu, while the CIG natural gas index price rangedfrom a high of $7.11 per MMBtu to a low of $0.78 per MMBtu. Duringthe year ended December 31, 2006, the NYMEX natural gas index price rangedfrom a high of $11.23 per MMBtu to a low of $4.20 per MMBtu, whilethe CIG natural gas index price ranged from a high of $7.90 per MMBtu to alow of $1.30 per MMBtu. Changes in natural gas pricing have impacted ourrevenue streams, production taxes, prices used in reserve calculations,borrowing base calculations and the valuation of potential propertyacquisitions. During the three and six months ended June 30, 2007, estimatedfuture gas prices had an impact on both our revenues and the costs attributableto our future operations. We expect that changing natural gas prices willcontinue to impact our operations and financial results in the future.

Transportation of natural gas and access to throughputcapacity have a direct impact on natural gas prices in the Rocky Mountainregion, where our operations are concentrated. As drilling activity increases throughout the Rocky Mountain region, 

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additional production may come on line, which could cause bottlenecks orcapacity constraints. Generally speaking, a surplus of natural gas productionrelative to available transportation capacity has a negative impact on prices.Conversely, as capacity increases, and bottlenecks are eliminated, pricesgenerally increase. Although there is currently adequate transportationcapacity out of the Powder River Basin, a surplus of natural gas arriving atkey marketing hubs from the Powder River Basin and elsewhere relative toavailable takeaway capacity from these hubs has caused Rocky Mountain gas totrade at a discount to the NYMEX natural gas index price.  Two major projects that are expected to becompleted in 2008 will increase takeaway capacity from these hubs, and weexpect that they will therefore help reduce the differential between gasproduced in the Rocky Mountain region and the NYMEX natural gas index price.

**Results of Operations**

***Three Months Ended June 30, 2007 ComparedTo Three Months Ended June 30, 2006***

Net loss attributable to stockholders for the threemonths ended June 30, 2007 was $2.1 million, or $0.08 per diluted share,on total revenues of $3.4 million. Net loss attributable to stockholdersfor the three months ended June 30, 2007 included a $0.6 millionunrealized loss associated with the change in the fair valuation of our naturalgas hedges in place in accordance with the provisions of SFAS No. 133.Absent such a change in the valuation, we would have shown a net lossattributable to stockholders of $1.5 million on total revenues of$3.4 million. This compares to net loss attributable to stockholders of $19.9million for the three months ended June 30, 2006 on total revenues of$3.0 million. Adjusted for an unrealized gain in the fair valuation of ournatural gas hedges in place of $1.0 million, our results for the threemonths ended June 30, 2006 would have been a net loss attributable tostockholders of $20.9 million on total revenues of $3.0 million.

*Gas sales volume.*

Gas sales volume increased 53%, from 601 MMcf in thethree months ended June 30, 2006 to 917 MMcf in the three months ended June 30,2007. Daily sales volume was 10.1 MMcf for the three months ended June 30, 2007as compared to 6.6 MMcf for the three months ended June 30, 2006, a 3.5 MMcfper day increase. The increase was primarily due to production coming online inour Cabin Creek, Kirby and Deer Creek project areas.  On average, we had a greater working and netrevenue interest in these areas compared to some of our other areas.

*Gas sales revenue.*

Revenue from gas sales increased $0.5 million during thethree months ended June 30, 2007, to $3.4 million, a 16% increase comparedto the three months ended June 30, 2006. This increase was primarily due to anincrease in gas sales volume which was partially offset by a decrease in theaverage realized price per Mcf.  Theaverage realized price per Mcf decreased 24%, from $4.95 per Mcf in the threemonths ended June 30, 2006 to $3.75 per Mcf in the three months ended June 30,2007.

*Derivatives.*

For the three months ended June 30, 2007, we had anunrealized loss of $0.6 million compared to an unrealized gain of$1.0 million for the three months ended June 30, 2006. The unrealized lossis a noncash expense based primarily on the Black-Scholes model forvaluing future cash flows utilizing price volatility with a normal discountrate. Hedges settled in the three months ended June 30, 2007 resulted in arealized gain of $1.2 million compared to hedging gains of $0.2 million inthe three months ended June 30, 2006. The hedge gains were primarily due to thefact that gas prices were lower than the weighted average floor price of ourhedges in place.

*Lease operating expenses.*

Lease operating expenses increased $0.6 million inthe three months ended June 30, 2007 to $1.2 million, a 90% increasecompared to the three months ended June 30, 2006. This increase resulted from anincrease in the number of wells in the productive cycle during the three monthsended June 30, 2007. On an Mcf basis, lease operating expenses increased 24%from $1.07 per Mcf in the three months ended June 30, 2006 to $1.33 per Mcf inthe three months ended June 30, 2007. The increase per Mcf was primarily due toa number of wells being in the early stages of their productive life cycle asproduction did not increase proportionately to the number of wells comingonline. Additionally, increases in generator rentals and associated fuel whilewaiting on permanent power contributed to the increase.

