** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION********Washington, D.C. 20549**

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

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

 

**Commissionfile number: 001-33457**

**Pinnacle Gas Resources, Inc.**

(Exactname of registrant as specified in its charter)

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

 

**(307) 673-9710**

(Registrant’s telephonenumber, including area code)

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

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

Large AcceleratedFiler o      Accelerated Filer o      Non-Accelerated Filer x

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

29,025,751 shares of the registrant’s Common Stockwere outstanding as of November 13, 2007.

 

 

 

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**PINNACLEGAS RESOURCES, INC.**

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

 

 

 

 

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**CAUTIONARYSTATEMENT CONCERNING FORWARD-LOOKING STATEMENTS**

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

·                  projections and estimates concerning the timing andsuccess of specific projects;

·                  our financial position oroperating results;

·                  our business strategy;

·                  our budgets;

·                  the amount, nature and timingof capital expenditures;

·                  the drilling of wells;

·                  the development of recentlyacquired natural gas and oil properties;

·                  the timing and amount offuture production 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 and objectives for future operations.

When we use the words “believe,” “intend,” “expect,” “may,”“should,” “anticipate,” “could,” “estimate,” “plan,” “predict,” “project,”their negatives, or other similar expressions, the statements which includethose words are usually forward-looking statements. When we describestrategy that involves risks or uncertainties, we are making forward-lookingstatements. The forward-looking statements in this quarterly report onForm 10-Q speak only as of the date of this report. We disclaim any obligationto update these statements unless required by securities law, and we caution younot to rely on them unduly. We have based these forward-lookingstatements on our current expectations and assumptions about future events.While our management considers these expectations and assumptions to bereasonable, they are inherently subject to significant business, economic,competitive, regulatory and other risks, contingencies and uncertainties, mostof which are difficult to predict and many of which are beyond our control.These risks, contingencies and uncertainties relate to, among other matters,the following:

·                  our ability to implement ourbusiness strategy;

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

·                  fluctuations in thecommodity prices for natural gas and crude oil;

·                  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;

 

1

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·                  labor problems;

·                  environmental-relatedproblems;

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

·                  production variances fromexpectations;

·                  the substantial capitalexpenditures required for construction of pipelines and the drilling of wellsand the related need to fund such capital requirements through commercial banksand/or public securities markets;

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

·                  our ability to effectivelymarket our production;

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

·                  our ability to develop andreplace reserves;

·                  our dependence upon key personnel;

·                  the lack of liquidity of ourequity securities;

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

·                  potential mechanical failureor under-performance of significant wells;

·                  climatic conditions ornatural disasters;

·                  acts of terrorism;

·                  the availability and cost ofmaterials and equipment;

·                  delays in anticipatedstart-up dates;

·                  our ability to find andretain skilled personnel;

·                  the availability of capital;

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

·                  general economic conditions; and

·                  regional price differentials.

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

 

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**PART I. FINANCIAL INFORMATION**

**ITEM 1. FINANCIAL STATEMENTS**

**PINNACLE GAS RESOURCES, INC.Balance Sheets**
| ** **                                                                                                                                                                    | ** ** | **September  30,  2007**                                                  | ** ** | **December 31,  2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                    | ** ** | **(unaudited)**                                                                | ** ** | ** **                  | ** ** |
| ** **                                                                                                                                                                    | ** ** | **(in thousands, except  share and  per share data)** | ** ** |
| Assets                                                                                                                                                                        |       |                                                                           |       |                        |       |
| Current assets                                                                                                                                                                |       |                                                                           |       |                        |       |
| Cash and cash equivalents                                                                                                                                                     |       | $                                                                              | 12,147     |                        | $          | 4,762 |   |
| Receivables                                                                                                                                                                   |       |                                                                           |       |                        |       |
| Accrued gas sales                                                                                                                                                             |       | 1,148                                                                          |       | 2,364                       |       |
| Joint interest receivables, net of $100 allowance  for doubtful accounts                                                                                                      |       | 6,656                                                                          |       | 9,237                       |       |
| Derivative instruments                                                                                                                                                        |       | 1,719                                                                          |       | 2,856                       |       |
| Inventory of material for drilling and completion                                                                                                                             |       | 314                                                                            |       | 271                         |       |
| Prepaid expenses                                                                                                                                                              |       | 277                                                                            |       | 394                         |       |
| Total current assets                                                                                                                                                          |       | 22,261                                                                         |       | 19,884                      |       |
| Property and equipment,  at cost, net of accumulated depreciation                                                                                                             |       | 2,359                                                                          |       | 2,107                       |       |
| Oil and gas properties, using full cost accounting,  net of accumulated depletion and impairment                                                                              |       |                                                                           |       |                        |       |
| Proved                                                                                                                                                                        |       | 36,022                                                                         |       | 39,988                      |       |
| Unproved                                                                                                                                                                      |       | 85,348                                                                         |       | 85,094                      |       |
| Inventory of material  for drilling and completion                                                                                                                            |       | 827                                                                            |       | 944                         |       |
| Deposits                                                                                                                                                                      |       | 20                                                                             |       | 520                         |       |
| Restricted certificates  of deposit                                                                                                                                           |       | 1,752                                                                          |       | 1,795                       |       |
| Total assets                                                                                                                                                                  |       | $                                                                              | 148,589    |                        | $          | 150,332 |   |
| Liabilities and  Stockholders’ Equity                                                                                                                                    |       |                                                                           |       |                        |       |
| Current liabilities                                                                                                                                                           |       |                                                                           |       |                        |       |
| Long term debt-current portion                                                                                                                                                |       | $                                                                              | 23         |                        | $          | 21 |   |
| Trade accounts payable                                                                                                                                                        |       | 8,602                                                                          |       | 17,567                      |       |
| Revenue distribution payable                                                                                                                                                  |       | 5,740                                                                          |       | 7,301                       |       |
| Drilling prepayments from joint interest owners                                                                                                                               |       | 142                                                                            |       | 289                         |       |
| Accrued liabilities                                                                                                                                                           |       | 1,946                                                                          |       | 2,375                       |       |
| Total current liabilities                                                                                                                                                     |       | 16,453                                                                         |       | 27,553                      |       |
| Asset retirement  obligations                                                                                                                                                 |       | 2,655                                                                          |       | 2,321                       |       |
| Derivative instruments                                                                                                                                                        |       | 92                                                                             |       | —                      |       |
| Production taxes,  non-current                                                                                                                                                |       | 925                                                                            |       | 843                         |       |
| Long term debt-net of  current portion                                                                                                                                        |       | 769                                                                            |       | 786                         |       |
| Total liabilities                                                                                                                                                             |       | 20,894                                                                         |       | 31,503                      |       |
| Contingencies                                                                                                                                                                 |       |                                                                           |       |                        |       |
|                                                                                                                                                                          |       |                                                                           |       |                        |       |
| Series A Redeemable Preferred stock, $0.01 par  value; 25,000,000 authorized, 0 shares issued and outstanding at September  30, 2007 and December 31, 2006, respectively      |       | —                                                                         |       | —                      |       |
| Stockholders’ equity                                                                                                                                                     |       |                                                                           |       |                        |       |
| Common stock, $0.01 par value; 100,000,000  authorized and 29,025,751 and 25,131,301 shares issued and outstanding at  September 30, 2007 and December 31, 2006, respectively |       | 289                                                                            |       | 251                         |       |
| Additional paid-in capital                                                                                                                                                    |       | 149,555                                                                        |       | 119,354                     |       |
| Accumulated deficit                                                                                                                                                           |       | (22,149                                                                        | )          | (776                        | )          |
| Total stockholders’ equity                                                                                                                                               |       | 127,695                                                                        |       | 118,829                     |       |
| Total liabilities and  stockholders’ equity                                                                                                                              |       | $                                                                              | 148,589    |                        | $          | 150,332 |   |

 

See Notes to FinancialStatements (unaudited)

 

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**PINNACLE GAS RESOURCES, INC.**

**Statements ofOperations**

**(unaudited)**
| ** **                                             | ** ** | **Three Months Ended   September 30,**                                  | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                             | ** ** | **2007**                                                                               | ** ** | **2006**                                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                             | ** ** | **(in thousands, except share and per share data)** | ** ** |
| Revenues                                               |       |                                                                                   |       |                                           |       |   |   |   |   |
| Gas sales                                              |       | $                                                                                      | 2,722      |                                           | $          | 2,912 |   | $ | 9,812 |   | $ | 9,511 |   |
| Earn-in joint  venture                                 |       | —                                                                                 |       | —                                         |       | — |   | 379 |   |
| Total revenues                                         |       | 2,722                                                                                  |       | 2,912                                          |       | 9,812 |   | 9,890 |   |
| Cost of revenues  and expenses                         |       |                                                                                   |       |                                           |       |   |   |   |   |
| Lease operating  expenses                              |       | 1,322                                                                                  |       | 777                                            |       | 3,458 |   | 1,934 |   |
| Production taxes                                       |       | 278                                                                                    |       | 332                                            |       | 1,037 |   | 1,085 |   |
| Marketing and  transportation                          |       | 911                                                                                    |       | 537                                            |       | 2,594 |   | 1,397 |   |
| General and  administrative, net                       |       | 1,488                                                                                  |       | 1,421                                          |       | 3,816 |   | 3,907 |   |
| Depreciation,  depletion, amortization and accretion   |       | 1,704                                                                                  |       | 2,015                                          |       | 4,800 |   | 5,060 |   |
| Impairment of  oil and gas properties                  |       | 70                                                                                     |       | —                                         |       | 18,225 |   | — |   |
| Total cost of  revenues and expenses                   |       | 5,773                                                                                  |       | 5,082                                          |       | 33,930 |   | 13,383 |   |
| Operating loss                                         |       | (3,051                                                                                 | )          | (2,170                                         | )          | (24,118 | ) | (3,493 | ) |
| Other  income(expense)                                 |       |                                                                                   |       |                                           |       |   |   |   |   |
| Gain on  derivatives                                   |       | 1,604                                                                                  |       | 2,809                                          |       | 2,069 |   | 5,863 |   |
| Interest income                                        |       | 234                                                                                    |       | 191                                            |       | 532 |   | 504 |   |
| Other income                                           |       | 88                                                                                     |       | 154                                            |       | 312 |   | 322 |   |
| Unrealized  derivative loss                            |       | —                                                                                 |       | —                                         |       | — |   | (26 | ) |
| Interest expense                                       |       | (26                                                                                    | )          | (70                                            | )          | (168 | ) | (129 | ) |
| Total other  income                                    |       | 1,900                                                                                  |       | 3,084                                          |       | 2,745 |   | 6,534 |   |
| Net  (loss)/income before income taxes                 |       | (1,151                                                                                 | )          | 914                                            |       | (21,373 | ) | 3,041 |   |
| Income taxes                                           |       | —                                                                                 |       | —                                         |       | — |   | — |   |
| Net  (loss)/income                                     |       | (1,151                                                                                 | )          | 914                                            |       | (21,373 | ) | 3,041 |   |
| Preferred  dividends                                   |       | —                                                                                 |       | —                                         |       | — |   | (20,964 | ) |
| Net (loss)/income  attributable to common stockholders |       | $                                                                                      | (1,151     | )                                              | $          | 914 |   | $ | (21,373 | ) | $ | (17,923 | ) |
| Basic net  (loss)/income per share                     |       | $                                                                                      | (0.04      | )                                              | $          | 0.04 |   | $ | (0.80 | ) | $ | (1.00 | ) |
| Diluted net  (loss)/income per share                   |       | $                                                                                      | (0.04      | )                                              | $          | 0.04 |   | $ | (0.80 | ) | $ | (1.00 | ) |
| Weighted average  shares outstanding — basic      |       | 29,014,299                                                                             |       | 25,139,699                                     |       | 26,695,765 |   | 17,980,800 |   |
| Weighted average  shares outstanding — diluted    |       | 29,014,299                                                                             |       | 25,546,199                                     |       | 26,695,765 |   | 17,980,800 |   |

