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**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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

 

**For the quarterly period ended September 30, 2010**

 

**or**

 

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For thetransition period from               to               **

 

**Commission file number: 001-33457**

 

**Pinnacle Gas Resources, Inc.**

(Exact name of registrant as specified inits 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 telephone number, includingarea code)

 

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Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x No o

 

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

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer or a smaller reporting company. Seethe definitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

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

 

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act). Yes o No x

 

30,296,710shares of the registrant’s Common Stock were outstanding as of November 15,2010.

 

 

 

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**PINNACLE GAS 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, 2009 and  September 30, 2010 (unaudited)                        | 3        |
| Statements  of Operations for the three and nine months ended September 30, 2010 and  2009 (unaudited) | 4        |
| Statements  of Cash Flows for the nine months ended September 30, 2010 and 2009 (unaudited)            | 5        |
| Statement of Stockholders’ Equity at September 30,  2010 (unaudited)                              | 6        |
| Notes to Financial Statements (unaudited)                                                                   | 7        |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations         | 20       |
| Overview                                                                                                    | 20       |
| Economic and Natural Gas Pricing Environment                                                                | 21       |
| Credit Facility and Liquidity                                                                               | 21       |
| Critical Accounting Policies                                                                                | 22       |
| Trends Affecting Our Business                                                                               | 26       |
| Results  of Operations                                                                                      | 27       |
| Liquidity and Capital Resources                                                                             | 30       |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                         | 34       |
| Item 4T. Controls and Procedures                                                                            | 35       |
| Part II.  OTHER INFORMATION                                                                            | 35       |
| Item  1. Legal Proceedings                                                                                  | 35       |
| Item  1A. Risk Factors                                                                                      | 36       |
| Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                        | 37       |
| Item 3. Defaults Upon Senior Securities                                                                     | 37       |
| Item 4. Submission of Matters to a Vote of Security  Holders                                                | 37       |
| Item  5. Other Information                                                                                  | 37       |
| Item 6.  Exhibits                                                                                           | 38       |

 

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**CAUTIONARYSTATEMENT CONCERNING FORWARD-LOOKING STATEMENTS**

 

Weare including the following discussion to inform you of some of the risks anduncertainties that can affect our decreased and to take advantage of the “safeharbor” protection for forward-looking statements that applicable federalsecurities law affords. Various statements in this prospectus, including thosethat express a belief, expectation, or intention, as well as those that are notstatements of historical fact, are forward looking statements. These includestatements relating to such matters as:

 

·**               **our financial position oroperating results;

 

·                projections and estimatesconcerning the timing and success of specific projects;

 

·**               **our business strategy;

 

·**               **our budgets;

 

·**               **the amount, nature andtiming of capital expenditures;

 

·**               **the drilling of wells;

 

·**               **the development of recentlyacquired natural gas and oil properties;

 

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

 

·**               **our operating costs andother expenses;

 

·**               **our estimated future netrevenues from natural gas and oil reserves and the present value thereof;

 

·**               **our cash flow andanticipated liquidity; and

 

·**               **our other plans andobjectives for future operations.

 

Whenwe use the words “believe,” “intend,” “expect,” “may,” “should,” “anticipate,” “could,”“estimate,” “plan,” “predict,” “project,” their negatives, or other similarexpressions, the statements which include those words are usually forwardlooking statements. When we describe strategy that involves risks oruncertainties, we are making forward looking statements. The forward lookingstatements in this quarterly report on Form 10-Q speak only as of the dateof this report. We disclaim any obligation to update these statements unlessrequired by securities law, and we caution you not to rely on them unduly. Wehave based these forward looking statements on our current expectations andassumptions about future events. While our management considers theseexpectations and assumptions to be reasonable, they are inherently subject tosignificant business, economic, competitive, regulatory and other risks,contingencies and uncertainties, most of which are difficult to predict andmany of which are beyond our control. These risks, contingencies anduncertainties relate to, among other matters, the following:

 

· our ability to successfully close ourproposed merger;

 

· the availability of capital;

 

· fluctuations in the commodity prices fornatural gas and crude oil and their related effects, including on cash flowsand potential impairments of oil and gas properties;

 

· regional price differentials;

 

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

 

· the lack of liquidity of our equitysecurities;

 

· thesubstantial capital expenditures required for construction of pipelines and thedrilling of wells and the related need to fund such capital requirementsthrough commercial banks and/or public securities markets;

 

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

 

· the effects of governmentregulation and permitting and other legal requirements;

 

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

 

· production variances fromexpectations;

 

· our ability to develop andreplace reserves;

 

· operating hazards attendantto the natural gas and oil business, including down-hole drilling andcompletion risks that are generally not recoverable from third parties orinsurance;

 

· potential mechanicalfailure or under-performance of significant wells;

 

· environmental-relatedproblems;

 

· the availability and costof materials and equipment;

 

· our dependence upon keypersonnel;

 

· our ability to find andretain skilled personnel;

 

· delays in anticipatedstart-up dates;

 

· disruptions of, capacityconstraints in or other limitations on our or others’ pipeline systems;

 

· land issues and the costsassociated with perfecting title for natural gas rights in some of ourproperties;

 

· our ability to effectivelymarket our production;

 

· competition from, and thestrength and financial resources of, our competitors; and

 

· general economic conditions.

 

Whenyou consider these forward-looking statements, you should keep in mind thesefactors and the other factors discussed in the “Risk Factors” section of ourannual report on Form 10-K for the year ended December 31, 2009 andthis quarterly report on Form 10-Q.

 

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**PART I. FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**PINNACLE GAS RESOURCES, INC.**

**Balance Sheets**

 
| ** **                                                                                                                                                                              | ** ** | **September 30,********2010** | ** ** | **December 31,********2009** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                                                                              | ** ** | **(unaudited)**                    | ** ** | **(audited)**                     | ** ** |
| ** **                                                                                                                                                                              | ** ** | **(in thousands)**            | ** ** |
| **Assets**                                                                                                                                                                              |       |                               |       |                              |       |
| Current assets                                                                                                                                                                          |       |                               |       |                              |       |
| Cash and cash equivalents                                                                                                                                                               |       | $                                  | 393        |                              | $          | 175 |   |
| Receivables                                                                                                                                                                             |       |                               |       |                              |       |
| Accrued gas sales                                                                                                                                                                       |       | 496                                |       | 1,240                             |       |
| Joint interest receivables, net of $14 and $100  allowance for doubtful accounts                                                                                                        |       | 2,102                              |       | 1,207                             |       |
| Derivative instruments                                                                                                                                                                  |       | 775                                |       | —                            |       |
| Inventory of material held for exploration and  development                                                                                                                             |       | 55                                 |       | 229                               |       |
| Restricted certificates of deposits                                                                                                                                                     |       | —                             |       | 142                               |       |
| Prepaid expenses                                                                                                                                                                        |       | 66                                 |       | 134                               |       |
| Total current assets                                                                                                                                                                    |       | 3,887                              |       | 3,127                             |       |
| Property and equipment, at cost, net of  accumulated depreciation                                                                                                                       |       | 216                                |       | 1,055                             |       |
| Oil and gas properties, using full cost  accounting, net of accumulated depletion and impairment                                                                                        |       |                               |       |                              |       |
| Proved                                                                                                                                                                                  |       | 9,412                              |       | 9,477                             |       |
| Unproved                                                                                                                                                                                |       | 49,904                             |       | 48,700                            |       |
| Inventory of material held for exploration and  development                                                                                                                             |       | 388                                |       | 223                               |       |
| Deposits                                                                                                                                                                                |       | 57                                 |       | 76                                |       |
| Restricted certificates of deposit                                                                                                                                                      |       | 500                                |       | 1,842                             |       |
| Total assets                                                                                                                                                                            |       | $                                  | 64,364     |                              | $          | 64,500 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                          |       |                               |       |                              |       |
| Current liabilities                                                                                                                                                                     |       |                               |       |                              |       |
| Long term debt, current                                                                                                                                                                 |       | $                                  | 5,163      |                              | $          | 6,148 |   |
| Derivative instruments, current                                                                                                                                                         |       | —                             |       | 1,375                             |       |
| Trade accounts payable                                                                                                                                                                  |       | 10,249                             |       | 9,058                             |       |
| Revenue distribution payable                                                                                                                                                            |       | 4,260                              |       | 3,328                             |       |
| Drilling prepayments from joint interest owners                                                                                                                                         |       | 42                                 |       | 63                                |       |
| Asset retirement obligations, current                                                                                                                                                   |       | 880                                |       | 721                               |       |
| Accrued liabilities                                                                                                                                                                     |       | 4,009                              |       | 3,090                             |       |
| Total non-current liabilities                                                                                                                                                           |       | 24,603                             |       | 23,783                            |       |
| Asset retirement  obligations, non-current                                                                                                                                              |       | 2,139                              |       | 2,216                             |       |
| Production taxes, non-current                                                                                                                                                           |       | 626                                |       | 385                               |       |
| Long term debt, non-current                                                                                                                                                             |       | 705                                |       | 743                               |       |
| Total liabilities                                                                                                                                                                       |       | 28,073                             |       | 27,127                            |       |
| Commitments and contingencies                                                                                                                                                           |       |                               |       |                              |       |
| Stockholders’ equity                                                                                                                                                               |       |                               |       |                              |       |
| Common stock, $0.01 par value; 100,000,000  authorized and 30,296,710 and 30,108,023 shares issued and outstanding at  September 30, 2010 and December 31, 2009, respectively |       | 289                                |       | 289                               |       |
| Additional paid-in capital                                                                                                                                                              |       | 152,013                            |       | 151,725                           |       |
| Accumulated deficit                                                                                                                                                                     |       | (116,011                           | )          | (114,641                          | )          |
| Total stockholders’ equity                                                                                                                                                         |       | 36,291                             |       | 37,373                            |       |
| Total liabilities and stockholders’ equity                                                                                                                                         |       | $                                  | 64,364     |                              | $          | 64,500 |   |

 

See Notes to Financial Statements (unaudited)

 

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**PINNACLE GAS RESOURCES, INC.**

**Statementsof Operations**

**(unaudited)**

 
| ** **                                                    | ** ** | **Three Months Ended**                                                   | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                    | ** ** | **September 30,**                                                             | ** ** | **September 30,**          | ** ** |
| ** **                                                    | ** ** | **2010**                                                                           | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| ** **                                                    | ** ** | **(in thousands, except share and  per share data)** | ** ** |
| Revenues                                                      |       |                                                                               |       |                            |       |   |   |   |   |
| Gas sales                                                     |       | $                                                                                  | 1,798      |                            | $          | 1,687 |   | $ | 6,580 |   | $ | 6,057 |   |
| Realized gain on derivatives                                  |       | 796                                                                                |       | 2,038                           |       | 920 |   | 5,548 |   |
| Total revenues                                                |       | 2,594                                                                              |       | 3,725                           |       | 7,500 |   | 11,605 |   |
| Cost of revenues and expenses                                 |       |                                                                               |       |                            |       |   |   |   |   |
| Lease operating expenses                                      |       | 872                                                                                |       | 923                             |       | 2,659 |   | 3,047 |   |
| Production taxes                                              |       | 194                                                                                |       | 167                             |       | 720 |   | 585 |   |
| Marketing and transportation                                  |       | 724                                                                                |       | 785                             |       | 2,200 |   | 2,930 |   |
| General and administrative, net                               |       | 1,047                                                                              |       | 868                             |       | 3,471 |   | 3,082 |   |
| Depreciation, depletion, amortization and  accretion          |       | 522                                                                                |       | 2,319                           |       | 2,080 |   | 5,063 |   |
| Impairment of oil and gas properties                          |       | —                                                                             |       | 34,594                          |       | — |   | 57,844 |   |
| Total cost of revenues and expenses                           |       | 3,359                                                                              |       | 39,656                          |       | 11,130 |   | 72,551 |   |
| Operating loss                                                |       | (765                                                                               | )          | (35,931                         | )          | (3,630 | ) | (60,946 | ) |
| Other income (expense)                                        |       |                                                                               |       |                            |       |   |   |   |   |
| Unrealized gain/(loss) on derivatives                         |       | (129                                                                               | )          | (3,074                          | )          | 2,149 |   | (5,207 | ) |
| Interest income                                               |       | 28                                                                                 |       | 17                              |       | 61 |   | 51 |   |
| Other income                                                  |       | 243                                                                                |       | 102                             |       | 481 |   | 302 |   |
| Interest expense                                              |       | (127                                                                               | )          | (76                             | )          | (431 | ) | (131 | ) |
| Total other income (expense)                                  |       | 15                                                                                 |       | (3,031                          | )          | 2,260 |   | (4,985 | ) |
| Net loss before income taxes                                  |       | (750                                                                               | )          | (38,962                         | )          | (1,370 | ) | (65,931 | ) |
| Income taxes                                                  |       | —                                                                             |       | —                          |       | — |   | — |   |
| Net loss attributable to common stockholders                  |       | $                                                                                  | (750       | )                               | $          | (38,962 | ) | $ | (1,370 | ) | $ | (65,931 | ) |
| Basic and diluted net loss per share                          |       | $                                                                                  | (0.02      | )                               | $          | (1.31 | ) | $ | (0.05 | ) | $ | (2.24 | ) |
| Weighted average shares outstanding — basic and  diluted |       | 30,301,591                                                                         |       | 29,783,933                      |       | 30,289,125 |   | 29,446,568 |   |

 

See Notes to Financial Statements (unaudited)

 

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**PINNACLE GAS RESOURCES, INC.**

**Statementsof Cash Flows**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                                | ** ** | **For the Nine Months********Ended********September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2010**                                                                 | ** ** | **2009** | ** ** |
| Cash flows from operating activities                                                      |       |                                                                     |       |   |   |
| Net loss                                                                                  |       | $                                                                        | (1,370     | ) | $ | (65,931 | ) |
| Adjustments to reconcile net loss to net cash  provided by (used in) operating activities |       |                                                                     |       |   |   |
| Impairment of oil and gas properties                                                      |       | —                                                                   |       | 57,844 |   |
| Depreciation, depletion, amortization and  accretion                                      |       | 2,080                                                                    |       | 5,063 |   |
| Gain on derivatives                                                                       |       | (3,070                                                                   | )          | (341 | ) |
| Stock-based compensation                                                                  |       | 288                                                                      |       | 683 |   |
| Changes in assets and liabilities                                                         |       |                                                                     |       |   |   |
| (Increase) decrease in receivables                                                        |       | (151                                                                     | )          | 1,933 |   |
| Decrease in inventory of material for drilling and  completion                            |       | 174                                                                      |       | 26 |   |
| Asset retirement obligations settled this period                                          |       | (81                                                                      | )          | (129 | ) |
| Decrease in prepaid expenses                                                              |       | 68                                                                       |       | 5 |   |
| Increase in trade accounts payable, accrued  liabilities and production taxes             |       | 2,362                                                                    |       | 718 |   |
| Increase (decrease) in revenue distribution  payable                                      |       | 931                                                                      |       | (1,606 | ) |
| (Decrease) increase in drilling prepayments from  joint interest owners                   |       | (20                                                                      | )          | 48 |   |
| Net cash provided by (used in) operating  activities                                      |       | 1,211                                                                    |       | (1,687 | ) |
| Cash flows from investing activities                                                      |       |                                                                     |       |   |   |
| Capital expenditures — exploration and production                                    |       | (2,123                                                                   | )          | (3,026 | ) |
| Capital expenditures — property and equipment                                        |       | (90                                                                      | )          | (99 | ) |
| Proceeds received from sale of oil and gas  properties                                    |       | —                                                                   |       | 3,200 |   |
| Decrease in purchase of restricted certificate of  deposit and deposits                   |       | 1,502                                                                    |       | 720 |   |
| Increase in inventory held for exploration and  development                               |       | (165                                                                     | )          | (18 | ) |
| Realized gain on derivatives                                                              |       | 920                                                                      |       | 5,548 |   |
| Net cash provided by investing activities                                                 |       | 44                                                                       |       | 6,325 |   |
| Cash flows from financing activities                                                      |       |                                                                     |       |   |   |
| Principal payments on note payable                                                        |       | (1,037                                                                   | )          | (4,977 | ) |
| Net cash used in financing activities                                                     |       | (1,037                                                                   | )          | (4,977 | ) |
| Net decrease in cash and cash equivalents                                                 |       | 218                                                                      |       | (339 | ) |
| Cash and cash equivalents at beginning of the year                                        |       | 175                                                                      |       | 346 |   |
| Cash and cash equivalents at September 30,  2010 and 2009, respectively              |       | $                                                                        | 393        |   | $ | 7 |   |
| Noncash investing and financing activities                                                |       |                                                                     |       |   |   |
| Capital expenditures included in trade accounts  payable                                  |       | $                                                                        | 6,396      |   | $ | 6,869 |   |
| Asset retirement obligation included in oil and  gas properties                           |       | 1                                                                        |       | — |   |
| Supplemental cash flow information                                                        |       |                                                                     |       |   |   |
| Cash payments for interest, net of amount  capitalized                                    |       | $                                                                        | 430        |   | $ | 131 |   |

 

See Notes to Financial Statements (unaudited)

 

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**PINNACLE GAS RESOURCES, INC.**

**Statementof Stockholders’ Equity**

**(in thousands, except for share data)**

 
| ** **                                     | ** ** | **Common Stock** | ** ** | **Additional********Paid-In** | ** ** | **Accumulated** | ** ** | ** **  | ** ** |
|------------------------------------------------|------------|-----------------------|------------|-------------------------------|------------|-----------------|------------|-------------|------------|
| ** **                                     | ** ** | **Shares**            | ** ** | **Amount**                    | ** ** | **Capital**     | ** ** | **Deficit** | ** ** | **Total** | ** ** |
|                                           |       |                  |       |                          |       |            |       |        |       |   |   |
| Balance at December 31, 2009              |       | 30,108,023            |       | $                             | 289        |            | $          | 151,725     |       | $ | (114,641 | ) | $ | 37,373 |   |
| Issuance of restricted shares (unaudited)      |       | 212,502               |       | —                        |       | 245             |       | —      |       | 245 |   |
| Forfeiture of restricted shares (unaudited)    |       | (23,815               | )          | —                        |       | —          |       | —      |       | — |   |
| Stock-based compensation (unaudited)           |       | —                |       | —                        |       | 43              |       | —      |       | 43 |   |
| Net loss (unaudited)                           |       | —                |       | —                        |       | —          |       | (1,370      | )          | (1,370 | ) |
| Balance at September 30, 2010 (unaudited) |       | 30,296,710            |       | $                             | 289        |            | $          | 152,013     |       | $ | (116,011 | ) | $ | 36,291 |   |

 

See Notes to Financial Statements (unaudited)

 

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**Notes toFinancial Statements**

**(Unaudited)**

 

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

 

Pinnacle Gas Resources, Inc. (the “Company”) was formed as aDelaware corporation in September 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.