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*Production taxes.*

Production taxes increased $0.02 million in thethree months ended June 30, 2007 to $0.4 million, a 6% increase from thethree months ended June 30, 2006. Production taxes generally correlate to grosssales revenue because production taxes are based on a percentage of salesvalue. In Wyoming, the percentage averages 11% to 13%, depending on rates ineffect for the respective year. The increase in production taxes for the threemonths ended June 30, 2007 was less than the increase in our gasproduction  primarily due to Montanaproduction taxes, which are 1% for the first year of production and 9%thereafter.  On an Mcf basis, productiontaxes were $0.39 per Mcf for the three months ended June 30, 2007 and $0.56 perMcf for the three months ended June 30, 2006, a 31% decrease, which correlatesto the decrease in the price per Mcf received in the three months ended June30, 2007 from the three months ended June 30, 2006.

*Marketing and transportation.*

Marketing and transportation expenses increased$0.4 million in the three months ended June 30, 2007 to $0.9 million,a 98% increase from the three months ended June 30, 2006. The increase relatedprimarily to the increased sales volume in the three months ended June 30,2007, together with a slight increase in transportation fees and compressiondue to inflationary adjustments in the contracts along with fees paid forcompression design capacity which was not used. On an Mcf basis, marketing and transportation expenses increased 29% to$0.98 per Mcf in the three months ended June 30, 2007 from $0.76 per Mcf in thethree months ended June 30, 2006.

*General and administrative expenses,net.*

General and administrative expenses are offset byoperating income from drilling and production activities for which we cancharge an overhead fee to nonoperating working interest owners. These welloperating overhead fees increased 37% in the three months ended June 30, 2007,from $0.3 million to $0.4 million, due to increased productive wellswhich we operate and for which we charge an overhead fee. General andadministrative expenses, net decreased $0.5 million in the three monthsended June 30, 2007 to $1.2 million from $1.7 million in the threemonths ended June 30, 2006. This decrease during the three months ended June30, 2007 was due primarily to an increase in payroll expenses due to the hiringof additional employees during the three months ended June 30, 2006 along withbonuses paid to certain executive officers during the three months ended June30, 2006 in connection with  our privateplacement.   On an Mcf basis, general andadministrative expenses, net decreased 53% from $2.86 per Mcf in the threemonths ended June 30, 2006 to $1.33 per Mcf in the three months ended June 30,2007.

*Depreciation, depletion, amortizationand accretion.*

Depreciation, depletion, amortization and accretionexpense increased $0.04 million for the three months ended June 30, 2007 to $1.6 million,a 2% increase compared to the three months ended June 30, 2006. This increasewas due to an increase in capital expenditures that were added into the fullcost pool used for the computation of depletion, as well as increasedproduction coupled with lower quarter-end reserves due to lower quarter-endpricing. On an Mcf basis, the depreciation, depletion, amortization andaccretion rate decreased 33% to $1.76 per Mcf in the three months ended June30, 2007 from $2.62 per Mcf in the three months ended June 30, 2006.

*Impairment.*

AtJune 30, 2007, the carrying amount of oil and gas properties exceeded the fullcost ceiling limitation by approximately $1.2 million, based upon anatural gas price of approximately $3.98 per Mcf in effect at that date.  The impairment of our oil and gas propertiesresulted from low commodity prices at June 30, 2007.  For further informationregarding this impairment, please see note 2 included in the accompanyingunaudited Notes to Financial Statements.

***Six Months Ended June 30, 2007 Compared ToSix Months Ended June 30, 2006***

Net loss attributable to stockholders for the six monthsended June 30, 2007 was $20.2 million, or $0.79 per diluted share, ontotal revenues of $7.1 million. Net loss attributable to stockholders for thesix months ended June 30, 2007 included a $1.2 million unrealized lossassociated with the change in the fair valuation of our natural gas hedges inplace in accordance with the provisions of SFAS No. 133. Absent such achange in the valuation, we would have shown a net loss attributable tostockholders of $19.0 million on total revenues of $7.1 million. Thiscompares to net loss attributable to stockholders of $18.8 million for the sixmonths ended June 30, 2006 on total revenue of $7.0 million. Adjusted foran unrealized gain in the fair 

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valuation of our natural gas hedges in place of $3.1 million, ourresults for the six months ended June 30, 2006 would have been a net lossattributable to stockholders of $21.9 million on total revenues of$7.0 million.

*Gas sales volume.*

Gas sales volume increased 40%, from 1,166 MMcf in thesix months ended June 30, 2006 to 1,634 MMcf in the six months ended June 30,2007. Daily sales volume was 9.0 MMcf for the six months ended June 30, 2007 ascompared to 6.4 MMcf for the six months ended June 30, 2006, a 2.6 MMcf per dayincrease. The increase was primarily due to production coming online in ourCabin Creek, Kirby and Deer Creek project areas.

*Gas sales revenue.*

Revenue from gas sales increased $0.5 million during thesix months ended June 30, 2007, to $7.1 million, a 7% increase compared tothe six months ended June 30, 2006. This increase was primarily due to anincrease in gas sales volume which was partially offset by a decrease in theaverage realized price per Mcf.  Theaverage realized price per Mcf decreased 23%, from $5.66 per Mcf in the sixmonths ended June 30, 2006 to $4.34 per Mcf in the six months ended June 30,2007.