 

See Notes to FinancialStatements (unaudited)

 

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

**(unaudited)**
| ** **                                                                                          | ** ** | **Nine  Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2007**                                        | ** ** | **2006** | ** ** |
| Cash flows from  operating activities                                                               |       |                                            |       |   |   |
| Net  (loss)/income                                                                                  |       | $                                               | (21,373    | ) | $ | 3,041 |   |
| Adjustments to  reconcile net (loss)/income to net cash (used in)/provided by operating  activities |       |                                            |       |   |   |
| Impairment of  oil and gas properties                                                               |       | 18,225                                          |       | — |   |
| Depreciation,  depletion, amortization and accretion                                                |       | 4,800                                           |       | 5,060 |   |
| Gain on  derivatives                                                                                |       | (2,069                                          | )          | (5,837 | ) |
| Allowance for  doubtful accounts                                                                    |       | —                                          |       | 100 |   |
| Stock-based  compensation                                                                           |       | 619                                             |       | 242 |   |
| Changes in  assets and liabilities                                                                  |       |                                            |       |   |   |
| Decrease  (increase) in receivables                                                                 |       | 3,797                                           |       | (372 | ) |
| Increase in  inventory of material for drilling and completion                                      |       | (43                                             | )          | (146 | ) |
| Decrease  (increase) in prepaid expenses                                                            |       | 117                                             |       | (46 | ) |
| (Decrease)  increase in accounts payable and accrued liabilities                                    |       | (12,764                                         | )          | 2,775 |   |
| Decrease in  revenue distribution payable                                                           |       | (1,561                                          | )          | (1,426 | ) |
| (Decrease)  increase in drilling prepayments                                                        |       | (147                                            | )          | 351 |   |
| Net cash (used  in)/provided by operating activities                                                |       | (10,399                                         | )          | 3,742 |   |
| Cash flows from  investing activities                                                               |       |                                            |       |   |   |
| Capital  expenditures — exploration and production                                             |       | (14,940                                         | )          | (47,475 | ) |
| Capital  expenditures — property and equipment                                                 |       | (840                                            | )          | (735 | ) |
| Decrease  (increase) in restricted certificates of deposit                                          |       | 43                                              |       | (1,607 | ) |
| Decrease  (increase) in inventory held for exploration and development                              |       | 117                                             |       | (3,091 | ) |
| Decrease  (increase) in deposits                                                                    |       | 500                                             |       | (520 | ) |
| Realized gain on  derivatives                                                                       |       | 3,299                                           |       | 151 |   |
| Proceeds from  the sale of assets held for sale                                                     |       | —                                          |       | 394 |   |
| Net cash used in  investing activities                                                              |       | (11,821                                         | )          | (52,883 | ) |
| Cash flows from  financing activities                                                               |       |                                            |       |   |   |
| Proceeds from  the issuance of common stock                                                         |       | 33,750                                          |       | 141,187 |   |
| Issuance costs  related to common stock                                                             |       | (4,130                                          | )          | (11,417 | ) |
| Dividends paid  on preferred stock                                                                  |       | —                                          |       | (1,397 | ) |
| Redemption of  preferred stock                                                                      |       | —                                          |       | (52,175 | ) |
| Repurchase and  cancellation of common shares                                                       |       | —                                          |       | (16,304 | ) |
| Principal  payments on note payable and capital leases                                              |       | (15                                             | )          | (111 | ) |
| Net cash  provided by financing activities                                                          |       | 29,605                                          |       | 59,783 |   |
| Net increase in  cash and cash equivalents                                                          |       | 7,385                                           |       | 10,642 |   |
| Cash and cash  equivalents at beginning of year                                                     |       | 4,762                                           |       | 2,672 |   |
| Cash and cash  equivalents at end of period                                                         |       | $                                               | 12,147     |   | $ | 13,314 |   |
| Noncash  investing and financing activities                                                         |       |                                            |       |   |   |
| Capital  expenditures included in trade accounts payable                                            |       | $                                               | 3,452      |   | $ | 3,838 |   |
| Asset retirement  obligation included in oil and gas properties                                     |       | 182                                             |       | 869 |   |
| Dividend paid in  kind with the issuance of additional preferred stock                              |       | —                                          |       | 1,213 |   |
| Derivative  liability related to preferred stock                                                    |       | —                                          |       | 232 |   |
| Cashless  exercise of warrants and options                                                          |       | —                                          |       | 15,428 |   |
| Inventory used  in oil and gas properties                                                           |       | —                                          |       | 2,708 |   |
| Supplemental  cash flow information                                                                 |       |                                            |       |   |   |
| Cash payments  for interest, net of amount capitalized                                              |       | $                                               | 168        |   | $ | 129 |   |

 

See Notes to FinancialStatements (unaudited)

 

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**PINNACLE GAS RESOURCES, INC.Statements of Redeemable Preferred Stock and Stockholders’ Equity**
| ** **                                                      | ** ** | ** **                                                  | ** ** | ** **            | ** ** | **Stockholders’ Equity** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------------------------------------------|------------|-----------------------|------------|------------------------------------|------------|
| ** **                                                      | ** ** | **Redeemable  Preferred Stock**                        | ** ** | **Common Stock** | ** ** | **Additional  Paid-In**            | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                                      | ** ** | **Shares**                                                  | ** ** | **Amount**            | ** ** | **Shares**                         | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| ** **                                                      | ** ** | **(in thousands except share amounts)** | ** ** |
| Balance at  December 31, 2006                                   |       | —                                                      |       | $                     | —     |                               | 25,131,301 |   | $ | 251 |   | $ | 119,354 |   | $ | (776 | ) | $ | 118,829 |   |
| Issuance of  restricted shares                                  |       | —                                                      |       | —                |       | 155,500                            |       | — |   | 243 |   | — |   | 243 |   |
| Forfeiture of  restricted shares                                |       | —                                                      |       | —                |       | (11,050                            | )          | — |   | — |   | — |   | — |   |
| Sale of common  stock for cash, net of offering costs of $4,130 |       | —                                                      |       | —                |       | 3,750,000                          |       | 38 |   | 29,582 |   | — |   | 29,620 |   |
| Stock-based  compensation                                       |       | —                                                      |       | —                |       | —                             |       | — |   | 376 |   | — |   | 376 |   |
| Net loss                                                        |       | —                                                      |       | —                |       | —                             |       | — |   | — |   | (21,373 | ) | (21,373 | ) |
| Balance at  September 30, 2007 (unaudited)                      |       | —                                                      |       | $                     | —     |                               | 29,025,751 |   | $ | 289 |   | $ | 149,555 |   | $ | (22,149 | ) | $ | 127,695 |   |

 

See Notes to FinancialStatements (unaudited)

 

 

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**Notes to Financial Statements**

**Unaudited**

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

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

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

**Note 2 — Basis of Presentation**

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

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

*Use of Estimates*

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

*Oil and Gas Properties*

The Company utilizes the full cost method ofaccounting for oil and gas producing activities. Under this method, all costsassociated with property acquisition, exploration and development, includingcosts of unsuccessful exploration, costs of surrendered and abandonedleaseholds, delay lease rentals and the fair value of estimated future costs ofsite restoration, dismantlement and abandonment activities are capitalizedwithin a cost center. The Company’s oil and gas properties are all locatedwithin the United States, which constitutes a single cost center. The Companyhas not capitalized any overhead costs. No gain or loss is recognized upon thesale or abandonment of undeveloped or producing oil and gas properties unlessthe sale represents a significant portion of gas properties and the gainsignificantly alters the relationship between capitalized costs and proved gasreserves of the cost center. Expenditures for maintenance and repairs arecharged to lease operating expense in the period incurred.

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

 

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whetherproved oil and gas reserves will be established is still under evaluation, andany capitalized interest are included in unproved oil and gas properties at thelower of cost or estimated fair market value and are not subject toamortization. On a quarterly basis, such costs are evaluated for inclusion inthe costs to be amortized resulting from the determination of proved reserves,impairments, or reductions in value. To the extent that the evaluationindicates these properties are impaired, the amount of the impairment is addedto the capitalized costs to be amortized. Abandonment of unproved properties isaccounted for as an adjustment to capitalized costs related to proved oil andgas properties, with no losses recognized. The Company recorded an impairmentof unevaluated properties of $0 and $740,000 during the three and nine months ended September 30, 2007,respectively. Substantially all of the remaining unproved property costs areexpected to be developed and included in the amortization base over the nextthree to five years. Salvage value is taken into account in determiningdepletion rates and is based on the Company’s estimate of the value ofequipment and supplies at the time the well is abandoned. As of September 30, 2007 and December 31, 2006,the estimated salvage value was $6,237,000 and $5,736,000, respectively.