 

The Company’s primary business is the exploration for, and theacquisition, development and production of, coalbed methane natural gas in theUnited States. The Company is also engaged in gas property operations and theconstruction of low pressure gas collection systems which providetransportation for the Company’s coalbed methane production.

 

On February 23, 2010, the Company entered into an Agreement andPlan of Merger with Powder Holdings, LLC, a Delaware limited liability companyand Powder Acquisition Co., a direct, wholly owned subsidiary of PowderHoldings (“merger agreement”).  PowderHoldings is controlled by an investor group led by Scotia Waterous (USA) Inc.and includes certain members of the Company’s management team. On April 2,2010, the Company filed a preliminary proxy statement relating to the mergerand on June 29, 2010, the Company filed a definitive proxy statement relatingto the merger, with the U.S. Securities and Exchange Commission.  At the special meeting of the shareholders onAugust 9, 2010, the shareholders of the Company voted to approve a proposal toadopt the merger agreement. On September 29, 2010, the Company entered into anamendment that extended the Outside Date as defined in Section 7.1(b)(i) of themerger agreement, from August 23, 2010 to October 29, 2010.  Although the Outside Date of the merger haspassed, the merger agreement has not been terminated.  The Company is currently working on anadditional extension to the Outside Date with Powder Acquisition Co. and PowderHoldings, LLC to provide additional time for the parties to satisfy theconditions to closing for the contemplated merger transaction. However therecan be no assurance that the transaction will close.

 

The Company’s most recent waiver with its lender expired on June 15,2010.  On July 8, 2010, the Company was notified by its lender thatit failed to make the principal and interest payments due on July 1, 2010 andthat such missed payments constituted an Event of Default under the creditagreement.  On October 28, 2010, the administrative agent of the creditfacility notified the counterparty to the Company’s derivative contracts thatan Event of Default had occurred and advised the counterparty to remit fundsdirectly to the administrative agent.  On November 5, 2010, thecounterparty to the Company’s derivative transactions advised the Company thatfunds ($363,000 for November 2010) will be held in escrow pending furtherinvestigation of the administrative agent’s request or additional directionfrom the Company.

 

Further,the Company’s lender has indicated that it will exercise additional remediesunder the credit agreement to obtain the Company’s liquid cash payments orother collateral.  The diversion of the Company’s liquid collateral willmaterially impact its abilities to meet its ongoing payment obligations. On November 8, 2010, Scotia Waterous (USA), Inc. provided a $0.5 millioncapital contribution to Powder Holdings, LLC to fund general working capitalrequirements of the Company pending closing, which is anticipated in thefourth quarter of 2010 subject to the satisfaction of certain closingconditions.  This capital will help the Company with its immediate capitalneeds, but may still needs it to find other means to satisfy its obligationsprior to closing.

 

Although the Company anticipates closing will occurin the fourth quarter, the Company continues to communicate with key vendors tomanage its obligations and payables. The Company has entered into agreementswith various vendors to make minimum monthly payments ranging from $1,000 to$45,000 at interest rates between 2% and 12% for the remainder of 2010. TheCompany has also implemented various cost cutting measures, including reducinggeneral and administrative costs through staff reductions, wage and benefitcuts and a hiring freeze. The Company has reduced lease operating expenses byrenegotiating water disposal contracts, reducing service costs and temporarilyshutting-in marginal wells.  Managementbelieves that appropriate steps, including cost-cutting measures, are beingtaken to make operations sustainable in the future. Although the Company ispursuing various alternatives to provide additional liquidity, including itsshareholder approved merger with Powder, there is no assurance of thelikelihood or timing of any of these transactions.

 

In addition the Company hasexecuted hedges of its gas to secure certain operating cash flow levels duringthe remainder of 2010. From January through April 2010, the Companyhad 5,500 MMbtu per day hedged through fixed price swaps at a weighted averageCIG Rocky Mountain Index price of $4.19 per MMbtu.  From May through December 2010, theCompany has 5,500 MMbtu per day hedged through fixed price swaps at a weightedaverage CIG Rocky Mountain Index price of $5.08 per MMbtu.

 

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**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 participating interest.The Company has no subsidiaries or affiliates with which intercompanytransactions are recorded.

 

The accompanying financial statements areunaudited, and in the opinion of management, reflect all adjustments that arenecessary for a fair presentation of the financial position and results ofoperations for the periods presented. All such adjustments are of a normal andrecurring nature. The following Notes describe only the material changes inaccounting policies, account details, or financial statement Notes during thefirst nine months of 2010. The results for the three and nine months endingSeptember 30, 2010 are not necessarily indicative of the results expected forthe entire year. These financial statements should be read in conjunction withthe audited financial statements and the summary of significant accountingpolicies for prior years contained in the reports the Company files with theSecurities and Exchange Commission, which can be found on the Company’s websiteat www.pinnaclegas.com or on the Securities and Exchange Commission website at *www.sec.gov*.

 

*Use of Estimates*

 

The preparation of the Company’s financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamount of assets and liabilities, disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period. Actual results could differfrom these estimates. Significant estimates with regard to the Company’sfinancial 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, the ceiling test applied tocapitalized oil and gas properties, the estimate of the timing and cost of theCompany’s future drilling activity, the estimated cost and timing related toasset retirement obligations, the estimated fair value of derivative assets andliabilities, the realizability of deferred tax assets, the estimates ofexpenses and timing of exercise of stock options, accrual of operating costsand capital expenditures and revenue.

 

*Oil and Gas Properties*

 

The Company utilizes thefull cost method of accounting for oil and gas producing activities. Under thismethod, all costs associated with property acquisition, exploration anddevelopment, including costs of unsuccessful exploration, costs of surrenderedand abandoned leaseholds, delay lease rentals and the fair value of estimatedfuture costs of site restoration, dismantlement and abandonment activities arecapitalized within a cost center. The Company’s oil and gas properties are alllocated within the United States, which constitutes a single cost center. TheCompany capitalizes lease operating expenses associated with exploration anddevelopment of unevaluated oil and gas properties. No gain or loss isrecognized upon the sale or abandonment of undeveloped or producing oil and gasproperties unless the sale represents a significant portion of gas propertiesand the gain significantly alters the relationship between capitalized costsand proved gas reserves of the cost center. Expenditures for maintenance andrepairs are charged to lease operating expense in the period incurred.

 

Depreciation,depletion and amortization of oil and gas properties (“DD&A”) are computedon the unit-of-production method based on proved reserves. Amortizable costsinclude estimates of future development costs of proved undeveloped reservesand asset retirement obligations. The Company invests in unevaluated oil andgas properties for the purpose of exploration for proved reserves. The costs ofsuch assets, including exploration costs on properties where a determination ofwhether proved oil and gas reserves will be established is still underevaluation, and any capitalized interest and lease operating expenses 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.Abandonment of unproved properties is accounted for as an adjustment tocapitalized costs related to proved oil and gas properties, with no lossesrecognized. No impairment was recorded for unevaluated properties for the threeand nine months ended September 30, 2010.

 

Substantiallyall of the remaining unproved properties are expected to be developed andincluded in the amortization base over the next three to five years, based onprojected cash flow from operations combined with raising additional capital.Salvage value is taken into account in determining depletion rates and is basedon the Company’s estimate of the value of equipment and supplies at the timethe well is abandoned. As of September 30, 2010 and December 31, 2009, theestimated value was approximately $6.8 million.

 

Underthe full cost method of accounting rules, capitalized costs less accumulateddepletion and related deferred income taxes may not exceed a ‘‘ceiling’’ valuewhich is the sum of (1) the present value discounted at 10% of estimated futurenet revenue using current costs and first day of the month twelve month averageCIG prices, including the effects of derivative instruments 

 

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designatedas cash flow hedges but excluding the future cash outflows associated withsettling asset retirement obligations that have been accrued on the balancesheet, less any related income tax effects; plus (2) the cost of properties notbeing amortized, if any; plus (3) the lower of costs or estimated fair value ofunproved properties; less (4) the income tax effects related to differences inthe book to tax basis of oil and gas properties. This is referred to as the ‘‘fullcost ceiling limitation.’’ If capitalized costs exceed the limit, the excessmust be charged to expense. The expense may not be reversed in future periods.At the end of each quarter, the Company calculates the full cost ceilinglimitation. At September 30, 2010, the full cost ceiling limitation exceededthe capitalized cost of the Company’s oil and gas properties by approximately$13.2 million based on the first day of the month, twelve month average CIGprice of approximately $4.01 per Mcf. Therefore, no impairment was taken forthe three and nine months ended September 30, 2010. Approximately $34.6 and$57.8 million impairment was recorded for the three and nine months endedSeptember 30, 2009.

 

*Per Share Information*

 

Basic loss per share is computed by dividing netloss from continuing operations attributable to common stock by the weightedaverage number of shares of common stock outstanding during each period.Diluted earnings per share are computed by adjusting the average number ofshares of common stock outstanding for the dilutive effect, if any, of commonstock equivalents such as stock options and warrants. For the nine months endedSeptember 30, 2010, basic and diluted net loss per share was $0.05. During thenine months ended September 30, 2010, 813,412 options and stock appreciationrights were excluded because they were anti-dilutive.

 

Asummary of the net income/(loss) per share calculation is shown below (inthousands, except per share amounts):

 
| ** **                                                   | ** ** | **For the Three********Months Ended********September 30,** | ** ** | **For the Nine********Months Ended********September 30,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **2010**                                                                       | ** ** | **2009**                                                                      | ** ** | **2010** | ** ** | **2009** | ** ** |
| Net loss                                                     |       | $                                                                              | (750       | )                                                                             | $          | (38,962 | ) | $ | (1,370 | ) | $ | (65,931 | ) |
| Common shares outstanding:                                   |       |                                                                           |       |                                                                          |       |   |   |   |   |
| Historical common shares outstanding at beginning  of period |       | 30,318                                                                         |       | 29,722                                                                        |       | 30,108 |   | 29,278 |   |
| Weighted average common shares issued (forfeited)            |       | (16                                                                            | )          | 62                                                                            |       | 181 |   | 169 |   |
| Weighted average common shares outstanding-basic             |       | 30,302                                                                         |       | 29,784                                                                        |       | 30,289 |   | 29,447 |   |
| Net loss per share-basic and diluted                         |       | $                                                                              | (0.02      | )                                                                             | $          | (1.31 | ) | $ | (0.05 | ) | $ | (2.24 | ) |

 

*Income Taxes*

 

TheCompany uses the asset and liability method of accounting for income taxes.Deferred tax assets and liabilities are recognized for the expected future taxconsequences of temporary differences between the financial statement 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 September 30, 2010 and December 31,2009, the Company had recorded a full valuation allowance for its net deferredtax asset.

 

*New Accounting Pronouncements*

 

TheCompany adopted FASB ASC Update 2010-06, “Fair Value Measurements andDisclosures” which amends ASC Update 2010-06 to require additional disclosuresconcerning transfers between Levels 1 and 2, inputs and valuation techniquesused to value Level 2 and 3 measurements, and push down of previouslyprescribed fair value disclosures to each class of asset and liability forLevels 1, 2, and 3. These disclosures were effective for the Company for thequarter ended September 30, 2010. The adoption of this pronouncement did nothave a material impact on the Company’s consolidated financial statements.

 

Inaddition, ASC Update 2010-06 requires that purchases, sales, issuances, andsettlements for Level 3 measurements be disclosed. This portion of the newauthoritative guidance is effective for interim and annual reporting periodsbeginning after December 15, 2010. As such, the Company will apply this newauthoritative guidance in the Company’s March 31, 2011, Quarterly Report onForm 10-Q. The adoption of ASC Update 2010-06 will not have a material impacton the Company’s financial statements.

 

TheCompany adopted FASB ASC Update 2010-09, “Amendments to Certain Recognition andDisclosure Requirements.*”* ASU

 

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No.2010-09 was effective upon issuance and its adoption had no impact on theCompany’s financial position, results of operations or cash flows.

 

**Note 3 — Asset Retirement Obligations**

 

TheCompany follows certain accounting provisions that apply to legal obligationsassociated with the retirement of longlived assets that result from theacquisition, construction, development and/or the normal operation of along-lived asset. These provisions require the Company to recognize anestimated liability for costs associated with the abandonment of its oil andgas properties.

 

Aliability for the fair value of an asset retirement obligation with acorresponding increase to the carrying value of the related long-lived asset isrecorded at the time a well is completed or acquired. The increased carryingvalue is depleted using the units-of-production method, and the discountedliability is increased through accretion over the remaining life of therespective oil and gas properties.

 

Theestimated liability is based on historical gas industry experience inabandoning wells, including estimated economic lives, external estimates as tothe cost to abandon the wells in the future and federal and state regulatoryrequirements. The Company’s liability is discounted using its best estimate ofits credit-adjusted risk-free rate. Revisions to the liability could occur dueto changes in estimated abandonment costs, changes in well economic lives or iffederal or state regulators enact new requirements regarding the abandonment ofwells.

 

The following is a summaryof the Company’s asset retirement obligation activity for the three and ninemonths ended September 30, 2010 and 2009 (in thousands).

 
| ** **                                     | ** ** | **For the Three********Months Ended********September 30,** | ** ** | **For the Nine********Months Ended********September 30,** | ** ** | **For the Three********Months Ended********September 30,** | ** ** | **For the Nine********Months Ended********September 30,** | ** ** |
|------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **2010**                                                                       | ** ** | **2009**                                                                      | ** ** |
| Beginning balance asset retirement obligations |       | $                                                                              | 2,995      |                                                                          | $          | 2,937                                                                          |       | $                                                                             | 3,457      |   | $ | 3,366 |   |
| Additional obligations added during the period |       | —                                                                         |       | 1                                                                             |       | —                                                                         |       | —                                                                        |       |
| Obligations settled during the period          |       | (32                                                                            | )          | (81                                                                           | )          | (106                                                                           | )          | (129                                                                          | )          |
| Accretion expense                              |       | 56                                                                             |       | 162                                                                           |       | 58                                                                             |       | 172                                                                           |       |
| Ending balance of asset retirement obligations |       | $                                                                              | 3,019      |                                                                          | $          | 3,019                                                                          |       | $                                                                             | 3,409      |   | $ | 3,409 |   |

 

**Note 4 —****RestrictedAssets (Certificates of Deposit), Surety Bonds and Deposits**

 

*Certificates of deposit.*

 

TheCompany holds a certificate of deposit (“CD”), which expires in July 2011,totaling approximately $161,000. The CD is collateral for bonding required bythe State of Wyoming, the State of Montana and the Federal Bureau of LandManagement. Because the Company intends to renew the CD in order to maintainits bonding requirements, the Company has included the CD in other noncurrentassets as of September 30, 2010. The issuer of the bond has commencedlitigation against the Company to increase its collateral position, althoughthis litigation was tolled through June 15, 2010 (see Note 9).

 

OnJanuary 1, 2010 the Company held two CDs for $604,000 and $964,000. These CDscollateralized letters of credit in favor of Powder River Energy Corporation (“PRECorp”)in order to secure power lines in the Recluse, Kirby, Deer Creek and CabinCreek areas. These CDs were to be renewed annually as the amount of the CDswould decrease over time as the Company paid down the capital cost recoveryamounts on its monthly billing. On February 14, 2010, the $604,000 CD waslowered to $513,000 and renewed on February 19, 2010. The $964,000 CD was setto expire on May 27, 2010. However, the Company was presented with anopportunity to pay the capital cost recovery work orders in full which wouldresult in a savings of approximately $282,000 in interest costs. On May 18,2010, the Company cashed the $513,000 CD and received approximately $506,000 inproceeds and on May 21, 2010, the Company cashed the second CD and receivedapproximately $966,000 in proceeds. On May 20, 2010 the Company wired $500,000to PRECorp and on May 28, 2010 the Company wired approximately $690,000 toPRECorp which fulfilled its obligation to 

PRECorp.In March 2010 the Company posted a cash security deposit to Powder River EnergyCorp. of approximately $225,000 to collateralize electrical usage in itsRecluse, Kirby, Deer Creek and Cabin Creek areas. In April 2007, the Companyissued a $1,000,000 letter of credit (“LOC”), which was collateralized by a CDin favor of Bitter Creek Pipelines, LLC to secure the construction of a highpressure pipeline and related compression facilities to the Company’s DeerCreek and Kirby areas. Bitter Creek 

 

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Pipelines,LLC drew approximately $858,000 on this LOC for compression services providedto the Company in 2009. In January of 2010, Bitter Creek Pipelines, LLC drewthe remaining balance of the CD collateralizing this LOC.

 

*Surety Bonds.*

 

FromJune 2009 through September 30, 2010, the Company posted idle well surety forapproximately $64,000 to the Wyoming Oil and Gas Conservation Commission. TheCommission has requested the Company make 18 monthly installments of $12,777for surety on wells that will need to be plugged by the Company. The suretyamount may be adjusted downward by the Commission if the Company successfullyplugs the proposed wells in question. In addition, the Company has included a$50,000 payment for bonding requirements in the Company’s Kirby Montana area.