*Derivatives.*

For the six months ended June 30, 2007, we had anunrealized loss of $1.2 million compared to an unrealized gain of$3.2 million for the six months ended June 30, 2006. The unrealized lossis a noncash expense based primarily on the Black-Scholes model forvaluing future cash flows utilizing price volatility with a normal discountrate. Hedges settled in the six months ended June 30, 2007 resulted in arealized gain of $1.7 million compared to hedge losses of$0.1 million in the six months ended June 30, 2006. The hedge gains wereprimarily due to the fact that gas prices were lower than the weighted averagefloor price of our hedges in place.

*Lease operating expenses.*

Lease operating expenses increased $1.0 million inthe six months ended June 30, 2007 to $2.1 million, an 85% increasecompared to the six months ended June 30, 2006. This increase resulted from anincrease in the number of wells in the productive cycle during the six monthsended June 30, 2007. On an Mcf basis, lease operating expenses increased 32%from $0.99 per Mcf in the six months ended June 30, 2006 to $1.31 per Mcf inthe six months ended June 30, 2007. The increase per Mcf was primarily due to anumber of wells being in the early stages of their productive life cycle asproduction did not increase proportionately to the number of wells comingonline.  Additionally, increases ingenerator rentals and associated fuel while waiting on permanent powercontributed to the increase.

*Production taxes.*

Production taxes increased $0.01 million in the sixmonths ended June 30, 2007 to $0.8 million, a 1% increase from the sixmonths ended June 30, 2006. Production taxes generally correlate to gross salesrevenue because production taxes are based on a percentage of sales value. InWyoming, the percentage averages 11% to 13%, depending on rates in effect forthe respective year. The increase in production taxes for the six months endedJune 30, 2007 was less than the increase in our gas production  primarily due to Montana production taxes,which are 1% for the first year of production and 9% thereafter.  . On an Mcf basis, production taxes were$0.46 per Mcf for the six months ended June 30, 2007 and $0.65 per Mcf for thesix months ended June 30, 2006, a 28% decrease, which correlates to thedecrease in the price per Mcf received in the six months ended June 30, 2007 fromthe six months ended June 30, 2006.

*Marketing and transportation.*

Marketing and transportation expenses increased$0.8 million in the six months ended June 30, 2007 to $1.7 million, a96% increase from the six months ended June 30, 2006. The increase relatedprimarily to the increased sales volume in the six months ended June 30, 2007,together with a slight increase in transportation fees and compression due toinflationary adjustments in the contracts along with fees paid for compressiondesign capacity which was not used.  Onan Mcf basis, marketing and transportation expenses increased 40% to $1.03 perMcf in the six months ended June 30, 2007 from $0.74 per Mcf in the six monthsended June 30, 2006.

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*General and administrative expenses,net.*

General and administrative expenses are offset byoperating income from drilling and production activities for which we cancharge an overhead fee to nonoperating working interest owners. These welloperating overhead fees increased 41% in the six months ended June 30, 2007,from $0.5 million to $0.8 million, due to increased productive wellswhich we operate and for which we charge an overhead fee. General andadministrative expenses, net decreased $0.2 million in the six monthsended June 30, 2007 to $2.3 million from $2.5 million in the sixmonths ended June 30, 2006. This decrease was due primarily to an increase inpayroll expenses due to the hiring of additional employees during the sixmonths ended June 30, 2006 along with bonuses paid to certain executive officersduring the three months ended June 30, 2006 in connection with our privateplacement.  On an Mcf basis, general andadministrative expenses, net decreased 33% from $2.13 per Mcf in the six monthsended June 30, 2006 to $1.42 per Mcf in the six months ended June 30, 2007.

*Depreciation, depletion, amortizationand accretion.*

Depreciation, depletion, amortization and accretionexpense increased $0.05 million for the six months ended June 30, 2007 to$3.1 million, a 2% increase compared to the six months ended June 30,2006. This increase was due to an increase in capital expenditures that wereadded into the full cost pool used for the computation of depletion, as well asincreased production coupled with lower quarter-end reserves due to lowerquarter-end pricing. On an Mcf basis, the depreciation, depletion, amortizationand accretion rate decreased 27% to $1.89 per Mcf in the six months ended June30, 2007 from $2.61 per Mcf in the six months ended June 30, 2006.

*Impairment.*

AtJune 30, 2007, the carrying amount of oil and gas properties exceeded the fullcost ceiling limitation by approximately $1.2 million, based upon anatural gas price of approximately $3.98 per Mcf in effect at that date.  This impairment, along with the impairmentrecorded for the three months ended March 31, 2007 of $17.0 million, resultedin a total impairment for the six months ended June 30, 2007 of $18.2 million.The impairment of our oil and gas properties resulted from low commodity pricesat June 30, 2007.  For further information regarding thisimpairment, please see note 2 included in the accompanying unaudited Notes toFinancial Statements.