Underfull 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 prices and costs, including the effects of derivativeinstruments designated as cash flow hedges but excluding the future cashoutflows associated with settling asset retirement obligations that have beenaccrued on the balance sheet, less any related income tax effects;  plus (2) the cost of properties not beingamortized, 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, 2007, thecapitalized cost of oil and gas properties exceeded the full cost ceilinglimitation by approximately $37.5 million, based upon a natural gas priceof $0.35 per Mcf in effect at that date. Basedon subsequent price increases to approximately $4.10 per Mcf at the measurementdate of November 12, 2007, the capitalized cost of the Company’s oil and gasproperties exceeded the full cost ceiling limitation by approximately $70,000and the Company recorded an impairment of that amount in addition to the approximately$18.2 million recorded at June 30, 2007. The impairment of the Company’soil and gas properties resulted from low commodity prices at September 30, 2007. A decline in gas prices or an increase inoperating costs subsequent to the measurement date or reductions ineconomically recoverable reserve quantities could result in the recognition ofadditional impairments of the Company’s oil and gas properties in futureperiods.

*Per Share Information*

Basic earnings (loss) pershare is computed by dividing net income (loss) from continuing operationsattributable to common stock by the weighted average number of shares of commonstock outstanding during each period. Diluted earnings per share is computed byadjusting the average number of shares of common stock outstanding for thedilutive effect, if any, of common stock equivalents such as stock options andwarrants. Diluted net loss per share was the same as basic loss per share forthe three months ended September 30, 2007 and nine months ended September 30,2006 and 2007 because potential common stock equivalents were anti-dilutive.

Certain options to purchase shares of Pinnacle’scommon stock were excluded from the dilution calculations because the shareswere antidilutive.  During the three andnine months ended September 30, 2007, 907,000 options were excluded becausethey were antidilutive.  During the threemonths ended September 30, 2006, 342,500 options were excluded because theexercise price was the same as the stock price. During the nine months ended September 30, 2006, 1,050,000 option wereexcluded because they were antidilutive.

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

*Income Taxes*

The Company uses the asset and liability method ofaccounting for income taxes, in accordance with Statement of FinancialAccounting Standard (SFAS) No. 109, “Accounting for Income Taxes.”Deferred tax assets and liabilities are recognized for the expected future taxconsequences of temporary differences between the financial statements and taxbases of assets and liabilities. If appropriate, deferred tax assets arereduced by a valuation allowance which reflects expectations of

 

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theextent to which such assets will be realized. As of September 30, 2007 andDecember 31, 2006, the Company had recorded a full valuation allowance forits net deferred tax asset.

On January 1, 2007, the Company adopted FinancialAccounting Standards Board (“FASB”) Interpretation No. 48, “Accounting forUncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN48”).  FIN 48 prescribes a measurementprocess for recording in the financial statements uncertain tax positions takenor expected to be taken in a tax return. Additionally, FIN 48 provides guidance regarding uncertain tax positionsrelating to derecognition, classification, interest and penalties, accountingin interim periods, disclosure and transition. At September 30, 2007, the Company had no material uncertain taxpositions.

*Recent Accounting Pronouncements*

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

In February 2007, the FASB issued SFAS No. 159,“The Fair Value Option for Financial Assets and Financial Liabilities.” SFASNo. 159 permits entities to choose to measure eligible financial instrumentsand certain other items at fair value. The objective is to improve financialreporting by providing entities with the opportunity to mitigate volatility inreported earnings caused by measuring related assets and liabilitiesdifferently without having to apply complex hedge accounting provisions. TheStatement will be effective as of January 1, 2008 for the Company. SFASNo. 159 offers various options in electing to apply the provisions of thisStatement, and at this time the Company has not made any decisions in itsapplication to its financial position or results of operations.

**Note 3****— Asset Retirement Obligations**

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

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

 

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The following is a summary of the Company’s assetretirement obligation activity for the three and nine months ended September30, 2007 and 2006 (in thousands):

| ** **                                      | ** ** | **Three  Months Ended  September 30,** | ** ** | **Nine  Months Ended  September 30,** | ** ** | **Three  Months Ended  September 30,** | ** ** | **Nine  Months Ended  September 30,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                      | ** ** | **2007**                                         | ** ** | **2006**                                        | ** ** |
| ** **                                      | ** ** | **(unaudited)**                                  | ** ** | **(unaudited)**                                 | ** ** |
| Beginning  balance asset retirement obligations |       | $                                                | 2,533      |                                            | $          | 2,321                                            |       | $                                               | 1,965      |   | $ | 1,277 |   |
| Additional  obligation added during the period  |       | 69                                               |       | 182                                             |       | 252                                              |       | 870                                             |       |
| Obligations  settled during the period          |       | —                                           |       | —                                          |       | —                                           |       | —                                          |       |
| Revisions in  estimates                         |       | —                                           |       | —                                          |       | —                                           |       | —                                          |       |
| Accretion  expense                              |       | 53                                               |       | 152                                             |       | 45                                               |       | 115                                             |       |
| Ending balance  of asset retirement obligations |       | $                                                | 2,655      |                                            | $          | 2,655                                            |       | $                                               | 2,262      |   | $ | 2,262 |   |

 

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

*Certificates of deposit.*The Company holds a certificate ofdeposit (“CD”), which expires in July 2008, totaling $148,000. The CD iscollateral on bonding required by the State of Wyoming, the State of Montanaand the Federal Bureau of Land Management. Because the Company intends to renewthe CD in order to maintain its bonding requirements, the Company has includedthe CD in other non-current assets as of September 30, 2007.  Additionally, the Company holds another CDfor $604,000 which was issued in February 2006 and expires in February2008.  This CD collateralizes a letter ofcredit in favor of Powder River Energy Corporation, a local rural electricassociation, in order to secure power lines to the Kirby and Deer Creek areas.The Company has included this amount in non-current assets as of September 30,2007 because the Company also intends to renew the CD in order to maintain a powersupply on a long-term basis. In April 2006, the Company issued a $1,000,000letter of credit that expires in April 2008 in favor of Bitter Creek Pipelines,LLC to secure the construction of a high pressure pipeline and relatedcompression facilities to the Company’s Deer Creek and Kirby areas.  The Company has included this amount innon-current assets as of September 30, 2007 because the Company anticipates itwill be required to renew the letter of credit because construction of thepipeline and compression facility is not expected to be completed until thesecond quarter of 2009.

*Deposits.* The Company hasincluded approximately $20,000 related to royalty payments in deposits.  These amounts are included in deposits in theaccompanying balance sheet at September 30, 2007.

**Note 5 — Derivatives**

The Company accounts for derivative instruments orhedging activities under the provisions of SFAS No. 133, “Accounting forDerivative Instruments and Hedging Activities.” SFAS No. 133 requires theCompany to record derivative instruments at their fair value. If the derivativeis designated as a fair value hedge, the changes in the fair value of thederivative and of the hedged item attributable to the hedged risk arerecognized in earnings. If the derivative is designated as a cash flow hedge,the effective portions of changes in the fair value of the derivative arerecorded in other comprehensive income (loss) and are recognized in thestatement of operations when the hedged item affects earnings. Ineffective portionsof changes in the fair value of cash flow hedges, if any, are recognized inearnings. Changes in the fair value of derivatives that do not qualify forhedge treatment are recognized in earnings.

The Company periodically hedges a portion of its oil andgas production through swap and collar agreements. The purpose of the hedges isto provide a measure of stability to the Company’s cash flows in an environmentof volatile oil and gas prices and to manage the exposure to commodity pricerisk. Management of the Company decided not to use hedge accounting for theseagreements. Therefore, in accordance with the provisions of SFAS No. 133,the changes in fair market value are recognized in earnings.

 

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As of September 30, 2007 and 2006, the Company hadnatural 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,  2007 (unaudited)                                   |       |                    |       |                                                   |        |             |       |
| Natural  Gas—Collar                                          |       | 1,000                   |       | $                                                      | 5.00-$5.20  |             | 10/04-9/07 |   |
| Natural  Gas—Collar                                          |       | 1,000                   |       | $                                                      | 6.50-$10.50 |             | 9/06-12/07 |   |
| Natural  Gas—Collar                                          |       | 3,000                   |       | $                                                      | 7.00-$9.05  |             | 1/07-12/07 |   |
| Natural  Gas—Collar                                          |       | 3,000                   |       | $                                                      | 6.50-$8.20  |             | 1/08-12/08 |   |
| September 30,  2006 (unaudited)                                   |       |                    |       |                                                   |        |             |       |
| Natural  Gas—Collar                                          |       | 1,000                   |       | $                                                      | 5.00-$5.20  |             | 10/04-9/07 |   |
| Natural  Gas—Collar                                          |       | 1,750                   |       | $                                                      | 6.70-$7.90  |             | 1/06-12/06 |   |
| Natural  Gas—Collar                                          |       | 1,000                   |       | $                                                      | 6.50-$10.50 |             | 9/06-12/07 |   |
| Natural  Gas—Collar                                          |       | 3,000                   |       | $                                                      | 7.00-$9.05  |             | 1/07-12/07 |   |

 

The Company realized hedging gains of $1,623,000 and$266,000 during the three months ended September 30, 2007 and 2006,respectively. As a result of the change in the fair value of the commodityderivatives, the Company had an unrealized loss of $19,000 for the three monthsended September 30, 2007 and an unrealized gain of $2,543,000 for the threemonths ended September 30, 2006.   Theaggregate of these contracts resulted in a gain on derivatives of $1,604,000and $2,809,000 for the three months ended September 30, 2007 and 2006, respectively.For the nine months ended September 30, 2007, the Company realized a hedginggain of $3,299,000 as compared to a hedging gain of $151,000 for the ninemonths ended September 30, 2006. The Company had an unrealized loss of$1,230,000 for the nine months ended September 30, 2007 and an unrealized gainof $5,712,000 for the nine months ended September 30, 2006. The aggregate ofthese contracts resulted in a gain on derivatives of $2,069,000 and $5,863,000for the nine months ended September 30, 2007 and 2006, respectively. Unrealizedand realized gains and losses are included in gains or losses on derivatives inthe accompanying statements of operations. Because the Company’s derivativecontracts were not accounted for as cash flow hedges, the Company classifiesthe realized gains and losses in investing activities in the accompanyingstatements of cash flows.