 

*Deposits.*

 

The Company has includedapproximately $57,000 related to royalty payments in deposits. These amountsare included in Deposits in the accompanying balance sheet at September 30,2010.

 

**Note 5 — Derivatives**

 

TheCompany has elected not to designate its derivatives as cash flow hedges underauthoritative guidance prescribed by the FASB. These derivative instruments aremarked to market at the end of each reporting period and changes in the fairvalue are recorded in the accompanying statements of operations. The aggregatefair values of these contracts were estimated to be an asset totaling $775,000and a liability of $862,000 at September 30, 2010 and 2009, respectively. TheCompany realized hedging gains of $796,000 and $2,038,000 for the quartersended September 30, 2010 and 2009, respectively. As a result of the change inthe fair value of the commodity derivatives, the Company had an unrealized lossof $129,000 for the quarter ended September 30, 2010 and an unrealized loss of$3,074,000 for the quarter ended September 30, 2009. For the nine months endedSeptember 30, 2010, the Company realized a hedging gain of $920,000 compared toa hedging gain of $5,548,000 for the nine months ended September 30, 2009. Forthe nine months ended September 30, 2010, the Company had an unrealized gain of$2,149,000 compared to an unrealized loss of $5,207,000 for the nine monthsended September 30, 2009. The aggregate of these contracts resulted in a gainon derivatives of $3,070,000 and $341,000 for the nine months ended September30, 2010 and 2009, respectively. Unrealized gains and losses are included ingains or losses on derivatives in the statement of operations. Realized gainsand losses are included in revenues in the statements of operations. As ofSeptember 30, 2010 and 2009, the Company had natural gas hedges in place asfollows:

 

As of September 30, 2010 and2009, the Company had natural gas hedges in place as follows: 

 
| **Product and Type of Hedging Contract** | ** ** | **MMbtu Per********Day** | ** ** | **Fixed Price********Range********CIG Index Price** | ** ** | **Time********Period** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------------|------------|--------------------------------------------------------------------|------------|------------------------|------------|
| September 30, 2010 (unaudited)                                    |       |                          |       |                                                               |       |                   |       |
| Natural Gas—Swap                                             |       | 2,000                         |       | $4.48                                                              |       | 01/10-12/10            |       |
| Natural Gas—Swap                                             |       | 1,000                         |       | $5.50                                                              |       | 01/10-12/10            |       |
| Natural Gas—Swap                                             |       | 2,500                         |       | $5.40                                                              |       | 05/10-12/10            |       |
| September 30, 2009 (unaudited)                                    |       |                          |       |                                                               |       |                   |       |
| Natural Gas—Collar                                           |       | 2,000                         |       | $6.50–$7.50                                                   |       | 01/09-12/09            |       |
| Natural Gas—Swap                                             |       | 2,500                         |       | $7.17                                                              |       | 01/09-12/09            |       |
| Natural Gas—Swap                                             |       | 1,000                         |       | $4.00                                                              |       | 06/09-12/09            |       |
| Natural Gas—Swap                                             |       | 2,500                         |       | $3.45                                                              |       | 05/09-04/10            |       |
| Natural Gas—Swap                                             |       | 2,000                         |       | $4.48                                                              |       | 01/10-12/10            |       |
| Natural Gas—Swap                                             |       | 2,500                         |       | $5.40                                                              |       | 05/10-12/10            |       |
| Natural Gas—Collar                                           |       | 1,000                         |       | $5.50                                                              |       | 01/10-12/10            |       |

 
| ** **                   | ** ** | **Location on  Consolidated  Balance Sheet** | ** ** | **Fair Value at  September 30,  2010** | ** ** |
|------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                   | ** ** | ** **                                             | ** ** | **(in thousands)**                               | ** ** |
| Derivative Assets:           |       |                                                   | ** ** |                                                  | ** ** |
| Natural gas, commodity swaps |       | Current asset                                          |       | $                                                     | 775        |   |
| Total derivative assets      |       |                                                   |       | $                                                     | 775        |   |

 

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TheCompany is exposed to credit risk to the extent of nonperformance by thecounterparties in the derivative contracts discussed above; however, theCompany does not anticipate such nonperformance.

 

The Company’s most recentwaiver with its lender expired on June 15, 2010.  On July 8, 2010,the Company was notified by its lender that it failed to make the principal andinterest payments due on July 1, 2010 and that such missed payments constitutedan Event of Default under the credit agreement.  On October 28, 2010, theadministrative agent of the credit facility notified the counterparty to theCompany’s derivative contracts that an Event of Default had occurred andadvised the counterparty to remit funds directly to the administrativeagent.  On November 5, 2010, the counterparty to the Company’s derivativetransactions advised the Company that funds ($363,000 for November 2010) willbe held in escrow pending further investigation of the administrative agent’srequest or additional direction from the Company.

 

**Note 6 — Stock Based Compensation**

 

*Options under Stock Incentive Plan*

 

The Company has adopted a stock incentive plan authorizing the grant ofboth incentive and non-statutory stock options. All options allow for thepurchase of common stock at prices not less than the fair market value of suchstock at the date of grant. If the option holder owns more than 10% of thetotal combined voting power of all classes of the Company’s stock, the exerciseprice cannot be less than 110% of the fair market value of such stock at thedate of grant.

 

Options granted under theplan become vested as directed by the Company’s Board of Directors andgenerally expire seven or ten years after the date of grant, unless the optionholder owns more than 10% of the total combined voting power of all classes ofthe Company’s stock, in which case the non-statutory stock options must beexercised within five years of the date of grant. At September 30, 2010, therewere options to purchase 630,000 shares granted under the plan.

 

Theoptions granted since formation in September 2003 vest in general asfollows:

 
| Year 1 |   | 20  | % |
|--------|--------|-----|---|
| Year 2 |   | 30  | % |
| Year 3 |   | 50  | % |
|   |   | 100 | % |

 

Duringthe three and nine months ended September 30, 2010, the Company did not grantany options to purchase common stock. During the three and nine months endedSeptember 30, 2010 the Company recognized an expense of approximately $0 and$25,000, respectively, based on the fair value of the vested options.

 

Thefollowing table summarizes stock option activity for the nine months endedSeptember 30, 2010:

 
| ** **                                  | ** ** | **Number of********Shares** | ** ** | **Weighted Average********Exercise Price********Per Share** | ** ** | **Weighted********Average********Remaining********Contractual Life** | ** ** | **Aggregate********Intrinsic value** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| Outstanding, December 31, 2009         |       | 640,000                          |       | $                                                                          | 5.81       |                                                                      | —     |                                      | —     |   |
| Canceled or forfeited                       |       | (10,000                          | )          | 8.40                                                                       |       | —                                                                    |       | —                                    |       |
| Outstanding, September 30, 2010 (unaudited) |       | 630,000                          |       | $                                                                          | 5.77       |                                                                      | 1.57       |                                      | $          | — |   |
| Exercisable, September 30, 2010 (unaudited) |       | 630,000                          |       | $                                                                          | 5.77       |                                                                      | 1.57       |                                      | $          | — |   |

 

Thefollowing table summarizes information about stock options outstanding atSeptember 30, 2010: 

 
| ** **               | ** ** | **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                                             |       | 0.1 years                                                                 |       | 137,500                       |       | $ | 4.00 |   | Black-Scholes  (minimum value) |   |
| $4.80                    |       | 265,000                                             |       | 1.5 years                                                                 |       | 265,000                       |       | $ | 4.80 |   | Black-Scholes  (minimum value) |   |
| $5.20                    |       | 112,500                                             |       | 2.3 years                                                                 |       | 112,500                       |       | $ | 5.20 |   | Black-Scholes |   |
| $8.40                    |       | 15,000                                              |       | 3.7 years                                                                 |       | 15,000                        |       | $ | 8.40 |   | Black-Scholes |   |
| $11.00                   |       | 100,000                                             |       | 2.7 years                                                                 |       | 100,000                       |       | $ | 11.00 |   | Black-Scholes |   |
| Total                    |       | 630,000                                             |       |                                                                      |       | 630,000                       |       |   |   |   |   |

 

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*Stock Appreciation rights under the Stock Incentive Plan*

 

TheCompany has adopted a stock incentive plan authorizing the grant of Stock AppreciationRights (“SARs”). A SAR confers on the participant a right to receive, uponexercise, the excess of the fair market value of a share of Common Stock on thedate of the exercise over $1.00. Such excess shall be paid in cash or commonstock or a combination thereof to the participant. On June 1, 2009,202,280 SARs were granted and 183,412 were outstanding as of September 30,2010.

 

TheSARs granted in September 2010 vest in general as follows:

 
| Year 1 |   | 33.33  | % |
|--------|--------|--------|---|
| Year 2 |   | 33.33  | % |
| Year 3 |   | 33.34  | % |
|   |   | 100.00 | % |

 

AtSeptember 30, 2010 the Company had unvested options to purchase 115,991 shareswith a weighted average grant date fair market value of $38,000. During thethree and nine months ended September 30, 2010 the Company recognizedcompensation expense of approximately $6,000 and $18,000 respectively on thefair value of SAR’s vested.

 

Thefollowing table summarizes stock appreciation activity for the six months endedSeptember 30, 2010:

 
| ** **                                    | ** ** | **Shares** | ** ** | **Weighted-********Average********Grant-Date********Fair Value** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** |
|-----------------------------------------------|------------|------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Outstanding at December 31, 2009              |       | 202,280    |       | 0.41                                                                  |       | —                                              |       |
| Canceled or forfeited                         |       | (18,868    | )          | —                                                                |       | —                                              |       |
| Outstanding at September 30, 2010 (unaudited) |       | 183,412    |       | $                                                                     | 0.41       |                                                | 5.7        |   |
|                                               |            |            |            |                                                                       |            |                                                     |            |  |

 

*Restricted Stock under the Stock Incentive Plan*

 

TheCompany has an incentive program whereby grants of restricted stock have beenawarded to members of the Board of Directors and certain employees.Restrictions and vesting periods for the awards are determined at thediscretion of the Board of Directors and are set forth in the award agreements.During the three and nine months ended September 30, 2010, the Companyrecognized compensation expense of approximately $58,000 and $245,000,respectively, based on the fair value of the vested shares.

 

A summary of the status and activity of therestricted stock for the six months ended September 30, 2010 is presentedbelow:

 
| ** **                                 | ** ** | **Shares** | ** ** | **Weighted-********Average********Grant-Date********Fair Value** | ** ** |
|--------------------------------------------|------------|------------|------------|-----------------------------------------------------------------------|------------|
| Unvested December 31, 2009            |       | 342,993    |       | $                                                                     | 2.18       |   |
| Granted                                    |       | 212,502    |       | $                                                                     | 0.31       |   |
| Forfeited                                  |       | (23,815    | )          | $                                                                     | 1.03       |   |
| Vested                                     |       | (345,898   | )          | $                                                                     | 1.18       |   |
| Unvested at September 30, 2010 (unaudited) |       | 185,782    |       | $                                                                     | 2.06       |   |

 

Asof September 30, 2010, the Company had approximately $0.3 million ofunrecognized share-based compensation expense related to non-vested stockawards, which is expected to be amortized over the remaining vesting periods ofthree years.

 

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**Note 7 — Long-Term Debt**

 

*Credit Facility*

 

EffectiveFebruary 12, 2007, the Company entered into a credit facility which permitsborrowings up to the borrowing base as designated by the administrative agent.As of September 30, 2010 and December 31, 2009, the Company had $5.1 millionand $6.1 million, respectively, of debt outstanding under the facility. Asdescribed below, the Company is currently unable to borrow additional amountsunder the credit facility due to covenant and borrowing base limitations andmay be further limited in the future based on borrowing base limitations.

 

Asof December 31, 2008, the borrowing base under the credit facility wasapproximately $13.2 million. The borrowing base was subject to automaticreductions for approximately $666,667 per month until it reached $10.5 millionon April 1, 2009. As of April 14, 2009, the borrowing base was further reducedto $9.0 million, subject to automatic reductions of $500,000 per month until itreached $6.5 million on October 1, 2009. As of October 20, 2009, the borrowingbase was subject to automatic reductions of $200,000 per month until it reachesmaturity or until a redetermination is received.

 

Theborrowing base is determined on a semi-annual basis and at such otheradditional times, up to twice yearly, as may be requested by either the Companyor the administrative agent and is determined by the administrative agent inaccordance with customary practices and standards for loans of a similarnature, although such determination is at the administrative agent’s discretionas the credit agreement does not provide a specific borrowing base formula.

 

Borrowingsunder this credit facility may be used solely to acquire, explore or developoil and gas properties and for general corporate purposes. The credit facilitymatured June 15, 2010.

 

TheCompany’s obligations under the credit facility are secured by liens on (i) noless than 90% of the net present value of the oil and gas to be produced fromits oil and gas properties that are included in the borrowing basedetermination, calculated using a discount rate of 10% per annum and reserveestimates, prices and production rates and costs, (ii) options to lease,seismic options, permits, and records related to such properties, and (iii)seismic data.

 

Borrowingsunder the Company’s credit facility, as amended, bear interest either: (i) atthe greater of the one month London Interbank Offered Rate, or LIBOR, plus1.00% or a domestic bank rate, plus in either case an applicable margin of0.75% to 1.75% based on utilization, or (ii) on a sliding scale from the one,two, three or six month LIBOR, plus an applicable margin of 2.00% to 3.00%based on utilization. The weighted average interest rate as of September 30,2010 was 5.0%. The credit agreement provides for various fees, including a quarterlycommitment fee of 0.5% per annum and engineering fees to the administrativeagent in connection with a borrowing base determination. In addition, thecredit facility provided for an up front fee of $27,000, which was paid on theclosing date of the credit facility, and an additional arrangement fee of 1%based on utilization. Borrowings under this credit facility may be prepaidwithout premium or penalty, except on Eurodollar advances.

 

TheCredit agreement contains covenants that, among other things, restrict theCompany’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.

 

Withregard to hedging arrangements, the credit agreement provides that acceptablecommodity hedging arrangements cannot be greater than 80 to 85%, depending onthe measurement date, of the Company’s monthly production 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.

 

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Thecredit agreement, as amended, also requires that the Company satisfy certainaffirmative covenants, meet certain financial tests, maintain certain financialratios and make certain customary indemnifications to lenders and theadministrative agent. The financial covenants include requirements to maintain:(i) a ratio of EBITDA to cash interest expense of not less than 3.00 to1.00, (ii) a ratio of current assets to current liabilities of not lessthan 1.00 to 1.00, (iii) a total debt to annualized EBITDA ratio of notmore than 3.0 to 1.0, (iv) a quarterly total senior debt to annualizedEBITDA ratio equal to or less than 3.0 to 1.0, and (v) a total provedPV-10 value to total debt ratio of at least 1.50 to 1.00.

 

Thecredit agreement, as amended, contains customary events of default, includingpayment defaults, covenant defaults, certain events of bankruptcy andinsolvency, defaults in the payment of other material debt, judgment defaults,breaches of representations and warranties, loss of material permits andlicenses and a change in control. The credit agreement requires anywholly-owned subsidiaries to guarantee the obligations under the creditagreement.

 

After an event of default,the outstanding debt bears interest at the default rate under the terms of thecredit agreement. The default rate is (i) with respect to principal, 2%over the otherwise applicable rate and (ii) with respect to interest, feesand other amounts, the Base Rate (as defined in the credit agreement), plus theApplicable Margin (as defined in the credit agreement), plus 2%. Any defaultinterest is payable on demand. Failure to pay the default interest when theadministrative agent demands would be another default. The lenders’ remediesfor defaults under the credit agreement are to terminate further borrowings,accelerate the repayment of indebtedness and/or ultimately foreclose on thecollateral property.

 

OnApril 14, 2009, the Company and the administrative agent entered into thefourth amendment to the credit agreement which reduced the borrowing base asdescribed above and waived compliance with the current ratio financial covenantas of December 31, 2009 and March 31, 2009 and with the restrictivecovenants related to accounts payable, permitted liens and permitted debt untilthe next borrowing base redetermination, subject to certain financialcaps.  On August 19, 2009, thelenders waived compliance with the current ratio financial covenant under thecredit agreement for the period ending August 26, 2009 and the quarterending September 30, 2009.

 

OnAugust 26, 2009, the Company and the lenders entered into a fifth amendment tothe credit agreement which provided a waiver of the current ratio covenantthrough October 26, 2009 and for the quarter ending September 30, 2009.  The fifth amendment to the credit agreementalso extended restrictive covenants related to accounts payable, permittedliens and permitted debt until October 26, 2009 subject to certain financialcaps.

 

OnOctober 20, 2009, the Company and the Lenders executed the Sixth Amendment tothe credit agreement.  This amendmentestablished the Borrowing Base for the following amounts in the followingapplicable periods:

 
| December 1, 2009 through December 31, 2009 |   | $ | 6,300,000 |   |
|--------------------------------------------|--------|---|-----------|--------|
| January 1, 2010 through January 31, 2010   |   | $ | 6,100,000 |   |
| February 1, 2010 through February 28, 2010 |   | $ | 5,900,000 |   |
| March 1, 2010 through March 31, 2010       |   | $ | 5,700,000 |   |
| April 1, 2010 through April 30, 2010       |   | $ | 5,500,000 |   |

 

EachCalendar month thereafter commencing May 1, 2010; the Borrowing Base for thepreceding calendar month will be reduced by $200,000.

 

OnOctober 26, 2009, the lenders provided a waiver effectively extending the termsof the fifth amendment to the Credit agreement through November 16, 2009.  On November 16, 2009, the lenders provided anadditional waiver effectively extending the terms of the fifth amendment to theCredit agreement through November 23, 2009.