**Liquidity and Capital Resources**

Our primary source of liquidity since our formation hasbeen the sale of our equity. During the period from our formation in June 2003through September 2005, DLJ Merchant Banking contributed $44.1 millioncash in exchange for shares of our common stock, shares of our Series ARedeemable Preferred Stock and detachable warrants to purchase additional sharesof common stock. The proceeds were used to fund our acquisitions and capitalexpenditures. In April 2006, we completed a private placement of anaggregate of 12,835,230 shares of our common stock at a price per share of$11.00, or $10.23 net of the initial purchaser’s discount and placement fee. InMay 2007, we completed an initial public offering of an aggregate of 3,750,000shares of our common stock at a price per share of $9.00, or $8.37 net of theunderwriters’ discounts and commissions. Please see “—Cash Flow from Financing Activities—Sales and Issuances ofEquity.”

*Credit Facility.*  EffectiveFebruary 12, 2007, we entered into a $100 million credit facilitywith an initial commitment of $27 million which permits borrowings up tothe borrowing base as designated by the administrative agent. As of June 30,2007, the initial borrowing base was $22 million although our borrowingavailability is less than our initial borrowing base due to covenantlimitations. As of June 30, 2007, the actual borrowing availability was$16.7 million. The borrowing base is determined on a semi-annual basis andat such other additional times, up to twice yearly, as may be requested byeither the borrower or the administrative agent and is determined by the administrativeagent in accordance with customary practices and standards for loans of asimilar nature; provided that such determination is at the administrative agent’sdiscretion as the credit agreement does not provide a specific borrowing baseformula. Based on future reserve reports, low CIG prices and possible titledefects on certain of our properties, we expect that our borrowing base andborrowing availability could be further reduced below the initial levels.Borrowings under this credit facility may be used solely to acquire, explore ordevelop oil and gas properties and for general corporate purposes. The creditfacility matures February 12, 2011. At June 30, 2007 and August 13, 2007,we had no indebtedness outstanding under our credit facility.

Our obligations under the credit facility are secured byliens on (i) no less than 90% of the net present value of the oil and gasto be produced from our oil and gas properties that are included in theborrowing base determination, calculated using a 

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discount rate of 10% per annum and reserve estimates, prices andproduction rates and costs, (ii) options to lease, seismic options,permits, and records related to such properties, and (iii) seismic data.

Borrowings under our credit facility may be either (i) adomestic bank rate plus an applicable margin between 0.25% and 1.25% per annumbased on utilization, or (ii) the London interbank offered rate, or LIBOR, plusan applicable margin between 1.25% and 2.25% per annum based on utilization.The credit agreement provides for various fees, including a quarterlycommitment fee of 1¤2 of 1.00% per annum and engineering fees to theadministrative agent in connection with a borrowing base determination. Inaddition, the credit agreement provides for an up front fee of $27,000, whichwas paid on the closing date of the credit agreement, and an additionalarrangement fee of up to 1% based on utilization. Borrowings under this creditfacility may be prepaid without premium or penalty, except on Eurodollaradvances. If an event of default exists, the default rate shall be equal to 2%plus the floating rate.

The credit agreement contains covenants that, among otherthings, restrict our ability, subject to certain exceptions, to do thefollowing:

·                  incurliens;

·                  incurdebt;

·                  makeinvestments in other persons;

·                  declaredividends or redeem or repurchase stock;

·                  engagein mergers, acquisitions, consolidations and asset sales or amend ourorganizational documents;

·                  enterinto certain hedging arrangements;

·                  amendmaterial contracts; and

·                  enterinto related party transactions.

Withregard to hedging arrangements, the credit facility provides that acceptablecommodity hedging arrangements cannot be greater than 80 to 85%, depending onthe measurement date, of our monthly production from our hydrocarbon propertiesthat are used in the borrowing base determination and that the fixed or floorprice of our hedging arrangements must be equal to or greater than the gasprice used by the lenders in determining the borrowing base.

The credit agreement also requires that we satisfycertain affirmative covenants, meet certain financial tests, maintain certainfinancial ratios and make certain customary indemnifications to lenders and theadministrative agent. The financial covenants include requirements to maintain:(i) EBITDA to cash interest expense of not less than 3.00 to 1.00, (ii) currentratio of not less than 1.00 to 1.00, (iii) total debt to annualized EBITDAof not more than 3.0 to 1.0, (iv) quarterly total senior debt to annualizedEBITDA equal to or less than 3.0 to 1.0 until June 30, 2007 and 2.00 to 1.0thereafter, and (v) total proved PV-10 value to total debt of at least1.50 to 1.00.

Thecredit agreement contains customary events of default, including, withoutlimitation, payment defaults, covenant defaults, certain events of bankruptcyand insolvency, defaults in the payment of other material debt, judgmentdefaults, breaches of representations and warranties, loss of material permitsand licenses and a change in control. In addition, the credit agreementrequired us to cure specified title defects within certain time periods. Exceptfor the title defect covenant the compliance with which was waived, we were incompliance with the covenants under our credit agreement as of June 30, 2007.

The credit agreement requires all of our wholly ownedsubsidiaries to guarantee the obligations under the credit agreement.