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

**Note 6 — Stock Based Compensation**

*Options under Employee Option Plans*

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

Options granted under the plan become vested asdirected by the Company’s Board of Directors and generally expire seven or tenyears after the date of grant, unless the option holder owns more than 10% ofthe total combined voting power of all classes of the Company’s stock, in whichcase the non-statutory stock options must be exercised within five years of thedate of grant. At September 30, 2007, there were options to purchase 907,000shares granted under the plan.

Theoptions granted since formation in June 2003 vest as follows:

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

 

 

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*Stock-Based Compensation*

At September 30, 2007, the Company had unvestedoptions to purchase 525,500 shares with a weighted average grant date fairvalue of $1.1 million.  During the threeand nine months ended September 30, 2007, the Company granted options to purchase0 and 120,000 shares of common stock, respectively, and recognized compensationexpense of approximately $139,000 and $376,000, respectively. The Company willrecognize compensation expense relating to nonvested options granted afterJanuary 1, 2006 of approximately $1.1 million ratably over the next threeyears.

The following table summarizes stock option activityfor the nine months ended September 30, 2007:
| ** **                                                        | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price  Per Share** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Aggregate  Intrinsic value** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding,  December 31, 2006                                   |       | 1,035,000                  |       | $                                                              | 6.68       |                                                    |       |                                |       |   |
| Granted                                                           |       | 120,000                    |       | 10.03                                                          |       |                                                    |       |                                |       |
| Canceled or  forfeited                                            |       | (248,000                   | )          | 8.11                                                           |       |                                                    |       |                                |       |
|                                                              |       |                       |       |                                                           |       |                                                    |       |                                |       |
| Outstanding,  September 30, 2007                                  |       | 907,000                    |       | $                                                              | 6.73       |                                                    | 4.84       |                                | $          | 178,000 |   |
|                                                              |       |                       |       |                                                           |       |                                                    |       |                                |       |
| Exercisable,  September 30, 2007                                  |       | 381,500                    |       | $                                                              | 5.41       |                                                    | 4.05       |                                | $          | 152,700 |   |
| Weighted average  fair value of options granted during the period |       |                       |       | $                                                              | 10.03      |                                                    |       |                                |       |   |

 

The following table summarizes information about stockoptions outstanding at September 30, 2007:
| ** **               | ** ** | **Options Outstanding**            | ** ** | **Options Exercisable**                            | ** ** | ** **              | ** ** |
|--------------------------|------------|-----------------------------------------|------------|---------------------------------------------------------|------------|-------------------------|------------|
| **Exercise Prices** | ** ** | **Number of  shares  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Fair Value  Determination** | ** ** |
| $4.00                    |       | 137,500                                 |       | 3.0 years                                               |       | 137,500                 |       | $ | 4.00 |   | Black-Scholes |   |
|                     |       |                                    |       |                                                    |       |                    |       |   |   | (minimum value) |   |
| $4.80                    |       | 346,000                                 |       | 4.5 years                                               |       | 167,500                 |       | $ | 4.80 |   | Black-Scholes |   |
|                     |       |                                    |       |                                                    |       |                    |       |   |   | (minimum value) |   |
| $5.20                    |       | 112,500                                 |       | 5.3 years                                               |       | 22,500                  |       | $ | 5.20 |   | Black-Scholes |   |
| $8.40                    |       | 45,000                                  |       | 6.7 years                                               |       | —                  |       | $ | 8.40 |   | Black-Scholes |   |
| $11.00                   |       | 266,000                                 |       | 5.7 years                                               |       | 54,000                  |       | $ | 11.00 |   | Black-Scholes |   |
|                     |       | 907,000                                 |       |                                                    |       | 381,500                 |       |   |   |   |   |

 

*Restricted Stock*

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

Effective February 12, 2007, the Company granted andissued an aggregate of 12,000 shares of restricted common stock to itsnon-employee directors and 25,000 shares of restricted common stock to certainemployees pursuant to the Company’s stock incentive plan.  In addition, on March 26, 2007, the Companygranted an additional 10,000 shares of restricted common stock to an employeepursuant to the stock incentive plan. The 12,000 restricted shares issued to the non-employee directors willbe fully vested on February 12, 2008. The other restricted shares issued to employees will vest according tothe option vesting schedule set forth above. Effective July 1, 2007, the Company granted and issued an aggregate of54,000 shares of restricted common stock to certain employees.  These shares will vest equally over threeyears.  In addition, on July 20, 2007,the Company entered into employment agreements with certain of its executiveofficers. In conjunction with the employment agreements, these executiveofficers were granted 50,000 shares of restricted common stock.  These shares will vest 33.34%, 33.33% and33.33% on the third, fourth and fifth anniversary of the grant date.  Effective August 22, 2007, the Companygranted and issued 4,500 shares of restricted common stock to a new boardmember.  These shares will vest equallyover three years.  The Company recognizedan expense of approximately $116,000

 

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and $243,000 for the quarter and nine months ended September 30, 2007,respectively, based on the fair value of the vested shares during the period.

 

A summary of the status and activity of the restrictedstock for the nine months ended September 30, 2007 is presented below.

| ** **                        | ** ** | **Shares** | ** ** | **Weighted-Average  Grant-Date  Fair Value** | ** ** |
|-----------------------------------|------------|------------|------------|---------------------------------------------------|------------|
| Non-vested at  December 31, 2006  |       | 27,270     |       | $                                                 | 11.00      |   |
| Granted                           |       | 155,500    |       | 8.41                                              |       |
| Forfeited                         |       | (11,050    | )          | 10.69                                             |       |
| Vested                            |       | (9,090     | )          | 11.00                                             |       |
| Non-vested at  September 30, 2007 |       | 162,630    |       | $                                                 | 8.54       |   |

 

As of September 30, 2007,the Company had approximately $1,389,000 of unrecognized share-basedcompensation expense related to non-vested stock awards, which is expected tobe amortized over the remaining vesting periods of three to five years.

**Note 7 — Long-Term Debt**

*Credit Facility*

Effective February 12, 2007, the Company enteredinto a new $100 million credit facility (the “Credit Agreement”) with The RoyalBank of Scotland (“RBS”), with an initial commitment of $27 million whichpermits borrowings up to the borrowing base as designated by the administrativeagent.  As of September 30, 2007, theborrowing base under the Credit Agreement was $22 million although theborrowing availability is less than the initial borrowing base due to covenantlimitations. As of September 30, 2007, the borrowing availability was $16.7million. The borrowing base is determined on a semi-annual basis and at suchother times as may be requested by the borrower or administrative agent.  Borrowing under the Credit Agreement bearsinterest either: (i) at a domestic bank rate plus an applicable margin between0.25% and 1.25% per annum based on utilization or (ii) on a sliding scale fromthe one, two, three, or six month LIBOR rate plus 1.25% to 2.25% per annumbased on utilization. The Credit Agreement matures February 12, 2011 andreplaced the Company’s previous credit facility.  The Credit Agreement with RBS iscollateralized by substantially all of the Company’s producing assets.  At September 30, 2007, the Company had no debtoutstanding under the Credit Agreement. The Company used a portion of the net proceeds from its initial publicoffering in May 2007 to pay down all of the outstanding indebtedness under theCredit Agreement.

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

·      incur liens;

·      incur debt;

·      make investments in other persons;

·      declare dividends or redeem or repurchase stock;

·      engage in mergers, acquisitions, consolidations andasset sales or amend the Company’s organizational documents;

·      enter into certain hedging arrangements;

·      amend material contracts; and

·      enter into related party transactions.

 

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With regard to hedgingarrangements, the Credit Agreement provides that acceptable commodity hedgingarrangements cannot be greater than 80 to 85%, depending on the measurementdate, of the Company’s monthly production from its hydrocarbon properties thatare used in the borrowing base determination and that the fixed or floor priceof the Company’s hedging arrangements must be equal to or greater than the gasprice used by the lenders in determining the borrowing base.

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

*OfficeBuilding Loan*

On November 15,2005, the Company entered into a mortgage loan secured by its office buildingin Sheridan, Wyoming in the aggregate principal amount of $829,000. Thepromissory note provides for monthly payments of principal and interest in theinitial amount of $6,400, and unpaid principal bears interest at 6.875% duringthe first three years, at a variable base rate thereafter and at 18% upon adefault. The variable base rate is based on the lender’s base rate. Thematurity date of this mortgage is November 15, 2015, at which time a principaland interest payment of $615,400 will become due. As of September 30, 2007, theCompany had $792,000 outstanding in principal on this mortgage.

**Note 8 — Equity**

*Common Stock*. In April 2006, the Company completed a privateplacement of 12,835,230 shares of common stock at a price of $11.00 pershare.  The Company received net proceedsof approximately $129.9 million, before offering costs,  which were used as follows: (i) approximately$53.6 million to redeem all of the outstanding shares of Series A RedeemablePreferred Stock, including the payment of all accrued and unpaid dividends anda redemption premium, (ii) approximately $27.0 million for the acquisitionof the Green River Basin assets, (iii) approximately $16.3 million torepurchase an aggregate of 1,593,783 shares of common stock at a price of$10.23 per share from certain stockholders, and (iv) approximately$33.0 million to fund the Company’s development drilling program,additional out of pocket offering costs and for general corporate purposes.

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

*Preferred Stock.*As of September 30, 2007, there were no shares ofpreferred stock issued and outstanding. In April 2006, following the initialclosing of the Company’s private placement discussed above, the Companyredeemed all of the outstanding shares of Series A Redeemable Preferred Stockwith a portion of the proceeds from the private placement including the paymentof accrued and unpaid dividends of $1.4 million.  The difference between the redemption priceand the carrying value of the Series A Redeemable Preferred Stock resulted in a$19.6 million redemption premium that was recorded as a dividend expense in theaccompanying statements of operations for the nine months ended September 30,2006.

*Warrants.*As of December 31, 2005, there were Series Awarrants outstanding to purchase an aggregate 10,530,725 shares of common stockwith an exercise price of $4.00 per share. However, immediately prior tothe initial closing of the private placement, all outstanding warrants and1,168,204 escalating options were exchanged in a cashless transaction into an

 

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aggregateof 8,062,584 shares of common stock.  Asof September 30, 2007, there were no outstanding warrants to purchase shares ofthe Company’s common stock.