 

OnNovember 23, 2009, the lenders provided an additional waiver extending theterms of the fifth amendment to the credit agreement through December 1, 2009and for the quarter ended December 31, 2009.

 

OnDecember 1, 2009 the lenders provided an additional waiver extending the termsof the fifth amendment to the credit agreement through January 5, 2010.

 

OnJanuary 5, 2010 the lenders provided an additional waiver extending the termsof the fifth amendment to the credit agreement through January 12, 2010.

 

On January 13, 2010, the Company entered into aseventh amendment and waiver to credit agreement (“*waiver agreement*”) with the lenders party thereto. Thewaiver agreement provided that the lenders would waive (i) its compliance withcertain restrictions

 

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based on the current ratio in the credit agreement,(ii) certain requirements pertaining to the aging of certain accounts payable,and (iii) certain restrictions regarding the amount of liens the Company has.Default remedies available to the lenders under the credit agreement includeacceleration of all principal and interest amounts due under the creditagreement. The waiver agreement extends the waiver period for these items until the earlier of June 15, 2010 and the date of anydefault arising out of a breach or non-compliance with the credit agreement notexpressly waived in the waiver agreement or a breach of the waiver agreement.

 

In addition, the waiver agreement amends the definition of “Final MaturityDate” under the credit agreement to the earlier of (i) June 15, 2010 or (ii)the date that is thirty days following the earlier of (A) the date the mergeris withdrawn or terminated in whole or in part or (B) the date that the lendershave been advised that the merger will not proceed.

 

On July 8, 2010, the Company was notified by its lender that it failed tomake the principal and interest payments due on July 1, 2010 and that suchmissed payments constituted an Events of Default under the Credit agreement.The Company remains obligated to pay all amounts outstanding under the creditagreement. The current amount outstanding under the credit facility isapproximately $5,100,000 plus accrued interest.

 

TheCompany has requested additional waivers from its lender; however, no waivershave been obtained to date. On October 28, 2010, the administrative agent ofthe Company’s credit facility notified the counterparty to the Company’sderivative contracts that an Event of Default had occurred. Further, theadministrative agent, pursuant to Section 5.1 (and Article VI) of the creditagreement, advised the counterparty to withhold funds payable to the Companyand remit these funds directly to the administrative agent. The counterparty tothe Company’s derivative transactions, by letter dated November 5, 2010, hasadvised the Company that funds payable to Pinnacle will be held in escrowpending further investigation of the administrative agent’s request oradditional direction from Pinnacle. Approximately $363,000 payable to theCompany by the counterparty on November 8, 2010 is being held in escrow.

 

Further,the Company’s lender has indicated that it will exercise additional remediesunder the credit agreement to obtain the Company’s liquid cash payments orother collateral.  The diversion of the Company’s liquid collateral willmaterially impact the Company’s abilitiy to meet its ongoing paymentobligations.  On November 8, 2010, Scotia Waterous (USA), Inc. provided a$0.5 million capital contribution to Powder Holdings, LLC to fund generalworking capital requirements of the Company’s pending closing, which isanticipated in the fourth quarter of 2010 subject to the satisfaction ofcertain closing conditions.  This capital will help the Company with itsimmediate capital needs, however it may still need to find other means tosatisfy its obligations prior to closing.

 

*Office Building Loan*

 

On November 15, 2005, the Company entered into amortgage loan secured by its office building in Sheridan, Wyoming in theaggregate principal amount of $829,000. Thepromissory note provides for monthly payments of principal and interest in theinitial amount of $6,400 and unpaid principal that bore interest at 6.875%until November 15, 2008, currently bears interest at a variable base rate plus0.5% and will bear interest at 18% upon a default. The variable base rate isbased on the lender’s base rate. The maturity date of this mortgage is November15, 2015, at which time a principal and interest payment of $520,800 willbecome due. As of September 30, 2010, the Company had $708,000 outstanding inprincipal on this mortgage. On November 15, 2008, the interest rate on themortgage loan changed from a fixed rate of 6.875% to a variable rate. As ofSeptember 30, 2010, the variable rate was 4.00%.

 

**Note 8 — Fair Value Measurements**

 

EffectiveJanuary 1, 2009, the Company adopted FASB’s guidance related to fair valuemeasurements for all financial assets and liabilities measured at fair value ona recurring basis. This criteria establishes a framework for measuring fairvalue and requires enhanced disclosures about fair value measurements. The guidance establishes a hierarchy for inputs used in measuring fairvalue that maximizes the use of observable inputs and minimizes the use ofunobservable inputs by requiring that the most observable inputs be used whenavailable. Observable inputs are inputs that market participants would use inpricing the asset or liability developed based on market data obtained fromsources independent of the Company. Unobservable inputs are inputs that reflectthe Company’s assumptions of what market participants would use in pricing theasset or liability based on the best information available in thecircumstances. The financial and nonfinancial assets and liabilities areclassified based on the lowest level of input that is significant to the fairvalue measurement. The hierarchy is broken down into three levels based on thereliability of the inputs as follows:

 

Level1—Quoted prices in active markets for identical assets or liabilities;

Level2—Quoted prices in active markets for similar assets and liabilities, that areobservable for the asset or liability; or

Level3—Unobservable pricing inputs that are generally less observable from objectivesources, such as discounted cash flow models or valuations.

 

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Thefollowing is a listing of the Company’s assets and liabilities required to bemeasured at fair value on a recurring basis and where they are classifiedwithin the hierarchy as of September 30, 2010 (in thousands):

 
| ** **                          | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|-------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|-----------|------------|
| Assets                              |       |             |       |             |       |             |       |      |       |
| Oil and gas derivative  instruments |       | $                | —     |             | $          | 775              |       | $         | —     |   | $ | 775 |   |
| Total                               |       | $                | —     |             | $          | 775              |       | $         | —     |   | $ | 775 |   |

 

TheCompany adopted FASB ASC Update 2010-06, “Fair Value Measurements andDisclosures” which amends ASC Update 2010-06 to require additional disclosuresconcerning transfers between Levels 1 and 2, inputs and valuation techniquesused to value Level 2 and 3 measurements, and push down of previously prescribedfair value disclosures to each class of asset and liability for Levels 1, 2,and 3. The Company determines the fair value of these swap contracts under theincome approach using a discounted cash flow model. The valuation modelrequires a variety of inputs, including contractual terms, projected gas marketprices, discount rate, and credit risk adjustments, as appropriate. The Companyhas consistently applied this valuation technique in all periods presented andbelieves it has obtained the most accurate information available for the typesof derivative instruments it holds. These disclosures were effective for theCompany for the quarter ended June 30, 2010. The adoption of this pronouncementdid not have a material impact on the Company’s consolidated financialstatements.

 

TheCompany’s estimate of the fair value of derivative financial instrumentsincludes consideration of the counterparty’s credit worthiness, the Company’scredit worthiness, and the time value of money. The consideration of these factorsresults in an estimated exit-price for each derivative asset or liability undera market place participant’s view.

 

**Note 9 —Commitments and Contingencies**

 

*Operating Lease*

 

Uponpurchase of its building in August 2005, the Company was assigned the leaseagreements for existing tenants and executed lease agreements with new tenantsin the building. The leases expire from January 2010 to January 2013. Futureminimum lease income under noncancelable operating leases is as follows:

 
| **Year Ending December 31:** | ** ** | ** ** | ** **    |
|---------------------------------------------|------------|------------|---------------|
| 2010                                        |       | $          |  34,000  |   |
| 2011                                        |       | 60,000     |          |
| 2012                                        |       | 44,000     |          |
| 2013                                        |       | 44,000     |          |
| Total minimum lease payments                |       | $          |  182,000 |   |

 

*GasGathering Contracts*

 

TheCompany has entered into gas gathering and compression agreements with serviceproviders in order to compress and transport its gas to the point of sale.Compression agreements and gathering agreements are based on a fee per Mcfeither compressed or gathered. The Company accounts for these fees as amarketing and transportation expense. The Company does not pay or chargemarketing fees associated with the movement and sale of natural gas.

 

*Litigation*

 

From time to time, the Company is subject to legal proceedings andclaims that arise in the ordinary course of its business. In addition, likeother natural gas and oil producers and marketers, the Company’s operations aresubject to extensive and rapidly changing federal and state environmental,health and safety and other laws and regulations governing air emissions,wastewater discharges, and solid and hazardous waste management activities. Asa result, it is extremely difficult to reasonably quantify future environmentaland regulatory related expenditures.

 

The following represent legal actions in which the Company is involved.No assurance can be given that these legal actions will be resolved in theCompany’s favor. However, the Company’s management believes, based on itsexperiences to date, that these matters will not have a material adverse impacton the Company’s business, financial position or results of operations.

 

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The Company, together with the State of Montana, the Montana Departmentof Environmental Quality, the Montana Board of Oil and Gas Conservation and theDepartment of Natural Resources, were named as defendants in a lawsuit (CivilCause No. DV-05-27) filed on May 19, 2005 in the Montana22nd Judicial District Court, Bighorn County by Diamond Cross Properties, LLCrelating to the Coal Creek POD. The plaintiff is a surface owner withproperties located in Big Horn County and Rosebud County, Montana where theCompany has a lease for approximately 10,300 acres, serves as operator and ownsa working interest in the minerals under lease. The plaintiff sought topermanently enjoin the State of Montana and its administrative bodies fromissuing licenses or permits, or authorizing the removal of ground water fromunder the plaintiff’s ranch. In addition, the plaintiff further sought topreliminarily and permanently enjoin the Company on the basis that the Company’soperations lacked adequate safeguards required under the Montana stateconstitution. On August 25, 2005, the district judge issued an orderdenying without prejudice the application for temporary restraining order andpreliminary injunction requested by the plaintiff. The case was appealed by theplaintiff to the Montana Supreme Court. On November 16, 2005, the MontanaSupreme Court issued an order that denied enjoining the Coal Creek POD, andsubsequently, the Montana Supreme Court remanded the case back to the districtcourt for a decision on the merits.

 

The Company, together with the defendants above, was also named asdefendants in a related lawsuit (Civil Cause No. DV-05-70) filed onSeptember 21, 2005 in the Montana 22nd Judicial District Court,Bighorn County by Diamond Cross Properties, LLC relating to the Dietz POD.The plaintiff sought similar relief as in the Coal Creek POD suit. The twocases were combined.

 

On July 14, 2008, the district court issued a summary judgmentorder in the combined case, and the order was subsequently entered as ajudgment on August 15, 2008. As a result, the Company has continued itsoperations in the two project areas. To date, there has been no appeal by theplaintiff.

 

In April and September 2005, the U.S. Bureau of LandManagement in Miles City, Montana issued suspensions of operations for themajority of the Company’s federal leases in Montana. The suspensions were issuedbased upon a court order issued on April 5, 2005 by the U.S. DistrictCourt of Montana that required the BLM to complete a Supplemental EnvironmentalImpact Statement (SEIS) to address phased development of coal bed natural gas.The U.S. Ninth Circuit Court of Appeals also issued an order on May 31,2005 which enjoined the BLM from approving coal bed natural gas productionprojects in the Powder River Basin of Montana. Both of these actions placedlimitations on lease development until completion of the SEIS.

 

The 2005 injunction was lifted by the Ninth Circuit Court of Appeals onOctober 29, 2007. The record of decision (ROD) for the SEIS was signed bythe BLM on December 30, 2008 and went into effect on January 14,2009. The Suspension of Operations and Production for the suspended leases wasterminated effective February 1, 2009. The Company has received lettersfrom the BLM with amended lease terms of the affected leases. Leases that weresuspended have been placed back into an active lease status with the primaryterm increasing for approximately three to five years based on the time periodthe leases were in suspension.

 

On July 6, 2009, the Company filed suit (Cause No. DV09-35)against Big Sky Energy LLC and Quaneco L.L.C., in the Twenty-Second JudicialDistrict Court, Big Horn County, Montana alleging claims for breach ofcontract, breach of implied covenant of good faith and fair dealing, tortuousinterference with business, tortuous interference with contractual relationsand slander of title. The Company is amending the complaint to add aforeclosure action against Big Sky Energy LLC’s and Quaneco L.L.C.’scollective interest in the developed properties in Montana for non payment ofinvoices in the amount of $792,624.

 

The Company will continue to vigorously pursue payment of the amountsowed including interest and attorney’s fees along with foreclosure proceedingsand any other rights and remedies available to us pursuant to the JointOperating Agreement dated June 23, 2003, as amended.

 

The Company was named as a defendant in litigation brought by RLIInsurance Company (Civil Cause No. 09-CV-157-J) filed in United StatesDistrict Court for the District of Wyoming on July 6, 2009.  The complaint alleged that the Company failedto provide $1,439,360 in additional collateral requested by plaintiff to securecertain bonds issued by plaintiff on behalf of the Company.  Plaintiff sought the additional bondcollateral plus attorney’s fees and costs. On March 18, 2010, Pinnacle Gas Resources, Inc. and RLIInsurance Company entered into a Tolling Agreement.  The agreement stipulated that the partiesdismiss all claims and counterclaims in the litigation captioned RLI InsuranceCompany v. Pinnacle Gas Resources, Inc., Case No. 09-CV-157-J (D.Wyo.), without prejudice.  The agreementfurther stipulated that each party will extend the period within which eitherparty may institute a claim, counterclaim, action or proceeding up to andincluding June 16, 2010.  Theagreement also obligated The Company to continue to solicit market quotes forthe purpose of replacing all bonds or bonding relationships which exist betweenthe Company and RLI Insurance Company. The Tolling Agreement has lapsed and, to the Company’s knowledge on thedate hereof, RLI Insurance Company has not re-filed its claims against theCompany.

 

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TheCompany is a party to two stockholder class action lawsuit filed in theDelaware Court of Chancery.  OnMarch 24, 2010, the Delaware Court of Chancery entered an orderconsolidating the two actions under the caption In re Pinnacle Gas ResourcesShareholder Litigation, C.A. No. 5313-CC (Del. Ch.) and appointing co-leadcounsel.

 

Theconsolidated complaint generally alleges that our directors breached theirfiduciary duties by, among other things, entering into the merger agreementwith Powder and Powder Holdings, taking actions designed to deter higher offersfrom other potential acquirers and failing to maximize the value of Pinnacle toits stockholders. In addition, the lawsuit alleges that DLJ, as a controllingstockholder of Pinnacle, violated fiduciary duties to Pinnacle stock holdersand that Powder and Merger Sub aided and abetted the alleged breaches offiduciary duties by the other defendants. The lawsuit seeks, among other relief, injunctive relief prohibiting theMerger, and costs of the action including reasonable attorneys’ fees.

 

OnMay 24, 2010, the Company and its directors entered into a Memorandum ofUnderstanding in anticipation of settling the shareholder lawsuit. Under theterms of the Memorandum of Understanding, the Company agreed to make additionalproxy disclosures regarding the interests of our executive officers in thesurviving entity and furnish additional information regarding FBR’s analysisand fairness opinion. In return the shareholders will provide a release oftheir claims against the Company, its directors, Powder and DLJ.  The Company and its directors, Powder and DLJdo not admit any wrongdoing and entered into the Memorandum of Understanding toavoid the distraction, burden and expense of further litigation. The settlementis subject to confirmatory discovery, negotiation of a definitive settlementagreement, and approval by the Delaware Chancery Court. The Memorandum ofUnderstanding is also conditioned upon consummation of the merger. Powder andDLJ have agreed to the terms of the Memorandum of Understanding.

 

*Regulations*

 

The Company’s oil and gas operations are subject to various federal,state and local laws and regulations. The Company could incur significantexpense to comply with the new or existing laws and non-compliance could have amaterial adverse effect on the Company’s operations.

 

*Environmental*

 

The Company produces significant amounts of water from its wells. Iffuture wells produce water of a lesser quality than allowed under state laws orif water is produced at rates greater than the Company can dispose of, theCompany could incur additional costs to dispose of the water.

 

**Note 10 — *NASDAQ Delisting***

 

On March 16, 2010, The NASDAQ Stock Market notified the Company ofits failure to comply with Listing Rule 5450(a)(1). Thisrule subjects a company’s stock to delisting on the NASDAQ exchange if itsstock price closes below $1 over the previous 30 consecutive business daysand then, after notification, fails to regain compliance within the subsequent180 days. Accordingly, unless the Company appealed this determination, thetrading of the Company’s stock would have been suspended on March 25,2010. The Company filed an appeal, pursuant to NASDAQ listingrule series 5800 on March 22, 2010.

 

OnApril 29, 2010, the Company met with representatives of NASDAQ to formallyrequest a 180 day extension to allow implementation of certain strategies toregain compliance.

 

OnMay 10, 2010, the Company received a determination letter from the NASDAQhearings panel granting the Company’s request for continued listing subject toa proxy being filed which included a proposal for a reverse stock split and aclosing bid price of $1.00 or more for a minimum of ten consecutive tradingdays prior to September 13, 2010.

 

On September 15, 2010, theCompany received written notice from NASDAQ that its shares of common stockwould be delisted from The NASDAQ Stock Market effective at the open of tradingon September 16, 2010 since it failed to meet the continued listingrequirements.

 

As of September 16, 2010,common shares of Pinnacle Gas Resources, Inc. are traded on the OTCQBMarketplace.

 

**Note 11 — Recent Developments**

 

The Company’s most recentwaiver with its lender expired on June 15, 2010.  On July 8, 2010,the Company was notified by its lender that it failed to make the principal andinterest payments due on July 1, 2010 and that such missed payments constitutedan Event of Default under the credit agreement.  On October 28, 2010, theadministrative agent of the credit facility notified the counterparty to theCompany’s derivative contracts that an Event of Default had occurred andadvised the counterparty to remit funds directly to the administrativeagent.  On November 5, 2010, the counterparty to the Company’s derivativetransactions advised the

 

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Company that funds ($363,000for November 2010) will be held in escrow pending further investigation of theadministrative agent’s request or additional direction from the Company.