*Office Building Loan.*  OnNovember 15, 2005, we entered into a mortgage loan secured by our officebuilding in Sheridan, Wyoming in the aggregate principal amount of $829,000.The promissory note provides for monthly payments of principal and interest inthe initial amount of $6,400, and unpaid principal bears interest at 6.875%during the first three years, at a variable base rate thereafter and at 18%upon a default. The variable base rate is based on the lender’s base rate. Thematurity 

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date of this mortgage is November 15, 2015, at which time aprincipal and interest payment of $615,400 will become due. As of June 30,2007, we had $797,000 outstanding in principal and interest on this mortgage.

*Capital Expenditure Budget.*  For 2007,we have reduced our total capital expenditure budget from approximately $52.6 millionto approximately $30.0 million. Consequently, we expect to reduce our drillingand completion targets for 2007 from approximately 260 gross (207 net) wells toapproximately 140 gross (102 net) wells. In addition, our revised 2007 capitalexpenditure budget will continue to be used to construct related gas and waterinfrastructure, to fund plans of development costs for future wells, to fundundeveloped leasehold acquisition costs carried over from 2006, to recompletecertain wells, and to fund infrastructure and completion costs related to wellsdrilled in 2006.  We incurred capitalexpenditures of $11.5 million during the six months ended June 30,2007,  which were primarily related todrilling, completion and infrastructure costs on our undeveloped acreage in ourKirby, Deer Creek, Cabin Creek and Green River Basin areas. While we believe wehave adequate resources from our credit facility and cash flows from operationsto implement the remainder of our revised 2007 drilling plan, our ability todevelop future projects will depend on access to additional capital.  The CIG index price has been extremelyvolatile since during 2007 and has at times reached unusually low levels.  If prices remain low, it would cause our cashflows from operations to decrease and could result in a reduction of theborrowing base and borrowing availability under our credit facility, and if wecould not obtain capital through our credit facility or otherwise, our abilityto execute our development and acquisition plans, replace our reserves andmaintain production levels could be greatly limited.

We participated in the drilling of 41 gross (25 net)wells during the six months ended June 30, 2007 and we are actively developingthe Kirby, Deer Creek, Cabin Creek and Green River Basin areas of ourundeveloped acreage.

***Cash Flow fromOperating Activities***

Net cash used by operating activities was$5.5 million for the six months ended June 30, 2007, compared to net cashprovided by operating activities of $2.7 million for the six months endedJune 30, 2006,  primarily due to areduction in our accounts payable balance.

While we believe that cash flows from operations andborrowings under our credit facility will be sufficient to meet our 2007revised capital expenditures and our other cash needs during the remainder of2007, the CIG index price has been extremely volatile during 2007 and has attimes reached unusually low levels. If prices remain low, it would cause ourcash flows from operations to decrease and could result in further reductionsof the borrowing base and borrowing availability under our credit facility.

***Cash Flow fromInvesting Activities***

Net cash used in investing activities was$10.9 million for the six months ended June 30, 2007 compared to $42.8million for the six months ended June 30, 2006. Net cash used in investingactivities decreased by approximately $31.9 million compared to the sixmonths ended June 30, 2006 due to  theacquisition of the Green River Basin acreage in April 2006.

***Cash Flow fromFinancing Activities***

During the period from our formation in June 2003 throughSeptember 2005, DLJ Merchant Banking contributed $44.1 million in cash inexchange for shares of our common stock, shares of our Series A RedeemablePreferred Stock and detachable warrants to purchase additional shares of commonstock.  As of June 30, 2006 and June 30,2007, we had 25,140,391 and 28,928,301 shares of common stock issued andoutstanding, respectively, of which 36,360 and 74,270 shares, respectively,were shares of restricted stock issued to employees and directors.

Netcash provided by financing activities was $29.7 million for the six monthsended June 30, 2007 as compared to $59.9 million for the six months ended June30, 2007.  The decrease was primarily dueto our April 2006 private placement.

In April 2006, we completed a private placement, exemptfrom registration under the Securities Act, of 12,835,230 shares of our commonstock to qualified institutional buyers, non-U.S. persons and accreditedinvestors at a price of $11.00 per share, or $10.23 per share net of theinitial purchaser’s discount and placement fee. Out of the aggregate ofapproximately $129.9 million of net proceeds (after the initial purchaser’sdiscount and placement fee and offering expenses) we received in the privateplacement, we used (i) approximately $53.6 million to redeem all ofthe outstanding shares of our Series A Redeemable Preferred Stock,including the payment of all accrued and unpaid dividends and a redemptionpremium, (ii) approximately $27.0 million for our acquisition of theGreen River Basin assets, (iii) approximately $16.3 million torepurchase an aggregate of 1,593,783 shares of common stock at a price of$10.23 per share from DLJ Merchant Banking and Gary W. Uhland, our former 

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President, and (iv) approximately $33.0 million to fund ourdevelopment drilling program and pay additional offering expenses and forgeneral corporate purposes.

Immediately prior to the initial closing of our privateplacement, DLJ Merchant Banking exchanged all of its outstanding warrants for6,894,380 shares of our common stock in a tax-free reorganization based on theprivate placement price of $11.00 per share. As of June 30, 2006 and 2007, wehad no warrants or escalating options issued and outstanding.