**Note 9 — Contingencies**

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

The Company is currentlya defendant in two lawsuits whereby the plaintiff, among other things, isseeking to permanently enjoin the State of Montana and its administrative bodiesfrom issuing licenses or permits to drill on, or from authorizing the removalof ground water from under, the plaintiff’s property. Based on the informationavailable to date, the Company believes the claims are without merit andintends to defend the cases vigorously. Additionally, the Company’s oil and gasoperations are subject to various Federal, state and local laws andregulations. The Company could incur significant expense to comply with the newor existing laws and non-compliance could have a material adverse effect on theCompany’s operations.

**Note 10 — Subsequent Events**

On October 15, 2007, the Company entered into anagreement and plan of merger with Quest Resources Corporation. The mergeragreement provides for Quest’s acquisition of all the issued and outstanding shares of the Company’s common stock,par value $0.01 per share, for aggregate consideration of approximately 19.1million shares of Quest’s common stock,. For further information, please see the Company’s Current Report on Form8-K filed on October 16, 2007.

 

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

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

**Overview**

We are an independent energy company engaged in theacquisition, exploration and development of domestic onshore natural gasreserves. We were formed in June 2003 as a Delaware corporation by fundsaffiliated with DLJ Merchant Banking III, Inc., which we refer to collectivelyas DLJ Merchant Banking, and subsidiaries of Carrizo Oil & Gas, Inc., orCarrizo, and U.S. Energy Corporation, or U.S. Energy.  We primarily focus our efforts on thedevelopment of CBM properties located in the Powder River Basin in northeasternWyoming and southern Montana. In addition, in April 2006, we acquiredproperties located in the Green River Basin in southern Wyoming. As ofSeptember 30, 2007, we owned natural gas and oil leasehold interests inapproximately 507,000 gross (336,000 net) acres, approximately 94% of which areundeveloped. As of February 28, 2007, we had estimated net proved reserves ofapproximately 25.9 Bcf based on the CIG index price of $6.28, with a pre-taxPV-10 value of $54.8 million.  We drilled67 gross (43 net) wells and completed 82 gross (51 net) wells during the ninemonths ended September 30, 2007, and we operated 100% of those wells. Weincurred capital expenditures of $14.9 million during the nine monthsended September 30, 2007 related to drilling, completion and infrastructurecosts on our undeveloped acreage in our Kirby, Deer Creek, Cabin Creek andGreen River Basin areas.

**RecentDevelopments**

**               **In May 2007, wecompleted an initial public offering of an aggregate of 3,750,000 shares of ourcommon stock at a price per share of $9.00, or $8.37 net of the underwriter’sdiscounts and commissions, and received approximately $30.0 million of netproceeds after offering expenses.  InJune 2007, the underwriters partially exercised their overallotment option topurchase 258,614 shares of our common stock from certain sellingstockholders.  We used a portion of thenet proceeds from our initial public offering to pay down all of theoutstanding indebtedness under our credit facility.  Please see “Liquidity and Capital Resources —Credit Facility” for further information regarding our credit facility.

On October 15, 2007, we entered into an agreement andplan of merger with Quest Resources Corporation. The merger agreement providesfor Quest’s acquisition of all the issued and outstanding shares of our commonstock, par value $0.01 per share, for aggregate consideration of approximately19.1 million shares of Quest’s common stock. For further information, please see our Current Report on Form 8-K filedon October 16, 2007.

**Critical Accounting Policies**

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

·                  Reserve evaluation and determination.

·                  Estimates of the timing and cost of our futuredrilling activity.

·                  Estimates of the fair valuation of hedges in place.

·                  Estimates of timing and cost of asset retirementobligations.

 

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·                  Estimates of the expense and timing of exercise ofstock options.

·                  Accruals of operating costs, capital expenditures andrevenue.

***Oiland Gas Properties***

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

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

Substantially all remaining unproved property costs areexpected to be developed and included in the amortization base ratably over thenext three to five years. Salvage value is taken into account in determiningdepletion rates and is based on our estimate of the value of equipment andsupplies at the time the well is abandoned. As of September 30, 2007 andDecember 31, 2006, the estimated salvage value was $6,237,000 and $5,736,000,respectively.

Underfull 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 prices and costs, including the effects of derivativeinstruments designated as cash flow hedges but excluding the future cashoutflows associated with settling asset retirement obligations that have beenaccrued on the balance sheet, less any related income tax effects;  plus (2) the cost of properties not beingamortized, 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, we calculate the full cost ceiling limitation.  At September 30, 2007, the capitalized costof our oil and gas properties exceeded the full cost ceiling limitation byapproximately $37.5 million, based upon a natural gas price of $0.35 perMcf in effect at that date. Based onsubsequent price increases to approximately $4.10 per Mcf at the measurementdate of November 12, 2007, the capitalized cost of our oil and gas propertiesexceeded the full cost ceiling limitation by approximately $70,000 and we recordedan impairment of that amount in addition to the approximately $18.2 millionrecorded at June 30, 2007.  Theimpairment of our oil and gas properties resulted from low commodity prices atSeptember 30, 2007. A decline in gas pricesor an increase in operating costs subsequent to the measurement date orreductions in economically recoverable reserve quantities could result in therecognition of additional impairments of our oil and gas properties in futureperiods.

***GasSales***

We use the sales method for recording natural gas sales.Sales of gas applicable to our interest in producing natural gas and oil leasesare recorded as revenues when the gas is metered and title transferred pursuantto the gas sales contracts covering our interest in gas reserves. During suchtimes as our sales of gas exceed our pro rata ownership in a well, such salesare recorded as revenues unless total sales from the well have exceeded ourshare of estimated total gas reserves underlying the property at which timesuch excess is recorded as a gas imbalance liability. At September 30, 2007 andDecember 31, 2006, there was no such liability recorded. Although therewas no such liability recorded for prior periods, gas reserves are an estimate 

 

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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 accrual atSeptember 30, 2007 and December 31, 2006 were based on the actual volumestatements from our purchasers and distribution process. If accruals were tochange by 10% at September 30, 2007 and at December 31, 2006, the impact wouldhave been a $371,000 and $319,000 change, respectively.

***AssetRetirement Obligations***

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

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

The estimated liability is based on historical gasindustry experience in abandoning wells, including estimated economic lives,external estimates as to the cost to abandon the wells in the future andfederal and state regulatory requirements. Our liability is discounted usingour best estimate of our credit-adjusted risk-free rate. Revisions to theliability could occur due to changes in estimated abandonment costs, changes inwell economic lives or if federal or state regulators enact new requirementsregarding the abandonment of wells. For example, a 10% change in our estimatedretirement costs would have a $247,000 effect on our asset retirementobligation liability at September 30, 2007.

Thefollowing is a summary of our asset retirement obligation activity for thethree and nine months ended September 30, 2007 and 2006 (in thousands):

| ** **                                      | ** ** | **Three  Months Ended  September 30,** | ** ** | **Nine  Months Ended  September 30,** | ** ** | **Three  Months Ended  September 30,** | ** ** | **Nine  Months Ended  September 30,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                      | ** ** | **2007**                                         | ** ** | **2006**                                        | ** ** |
| ** **                                      | ** ** | **(unaudited)**                                  | ** ** | **(unaudited)**                                 | ** ** |
| Beginning  balance asset retirement obligations |       | $                                                | 2,533      |                                            | $          | 2,321                                            |       | $                                               | 1,965      |   | $ | 1,277 |   |
| Additional  obligation added during the period  |       | 69                                               |       | 182                                             |       | 252                                              |       | 870                                             |       |
| Obligations  settled during the period          |       | —                                           |       | —                                          |       | —                                           |       | —                                          |       |
| Revisions in  estimates                         |       | —                                           |       | —                                          |       | —                                           |       | —                                          |       |
| Accretion  expense                              |       | 53                                               |       | 152                                             |       | 45                                               |       | 115                                             |       |
| Ending balance  of asset retirement obligations |       | $                                                | 2,655      |                                            | $          | 2,655                                            |       | $                                               | 2,262      |   | $ | 2,262 |   |

*** ***

***Inventory***

We acquired inventory of oil and gas equipment, primarilytubulars, in 2007 and 2006, to take advantage of quantity pricing and to securea readily available supply. Inventory is valued at the lower of average cost ormarket. Inventory is used in the development of gas properties and to theextent it is estimated that it will be billed to other working interest ownersduring the next year, it is included in current assets. Otherwise, it is recordedin other assets. The price of steel is a primary factor in valuing ourinventory. Under the valuation method of lower of average cost or market, a 10%reduction in the price of steel would cause a $74,000 reduction in ourinventory valuation as of September 30, 2007. The market price of steel isevaluated each quarter using prices quoted by authorized vendors in the area.

***Propertyand Equipment***

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

 

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***Long-LivedAssets***

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

***Generaland Administrative Expenses***

General and administrative expenses are reported net ofamounts allocated and billed to working interest owners of gas propertiesoperated by us. The administrative expenses billed to working interest ownersmay change in accordance with the terms of the joint operating agreements.Administrative expenses are charged to working interest owners based onproductive well counts. A 10% change in well counts for the three and ninemonths ended September 30, 2007 would have increased or decreased our expensesbilled to working interest owners by approximately $45,000 and $117,000,respectively. As we operate and drill additional wells in the future,additional administrative expenses will be charged to the working interest ownerswhen the wells become productive.

***Income Taxes***

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

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

***Derivatives***

We use derivative instruments to manage our exposure tofluctuating natural gas prices through the use of natural gas swap and optioncontracts. We account for derivative instruments or hedging activities underthe provisions of SFAS No. 133, “Accounting for Derivative Instruments andHedging Activities.” SFAS No. 133 requires us to record derivativeinstruments at their fair value. If the derivative is designated as a fairvalue hedge, the changes in the fair value of the derivative and of the hedgeditem attributable to the hedged risk are recognized in earnings. If thederivative is designated as a cash flow hedge, the effective portions ofchanges in the fair value of the derivative are recorded in other comprehensiveincome (loss) and are recognized in the statement of operations when the hedgeditem affects earnings. Ineffective portions of changes in the fair value ofcash flow hedges, if any, are recognized in earnings. Changes in the fair valueof derivatives that do not qualify for hedge treatment are recognized inearnings. Please see note 5 included in the accompanying unaudited Notesto Financial Statements for additional discussions of derivatives.