 

Further, the Compay’s lenderhas indicated that it will exercise additional remedies under the creditagreement to obtain the Company’s liquid cash payments or othercollateral.  The diversion of the Company’s liquid collateral willmaterially impact the Company’s ability to meet its ongoing paymentobligations.  On November 8, 2010, Scotia Waterous (USA), Inc. provided a$0.5 million capital contribution to Powder Holdings, LLC to fund generalworking capital requirements of the Company pending closing, which isanticipated in the fourth quarter of 2010 subject to the satisfaction ofcertain closing conditions.  This capital will help the Company with itsimmediate capital needs, however it will need to find other means to satisfyits obligations prior to closing.

 

Althoughthe Outside Date of the Merger Agreement has passed, the merger has not beenterminated.  The Company is currently working on an additional extension tothe Outside Date with Powder Acquisition Co. and Powder Holdings, LLC toprovide additional time for the parties to satisfy the conditions to closingfor the contemplated merger transaction, however there can be no assurance thatthis transaction will close.

 

********

 

**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS****OF OPERATIONS**

 

*Thediscussion and analysis that follows should be read together with the**accompanying financial statements and notes relatedthereto that are included**elsewherein this quarterly report on Form 10-Q. It includes forward looking**statements that may reflect our estimates,beliefs, plans and expected**performance.The forward looking statements are based upon events, risks and**uncertainties that may be outside our control. Ouractual results could differ**significantlyfrom those discussed in these forward looking statements. Factors**that could cause or contribute to these differencesinclude, but are not**limited to,market prices for natural gas and oil, regulatory changes,**estimates of proved reserves, economic conditions,competitive conditions,**developmentsuccess rates, capital expenditures and other uncertainties, as**well as those factors discussed below and elsewherein this quarterly report on**Form 10-Qand in our annual report on Form 10-K for the year ended December 31,**2009, including in “Risk Factors” and “CautionaryStatement Concerning Forward**LookingStatements,” all of which are difficult to predict. As a result of**these assumptions, risks and uncertainties, theforward looking matters**discussedmay not occur.*

 

**Overview**

 

Weare an independent energy company engaged in the acquisition, exploration anddevelopment of domestic onshore natural gas reserves. We primarily focus ourefforts on the development of CBM properties located in the Powder River Basinin northeastern Wyoming and southern Montana. In addition, in April 2006,we acquired properties located in the Green River Basin in southern Wyoming. Asof September 30, 2010, we owned natural gas and oil leasehold interests inapproximately 406,000 gross (297,000 net) acres, approximately 90% of whichwere undeveloped. As of December 31, 2009, we had estimated net provedreserves of approximately 15.0 Bcf based on the first day of the month, twelvemonth average CIG index price of approximately $3.04 per Mcf.

 

Thecontinued credit crisis and related turmoil in the global financial system havehad an adverse impact on our business and financial condition. In addition, theprices of oil and natural gas declined significantly in 2008 and have remainedlow in 2009 and during the first nine months of 2010. Therefore, total capitalexpenditures were limited to $4.2 million in 2009. As a result of low CIGindex prices, the economic climate and our limited capital resources, we expectto continue operating during 2010 with a reduced capital expenditure plan.Under our plan, we will generally make expenditures only as necessary to securedrilling permits in strategic areas, drill wells that secure leaseholdpositions and construct the necessary infrastructure to complete and hook-upwells that have already been drilled. Our capital expenditure budget for 2010will be dependent upon CIG index prices, our cash flows and the availability ofadditional capital resources.  We had total capital expenditures of $2.1million for the nine months ended September 30, 2010.

 

On February 23, 2010,we entered into an Agreement and Plan of Merger with Powder Holdings, LLC, andPowder Acquisition Co., a direct, wholly owned subsidiary of Powder Holdings.Powder Holdings is controlled by an investor group led by Scotia Waterous (USA)Inc. and includes certain members of our management team. On April 2,2010, we filed a preliminary proxy statement relating to the merger, with theU.S. Securities and Exchange Commission (SEC). On June 29, 2010, we fileda definitive proxy statement relating to the merger with the SEC. At thespecial meeting of the shareholders on August 9, 2010, our shareholdersvoted to approve a proposal to adopt the Agreement and Plan of Merger datedFebruary 23, 2010 (“Merger Agreement”) by and amongst us, Powder Holdings,LLC, and Powder Acquisition Co. (“Powder”), a wholly-owned subsidiary ofPowder. We anticipate that the closing will occur during the fourth quarter,subject to the satisfaction of customary closing conditions and the receipt ofwaivers from our lender, The Royal Bank of Scotland plc. On September 29, 2010we entered into an amendment to the Agreement

 

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and Plan of Merger (“MergerAgreement”) with Powder Acquisition Co. and Powder Holdings, LLC executed onFebruary 23, 2010. The amendment extended the Outside Date, as defined inSection 7.1(b)(i), from August 23, 2010 to October 29, 2010 to provideadditional time for the parties to satisfy the conditions to closing for thecontemplated merger transaction. Although the Outside Date of the MergerAgreement has passed, the merger has not been terminated.  We arecurrently working on an additional extension to the Outside Date with PowderAcquisition Co. and Powder Holdings, LLC to provide additional time for theparties to satisfy the conditions to closing for the contemplated mergertransaction, however there can be no assurance that this transaction willclose.

 

Sharesof our common stock are traded on the OTCQB under the symbol “PINN.”

 

**Economic and Natural Gas PricingEnvironment**

 

During 2009, the globaleconomy experienced a significant downturn. The downturn, which began overconcerns related to the U.S. financial markets, spread to other industries,including the energy industry. The initial effects of the downturn restrictedthe capital and credit markets to a degree that has not been seen in a numberof decades in the United States. We have been able to partially mitigate theconstraints imposed by the current economic climate through utilization of ourcredit facility and cash flows from operations.

 

The fear of global recessionled to an immediate drop in demand for natural gas, primarily by industrialusers, which in turn led to a significant reduction in natural gas prices. Thenatural gas index price in the Rocky Mountain region averaged $4.08 per Mcf forthe first nine months of 2010 and $2.77 per Mcf for the same period in 2009. Wehave curtailed drilling, except for wells that will hold significant blocks ofacreage, and have also reduced administrative, operating and transportationcosts. Even with cost reductions and a flexible capital spending budget, thecurrent natural gas pricing and economic environment remains challenging. Weare exploring strategic alternatives to increase our capital resources.

 

**Credit Facility and Liquidity**

 

In the past, our primary sources of liquidityhave been private and public sales of our equity securities, cash provided byoperating activities, and debt financing. All of these sources have been negativelyimpacted by the current economic climate, its impact on our industry, and bysignificant fluctuations in oil and gas prices, operating costs, and volumesproduced. We have no control over the market prices for oil and natural gas,although we are able to influence the amount of our net realized revenuesrelated to gas sales through the use of derivative contracts. A decrease inmarket prices would reduce expected cash flow from operating activities andcould reduce the borrowing base of our credit facility as well as the value ofassets we might consider selling. Historically, decreases in the market priceshave limited our industry’s access to the capital markets. During thesechallenging times, we have reduced our administrative, operating and transportationcosts. We are also actively marketing asset sales and exploring other strategicalternatives and capital restructuring options.

 

On January 13, 2010, we entered into aseventh amendment and waiver to credit agreement (“*waiver agreement*”) with the lenders party thereto. Thewaiver agreement provided that the lenders would waive (i) our compliancewith certain restrictions based on the current ratio in the credit agreement,(ii) certain requirements pertaining to the aging of certain accountspayable, and (iii) certain restrictions regarding the amount of liens wehave. Default remedies available to the lenders under the credit agreementinclude acceleration of all principal and interest amounts due under the creditagreement. The waiver agreement extends the waiver period for these items untilthe earlier of June 15, 2010 and the date of any default arising out of abreach or non-compliance with the credit agreement not expressly waived in thewaiver agreement or a breach of the waiver agreement.

 

In addition, the waiver agreement amends thedefinition of “Final Maturity Date” under the credit agreement to the earlierof (i) June 15, 2010 or (ii) the date that is thirty daysfollowing the earlier of (A) the date the merger (please see Note 10 inthe notes to the financial statements) is withdrawn or terminated in whole orin part or (B) the date that the lenders have been advised that the mergerwill not proceed.

 

On July 8, 2010, wewere notified by our lender that we failed to make the principal and interestpayments due on July 1, 2010 and that such missed payments constituted anEvent of Default under the Credit agreement. We remain obligated to pay allamounts outstanding under the credit agreement. The current amount outstanding under the credit facility isapproximately $5,100,000.

 

On October 28, 2010, theadministrative agent of the credit facility notified the counterparty to ourderivative contracts that an Event of Default had occurred and advised thecounterparty to remit funds directly to the administrative agent.  OnNovember 5,

 

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2010, the counterparty toour derivative transactions advised us that funds ($363,000 for November 2010)will be held in escrow pending further investigation of the administrativeagent’s request or additional direction from us.

 

Further, our lender hasindicated that it will exercise additional remedies under the credit agreementto obtain the our liquid cash payments or other collateral.  The diversionof our liquid collateral will materially impact its abilities to meet itsongoing payment obligations.  On November 8, 2010, Scotia Waterous (USA),Inc. provided a $.5 million capital contribution to Powder Holdings, LLC tofund general working capital requirements of our pending closing, which isanticipated in the fourth quarter of 2010 subject to the satisfaction ofcertain closing conditions.  This capital will help us with our immediatecapital needs, however we may still need to find other means to satisfy ourobligations prior to closing.

 

Wehave requested additional waivers from our lender; however, there can be noassurance that we will be able to obtain such waivers or that such waivers willbe obtained on acceptable terms. If we are unable to obtain future waiversand/or to comply with the restrictive covenants, the lender could foreclose onproperties held by liens.  Due to borrowing base limitations and waiverstipulations, we are currently unable to incur additional indebtedness underthe credit facility.

 

We have also implementedvarious cost cutting measures, including reducing general and administrativecosts through staff reductions, wage and benefit cuts and a hiring freeze.  We have reduced lease operating expenses byrenegotiating water disposal contracts, reducing service costs and temporarilyshutting-in marginal wells.  We continueto communicate with key vendors to manage our obligations and payables.  Management believes that appropriate steps,including cost-cutting measures, are being taken to make operations sustainablein the future.  Although we are pursuingvarious alternatives to provide additional liquidity, there is no assurance ofthe likelihood or timing of any of these transactions.****Wealso put additional hedges of our natural gas production in place to securecertain operating cash flow levels during 2010. From January throughApril 2010, we had 5,500 MMbtu per day hedged through fixed price swaps ata weighted average price of $4.19 per MMbtu. From May throughDecember 2010, we have 5,500 MMbtu hedged through fixed price swaps at aweighted average price of $5.08 per MMbtu. Although we are pursuing variousalternatives to provide additional liquidity, there is no assurance of thelikelihood or timing of any of these transactions.

 

**Critical Accounting Policies**

 

Themost subjective and complex judgments used in the preparation of our financialstatements are:

 

·**               **Reserve evaluation anddetermination;

 

·**               **Estimates of the timing andcost of our future drilling activity;

 

·**               **Estimates of the fairvaluation of hedges in place;

 

·**               **Estimates of timing and costof asset retirement obligations;

 

·**               **Estimates of the expense andtiming of exercise of stock options; and

 

·**               **Accruals of operating costs,capital expenditures and revenue.

 

·**               **Estimates for litigation.

 

***Oil and Gas Properties***

 

We use the full cost method of accounting for oil and gas producingactivities. Under this method, all costs associated with property acquisition,exploration and development, including costs of unsuccessful exploration, costsof surrendered and abandoned leaseholds, delay lease rentals and the fair valueof estimated future costs of site restoration, dismantlement and abandonmentactivities, are capitalized within a cost center. Our oil and gas propertiesare all located within the United States, which constitutes a single costcenter. We capitalize certain lease operating expenses associated withexploration and development of unevaluated oil and gas properties. No gain orloss is recognized upon the sale or abandonment of undeveloped or producing oiland gas 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.

 

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Depreciation, depletion and amortization of oil and gas properties arecomputed on the unit-of-production method based on proved reserves. Amortizablecosts include estimates of future development costs of proved undevelopedreserves and asset retirement obligations. We invest in unevaluated oil and gasproperties for the purpose of exploration for proved reserves. The costs ofsuch assets, including exploration costs on properties where a determination ofwhether proved oil and gas reserves will be established is still underevaluation, and any capitalized interest and lease operating expenses, 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. Noimpairment was recorded on unevaluated properties for the three and nine monthsended September 30, 2010. An impairment of $36.7 million was recorded onunevaluated properties for the three and nine months ended September 30, 2009.Abandonment of unproved properties is also accounted for as an adjustment tocapitalized costs related to proved oil and gas properties, with no lossesrecognized.

 

Substantially all remaining unproved property costs are expected to bedeveloped and included in the amortization base ratably over the next three tofive years. Salvage value is taken into account in determining depletion ratesand is based on our estimate of the value of equipment and supplies at the timethe well is abandoned. As of September 30, 2010 and December 31,2009, the estimated salvage value of equipment was $6.8 million.

 

Underthe full cost method of accounting rules, capitalized costs less accumulateddepletion and related deferred income taxes may not exceed a “ceiling” valuewhich is the sum of (1) the present value discounted at 10% of estimatedfuture net revenue using current costs and the first day of the month, twelvemonth average CIG price, including the effects of derivative instrumentsdesignated as cash flow hedges but excluding the future cash outflowsassociated with settling asset retirement obligations that have been accrued onthe balance sheet, less any related income tax effects; plus (2) the costof properties not being amortized, if any; plus (3) the lower of costs orestimated fair value of unproved properties; less (4) the income taxeffects related to differences in the book to tax basis of oil and gasproperties. This is referred to as the “full cost ceiling limitation.” Ifcapitalized costs exceed the limit, the excess must be charged to expense. Theexpense may not be reversed in future periods. At the end of each quarter, wecalculate the full cost ceiling limitation. At September 30, 2010, thefull cost ceiling limitation exceeded the capitalized cost of our oil and gasproperties by approximately $13.2 million based on the first day of the month,twelve month average CIG price of approximately $4.01 per Mcf. Therefore, noimpairment was taken for the quarter ended September 30, 2010. Animpairment of $34.6 million was taken for the quarter ended September 30,2009 based on a natural gas price of $3.22 per Mcf. A decline in gas prices oran increase in operating costs subsequent to the measurement date or reductionsin economically recoverable quantities could result in the recognition ofadditional impairments of our oil and gas properties in future periods.

 

***Gas Sales***

 

Weuse the sales method for recording natural gas sales. Sales of gas applicableto our interest in producing natural gas and oil leases are recorded asrevenues when the gas is metered and title transferred pursuant to the gassales contracts covering our interest in gas reserves. During such times as oursales of gas exceed our pro rata ownership in a well, such sales are recordedas revenues unless total sales from the well have exceeded our share ofestimated total gas reserves underlying the property at which time such excessis recorded as a gas imbalance liability. At September 30, 2010 andDecember 31, 2009, there was no such liability recorded.

 

Althoughthere was no such liability recorded for prior periods, gas reserves are anestimate and are updated on an annual and interim basis. Gas pricing, expensesand production may impact future gas reserves remaining which, in turn, couldimpact the recording of liabilities in the future. Gas sales accruals atSeptember 30, 2010, and December 31, 2009 were based on the actual volumestatements from our purchasers and distribution process. If accruals were tochange by 10% at September 30, 2010 and at December 31, 2009, the impactwould have been a change of $50,000 and $124,000, respectively.

 

***Asset Retirement Obligations***

 

Wefollow certain accounting provisions that apply to legal obligations associatedwith the retirement of long-lived assets that result from the acquisition,construction, development and/or the normal operation of a long-lived asset.These provisions requires us to recognize an estimated liability for costsassociated with the abandonment of our oil and gas properties.

 

Aliability for the fair value of an asset retirement obligation with acorresponding increase to the carrying value of the related long-lived asset isrecorded at the time a well is completed or acquired. The increased carryingvalue is depleted using the units-of-

 

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productionmethod, and the discounted liability is increased through accretion over theremaining life of the respective oil and gas properties.

 

Theestimated liability is based on historical gas industry experience in abandoningwells, including estimated economic lives, external estimates as to the cost toabandon the wells in the future and federal and state regulatory requirements.Our liability is discounted using our best estimate of our credit-adjustedrisk-free rate. Revisions to the liability could occur due to changes inestimated abandonment costs, changes in well economic lives or if federal orstate regulators enact new requirements regarding the abandonment of wells. Forexample, a 10% change in our estimated retirement costs would have had a$302,000 effect on our asset retirement obligation liability atSeptember 30, 2010.

 

The following is a summaryof our asset retirement obligation activity for the three and nine months endedSeptember 30, 2010 and September 30, 2009 (unaudited):

 
| ** **                                     | ** ** | **For the Three  Months ** | ** ** | **For the Nine** | ** ** | **For the Three** | ** ** | **For the Nine** | ** ** |
|------------------------------------------------|------------|-------------------------------------------|------------|----------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                     | ** ** | **Ended**                                 | ** ** | **Months Ended**      | ** ** | **Months Ended**       | ** ** | **Months Ended**      | ** ** |
| ** **                                     | ** ** | **September 30,**                    | ** ** | **September 30,**     | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                                     | ** ** | **2010**                                  | ** ** | **2009**                   | ** ** |
| ** **                                     | ** ** | **(In Thousands)**                   | ** ** |
| Beginning balance asset retirement obligations |       | $                                         | 2,995      |                       | $          | 2,937                       |       | $                          | 3,457      |   | $ | 3,366 |   |
| Additional obligation added during the period  |       | —                                    |       | 1                          |       | —                      |       | —                     |       |
| Obligations settled during the period          |       | (32                                       | )          | (81                        | )          | (106                        | )          | (129                       | )          |
| Accretion expense                              |       | 56                                        |       | 162                        |       | 58                          |       | 172                        |       |
| Ending balance of asset retirement obligations |       | $                                         | 3,019      |                       | $          | 3,019                       |       | $                          | 3,409      |   | $ | 3,409 |   |

 

***Inventory***

 

We have acquired inventory of oil and gas equipment, primarilytubulars, to take advantage of quantity pricing and to secure a readilyavailable supply. Inventory is valued at the lower of average cost or market.Inventory is used in the development of gas properties and to the extent it isestimated that it will be billed to other working interest owners during thenext year, it is included in current assets. Otherwise, it is recorded innon-current 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 have caused a $44,000 reduction in ourinventory valuation as of September 30, 2010. The market price of steel isevaluated each quarter using prices quoted by authorized vendors in the area.