In April 2006, following the initial closing of ourprivate placement, we redeemed all of the outstanding shares of Series ARedeemable Preferred Stock with a portion of the proceeds from our privateplacement including the payment of accrued and unpaid dividends of$1.4 million. The difference between the redemption price and the carryingvalue of the Series A Redeemable Preferred Stock resulted in a$19.6 million redemption premium that was recorded as a dividend expensein our statement of operations for the three months ended June 30, 2006.As of June 30, 2006 and 2007, we had no shares of preferred stock issued andoutstanding.

In May 2007, we completed an initial public offering of3,750,000 shares of our common stock at a price of $9.00 per share, or $8.37per share net of underwriters’ discounts and commissions.  Out of the approximately $30.3 million of netproceeds (after underwriters’ discounts and commissions and offering expenses)we received in our initial public offering, we used $7.0 million to pay downall of the outstanding indebtedness under our credit facility.  We have used and intend to continue to usethe remainder of the net proceeds from our initial public offering for capitalexpenditures, infrastructure development and general corporate purposes.

***ContractualObligations***

With the exception of borrowings and repayment ofindebtness under our credit facility and the payment of property taxes, therehave been no significant changes in our schedule of contractual obligations forthe year ended December 31, 2006 included in our amended registration statementon Form S-1 declared effective on May 10, 2007.  Please see note 7 of the unaudited FinancialStatements for information regarding our credit facility and otherindebtedness.

The following table summarizes byperiod our contractual obligations as of June 30, 2007:
| ** **                                     | ** ** | **Total**               | ** ** | **2007** | ** ** | **2008-2009** | ** ** | **2010-2011** | ** ** | **Thereafter** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|----------|------------|---------------|------------|---------------|------------|----------------|------------|
| ** **                                     | ** ** | **(in thousands)** | ** ** |
| Notes payable in  connection with the mortgage |       | $                       | 797        |     | $          | 22            |       | $             | 41         |           | $          | 42 |   | $ | 692 |   |
| Asset retirement  obligations                  |       | 2,533                   |       | —   |       | 214           |       | 356           |       | 1,963          |       |
| Non-current  production and property taxes     |       | 700                     |       | —   |       | 700           |       | —        |       | —         |       |
| Total                                          |       | $                       | 4,030      |     | $          | 22            |       | $             | 955        |           | $          | 398 |   | $ | 2,655 |   |

 

At June 30, 2007, the commodity derivatives asset wasvalued at $1,645,000 of which $1,958,000 represents a current receivableattributable to 2007 and $313,000 represents and obligation attributable to2008.

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

The primary objective of the following information is toprovide forward-looking quantitative and qualitative information aboutour potential exposure to market risk. The term “market risk” refers to therisk of loss arising from adverse changes in natural gas prices. This forward-lookinginformation provides indicators of how we view and manage our ongoing marketrisk exposure. All of our market risk sensitive instruments were entered intofor purposes other than speculative trading.

***Commodity Price Risk***

Our major market risk exposure is in the pricingapplicable to our natural gas production. The prices we receive for ourproduction depend on many factors beyond our control. We seek to reduce ourexposure to unfavorable changes in natural gas prices, which are subject tosignificant and often volatile fluctuation, through the use of fixed-pricecontracts. The fixed-price contracts are comprised of energy swaps andcollars. These contracts allow us to predict with greater certainty theeffective natural gas prices to be received for hedged production and benefitoperating cash flows and earnings when market prices are less than the fixedprices provided by the contracts. However, we will not benefit from marketprices that are higher than the fixed prices in the contracts for hedgedproduction. Collar structures provide for participation in price increases anddecreases to the extent of the ceiling prices and floors provided in thosecontracts.

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The following table summarizes the estimated volumes,fixed prices, fixed price sales and fair value attributable to the fixed pricecontracts as of June 30, 2007. At June 30, 2007, we had hedged volumes throughDecember 2008. Please see Note 5 included in the accompanying unauditedNotes to Financial Statements.
|                                             | ** ** | **Year Ending  December 31,** | ** ** | **Year Ending  December 31,** | ** ** |
|---------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **                                  | ** ** | **2007**                                | ** ** | **2008**                                | ** ** |
| ** **                                  | ** ** | **(Unaudited)**                         | ** ** | **(Unaudited)**                         | ** ** |
| **Natural  Gas Collars:**                   | ** ** | ** **                              | ** ** | ** **                              | ** ** |
| Contract volumes  (MMBtu):                  |       |                                    |       |                                    |       |
| Floor                                       |       | 828,000                                 |       | 1,098,000                               |       |
| Ceiling                                     |       | 828,000                                 |       | 1,098,000                               |       |
| Weighted-average  fixed price per MMBtu(1): |       |                                    |       |                                    |       |
| Floor                                       |       | $                                       | 6.66       |                                    | $          | 6.50 |   |
| Ceiling                                     |       | $                                       | 8.94       |                                    | $          | 8.20 |   |
| Fixed-price  sales(2)                       |       | $                                       | 8.94       |                                    | $          | 8.20 |   |
| Fair value, net  (thousands)(3)             |       | $                                       | 2,047      |                                    | $          | (402 | ) |
| **Total  Natural Gas Contracts:**           | ** ** | ** **                              | ** ** | ** **                              | ** ** |
| Contract volumes  (MMBtu)                   |       | 828,000                                 |       | 1,098,000                               |       |
| Weighted-average  fixed price per MMBtu(1)  |       | $                                       | 6.66       |                                    | $          | 6.50 |   |
| Fixed-price  sales(2)                       |       | $                                       | 8.94       |                                    | $          | 8.20 |   |
| Fair value, net  (thousands)(3)             |       | $                                       | 2,047      |                                    | $          | (402 | ) |