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

***Stock-BasedCompensation***

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

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

 

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

***AccountsReceivable***

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

***TransportationCosts***

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

***PerShare Information***

Basicearnings (loss) per share is computed by dividing net income (loss) fromcontinuing operations attributable to common stock by the weighted averagenumber of shares of common stock outstanding during each period. Dilutedearnings per share is computed by adjusting the average number of shares ofcommon stock outstanding for the dilutive effect, if any, of common stockequivalents such as stock options and warrants.  Diluted netloss per share was the same as basic loss per share for the three months endedSeptember 30, 2007 and nine months ended September 30, 2006 and 2007 becausepotential common stock equivalents were anti-dilutive. Certain options topurchase shares of Pinnacle’s common stock were excluded from the dilutioncalculations because the shares were antidilutive. During the three and ninemonths ended September 30, 2007, 907,000 options were excluded because theywere antidilutive. During the three months ended September 30, 2006, 342,500options were excluded because the exercise price was the same as the stockprice. During the nine months ended September 30, 2006, 1,050,000 options wereexcluded because they were antidilutive.

***New AccountingPronouncements***

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

**Trends Affecting Our Business**

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

Historically, natural gas prices have been extremelyvolatile, and we expect that volatility to continue. For example, during thethree months ended September 30, 2007, the NYMEX natural gas index price rangedfrom a high of $7.01 per MMBtu to a low of $5.43 per MMBtu, while the CIG natural gas index price ranged from ahigh of $4.50 per MMBtu to a low of $0.27 per MMBtu.  During the nine months ended September 30,2007, the NYMEX natural gas index price ranged from a high of $8.19 perMMBtu to a low of $5.43 per MMBtu, while the CIG natural gas index priceranged from a high of $7.11 per MMBtu to a low of $0.27 per MMBtu.During the year ended December 31, 2006, the NYMEX natural gas index priceranged from a high of $11.23 per MMBtu to a low of $4.20 per MMBtu,while the CIG natural gas index price ranged from a high of $7.90 perMMBtu to a low of $1.30 per MMBtu. Changes in natural gas pricing haveimpacted our revenue streams, production taxes, prices used in reservecalculations, borrowing base calculations and the valuation of potentialproperty acquisitions. During the three and nine months ended September 30,2007, estimated future gas prices had an impact on both our revenues and thecosts attributable to our future operations. We expect that changing naturalgas prices will continue to impact our operations and financial results in thefuture.

 

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

**Results of Operations**

***Three Months Ended September 30, 2007Compared To Three Months Ended September 30, 2006***

Net loss attributable to stockholders for the threemonths ended September 30, 2007 was $1.2 million, or $0.04 per dilutedshare, on total revenues of $2.7 million. Net loss attributable tostockholders for the three months ended September 30, 2007 included a$0.02 million unrealized loss associated with the change in the fair valuationof our natural gas hedges in place in accordance with the provisions of SFASNo. 133. Absent such a change in the valuation, we would have shown a netloss attributable to stockholders of $1.2 million on total revenues of$2.7 million. This compares to net income attributable to stockholders of$0.9 million for the three months ended September 30, 2006 on total revenues of$2.9 million. Adjusted for an unrealized gain in the fair valuation of ournatural gas hedges in place of $2.5 million, our results for the threemonths ended September 30, 2006 would have been a net loss attributable tostockholders of $1.6 million on total revenues of $2.9 million.

*Gas sales volume.*

Gas sales volume increased 42%, from 627 MMcf in thethree months ended September 30, 2006 to 893 MMcf in the three months endedSeptember 30, 2007. Daily sales volume was 9.7 MMcf for the three months endedSeptember 30, 2007 as compared to 6.8 MMcf for the three months ended September30, 2006, a 2.9 MMcf per day increase. The increase was primarily due toproduction coming online in our Cabin Creek, Kirby and Deer Creek projectareas.  On average, we have a greaterworking and net revenue interest in these areas compared to some of our otherareas.

*Gas sales revenue.*

Revenue from gas sales decreased $0.2 million during thethree months ended September 30, 2007, to $2.7 million, a 7% decreasecompared to the three months ended September 30, 2006. This decrease wasprimarily due to a decrease in the average realized price per Mcf which waspartially offset by an increase in gas sales volume. The average realized priceper Mcf decreased 34%, from $4.64 per Mcf in the three months ended September30, 2006 to $3.05 per Mcf in the three months ended September 30, 2007.

*Derivatives.*

For the three months ended September 30, 2007, we had anunrealized loss on derivatives of $0.02 million compared to an unrealized gainof $2.5 million for the three months ended September 30, 2006. Theunrealized loss is a noncash expense based primarily on the Black-Scholesmodel for valuing future cash flows utilizing price volatility with a normaldiscount rate. Hedges settled in the three months ended September 30, 2007resulted in a realized gain of $1.6 million compared to hedging gains of$0.3 million in the three months ended September 30, 2006. The hedge gains wereprimarily due to the fact that gas prices were lower than the weighted averagefloor price of our hedges in place.

*Lease operating expenses.*

Lease operating expenses increased $0.5 million inthe three months ended September 30, 2007 to $1.3 million, a 70% increasecompared to the three months ended September 30, 2006. This increase resultedfrom an increase in the number of wells in the productive cycle during thethree months ended September 30, 2007. On an Mcf basis, lease operatingexpenses increased 19% from $1.24 per Mcf in the three months ended September30, 2006 to $1.48 per Mcf in the three months ended September 30, 2007. Theincrease per Mcf was primarily due to a number of wells being in the early stagesof their productive 

 

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life cycle as production did not increase proportionately to the numberof wells coming online. Additionally, increases in generator rentals andassociated fuel while waiting on permanent power contributed to the increase.

*Production taxes.*

Production taxes decreased $0.05 million in thethree months ended September 30, 2007 to $0.3 million, a 16% decrease fromthe three months ended September 30, 2006. Production taxes generally correlateto gross sales revenue because production taxes are based on a percentage ofsales value. In Wyoming, the percentage averages 11% to 13%, depending on ratesin effect for the respective year. The decrease in production taxes for thethree months ended September 30, 2007 was primarily due to Montana productiontaxes, which are 1% for the first year of production and 9% thereafter, as wellas a decrease in the average realized price per Mcf. On an Mcf basis,production taxes were $0.31 per Mcf for the three months ended September 30,2007 and $0.53 per Mcf for the three months ended September 30, 2006, a 42%decrease, which correlates to the decrease in the price per Mcf received in thethree months ended September 30, 2007 from the three months ended September 30,2006.

*Marketing and transportation.*

Marketing and transportation expenses increased$0.4 million in the three months ended September 30, 2007 to$0.9 million, a 70% increase from the three months ended September 30,2006. The increase related primarily to the increased sales volume in the threemonths ended September 30, 2007, together with a slight increase intransportation fees and compression due to inflationary adjustments in thecontracts along with fees paid for compression design capacity which was notused.  On an Mcf basis, marketing andtransportation expenses increased 19% to $1.02 per Mcf in the three monthsended September 30, 2007 from $0.86 per Mcf in the three months ended September30, 2006.

*General and administrative expenses,net.*

General and administrative expenses are offset byoperating income from drilling and production activities for which we cancharge an overhead fee to nonoperating working interest owners. These welloperating overhead fees increased 55% in the three months ended September 30,2007, from $0.3 million to $0.4 million, due to increased productivewells which we operate and for which we charge an overhead fee. General andadministrative expenses, net increased $0.07 million in the three monthsended September 30, 2007 to $1.5 million.  On an Mcf basis, general and administrative expenses, net decreased 26%from $2.27 per Mcf in the three months ended September 30, 2006 to $1.67 perMcf in the three months ended September 30, 2007.

*Depreciation, depletion, amortizationand accretion.*

Depreciation, depletion, amortization and accretionexpense decreased $0.3 million for the three months ended September 30, 2007 to$1.7 million, a 15% decrease compared to the three months ended September30, 2006. This decrease was due to a decrease in the full cost pool due to theimpairments recorded in 2007 coupled with higher quarter-end reserves atSeptember 30, 2007 compared to September 30, 2006. On an Mcf basis, thedepreciation, depletion, amortization and accretion rate decreased 41% to $1.91per Mcf in the three months ended September 30, 2007 from $3.21 per Mcf in thethree months ended September 30, 2006.

*Impairment.*

AtSeptember 30, 2007, the capitalized cost of our oil and gas properties exceededthe full cost ceiling limitation by approximately $37.5 million, basedupon a natural gas price of approximately $0.35 per Mcf in effect at thatdate.  Based on subsequent priceincreases to approximately $4.10 per Mcf at the measurement date of November12, 2007, the capitalized cost of our oil and gas properties exceeded the fullcost ceiling limitation by approximately $70,000 and we recorded an impairmentof our oil and gas properties of that amount. The impairment of our oil and gas properties resulted from low commodityprices at September 30, 2007.  For further information regarding thisimpairment, please see note 2 included in the accompanying unaudited Notes toFinancial Statements.

***Nine Months Ended September 30, 2007Compared To Nine Months Ended September 30, 2006***

Net loss attributable to stockholders for the nine monthsended September 30, 2007 was $21.4 million, or $0.80 per diluted share, ontotal revenues of $9.8 million. Net loss attributable to stockholders forthe nine months ended September 30, 

 

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2007 included a $1.2 million unrealized loss associated with thechange in the fair valuation of our natural gas hedges in place in accordancewith the provisions of SFAS No. 133. Absent such a change in the valuation,we would have shown a net loss attributable to stockholders of$20.2 million on total revenues of $9.8 million. This compares to netloss attributable to stockholders of $17.9 million for the nine months endedSeptember 30, 2006 on total revenue of $9.9 million. Adjusted for anunrealized gain in the fair valuation of our natural gas hedges in place of$5.7 million, our results for the nine months ended September 30, 2006would have been a net loss attributable to stockholders of $23.6 million ontotal revenues of $9.9 million.

*Gas sales volume.*

Gas sales volume increased 41%, from 1,793 MMcf in thenine months ended September 30, 2006 to 2,527 MMcf in the nine months endedSeptember 30, 2007. Daily sales volume was 9.3 MMcf for the nine months endedSeptember 30, 2007 as compared to 6.6 MMcf for the nine months ended September30, 2006, a 2.7 MMcf per day increase. The increase was primarily due toproduction coming online in our Cabin Creek, Kirby and Deer Creek projectareas.