 

***Property and Equipment***

 

Property and equipment iscomprised primarily of a building, computer hardware and software, vehicles andequipment, and is recorded at cost. Renewals and betterments that substantiallyextend the useful lives of the assets are capitalized. Maintenance and repairsare expensed when incurred. Depreciation and amortization are provided usingthe straight-line method over the estimated useful lives of the assets, rangingas follows: buildings — 30 years; computer hardware and software — 3 to 5years; machinery, equipment and vehicles — 5 years; and office furniture andequipment — 3 to 5 years.

 

***Long-Lived Assets***

 

Long-lived assets to be heldand used in our business are reviewed for impairment whenever events or changesin circumstances indicate that the related carrying amount may not berecoverable. When the carrying amounts of long-lived assets exceed the fairvalue, which is generally based on discounted expected future cash flows, werecord an impairment. No impairments were recorded during the nine months endedSeptember 30, 2010 and the year ended December 31, 2009.

 

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***General and Administrative Expenses***

 

Generaland administrative expenses are reported net of amounts allocated and billed toworking interest owners of gas properties operated by us. The administrativeexpenses billed to working interest owners may change in accordance with theterms of the joint operating agreements. Administrative expenses are charged toworking interest owners based on productive well counts.  A 10% change in well counts for the three andnine months ended September 30, 2010 would have increased or decreased ourexpenses billed to working interest owners by approximately $27,000 and $89,000,respectively. As we operate and drill additional wells in the future,additional administrative expenses will be charged to the working interestowners when the wells become productive.

 

***Income Taxes***

 

Weuse the asset and liability method of accounting for income taxes. Deferred taxassets and liabilities are recognized for the expected future tax consequencesof temporary differences between the financial statement and tax bases ofassets and liabilities. If appropriate, deferred tax assets are reduced by avaluation allowance which reflects expectations of the extent to which suchassets will be realized. As of September 30, 2010 and December 31, 2009,we recorded a full valuation allowance for our net deferred tax asset.

 

OnJanuary 1, 2007, we adopted accounting provisions that prescribe arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. This provision requires that we recognize in our consolidatedfinancial statements only those tax positions that are “more-likely-than-not”of being sustained as of the adoption date, based on the technical merits ofthe position. As a result of the implementation of the provision, we performeda comprehensive review of our material tax positions in accordance with theserecognition and measurement standards. As a result of this review, we did notidentify any material deferred tax assets that required adjustment. As ofSeptember 30, 2010 and 2009, we had not recorded any material uncertain taxpositions.

 

Ourpolicy is to recognize interest and penalties related to uncertain tax benefitsin income tax expense. As of September 30, 2010 and 2009, we had not recognizedany interest or penalties in our statement of operations or statement of financialposition.

 

We are subject to thefollowing material taxing jurisdictions: U.S. federal. We also have materialoperations in the state of Wyoming; however, Wyoming does not impose acorporate income tax. The tax years that remain open to examination by the U.S.Internal Revenue Service are years 2005 through 2009. Due to our net operatingloss carry forwards, the Internal Revenue Service may also adjust the amount ofloss realizable under examination back to 2003.

 

***Derivatives***

 

OnJuly 21, 2010, the Dodd-Frank Wall Street Reform and Consumer ProtectionAct was enacted into law.  This financial reform legislation includesprovisions that require over-the-counter derivative transactions to be executedthrough an exchange or centrally cleared.  In addition, the legislationprovides an exemption from mandatory clearing requirements based on regulationsto be developed by the Commodity Futures Trading Commission (CFTC) and theSecurities and Exchange Commission for transactions by non-financial institutionsto hedge or mitigate commercial risk.  At the same time, the legislationincludes provisions under which the CFTC may impose collateral requirements fortransactions, including those that are used to hedge commercial risk. However, during drafting of the legislation, members of Congress adopted reportlanguage and issued a public letter stating that it was not their intention toimpose margin and collateral requirements on counterparties that utilizetransactions to hedge commercial risk.  Final rules on majorprovisions in the legislation will be established through rulemakings and willnot take effect until 12 months after the date ofenactment.  Although we cannot predict the ultimate outcome of theserulemakings, new regulations in this area may result in increased costs andcash collateral requirements for the types of oil and gas derivativeinstruments we use to hedge and otherwise manage our financial risks related tovolatility in oil and gas commodity prices.

 

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 authoritiveguidance prescribed by FASB that requires us to record derivative instrumentsat their 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 affectsearnings. Ineffective portions of changes in the fair value of cash flowhedges, if any, are recognized in earnings. Changes in the fair value ofderivatives that do not qualify for hedge treatment are recognized in earnings.

 

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Weperiodically hedge a portion of our oil and gas production through swap andcollar agreements. The purpose of the hedges is to provide a measure ofstability to our cash flows in an environment of volatile oil and gas pricesand to manage the exposure to commodity price risk. Our management decided notto use hedge accounting for these agreements. Therefore, in accordance withcertain accounting provisions, the changes in fair market value are recognizedin earnings

 

***Stock —Based Compensation***

 

EffectiveJanuary 1, 2006, we adopted accounting provisions, which require companiesto recognize compensation expense for share-based payments based on theestimated fair value of the awards. We recognized an expense of approximately$25,000 for the nine months ended September 30, 2010, based on the fair valueof vested options.  We recognized anexpense of approximately $245,000 for the nine months ended September 30, 2010,based on the fair value of restricted stock that vested during thequarter.  We recognized an expense ofapproximately $18,000 for the nine months ending September 30, 2010, based onthe fair market value of stock appreciation rights. This accountingprovision also requires that the benefits of tax deductions in excess ofcompensation cost recognized for stock awards and options (“excess tax benefits”)be presented as financing cash inflows in the Statement of Cash Flows.

 

***Accounts Receivable***

 

Our revenue producingactivities are conducted primarily in Wyoming. We grant credit to qualifiedcustomers, which potentially subjects us to credit risk resulting from, amongother factors, adverse changes in the industry in which we operate and thefinancial condition of our customers. We continuously monitor collections andpayments from our customers and, if necessary, record an allowance for doubtfulaccounts based upon historical experience and any specific customer collectionissues identified. We recorded an allowance of approximately $14,000 and$100,000 at each of September 30, 2010 and December 31, 2009 respectively.

 

***Transportation Costs***

 

We account fortransportation costs under authoritative guidance prescribed by FASB related tothe accounting for shipping andhandling fees and costs, whereby amounts paid for transportation areclassified as operating expenses.

 

***Legal Estimates***

 

From time to time, we aresubject to legal proceedings and claims that arise in the ordinary course ofbusiness. We account for these costs under an accounting provision, whichstates that a loss contingency be recorded if it is probable that a liabilityhas been incurred and it is reasonably estimatable. At each of September 30,2010 and December 31, 2009, we accrued no expenses for legal proceedings.

 

***Per Share Information***

 

Basic earnings (loss) per share is computed bydividing net income (loss) from continuing operations attributable to commonstock by the weighted average number of shares of common stock outstandingduring each period. Diluted earnings per share are computed by adjusting theaverage number of shares of common stock outstanding for the dilutive effect,if any, of common stock equivalents such as stock options and warrants. For thenine months ended September 30, 2010, basic and diluted net loss per sharewas $0.05. During the nine months ended September 30, 2010, 813,412options and stock appreciation rights were excluded because they wereanti-dilutive.

 

***Recent Accounting Pronouncements***

 

For information concerningnew accounting pronouncements, please see “Note 2 — Basis of Presentation” ofthe notes to the unaudited financial statements appearing elsewhere in thisquarterly report.

 

**Trends Affecting Our Business**

 

The continued credit crisis and related turmoil inthe global financial system have had an adverse impact on our business andfinancial condition. In addition, the prices of oil and natural gas declinedsignificantly in 2008 and remained low in 2009 and the first three quarters of2010. As a result of low CIG index prices, the economic climate and our limitedcapital resources, we expect to

 

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continueoperating during 2010 with a reduced capital expenditure plan for 2010. Underour plan, we will generally make expenditures only as are necessary to securedrilling permits in strategic areas, drill wells that secure leaseholdpositions and construct the necessary infrastructure to complete and hook-upwells that have already been drilled.

 

Historically, natural gasprices have been extremely volatile, and we expect that volatility to continue.For example, during the nine months ended September 30, 2010, the NYMEXnatural gas index price ranged from a high of $6.00 per MMBtu to a low of $3.65per MMBtu, while the CIG natural gas index price ranged from a high of $6.08per MMBtu to a low of $2.76 per MMBtu. During the year ended December 31,2009, the NYMEX natural gas index price ranged from a high of $6.07 per MMBtuto a low of $2.51 per MMBtu, while the CIG natural gas index price ranged froma high of $4.59 per MMBtu to a low of $1.33 per MMBtu. Changes in natural gaspricing have impacted our revenue streams, production taxes, prices used inreserve calculations, borrowing base calculations and the carrying value of ourproperties and the valuation of potential property acquisitions. During thenine months ended September 30, 2010, estimated future gas prices had animpact on both our revenues and the costs attributable to our futureoperations. We expect that changing natural gas prices will continue to impactour operations and financial results in the future.

 

Transportation of naturalgas and access to throughput capacity has a direct impact on natural gas pricesin the Rocky Mountain region, where our operations are concentrated. Asdrilling activity increases throughout the Rocky Mountain region, additionalproduction may come on line, which could cause bottlenecks or capacityconstraints. Generally speaking, a surplus of natural gas production relativeto 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 togenerally trade at a discount to the NYMEX natural gas index price. Forexample, from January 1, 2010 through September 30, 2010, RockyMountain gas traded at a differential to the NYMEX natural gas index price thatranged from a premium of $0.27 per Mcf to a discount of $1.16 per Mcf, with anaverage differential of a discount of $0.50 per Mcf. The Rockies Express Pipelinewhich was completed and placed into service in early 2008, has increasedtakeaway capacity by approximately 1.5 Bcf per day from these hubs. We expectthat the completion of additional proposed pipelines will help reduce thedifferential between gas produced in the Rocky Mountain region and the NYMEXnatural gas index price. Additional proposed pipelines are scheduled to becompleted in late 2010 and 2011. General economic conditions and the futuredemand for natural gas may change the development schedule of proposedpipelines.

 

**Results of Operations**

 

Netloss attributable to stockholders for the quarter ended September 30, 2010was $0.8 million, or $0.02 per diluted share, on total revenues of $2.6million. Other income for the quarter ended September 30, 2010 included a$0.1 million unrealized loss associated with the change in the fair valuationof our natural gas hedges in place in accordance with certain accountingprovisions. Absent such change in the valuation of hedges, we would have showna loss of $0.7 million.  This compares toa net loss attributable to stockholders of $39.0 million for the quarter endedSeptember 30, 2009 on total revenue of $3.7 million. Adjusted for anunrealized loss in the fair valuation of our natural gas hedges in place of$3.1 million shown in other income, our results for the quarter endedSeptember 30, 2009 would have been a net loss attributable to commonstockholders of $35.9 million.

 

In order to provide a measure of stability to the cash flow in anenvironment of volatile oil and gas prices and to manage the exposure tocommodity price risk, we chose to periodically hedge a portion of our oil andgas production using swap and collar agreements. We account for our derivativeinstruments under certain accounting provisions which require us to recordderivative instruments at their fair value. Management has chosen not to usehedge accounting for these arrangements. Therefore, in accordance with theseprovisions, changes in the fair market value are recognized in earnings.

 

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***Three Months Ended September 30, 2010Compared to Three Months Ended September 30, 2009***

 

*Gas sales volume.*

 

Gassales volume decreased 19%, from 674 MMcf in the three months endedSeptember 30, 2009 to 544 MMcf in the three months endedSeptember 30, 2010. Daily sales volume was 5.9 MMcf for the three monthsended September 30, 2010 as compared to 7.3 MMcf for the three monthsended September 30, 2009, a 1.4 MMcf per day decrease. The decreaseresulted primarily from shutting in wells due to low natural gas prices,reductions in volumes due to compression maintenance and repairs, and weatherrelated downtime.

 

*Gas sales revenue.*

 

Revenuefrom gas sales decreased approximately $1.1 million during the three monthsended September 30, 2010 to approximately $2.6 million, a 30% decrease comparedto the three months ended September 30, 2009. This decrease was primarily dueto a $1.2 million reduction in realized gains on derivatives.

 

*Derivatives.*

 

Forthe three months ended September 30, 2010, we had an unrealized loss of$129,000 compared to an unrealized loss of $3.1 million for the three monthsended September 30, 2009. The unrealized loss is a non-cash expense basedprimarily on the Black-Scholes model for valuing future cash flows utilizingprice volatility with a normal discount rate. Hedges settled during the threemonths ended September 30, 2010 and 2009 resulted in a realized gain of $0.8million and $2.0 million, respectively. The realized hedge gain for the threemonths ended September 30, 2010 was primarily due to the fact that gas priceswere lower than the weighted average floor price of our hedges in place.

 

*Lease operating expenses.*

 

Leaseoperating expenses decreased approximately $50,000 in the three months endedSeptember 30, 2010 to $0.9 million, a 6% decrease compared to the three monthsended September 30, 2009. On a Mcf basis, lease operating expenses increased17% from $1.37 per Mcf in the three months ended September 30, 2009 to $1.60per Mcf in the three months ended September 30, 2010.

 

*Production taxes.*

 

Productiontaxes increased approximately $27,000 in the three months ended September 30,2010 to $0.2 million, a 16% increase from the three months ended September 30,2009. Production taxes generally correlate to gross sales revenue becauseproduction taxes are based on a percentage of sales value. In Wyoming, thepercentage averages 11% to 13%, depending on rates in effect for the respectiveyear, while in Montana the percentage averages 9%. The increase in productiontaxes for the three months ended September 30, 2010 was primarily due todecreased revenues associated with decreased volume. On an Mcf basis,production taxes were $0.36 per Mcf for the three months ended September 30,2010 and $0.25 per Mcf for the three months ended September 30, 2009, a 44%increase, which correlates to the increase in the price per Mcf received in thethree months ended September 30, 2010 from the three months ended September 30,2009.

 

*Marketing and transportation.*

 

Marketingand transportation expenses decreased approximately $61,000 in the three monthsended September 30, 2010 to approximately $0.7 million, an 8% decrease from thethree months ended September 30, 2009. The decrease related primarily to lowerproduction volumes. On an Mcf basis, marketing and transportation expensesincreased 14% to $1.33 per Mcf in the three months ended September 30, 2010from $1.16 per Mcf in the three months ended September 30, 2009.

 

*General and administrative expenses, net.*

 

Generaland administrative expenses are offset by operating income from drilling andproduction activities for which we can charge an overhead fee to nonoperatingworking interest owners. These well operating overhead fees were $271,000 inthe three months ended September 30, 2010 compared to $286,000 for thethree months ended September 30, 2009. General and administrative expensesnet increased $0.2 million in the three months ended September 30, 2010 to$1.0 million. On a Mcf basis, general and administrative expenses, netincreased 49%, from $1.29 per Mcf in the three months ended September 30,2009 to $1.92 per Mcf in

 

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thethree months ended September 30, 2010. General and administrativeexpenses, for the quarter ended September 30, 2010, include $0.3 millionfor professional services expense incurred in connection with the mergeragreement with Powder and Powder Holdings.

 

*Depreciation, depletion, amortization and accretion.*

 

Depreciation,depletion, amortization and accretion expense decreased $1.8 million for thethree months ended September 30, 2010 to $0.5 million, a 77% decrease comparedto the three months ended September 30, 2009. The decrease was primarily due toa decrease in the capitalized basis in our full cost pool and completion of thedepreciable life of certain capitalized assets September 30, 2010. On an Mcfbasis, the depreciation, depletion, amortization and accretion rate decreasedto $0.96 per Mcf in the three months ended September 30, 2010 from $3.44 perMcf in the three months ended September 30, 2009.

 

*Impairment.*

 

AtSeptember 30, 2010, the full cost ceiling limitation of our oil and gasproperties exceeded the capitalized cost by approximately $13.2 million basedupon a natural gas price of approximately $4.01 per Mcf (based on the first dayof the month, twelve month average per Mcf on the Colorado Interstate Gas RockyMountain Index) in effect at that date. Therefore, no impairment was taken forthe three months ended September 30, 2010. An impairment of approximately$34.6 million was taken for the three months ended September 30,2009.  For further information regardingthis impairment, please see Note 2 — “Basis of Presentation” in the Notes tothe unaudited financial statements appearing elsewhere in this quarterlyreport. A decline in natural gas prices or an increase in operating costs ineconomically recoverable quantities could result in the recognition ofadditional impairments of our oil and gas properties in future periods.