 

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(1)           Volumes hedged using the CIG index price published in the first issue ofInside FERC’s Gas Market Report for each calendar month of the derivativetransaction.

(2)           Assumes ceiling prices for natural gas collar volumes.

(3)           Fair value based on CIG index price in effect foreach month as of June 30, 2007.

**ITEM 4T. CONTROLS AND PROCEDURES**

**Disclosure Controls and Procedures**

Based on their evaluation as of the end of the periodcovered by this report, our principal executive officer and principal financialofficer have concluded that our disclosure controls and procedures (as definedin Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, asamended (the Exchange Act)) are effective to ensure that information requiredto be disclosed in reports that we file or submit under the Exchange Act arerecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms.

**Changes in Internal Control OverFinancial Reporting**

During the most recent fiscal quarter, there have beenno changes in our internal control over financial reporting that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

**PART II. OTHER INFORMATION**

**ITEM 1. LEGAL PROCEEDINGS**

For a discussion of certain of our current legalproceedings, please read note 9 included in the accompanying unaudited Notes toFinancial Statements.

We were named as defendants intwo related lawsuits (Civil Action No. 06CV0047J) filed on March 30,2006 in the United States District Court, Wyoming by Burning Rock Energy, LLCand (Case No. 06-CV-01627-MDM-MEH) filed onApril 25, 2006 in the United States District Court for the District ofColorado by John R. Behrmann, et al. claiming various contract and tortclaims against us relating to a like-kind exchange between us and theplaintiffs of approximately 1,000 acres of leased acreage in January 2004.The plaintiffs claimed, in part, that the leases transferred by us to BurningRock did not terminate upon nonpayment of shut-in rentals and further,that we trespassed by releasing from the original lessors the properties 

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originally transferred to BurningRock under the exchange agreement. In April 2007, we settled these claims withthe plaintiffs and both lawsuits were dismissed. The settlement arrangementincluded a $500,000 payment by us to Burning Rock together with an assignmentby us to Burning Rock of a 69.5% carried working interest in the disputedleased acreage.

From time to time, we are subjectto legal proceedings and claims that arise in the ordinary course of ourbusiness.  While the outcome of theseproceedings cannot be predicted with certainty, we do not expect them to have amaterial adverse effect on the financial statements.

**ITEM 1A. RISK FACTORS**

There have been no material changes to the riskfactors disclosed in our amended registration statement on Form S-1 (File No.333-139556), which was declared effective on May 10, 2007.

**ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIESAND USE OF PROCEEDS**

On May 10, 2007, our registration statement on FormS-1 (File No. 333-139556), as amended, relating to our initial public offeringwas declared effective by the Securities and Exchange Commission.  The managing underwriters of the offeringwere Friedman, Billings, Ramsey & Co., Inc., RBC Capital MarketsCorporation, A.G. Edwards & Sons, Inc. and Johnson Rice & CompanyL.L.C.  The closing date of our initialpublic offering was May 18, 2007, and on that date we sold 3,750,000 shares ofour common stock, par value $0.01 per share, ata price per share of $9.00, or $8.37 net of the underwriters’ discounts andcommissions. Out of the approximately $30.3 million of net proceeds (afterunderwriters’ discounts and commissions of approximately $2.3 million andestimated offering expenses of approximately $1.1 million) we received in ourinitial public offering, we used $7.0 million to repay all of the outstandingindebtedness under our credit facility. We have used and intend to continue to use the remainder of the netproceeds for capital expenditures, infrastructure development and generalcorporate purposes.

**ITEM 3. DEFAULTS UPON SENIORSECURITIES**

Not applicable.

**ITEM 4. SUBMISSION OF MATTERS TO AVOTE OF SECURITY HOLDERS**

Not applicable.

**ITEM 5. OTHER INFORMATION**

Not applicable.