*Gas sales revenue.*

Revenue from gas sales increased $0.3 million during thenine months ended September 30, 2007, to $9.8 million, a 3% increasecompared to the nine months ended September 30, 2006. This increase wasprimarily due to an increase in gas sales volume which was partially offset bya decrease in the average realized price per Mcf.  The average realized price per Mcf decreased27%, from $5.30 per Mcf in the nine months ended September 30, 2006 to $3.88per Mcf in the nine months ended September 30, 2007.

*Derivatives.*

For the nine months ended September 30, 2007, we had anunrealized loss of $1.2 million compared to an unrealized gain of$5.7 million for the nine months ended September 30, 2006. The unrealizedloss is a noncash expense based primarily on the Black-Scholes model forvaluing future cash flows utilizing price volatility with a normal discountrate. Hedges settled in the nine months ended September 30, 2007 resulted in arealized gain of $3.3 million compared to a hedge gain of$0.2 million in the nine months ended September 30, 2006. The hedge gainswere primarily due to the fact that gas prices were lower than the weightedaverage floor price of our hedges in place.

*Lease operating expenses.*

Lease operating expenses increased $1.5 million inthe nine months ended September 30, 2007 to $3.5 million, an 79% increasecompared to the nine months ended September 30, 2006. This increase resultedfrom an increase in the number of wells in the productive cycle during the ninemonths ended September 30, 2007. On an Mcf basis, lease operating expensesincreased 27% from $1.08 per Mcf in the nine months ended September 30, 2006 to$1.37 per Mcf in the nine months ended September 30, 2007. The increase per Mcfwas primarily due to a number of wells being in the early stages of theirproductive life cycle as production did not increase proportionately to thenumber of wells coming online. Additionally, increases in generator rentals and associated fuel whilewaiting on permanent power contributed to the increase.

*Production taxes.*

Production taxes decreased $0.05 million in the ninemonths ended September 30, 2007 to $1.0 million, a 4% decrease from thenine months ended September 30, 2006. Production taxes generally correlate togross sales revenue because production taxes are based on a percentage of salesvalue. In Wyoming, the percentage averages 11% to 13%, depending on rates ineffect for the respective year. The decrease in production taxes for the ninemonths ended September 30, 2007 was primarily due to Montana production taxes,which are 1% for the first year of production and 9% thereafter, as well as adecrease in the average realized price per Mcf. On an Mcf basis, production taxes were $0.41 per Mcf for the nine monthsended September 30, 2007 and $0.61 per Mcf for the nine months ended September30, 2006, a 33% decrease, which correlates to the decrease in the price per Mcfreceived in the nine months ended September 30, 2007 from the nine months endedSeptember 30, 2006.

*Marketing and transportation.*

Marketing and transportation expenses increased$1.2 million in the nine months ended September 30, 2007 to$2.6 million, a 86% increase from the nine months ended September 30,2006. The increase related primarily to the increased sales volume in the ninemonths ended September 30, 2007, together with a slight increase intransportation fees and compression due to inflationary adjustments in thecontracts along with fees paid for compression design capacity which was not 

 

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used.  On an Mcf basis, marketingand transportation expenses increased 32% to $1.03 per Mcf in the nine monthsended September 30, 2007 from $0.78 per Mcf in the nine months ended September30, 2006.

*General and administrative expenses,net.*

General and administrative expenses are offset byoperating income from drilling and production activities for which we cancharge an overhead fee to nonoperating working interest owners. These welloperating overhead fees increased 46% in the nine months ended September 30,2007, from $0.8 million to $1.2 million, due to increased productivewells which we operate and for which we charge an overhead fee. General andadministrative expenses, net decreased $0.1 million in the nine months endedSeptember 30, 2007 to $3.8 million from $3.9 million in the ninemonths ended September 30, 2006. This decrease was due primarily to an increasein payroll expenses due to the hiring of additional employees during the ninemonths ended September 30, 2006 along with bonuses paid to certain executiveofficers during the second quarter of 2006 in connection with our privateplacement.  On an Mcf basis, general andadministrative expenses, net decreased 31% from $2.18 per Mcf in the ninemonths ended September 30, 2006 to $1.51 per Mcf in the nine months endedSeptember 30, 2007.

*Depreciation, depletion, amortizationand accretion.*

Depreciation, depletion, amortization and accretionexpense decreased $0.3 million for the nine months ended September 30, 2007 to$4.8 million, a 5% decrease compared to the nine months ended September30, 2006. This decrease was due to an decrease in the full cost pool due to theimpairments recorded in 2007 coupled with higher quarter-end reserves atSeptember 30, 2007 compared to September 30, 2006.  On an Mcf basis, the depreciation, depletion,amortization and accretion rate decreased 33% to $1.90 per Mcf in the ninemonths ended September 30, 2007 from $2.83 per Mcf in the nine months endedSeptember 30, 2006.

*Impairment.*

AtSeptember 30, 2007, the capitalized cost of our oil and gas properties exceededthe full cost ceiling limitation by approximately $37.5 million, basedupon a natural gas price of approximately $0.35 per Mcf in effect at thatdate.  Based upon subsequent priceincreases to approximately $4.10 per Mcf at the measurement date of November12, 2007, the capitalized cost of our oil and gas properties exceeded the fullcost ceiling limitation by approximately $70,000 and we recorded an impairmentof this amount.  This impairment, alongwith the impairment recorded for the six months ended June 30, 2007 of approximately$18.2 million, resulted in a total impairment for the nine months endedSeptember 30, 2007 of approximately $18.2 million. The impairment of our oiland gas properties resulted from low commodity prices at September 30, 2007.  Forfurther information regarding this impairment, please see note 2 included inthe accompanying unaudited Notes to Financial Statements.

**Liquidity and Capital Resources**

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

*Credit Facility.*  Effective February 12, 2007, we enteredinto a $100 million credit facility with an initial commitment of$27 million which permits borrowings up to the borrowing base asdesignated by the administrative agent. As of September 30, 2007, the initialborrowing base was $22 million although our borrowing availability is lessthan our initial borrowing base due to covenant limitations. As of September30, 2007, the actual borrowing availability was $16.7 million. Theborrowing base is determined on a semi-annual basis and at such otheradditional times, up to twice yearly, as may be requested by either theborrower or the administrative agent and is determined by the administrativeagent in accordance with customary practices and standards for loans of asimilar nature; provided that such determination is at the administrative agent’sdiscretion as the credit agreement does not provide a specific borrowing baseformula. Based on future reserve reports, low CIG prices and possible titledefects on certain of our properties, we expect that our borrowing base andborrowing availability could be further reduced below the initial levels.Borrowings under this credit facility may be used solely to acquire, explore ordevelop oil and gas properties and for general corporate purposes. The creditfacility matures February 12, 2011. At September 30, 2007 and November 13,2007, we had no indebtedness outstanding under our credit facility.

 

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Our obligations under the credit facility are secured byliens on (i) no less than 90% of the net present value of the oil and gasto be produced from our oil and gas properties that are included in theborrowing base determination, calculated using a discount rate of 10% per annumand reserve estimates, prices and production rates and costs, (ii) optionsto lease, seismic options, permits, and records related to such properties, and(iii) seismic data.

Borrowings under our credit facility may be either (i) adomestic bank rate plus an applicable margin between 0.25% and 1.25% per annumbased on utilization, or (ii) the London interbank offered rate, or LIBOR, plusan applicable margin between 1.25% and 2.25% per annum based on utilization.The credit agreement provides for various fees, including a quarterlycommitment fee of 1¤2 of 1.00% per annum andengineering fees to the administrative agent in connection with a borrowingbase determination. In addition, the credit agreement provides for an up frontfee of $27,000, which was paid on the closing date of the credit agreement, andan additional arrangement fee of up to 1% based on utilization. Borrowingsunder this credit facility may be prepaid without premium or penalty, except onEurodollar advances. If an event of default exists, the default rate shall beequal to 2% plus the floating rate.

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

·                  incur liens;

·                  incur debt;

·                  make investments in other persons;

·                  declare dividends or redeem or repurchase stock;

·                  engage in mergers, acquisitions, consolidations andasset sales or amend our organizational documents;

·                  enter into certain hedging arrangements;

·                  amend material contracts; and

·                  enter into related party transactions.

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

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

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

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

 

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*Office Building Loan.*  On November 15, 2005, we entered into amortgage loan secured by our office building in Sheridan, Wyoming in theaggregate principal amount of $829,000. The promissory note provides formonthly payments of principal and interest in the initial amount of $6,400, andunpaid principal bears interest at 6.875% during the first three years, at avariable base rate thereafter and at 18% upon a default. The variable base rateis based on the lender’s base rate. The maturity date of this mortgage isNovember 15, 2015, at which time a principal and interest payment of$615,400 will become due. As of September 30, 2007, we had $792,000 outstandingin principal and interest on this mortgage.

*Capital Expenditure Budget.*  For 2007, we have reduced our total capitalexpenditure budget from approximately $52.6 million to approximately $30.0million. Consequently, we expect to reduce our drilling and completion targetsfor 2007 from approximately 260 gross (207 net) wells to approximately 140gross (102 net) wells. In addition, our revised 2007 capital expenditure budgetwill continue to be used to construct related gas and water infrastructure, tofund plans of development costs for future wells, to fund undeveloped leaseholdacquisition costs carried over from 2006, to recomplete certain wells, and to fundinfrastructure and completion costs related to wells drilled in 2006.  We incurred capital expenditures of$14.9 million during the nine months ended September 30, 2007,  which were primarily related to drilling,completion and infrastructure costs on our undeveloped acreage in our Kirby,Deer Creek, Cabin Creek and Green River Basin areas. While we believe we haveadequate resources from our credit facility and cash flows from operations toimplement the remainder of our revised 2007 drilling plan, our ability todevelop future projects will depend on access to additional capital.  The CIG index price has been extremelyvolatile during 2007 and has at times reached unusually low levels.  If prices remain low, it would cause our cashflows from operations to decrease and could result in a reduction of theborrowing base and borrowing availability under our credit facility, and if wecould not obtain capital through our credit facility or otherwise, our abilityto execute our development and acquisition plans, replace our reserves andmaintain production levels could be greatly limited.

During the nine months ended September 30, 2007, wedrilled 67 gross (43 net) wells and we are actively developing the Kirby, DeerCreek, Cabin Creek and Green River Basin areas of our undeveloped acreage.