 

***Nine Months Ended September 30, 2010Compared to Nine Months Ended September 30, 2009***

 

*Gas sales volume.*

 

Gassales volume decreased 22%, from 2,189 MMcf in the nine months ended September30, 2009 to 1,713 MMcf in the nine months ended September 30, 2010. Daily salesvolume was 6.3 MMcf for the nine months ended September 30, 2010 as compared to8.0 MMcf for the nine months ended September 30, 2009, a 1.7 MMcf per daydecrease. The decrease resulted primarily from shutting in wells due to lownatural gas prices, reductions in volumes due to compression maintenance andrepairs, and weather related downtime.

 

*Gas sales revenue.*

 

Revenuefrom gas sales decreased approximately $4.1 million during the nine monthsended September 30, 2010, to approximately $7.5 million, a 35% decreasecompared to the nine months ended September 30, 2009. This decrease wasprimarily due to a reduction in realized gain on derivatives. The averagerealized price per Mcf decreased approximately 17%, from $5.30 per Mcf in thenine months ended September 30, 2009 to $4.38 per Mcf in the nine months endedSeptember 30, 2010.

 

*Derivatives.*

 

Forthe nine months ended September 30, 2010, we had an unrealized gain of $2.2million compared to an unrealized loss of $5.2 million for the nine monthsended September 30, 2009. The unrealized gain and losses are non-cash expensesbased primarily on the Black-Scholes model for valuing future cash flowsutilizing price volatility with a normal discount rate. Hedges settled duringthe nine months ended September 30, 2010 resulted in a realized gain of $0.9million compared to a realized hedge gain of $5.5 million during the ninemonths ended September 30, 2009. The realized hedge gain for the nine monthsended September 30, 2010 was primarily due to the fact that gas prices werelower than the weighted average floor price of our hedges in place.

 

*Lease operating expenses.*

 

Leaseoperating expenses decreased $0.4 million in the nine months ended September30, 2010 to $2.7 million, a 13% decrease compared to the nine months endedSeptember 30, 2009. This decrease resulted primarily from a reduction in labor,fuel, workover and water management related costs offset partially by anincrease in surface use expenses in the productive cycle during the nine monthsended September 30, 2010. On a Mcf basis, lease operating expenses increased12% from $1.39 per Mcf in the nine months ended September 30, 2009 to $1.55 perMcf in the nine months ended September 30, 2010.

 

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*Production taxes*

 

Productiontaxes increased $0.1 million in the nine months ended September 30, 2010 to$0.7 million, a 23% increase from the nine months ended September 30, 2009.Production taxes generally correlate to gross sales revenue because productiontaxes are based on a percentage of sales value. In Wyoming, the percentageaverages 11% to 13%, depending on rates in effect for the respective year,while in Montana the percentage averages 9%. The decrease in production taxesfor the nine months ended September 30, 2010 was primarily due to decreasedrevenues associated with decreased volume and realized pricing. On an Mcfbasis, production taxes were $0.42 per Mcf for the nine months ended September30, 2010 and $0.27 per Mcf for the nine months ended September 30, 2009, a 57%decrease.

 

*Marketing and transportation.*

 

Marketingand transportation expenses decreased approximately $0.7 million in the ninemonths ended September 30, 2010 to approximately $2.2 million, a 25% decreasefrom the nine months ended September 30, 2009. The decrease related primarilyto a decrease in transportation fees and compression due to lower productionvolumes. On an Mcf basis, marketing and transportation expenses decreased 4% to$1.28 per Mcf in the nine months ended September 30, 2010 from $1.34 per Mcf inthe nine months ended September 30, 2009.

 

*General and administrative expenses, net.*

 

Generaland administrative expenses are offset by operating income from drilling andproduction activities for which we can charge an overhead fee to nonoperatingworking interest owners. These well operating overhead fees were $0.9 millionand $0.9 million for the nine months ended September 30, 2010 and September 30,2009, respectively. General and administrative expenses, net, increased $0.4million in the nine months ended September 30, 2010 to $3.5 million. On an Mcfbasis, general and administrative expenses, net increased 44%, from $1.41 perMcf in the nine months ended September 30, 2009 to $2.03 per Mcf in the ninemonths ended September 30, 2010. The increase in general and administrativeexpenses was primarily a result of professional services expense incurred inconnection with the merger agreement with Powder and Powder Holdings.

 

*Depreciation, depletion, amortization and accretion.*

 

Depreciation,depletion, amortization and accretion expense decreased $3.0 million for thenine months ended September 30, 2010 to $2.1 million, a 59% decrease comparedto the nine months ended September 30, 2009. The decrease was primarily due toa decrease in the capitalized basis in our full cost pool and completion of thedepreciable life of certain capitalized assets at September 30, 2010. On an Mcfbasis, the depreciation, depletion, amortization and accretion rate decreasedto $1.21 per Mcf in the nine months ended September 30, 2010 from $2.31 per Mcfin the nine months ended September 30, 2009.

 

*Impairment.*

 

AtSeptember 30, 2010, the full cost ceiling limitation cost of our oil and gas propertiesexceeded the capitalized cost by approximately $13.2 million based upon anatural gas price of $4.01 per Mcf (based on the Colorado Interstate Gas RockyMountain Index) in effect at that date. Therefore, no impairment was recordedfor the nine months ended September 30, 2010. An impairment of approximately$57.8 million was recorded for the nine months ended September 30, 2009. Forfurther information regarding this impairment, please see Note 2 — “Basis ofPresentation” in the Notes to the unaudited financial statements appearingelsewhere in this quarterly report. A decline in natural gas prices or anincrease in operating costs in the economically recoverable quantities couldresult in the recognition of additional impairments of our oil and gasproperties in future periods.

 

**Liquidity and Capital Resources**

 

Inthe past, our primary sources of liquidity have been private and public salesof our equity securities, cash provided by operating activities, and debtfinancing. All of these sources have been negatively impacted by the currenteconomic climate, its impact on our industry, and by significant fluctuationsin oil and gas prices, operating costs, and volumes produced. We have nocontrol over the market prices for oil and natural gas, although we are able toinfluence the amount of our net realized revenues related to gas sales throughthe use of derivative contracts. A decrease in market prices would reduceexpected cash flow from operating activities and could reduce the borrowingbase of our credit facility as well as the value of assets we might considerselling. Historically, decreases in the market prices have limited our industry’saccess to the capital markets. During these challenging times, we have reducedour administrative, operating and transportation costs. We are also activelymarketing asset sales and exploring other strategic alternatives and capitalrestructuring options.

 

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*Credit Facility*.

 

EffectiveFebruary 12, 2007, we entered into a credit facility which permitsborrowings up to the borrowing base as designated by the administrative agent.As of September 30, 2010 and December 31, 2009, we had $5.1 million and$6.1 million, respectively, of debt outstanding under the facility. Asdescribed below, we are currently unable to borrow additional amounts under thecredit facility due to covenant limitations and may be further limited in thefuture based on borrowing base limitations.

 

Asof December 31, 2009, the borrowing base under the credit facility wasapproximately $13.2 million. The borrowing base was subject to automaticreductions for approximately $666,667 per month until it reached $10.5 millionon April 1, 2009.  As of April 14, 2009,the borrowing base was further reduced to $9.0 million, subject to automaticreductions of $500,000 per month until it reached $6.5 million on October 1,2009.  As of October 20, 2009, theborrowing base was subject to automatic reductions of $200,000 per month untilit reaches maturity or until a redetermination is received.

 

Theborrowing base is determined on a semi-annual basis and at such otheradditional times, up to twice yearly, as may be requested by either us or theadministrative agent and is determined by the administrative agent inaccordance with customary practices and standards for loans of a similarnature, although such determination is at the administrative agent’s discretionas the credit agreement does not provide a specific borrowing base formula.

 

Borrowingsunder this credit facility may be used solely to acquire, explore or developoil and gas properties and for general corporate purposes. The credit facilitymatures February 12, 2011.

 

Ourobligations under the credit facility are secured by liens on (i) no lessthan 90% of the net present value of the oil and gas to be produced from ouroil and gas properties that are included in the borrowing base determination,calculated using a discount rate of 10% per annum and reserve estimates, pricesand production rates and costs, (ii) options to lease, seismic options,permits, and records related to such properties, and (iii) seismic data.

 

Borrowingsunder our credit facility, as amended, bear interest either: (i) at thegreater of the one month London Interbank Offered Rate, or LIBOR, plus 1.00% ora domestic bank rate, plus in either case an applicable margin of 0.75% to1.75% based on utilization, or (ii) on a sliding scale from the one, two,three or six month LIBOR, plus an applicable margin of 2.00% to 3.00% based onutilization. The weighted average interest rate as of September 30, 2010 was5.0%.  The credit agreement provides forvarious fees, including a quarterly commitment fee of 0.5% per annum andengineering fees to the administrative agent in connection with a borrowingbase determination. In addition, the credit facility provided for an up frontfee of $27,000, which was paid on the closing date of the credit facility, andan additional arrangement fee of 1% based on utilization. Borrowings under thiscredit facility may be prepaid without premium or penalty, except on Eurodollaradvances.

 

Thecredit agreement contains covenants that, among other things, restrict our 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 our organizationaldocuments;

 

·**               **enter into certain hedging arrangements;

 

·**               **amend material contracts;and

 

·**               **enter into related partytransactions.

 

With regard to hedgingarrangements, our credit agreement provides that acceptable commodity hedgingarrangements cannot cover greater than 80 to 85%, depending on the measurementdate, of our monthly production from our hydrocarbon properties that are usedin the borrowing base determination, and that the fixed or floor price of ourhedging arrangements must be equal to or greater than the gas price used by thelenders in determining the borrowing base.

 

The credit agreement, asamended, also requires that we satisfy certain affirmative covenants, meetcertain financial tests, maintain certain financial ratios and make certaincustomary indemnifications to lenders and the administrative agent. Thefinancial covenants include requirements to maintain: (i) a ratio ofEBITDA to cash interest expense of not less than 3.00 to 1.00, (ii) aratio of current assets to current liabilities of not less than 1.00 to 1.00,(iii) a total debt to annualized EBITDA ratio of not more than 3.0 to

 

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1.0, (iv) a quarterlytotal senior debt to annualized EBITDA ratio equal to or less than 3.0 to 1.0,and (v) a total proved PV-10 value to total debt ratio of at least 1.50 to1.00.

 

The credit agreement, asamended, contains customary events of default, including payment defaults,covenant defaults, certain events of bankruptcy and insolvency, defaults in thepayment of other material debt, judgment defaults, breaches of representationsand warranties, loss of material permits and licenses and a change in control.The credit agreement requires any wholly-owned subsidiaries to guarantee theobligations under the credit agreement.

 

After an event of default,the outstanding debt bears interest at the default rate under the terms of thecredit agreement. The default rate is (i) with respect to principal, 2% overthe otherwise applicable rate and (ii) with respect to interest, fees andother amounts, the Base Rate (as defined in the credit facility), plus theApplicable Margin (as defined in the credit agreement), plus 2%. Any defaultinterest is payable on demand. Failure to pay the default interest when theadministrative agent demands would be another default. The lenders’ remediesfor defaults under the credit agreement are to terminate further borrowings,accelerate the repayment of indebtedness and/or ultimately foreclose on thecollateral property.

 

OnApril 14, 2009, we and the administrative agent entered into the fourthamendment to the credit agreement which reduced the borrowing base as describedabove and waived compliance with the current ratio financial covenant as ofDecember 31, 2009 and March 31, 2009 and with the restrictivecovenants related to accounts payable, permitted liens and permitted debt untilthe current ratio financial covenant and next borrowing base redetermination,subject to certain financial caps. On August 19, 2009, the lenders waivedcompliance with the current ratio financial covenant under the Credit agreementfor the period ending August 26, 2009 and the quarter ending June 30, 2009.

 

OnAugust 26, 2009, we entered into a fifth amendment to the credit agreementwhich provided a waiver of the current ratio covenant through October 26, 2009and for the quarter ending September 30, 2009. The fifth amendment to the credit agreement also extended restrictivecovenants related to accounts payable, permitted liens and permitted debt,until October 26, 2009, subject to certain financial caps.

 

OnOctober 20, 2009, we and the Lenders executed the Sixth Amendment to the creditagreement.  This amendment establishedthe Borrowing Base for the following amounts in the following applicableperiods:

 
| December 1, 2009 through December 31, 2009 |   | $ | 6,300,000 |   |
|--------------------------------------------|--------|---|-----------|--------|
| January 1, 2010 through January 31, 2010   |   | $ | 6,100,000 |   |
| February 1, 2010 through February 28, 2010 |   | $ | 5,900,000 |   |
| March 1, 2010 through March 31, 2010       |   | $ | 5,700,000 |   |
| April 1, 2010 through April 30, 2010       |   | $ | 5,500,000 |   |

 

EachCalendar month thereafter commencing May 1, 2010; the Borrowing Base for thepreceding calendar month reduced by $200,000.

 

OnOctober 26, 2009, the lenders provided a waiver effectively extending the termsof the fifth amendment to the Credit agreement through November 16, 2009.  On November 16, 2009, the lenders provided anadditional waiver effectively extending the terms of the fifth amendment to theCredit agreement through November 23, 2009.

 

On November 23, 2009, the lenders provided an additional waiverextending the terms of the fifth amendment to the credit agreement throughDecember 1, 2009 and for the quarter ended December 31, 2009.

 

On December 1, 2009 the lenders provided an additional waiverextending the terms of the fifth amendment to the credit agreement throughJanuary 5, 2010.

 

On January 5, 2010 the lenders provided an additional waiverextending the terms of the fifth amendment to the credit agreement throughJanuary 12, 2010.

 

On January 13, 2010, we entered into a seventh amendment andwaiver to credit agreement (“*waiveragreement*”) with the lenders party thereto. The waiver agreementprovided that the lenders would waive (i) our compliance with certainrestrictions based on the current ratio in the credit agreement,(ii) certain requirements pertaining to the aging of certain accounts payable,and (iii) certain restrictions regarding the amount of liens we have.Default remedies available to the lenders under the credit agreement includeacceleration of all principal and interest amounts due under the creditagreement. The waiver agreement extended the waiver

 

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periodfor these items until the earlier of June 15, 2010 and the date of anydefault arising out of a breach or non-compliance with the credit agreement notexpressly waived in the waiver agreement or a breach of the waiver agreement.

 

In addition, the waiver agreement amends the definition of “FinalMaturity Date” under the credit agreement to the earlier of(i) June 15, 2010 or (ii) the date that is thirty days followingthe earlier of (A) the date the merger is withdrawn or terminated in wholeor in part or (B) the date that the lenders have been advised that themerger will not proceed.

 

On July 8, 2010, we were notified by our lender that we failed tomake the principal and interest payments due on July 1, 2010 and that suchmissed payments constituted an Events of Default under the credit agreement. Weremain obligated to pay all amounts outstanding under the credit agreement. Thecurrent amount outstanding under the credit facility is approximately$5,100,000.

 

Wehave requested additional waivers from our lender; however, no waivers havebeen obtained to date. On October 28, 2010, the administrative agent ofour Credit Facility notified the counterparty to our derivative contracts thatan Event of Default had occurred. Further, the administrative agent, pursuantto Section 5.1 (and Article VI) of the credit agreement, advised thecounterparty to withhold funds payable to us and remit these funds directly tothe administrative agent. The counterparty to our derivative transactions, byletter dated November 5, 2010, has advised us that funds payable toPinnacle will be held in escrow pending further investigation of theadministrative agent’s request or additional direction from Pinnacle.Approximately $363,000 payable to us by the counterparty on November 8,2010 is being held in escrow.

 

Further,our lender has indicated that it will exercise additional remedies under thecredit agreement to obtain our liquid cash payments or other collateral. The diversion of our liquid collateral will materially impact our abilitiy tomeet our ongoing payment obligations.  On November 8, 2010, ScotiaWaterous (USA), Inc. provided a $0.5 million capital contribution toPowder Holdings, LLC to fund general working capital requirements forour pending closing, which is anticipated in the fourth quarter of 2010subject to the satisfaction of certain closing conditions.  This capitalwill help us with our immediate capital needs, however we will still need tofind other means to satisfy our obligations prior to closing.

 

*Office Building Loan*.

 

On November 15, 2005,we entered into a mortgage loan secured by our office building in Sheridan,Wyoming in the aggregate principal amount of $829,000. The promissory noteprovides for monthly payments of principal and interest in the initial amountof $6,400, and unpaid principal that bore interest at 6.875% untilNovember 15, 2009, currently bears interest at a variable base rate plus0.5% and will bear interest at 18% upon a default. The variable base rate isbased on the lender’s base rate. The maturity date of this mortgage isNovember 15, 2015, at which time a principal and interest payment of$531,300 will become due. As of September 30, 2010, we had $708,000outstanding in principal on this mortgage. On November 15, 2009, theinterest rate on our mortgage loan changed from a fixed rate of 6.875% to avariable rate. As of September 30, 2010, the variable rate was 4.00%.

 

*Capital Expenditure Budget*.

 

The continued credit crisis and related turmoil in the global financialsystem have had an adverse impact on our business and financial condition. Inaddition, the prices of oil and natural gas declined significantly in 2008 andremained low in 2009 and the nine months ending September 30, 2010.Therefore, total capital expenditures were limited to $4.2 million in2009. As a result of low CIG index prices, the economic climate and our limitedcapital resources, we expect to continue operating during 2010 with a reducedcapital expenditure plan. Under our plan, we will generally make expendituresonly as necessary to secure drilling permits in strategic areas, drill wellsthat secure leasehold positions and construct the necessary infrastructure tocomplete and hook-up wells that have already been drilled. Our capitalexpenditure budget for 2010 will be dependent upon CIG index prices, our cashflows and the availability of additional capital resources. We had totalcapital expenditures of $2.1 million for the nine months endedSeptember 30, 2010.

 

***Cash Flow from Operating Activities***

 

Net cash provided byoperating activities was $1.2 million for the nine months ended September 30,2010, compared to net cash used in operating activities of $1.7 million for thenine months ended September 30, 2009. The change was primarily due toincreases in accounts payable, accrued liabilities, and revenue distributionpayables.