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**ITEM 6. EXHIBITS**
| Exhibit No. | ** ** | **Description**                                                                                                                                                                                                                                                            |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1         |       | —Second Amended and Restated Certificate of  Incorporation of Pinnacle Gas Resources, Inc. (incorporated herein by  reference to Exhibit 3.1 to the Registration Statement on Form S-1 (File No.  333-133983) filed by Pinnacle Gas Resources, Inc. on May 10, 2006). |
|        |       |                                                                                                                                                                                                                                                                       |
| 3.2         |       | —Amended and Restated Bylaws of Pinnacle Gas  Resources, Inc. (incorporated herein by reference to Exhibit 3.2 to the  Registration Statement on Form S-1 (File No. 333-133983) filed by Pinnacle  Gas Resources, Inc. on May 10, 2006).                              |
|        |       |                                                                                                                                                                                                                                                                       |
| 4.1         |       | —Amended and Restated Securityholders Agreement,  dated February 16, 2006 (incorporated herein by reference to Exhibit 4.1 to  the Registration Statement on Form S-1 (File No. 333-133983) filed by  Pinnacle Gas Resources, Inc. on May 10, 2006).                  |
|        |       |                                                                                                                                                                                                                                                                       |
| 4.2         |       | —Registration Rights Agreement, dated April 11, 2006  (incorporated herein by reference to Exhibit 4.2 to the Registration  Statement on Form S-1 (File No. 333-133983) filed by Pinnacle Gas Resources,  Inc. on May 10, 2006).                                      |
|        |       |                                                                                                                                                                                                                                                                       |
| *31.1       |       | —Certification of President and Chief Executive  Officer of Pinnacle Gas Resources, Inc. pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                  |
|        |       |                                                                                                                                                                                                                                                                       |
| *31.2       |       | —Certification of Senior Vice President, Chief  Financial Officer and Secretary of Pinnacle Gas Resources, Inc. pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                           |
|        |       |                                                                                                                                                                                                                                                                       |
| *32.1       |       | —Certification of President and Chief Executive  Officer of Pinnacle Gas Resources, Inc. pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                   |
|        |       |                                                                                                                                                                                                                                                                       |
| *32.2       |       | —Certification of Senior Vice President, Chief  Financial Officer and Secretary of Pinnacle Gas Resources, Inc. pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                           |

 

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*              Filedherewith

†              Managementcontract or compensatory plan or arrangement

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
|        |       | PINNACLE GAS RESOURCES, INC. |
|--------|------------|------------------------------|
|   | ** ** | ** **                   | ** ** | ** ** |
|   |       | By:                          | /s/ Peter G.  Schoonmaker |   |
|   |       | Name:                        | Peter G.  Schoonmaker |   |
|   |       | Title:                       | *President,  Chief Executive* | * * |
|   |       |                         | *Officer  and Director* | * * |
|   |       |                         | (Principal  Executive Officer) |   |
|   |       |                         |   |   |
|   |       | Date:                        | August 14, 2007 |   |
|   |       |                         |   |   |
|   |       | By:                          | /s/ Ronald T.  Barnes |   |
|   |       | Name:                        | Ronald T. Barnes |   |
|   |       | Title:                       | *Senior  Vice President, Chief Financial* | * * |
|   |       |                         | *Officer  and Secretary* | * * |
|   |       |                         | (Principal  Financial Officer and |   |
|   |       |                         | Principal  Accounting Officer) |   |
|   |       |                         |   |   |
|   |       | Date:                        | August 14, 2007 |   |

 

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| Exhibit No. | ** ** | **Description**                                                                                                                                                                                                                                                            |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1         |       | —Second Amended and Restated Certificate of  Incorporation of Pinnacle Gas Resources, Inc. (incorporated herein by  reference to Exhibit 3.1 to the Registration Statement on Form S-1 (File No.  333-133983) filed by Pinnacle Gas Resources, Inc. on May 10, 2006). |
|        |       |                                                                                                                                                                                                                                                                       |
| 3.2         |       | —Amended and Restated Bylaws of Pinnacle Gas  Resources, Inc. (incorporated herein by reference to Exhibit 3.2 to the  Registration Statement on Form S-1 (File No. 333-133983) filed by Pinnacle  Gas Resources, Inc. on May 10, 2006).                              |
|        |       |                                                                                                                                                                                                                                                                       |
| 4.1         |       | —Amended and Restated Securityholders Agreement,  dated February 16, 2006 (incorporated herein by reference to Exhibit 4.1 to  the Registration Statement on Form S-1 (File No. 333-133983) filed by Pinnacle  Gas Resources, Inc. on May 10, 2006).                  |
|        |       |                                                                                                                                                                                                                                                                       |
| 4.2         |       | —Registration Rights Agreement, dated April 11, 2006  (incorporated herein by reference to Exhibit 4.2 to the Registration  Statement on Form S-1 (File No. 333-133983) filed by Pinnacle Gas Resources,  Inc. on May 10, 2006).                                      |
|        |       |                                                                                                                                                                                                                                                                       |
| *31.1       |       | —Certification of President and Chief Executive  Officer of Pinnacle Gas Resources, Inc. pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                  |
|        |       |                                                                                                                                                                                                                                                                       |
| *31.2       |       | —Certification of Senior Vice President, Chief  Financial Officer and Secretary of Pinnacle Gas Resources, Inc. pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                           |
|        |       |                                                                                                                                                                                                                                                                       |
| *32.1       |       | —Certification of President and Chief Executive  Officer of Pinnacle Gas Resources, Inc. pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                   |
|        |       |                                                                                                                                                                                                                                                                       |
| *32.2       |       | —Certification of Senior Vice President, Chief  Financial Officer and Secretary of Pinnacle Gas Resources, Inc. pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                           |

 

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*              Filedherewith

†              Managementcontract or compensatory plan or arrangement

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