***CashFlow from Operating Activities***

Net cash used by operating activities was$10.3 million for the nine months ended September 30, 2007, compared tonet cash provided by operating activities of $3.7 million for the nine monthsended September 30, 2006. This decrease was primarily due to a reduction in our accounts payable balance and a lowerunrealized gain on derivative instruments, partially offset by a decrease inour accounts receivable.  .

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

***Cash Flow fromInvesting Activities***

Net cash used in investing activities was$11.8 million for the nine months ended September 30, 2007 compared to$52.9 million for the nine months ended September 30, 2006. Net cash used ininvesting activities decreased by approximately $41.1 million compared tothe nine months ended September 30, 2006 primarily due to  the acquisition of the Green River Basinacreage in April 2006, a larger realized gain on hedge settlements, a decreasein inventory used for development and a decrease in the purchase of restrictedassets.

***Cash Flow fromFinancing Activities***

During the period from our formation in June 2003 throughSeptember 2005, DLJ Merchant Banking contributed $44.1 million in cash inexchange for shares of our common stock, shares of our Series A RedeemablePreferred Stock and detachable warrants to purchase additional shares of commonstock.  As of September 30, 2006 andSeptember 30, 2007, we had 25,131,301 and 29,025,751 shares of common stockissued and outstanding, respectively, of which 27,270 and 171,720 shares,respectively, were shares of restricted stock issued to employees anddirectors.

Netcash provided by financing activities was $29.6 million for the nine monthsended September 30, 2007 as compared to $59.8 million for the nine months endedSeptember 30, 2007.  The change wasprimarily due to our April 2006 private placement and our May 2007 initialpublic offering.

 

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In April 2006, we completed a private placement, exemptfrom registration under the Securities Act of 1933, as amended, or theSecurities Act, of 12,835,230 shares of our common stock to qualifiedinstitutional buyers, non-U.S. persons and accredited investors at a price of$11.00 per share, or $10.23 per share net of the initial purchaser’s discountand placement fee. Out of the aggregate of approximately $129.9 million ofnet proceeds (after the initial purchaser’s discount and placement fee andoffering expenses) we received in the private placement, we used(i) approximately $53.6 million to redeem all of the outstandingshares of our Series A Redeemable Preferred Stock, including the paymentof all accrued and unpaid dividends and a redemption premium,(ii) approximately $27.0 million for our acquisition of the Green RiverBasin assets, (iii) approximately $16.3 million to repurchase anaggregate of 1,593,783 shares of common stock at a price of $10.23 per sharefrom DLJ Merchant Banking and Gary W. Uhland, our former President, and(iv) approximately $33.0 million to fund our development drillingprogram and pay additional offering expenses and for general corporatepurposes.

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

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

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

***ContractualObligations***

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

The following table summarizes byperiod our contractual obligations as of September 30, 2007:
| ** **                                     | ** ** | **Total**               | ** ** | **2007** | ** ** | **2008-2009** | ** ** | **2010-2011** | ** ** | **Thereafter** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|----------|------------|---------------|------------|---------------|------------|----------------|------------|
| ** **                                     | ** ** | **(in thousands)** | ** ** |
| Notes payable in  connection with the mortgage |       | $                       | 792        |     | $          | 5             |       | $             | 47         |           | $          | 54 |   | $ | 686 |   |
| Asset retirement  obligations                  |       | 2,655                   |       | —   |       | 219           |       | 758           |       | 1,678          |       |
| Non-current  production and property taxes     |       | 925                     |       | —   |       | 925           |       | —        |       | —         |       |
| Total                                          |       | $                       | 4,372      |     | $          | 5             |       | $             | 1,191      |           | $          | 812 |   | $ | 2,364 |   |

 

At September 30, 2007, the commodity derivatives assetwas valued at $1,627,000 of which $1,719,000 represents a current receivableattributable to 2007 and $92,000 represents an obligation attributable to 2008.

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

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

 

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***Commodity Price Risk***

Our major market risk exposure is in the pricing applicableto our natural gas production. The prices we receive for our production dependon many factors beyond our control. We seek to reduce our exposure tounfavorable changes in natural gas prices, which are subject to significant andoften volatile fluctuation, through the use of fixed-price contracts. Thefixed-price contracts are comprised of energy swaps and collars. Thesecontracts allow us to predict with greater certainty the effective natural gasprices to be received for hedged production and benefit operating cash flowsand earnings when market prices are less than the fixed prices provided by thecontracts. However, we will not benefit from market prices that are higher thanthe fixed prices in the contracts for hedged production. Collar structuresprovide for participation in price increases and decreases to the extent of theceiling prices and floors provided in those contracts.

The following table summarizes the estimated volumes,fixed prices, fixed price sales and fair value attributable to the fixed pricecontracts as of September 30, 2007. At September 30, 2007, we had hedgedvolumes through December 2008. Please see Note 5 included in theaccompanying unaudited Notes to Financial Statements.
| ** **                                  | ** ** | **Year Ending  December 31,  2007** | ** ** | **Year Ending  December 31,  2008** | ** ** |
|---------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                  | ** ** | **(Unaudited)**                               | ** ** | **(Unaudited)**                               | ** ** |
| **Natural  Gas Collars:**                   | ** ** | ** **                                    | ** ** | ** **                                    | ** ** |
| Contract volumes  (MMBtu):                  |       |                                          |       |                                          |       |
| Floor                                       |       | 368,000                                       |       | 1,098,000                                     |       |
| Ceiling                                     |       | 368,000                                       |       | 1,098,000                                     |       |
| Weighted-average  fixed price per MMBtu(1): |       |                                          |       |                                          |       |
| Floor                                       |       | $                                             | 6.87       |                                          | $          | 6.50 |   |
| Ceiling                                     |       | $                                             | 9.41       |                                          | $          | 8.20 |   |
| Fixed-price  sales(2)                       |       | $                                             | 9.41       |                                          | $          | 8.20 |   |
| Fair value, net  (thousands)(3)             |       | $                                             | 1,421      |                                          | $          | 206 |   |
| **Total  Natural Gas Contracts:**           | ** ** | ** **                                    | ** ** | ** **                                    | ** ** |
| Contract volumes  (MMBtu)                   |       | 368,000                                       |       | 1,098,000                                     |       |
| Weighted-average  fixed price per MMBtu(1)  |       | $                                             | 6.87       |                                          | $          | 6.50 |   |
| Fixed-price  sales(2)                       |       | $                                             | 9.41       |                                          | $          | 8.20 |   |
| Fair value, net  (thousands)(3)             |       | $                                             | 1,421      |                                          | $          | 206 |   |

 

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(1)                                  Volumes hedged usingthe CIG index price published in the first issue of Inside FERC’s Gas MarketReport for each calendar month of the derivative transaction.

(2)                                  Assumes ceilingprices for natural gas collar volumes.

(3)           Fair value based on CIG indexprice in effect for each month as of September 30, 2007.

**ITEM 4T. CONTROLS AND PROCEDURES**

**Disclosure Controls and Procedures**

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

**Changes in Internal Control OverFinancial Reporting**

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

 

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**PART II. OTHER INFORMATION**

**ITEM 1. LEGAL PROCEEDINGS**

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

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

**ITEM 1A. RISK FACTORS**

The following information updates and supplements theinformation under the heading "Risk Factors - Risks Related to OurBusiness - The volatility of natural gas and oil prices could have a materialadverse effect on our business" in our amended registration statement onForm S-1 (File No. 333-139556), which was declared effective on May 10, 2007:

Historically, natural gas prices have been extremelyvolatile, and we expect that volatility to continue. For example, during thethree months ended September 30, 2007, the NYMEX natural gas index price rangedfrom a high of $7.01 per MMBtu to a low of $5.43 per MMBtu, while the CIG natural gas index price ranged from ahigh of $4.50 per MMBtu to a low of $0.27 per MMBtu.  During the nine months ended September 30,2007, the NYMEX natural gas index price ranged from a high of $8.19 perMMBtu to a low of $5.43 per MMBtu, while the CIG natural gas index priceranged from a high of $7.11 per MMBtu to a low of $0.27 per MMBtu.During the year ended December 31, 2006, the NYMEX natural gas index priceranged from a high of $11.23 per MMBtu to a low of $4.20 per MMBtu,while the CIG natural gas index price ranged from a high of $7.90 perMMBtu to a low of $1.30 per MMBtu. Changes in natural gas pricing have impactedour revenue streams, production taxes, prices used in reserve calculations,borrowing base calculations and the valuation of potential propertyacquisitions. During the three and nine months ended September 30, 2007,estimated future gas prices had an impact on both our revenues and the costsattributable to our future operations. We expect that changing natural gasprices will continue to impact our operations and financial results in thefuture.

There have been no other material changes to the riskfactors disclosed in such registration statement.

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

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

Effective February 12, 2007, we granted and issued anaggregate of 12,000 shares of restricted common stock to our non-employeedirectors and 25,000 shares of restricted common stock to certain employeespursuant to our stock incentive plan.  Inaddition, on March 26, 2007, we granted and issued an additional 10,000 sharesof restricted common stock to an employee pursuant to the stock incentiveplan.  The 12,000 restricted sharesissued to the non-employee directors will be fully vested on February 12, 2008.  The restricted shares issued to employeeswill vest 20%, 30% and 50% on the first, second and third anniversary of thedate of grant, respectively.  EffectiveJuly 1, 2007, we granted and issued an aggregate of 54,000 shares of restrictedcommon stock to certain employees.  Theseshares will vest equally over three years. In addition, on July 20, 2007, we entered into employment agreementswith certain of our executive officers. In conjunction with the employmentagreements, these executive officers were granted and issued 50,000 shares ofrestricted common stock.  These shareswill vest 33.34%, 33.33% and 33.33% on the third, fourth and fifth anniversaryof the grant date.  Effective August 22,2007, the Company granted and issued 4,500 shares of restricted common stock toa new board member.  These shares willvest equally over three years.  Theissuances of these securities were exempt from the registration requirements ofthe Securities Act pursuant to Rule 701.

 

**ITEM 3. DEFAULTS UPON SENIORSECURITIES**

Not applicable.

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

Not applicable.

**ITEM 5. OTHER INFORMATION**

Not applicable.

 

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

 

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*              Filedherewith

                Managementcontract or compensatory plan or arrangement

 

30

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** **

**SIGNATURES**

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

 

 

31

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

 

----

*              Filedherewith

                Managementcontract or compensatory plan or arrangement

 

 

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