 

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***Cash Flow from Investing Activities***

 

Netcash provided by investing activities was approximately $44,000 for the ninemonths ended September 30, 2010, compared to net cash provided by investingactivities of $6.3 million for the nine months ended September 30, 2009.The change in 2010 was primarily due to smaller realized gains on derivatives,a sale of properties in 2009, and a liquidation of certificate of deposits in2010.

 

***Cash Flow from Financing Activities***

 

Netcash used in financing activities was $1.0 million for the nine months ended September 30,2010, compared with net cash provided by financing activities of $5.0 millionfor the nine months ended September 30, 2009. The change was primarily dueto a reduction in the balance owed on the line of credit for the nine monthsended September 30, 2010.

 

***Contractual Obligations***

 

Pleasesee Notes 3 and 7 of the Notes to the unaudited financial statements appearingelsewhere in this quarterly report for information regarding our creditfacility and other indebtedness.

 

Thefollowing table summarizes by period our contractual obligations as of September 30,2010:

 
| ** **                                | ** ** | **Total**               | ** ** | **2010** | ** ** | **2011–2012** | ** ** | **2013–2014** | ** ** | **Thereafter** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|----------|------------|--------------------|------------|--------------------|------------|----------------|------------|
| ** **                                | ** ** | **(In Thousands)** | ** ** |
| Notes payable in connection with mortgage |       | $                       | 708        |     | $          | 8                  |       | $                  | 71         |           | $          | 76 |   | $ | 553 |   |
| Capital lease                             |       | 60                      |       | 5        |       | 45                 |       | 10                 |       | —         |       |
| Asset retirement obligations              |       | 3,019                   |       | 620      |       | 827                |       | 521                |       | 1,051          |       |
| Production and property taxes             |       | 3,833                   |       | 3,208    |       | 625                |       | —             |       | —         |       |
| Total                                     |       | $                       | 7,620      |     | $          | 3,841              |       | $                  | 1,568      |           | $          | 607 |   | $ | 1,604 |   |

 

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

Theprimary objective of the following information is to provide forward-lookingquantitative and qualitative information about our potential exposure to marketrisk. The term “market risk” refers to the risk of loss arising from adversechanges in natural gas prices and interest rates. 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 riskexposure is in the pricing applicable to our natural gas production. The priceswe receive for our production depend on many factors beyond our control. Weseek to reduce our exposure to unfavorable changes in natural gas prices, whichare subject to significant and often volatile fluctuation, through the use offixed-price contracts. Our fixed-price contracts are comprised of energy swaps andcollars. Fixed price 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. With regard to hedging arrangements, our credit facility providesthat acceptable commodity hedging arrangements cannot cover greater than 80 to85%, depending on the measurement date, of our monthly production from ourhydrocarbon properties that are used in the borrowing base determination, andthat the fixed or floor price of our hedging arrangements must be equal to orgreater than the gas price used by the lenders in determining the borrowingbase.

 

The following tablesummarizes the estimated volumes, fixed prices, fixed price sales and fairvalue attributable to the fixed price contracts as of September 30, 2010.At September 30, 2010, we had hedged volumes through December 2010.Please see Note 5 of the Notes to the unaudited financial statements appearingelsewhere in this quarterly report for further information regarding ourderivatives.

 

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| ** **                                      | ** ** | **Year Ending  December 31, 2010** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                      | ** ** | **(Unaudited)**                                   | ** ** |
| **Natural Gas Swaps:**                          |       |                                              |       |
| Contract volumes (MMBtu)                        |       | 506,000                                           |       |
| Weighted-average fixed price sales per MMBtu(1) |       | $                                                 | 5.08       |   |
| Fair value, net (thousands)(2)                  |       | $                                                 | 775        |   |
| **Total Natural Gas Contracts:**                |       |                                              |       |
| Contract volumes (MMBtu)                        |       | 506,000                                           |       |
| Fixed-price sales                               |       | $                                                 | 5.08       |   |
| Fair value, net (thousands)(2)                  |       | $                                                 | 775        |   |

 

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(1)          Volumes hedged using the CIG index price publishedin the first issue of Inside FERC’s Gas Market Report for each calendar monthof the derivative transaction.

 

(2)          Fair value based on CIG index price in effect foreach month as of September 30, 2010.

 

**Interest Rate Risk**

 

Borrowingsunder our credit facility bear interest at fluctuating market-based rates.  Accordingly, our interest expenses aresensitive to market changes, which expose us to interest rate risk on currentand future borrowings under our credit facility.

 

As of September 30, 2010, we had $5.1 million in outstandingindebtedness under our credit facility. Borrowings under the credit facilitybear interest either: (i) at the greater of the one month LIBOR plus 1.00%or a domestic bank rate, plus in either case an applicable margin of 0.75% to1.75% based on utilization, or (ii) on a sliding scale from one, two,three, or six month LIBOR, plus an applicable margin of 2.00% to 3.00% based onutilization. The weighted average interest rate for borrowings under our creditfacility was 5.25% for the nine months ended September 30, 2010 and 5% forthe year ended December 31, 2009. In light of the current economicclimate, we expect that interest rates on alternative financing options torange from 8% to 12%. The availability of alternative financing arrangementsand the interest rates thereof would depend on the type of financing and our abilityto restructure our current indebtness outstanding under our credit facility.Due to covenant restrictions in our credit facility, we are currently unable toborrow additional amounts.

 

Ahypothetical change of 1% in either the domestic bank rate or the LIBORinterest rates would increase or decrease gross interest expense approximately$51,000 per year based on our outstanding indebtness at September 30,2010.

 

**ITEM 4T. CONTROLS AND PROCEDURES**

 

**Disclosure Controls and Procedures**

 

Our principal executiveofficer and principal financial officer are responsible for establishing andmaintaining adequate disclosure controls and procedures.  Based on their evaluation as of the end ofthe period covered by this quarterly report, our principal executive officerand principal financial officer have concluded that our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the Exchange Act)) areeffective to ensure that information required to be disclosed in reports thatwe file or submit under the Exchange Act are recorded, processed, summarizedand reported within the time periods specified in the SEC’s rules andforms.

 

**Changes in Internal Control Over Financial Reporting**

 

Duringthe most recent fiscal quarter, there have been no changes in our internalcontrol over financial reporting that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**PART II.OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

Fromtime to time, we are subject to legal proceedings and claims that arise in theordinary course of our business. While the outcome of these proceedings cannotbe predicted with certainty, we do not currently expect them to have a materialadverse effect on the financial statements.

 

Therehave been no material developments during the quarter ended September 30,2010 regarding our currently pending legal proceedings. For a discussion ofcertain of our current legal proceedings, please see [“Note 9 — Contingencies”]of the notes to the unaudited financial statements appearing elsewhere in thisquarterly report.

 

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**ITEM 1A. RISK FACTORS**

 

Thefollowing discussion supplements or updates the risk factors set forth underthe heading “Risk Factors” in our annual report on Form 10-K for the yearended December 31, 2009.

 

***Due to the recent financial andcredit crisis, we may not be able to obtain funding, or obtain funding onacceptable terms, to meet our future capital needs, which could negativelyaffect our business, results of operations and financial condition.***

 

The continued credit crisis and the related turmoil in the globalfinancial system have had an adverse impact on our business and financialcondition, and we may face major challenges if conditions in the financialmarkets do not improve. Currently, we are not able to borrow additional amountsunder our credit facility. As a result, we curtailed substantially all newdrilling in 2009 and if our operating cash flow is not sufficient to carry outour drilling plans for 2010, we will be required to reduce the number of wellswe drill or seek alternative sources of financing. However, due to thefinancial crisis, financing through the capital markets or otherwise may not beavailable to us on acceptable terms or at all. If additional funding is notavailable, or is available only on unfavorable terms, we may be unable toimplement our drilling plans, make capital expenditures, withstand a furtherdownturn in our business or the economy in general, or take advantage ofbusiness opportunities that may arise. Any further curtailment of our operationswould have an additional adverse effect on our revenues and results ofoperations. In addition, current economic conditions have led to reduced demandfor, and lower prices of, oil and natural gas, and a sustained decline theprice of natural gas would adversely affect our business, results of operationsand financial condition.  Further, theeconomic situation could have an impact on our lenders or customers, causingthem to fail to meet their obligations to us, and on the liquidity of ouroperating partners, resulting in delays in operations or their failure to makerequired payments. Also, market conditions could have an impact on our naturalgas and oil derivatives transactions if our counterparties are unable toperform their obligations or seek bankruptcy protection.

 

***Our contemplated merger agreement may not be consummated.***

 

We have entered an Agreement and Plan of Merger, as further describedin Note 1 in the notes to the unaudited financial statements herein and inthe proxy statement filed June 29, 2010. There can be no assurances thatthe contemplated merger transaction will occur. If the merger is notconsummated, we will continue to need additional capital to remain a goingconcern and successfully operate our business.

 

***We are in default pursuant to ourcredit facility.***

 

As described inthe Liquidity and Capital Resources section in this report, the seventhamendment and waiver to credit agreement has expired and we failed to make theprincipal and interest payments due July 1, 2010 and August 1,2010.  As a result, we are in defaultpursuant to the credit facility and our lender may elect to pursue remediesunder the credit facility including foreclosure of our secured assets.

 

***Our credit facility has substantialrestrictions and financial covenants that may affect our ability tosuccessfully operate our business. In addition, we may have difficultyreturning to compliance with certain financial covenants.***

 

Our credit facility imposes certain operational and financialrestrictions on us. These restrictions, among other things, limit our abilityto:

 

·                  incur additionalindebtedness;

 

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·                  create liens;

 

·                  sell our assets orconsolidate or merge with or into other companies;

 

·                  make investments and otherrestricted payments, including dividends; and

 

·                  engage in transactions withaffiliates.

 

These limitations are subject to a number of important qualificationsand exceptions. In addition, our credit facility requires us to maintaincertain financial ratios and to satisfy certain financial conditions which mayrequire us to reduce our debt or to take some other action in order to complywith them. These restrictions in our credit facility could also limit ourability to obtain future financings, make needed capital expenditures,withstand a downturn in our business or the economy in general, or otherwiseconduct necessary corporate activities. We also may be prevented from takingadvantage of business opportunities that arise because of the limitationsimposed on us by the restrictive covenants under our credit facility.

 

We were not in compliance with the current ratio financial covenant andcertain other covenants related to accounts payable, permitted liens andpermitted debt under our credit facility, and would be in default absent awaiver or amendment. On January 13, 2010, the lenders waived compliancewith the current ratio as of December 31, 2009 through June 15, 2010,and with such other restrictive covenants, subject to certain financial caps.We have also not been in compliance with certain financial covenants for thelast seven quarters, but obtained waivers and/or amendments in each instance.In addition, the final maturity date of the funds outstanding under our creditfacility was accelerated to June 15, 2010. As a result of suchnon-compliance, we are unable to borrow additional funds under our creditagreement.

 

Pleasesee “Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Liquidity and Capital Resources—Credit Facility,” for furtherdiscussion of our credit facility.

 

**ITEM 2.UNREGISTERED SHARES OF EQUITY SECURITIES AND USE OF PROCEEDS**

 

Not applicable.

 

**ITEM 3.DEFAULTS UPON SENIOR SECURITIES**

 

Ourmost recent waiver with our lender pursuant to our credit facility expiredon June 15, 2010.  On July 8, 2010, we were notified by ourlender that we failed to make the principal and interest payments due on July 1,2010 and that such missed payments constituted an Event of Default under theCredit Agreement.  The current amount outstanding under the creditfacility is approximately $5,100,000 plus accrued interest.  On October 28,2010, the administrative agent of the credit facility notified the counterpartyto the Company’s derivative contracts that an Event of Default had occurred andadvised the counterparty to remit funds directly to the administrativeagent.  On November 5, 2010, the counterparty to the Company’sderivative transactions advised the Company that funds (totally $363,000 forthis month) will be held in escrow pending further investigation of theadministrative agent’s request or additional direction from the Company.

 

Further,our lender has indicated that it will exercise additional remedies under theCredit Agreement to obtain the Company’s liquid cash payments or othercollateral.  The diversion of the Company’s liquid collateral willmaterially impact its abilities to meet its ongoing payment obligations. On November 8, 2010, Scotia Waterous (USA), Inc. provided a $.5million capital contribution to Powder Holdings, LLC to fund general workingcapital requirements of the Company  pending closing, which is anticipatedin the fourth quarter of 2010 subject to the satisfaction of certain closingconditions.  This capital will help the Company with its immediate capitalneeds, but it will still need to find other means to satisfy its obligations.

 

**ITEM 4. SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

Atthe special meeting of the shareholders on August 9, 2010, theshareholders of Pinnacle Gas Resources, Inc. (the “Company”) voted toapprove a proposal to adopt the Agreement and Plan of Merger dated as ofFebruary 23, 2010 (“Merger Agreement”) by and among the Company, PowderHoldings, LLC, a Delaware limited liability company, and Powder Acquisition Co.(“Powder”), a Delaware corporation and wholly-owned subsidiary of Powder.

 

Thevotes with respect to the proposal were as follows:

 
| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|---------------------------|------------|
| 21,813,972 |       | 1,145,757   |       | 199,000     |       | 6,888,724                 |       |

 

TheCompany anticipates that the closing will occur during the fourth quarter,subject to the satisfaction of customary closing conditions and the receipt ofwaivers from the Company’s lender, The Royal Bank of Scotland plc.

 

**ITEM 5. OTHER INFORMATION**

 

Notapplicable.

 

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**ITEM 6. EXHIBITS**

 
| **Exhibit****No.** | ** ** | ** ** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                   |
|--------------------|------------|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                |       | —     |       | Amended  and Restated Agreement and Plan of Merger, dated as of February 23,  2010, among Powder Holdings, LLC, Pinnacle Gas Resources, Inc. and  Powder Acquisition, Co. (incorporated by reference to Exhibit 2.1  to the Current Report on Form 8-K (File No. 001-33457) filed by  Pinnacle Gas Resources, Inc. on February 26, 2010). |
| 2.2                |       | —     |       | Amendment  to Amended and Restated Agreement and Plan of Merger, dated as of  September 29, 2010 (incorporated by reference to Exhibit 2.2 to the  Current Report on Form 8-K (File No. 001-33457) filed by Pinnacle  Gas Resources, Inc. on September 29, 2010).                                                                                   |
| 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).                                                                                                                     |
|               |       |       |       |                                                                                                                                                                                                                                                                                                                                                                              |
| 10.1               |       | —     |       | Fourth  Amendment to Credit Agreement, dated as of April 14, 2009 (incorporated  herein by reference to Exhibit 10.21 to the Annual Report on  Form 10-K (File No. 001-33457) filed by Pinnacle Gas  Resources, Inc. on April 15, 2009).                                                                                                            |
|               |       |       |       |                                                                                                                                                                                                                                                                                                                                                                              |
| 10.2               |       | —     |       | Waiver  to Credit Agreement, dated as of August 19, 2009 (incorporated herein by  reference to Exhibit 10.2 to the Quarterly Report on Form 10-Q  filed by Pinnacle Gas Resources on August 19, 2009).                                                                                                                                                        |
|               |       |       |       |                                                                                                                                                                                                                                                                                                                                                                              |
| 10.3               |       | —     |       | Fifth  Amendment to the Credit Agreement, dated August 26, 2009 (incorporated  herein by reference to Exhibit 10.1 to the 8-K filed by Pinnacle Gas  Resources, Inc. on August 27, 2009).                                                                                                                                                                     |
|               |       |       |       |                                                                                                                                                                                                                                                                                                                                                                              |
| 10.4               |       | —     |       | Sixth  Amendment to the Credit Agreement, dated October 20, 2009 (incorporated  herein by reference to Exhibit 10.1 to the 8-K filed by Pinnacle Gas  Resources, Inc. on October 22, 2009).                                                                                                                                                                   |
|               |       |       |       |                                                                                                                                                                                                                                                                                                                                                                              |
| 10.5               |       | —     |       | Waiver  and Amendment, dated October 26, 2009 (incorporated herein by reference  to Exhibit 10.1 to the 8-K filed by Pinnacle Gas Resources, Inc. on  October 29, 2009).                                                                                                                                                                                      |
|               |       |       |       |                                                                                                                                                                                                                                                                                                                                                                              |
| 10.6               |       | —     |       | Waiver  and Amendment, dated November 16, 2009 (incorporated herein by reference  to Exhibit 10.1 to the 8-K filed by Pinnacle Gas Resources, Inc. on  November 19, 2009).                                                                                                                                                                                    |
|               |       |       |       |                                                                                                                                                                                                                                                                                                                                                                              |
| 10.7               |       | —     |       | Waiver  and Amendment, dated November 23, 2009 (incorporated herein by reference  to Exhibit 10.1 to the 8-K filed by Pinnacle Gas Resources, Inc. on  November 23, 2009).                                                                                                                                                                                    |
|               |       |       |       |                                                                                                                                                                                                                                                                                                                                                                              |
| 10.8               |       | —     |       | Waiver  and Agreement dated as of January 5, 2010 (incorporated herein by  reference to Exhibit 10.1 to the 8-K filed by Pinnacle Gas  Resources, Inc. on January 8, 2010).                                                                                                                                                                                   |
|               |       |       |       |                                                                                                                                                                                                                                                                                                                                                                              |
| 10.9               |       | —     |       | Seventh  Amendment and Waiver to the Credit Agreement dated as of January 13,  2010 (incorporated herein by reference to Exhibit 10.1 to the 8-K filed  by Pinnacle Gas Resources, Inc. on January 19, 2010).                                                                                                                                                 |
|               |       |       |       |                                                                                                                                                                                                                                                                                                                                                                              |
| *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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*    Filed herewith

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly 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:  November 15, 2010         |
|   |                                  |   |
|   | 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:  November 15, 2010         |

 

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