UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549









FORM
10-Q





(Mark
One)





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





FOR THE
QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008




OR





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





FOR THE
TRANSITION PERIOD FROM ____________ TO ____________




COMMISSION
FILE NUMBER: 333-134568





PEGASI ENERGY RESOURCES
CORPORATION


(Exact
name of registrant as specified in its charter)





Nevada
            
            20-4711443(State
      or other jurisdiction of
              incorporation
      or organization)
            
            (I.R.S.
      Employer
              Identification
      Number)




218
      N. Broadway, Suite 204
              Tyler,
      Texas 75702(Address
      of principal executive offices) (Zip
Code)





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





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





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




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





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





There
were 33,610,801 shares of the registrant's common stock outstanding as of
November 4, 2008.


























PEGASI
ENERGY RESOURCES CORPORATION


CONSOLIDATED
FINANCIAL STATEMENTS


FOR
THE QUARTER ENDED SEPTEMBER 30, 2008





TABLE
OF CONTENTS





PagePART
      I - FINANCIAL INFORMATIONItem
      1. Financial Statements
            3Item
      2. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
            11Item
      3. Quantitative and Qualitative Disclosures About Market
    Risk
            16Item
      4T. Controls and Procedures
            16PART
      II - OTHER INFORMATIONItem
      1. Legal Proceedings
            18Item
      1A. Risk Factors
            18Item
      2. Unregistered Sales of Equity Securities and Use of
    Proceeds
            18Item
      3. Defaults Upon Senior Securities
            18Item
      4. Submission of Matters to a Vote of Security Holders
            18Item
      5. Other Information
            18Item
      6. Exhibits
            18SIGNATURES
            19









2












PART
I - FINANCIAL INFORMATION





Item
1. Financial Statements.


PEGASI ENERGY
RESOURCES CORPORATION


CONSOLIDATED
BALANCE SHEETS











September
      30,
            
            
            December
      31,2008
            
            
            2007(Unaudited)
            
            
            (Audited)AssetsCurrent
      assets:Cash
      and cash equivalents
            
            $
            1,332,162
            
            
            $
            8,935,283Accounts
      receivable, trade
            
            
            523,177
            
            
            
            269,400Accounts
      receivable, related parties
            
            
            62,493
            
            
            
            106,926Joint-interest
      billings receivable, related parties, net
            
            
            245,962
            
            
            
            122,542Other
      current assets
            
            
            191,424
            
            
            
            322,110Total
      current assets
            
            
            2,355,218
            
            
            
            9,756,261Property
      and equipment:Equipment
            
            
            492,864
            
            
            
            635,090Pipelines
            
            
            594,604
            
            
            
            185,745Buildings
            
            
            19,916
            
            
            
            28,451Leasehold
      improvements
            
            
            7,022
            
            
            
            -Vehicles
            
            
            50,663
            
            
            
            50,663Office
      furniture
            
            
            124,886
            
            
            
            39,125Website
            
            
            15,000
            
            
            
            15,000Total
      property and equipment
            
            
            1,304,955
            
            
            
            954,074Less
      accumulated depreciation
            
            
            (351,337
            )
            
            
            (270,156
            )Property
      and equipment, net
            
            
            953,618
            
            
            
            683,918Oil
      and gas properties:Oil
      and gas properties, proved
            
            
            7,256,893
            
            
            
            4,044,670Oil
      and gas properties, unproved
            
            
            4,790,257
            
            
            
            4,035,920Capitalized
      asset retirement obligations
            
            
            220,237
            
            
            
            220,237Total
      oil and gas properties
            
            
            12,267,387
            
            
            
            8,300,827Less
      accumulated depreciation and depletion
            
            
            (769,845
            )
            
            
            (748,133
            )Oil
      and gas properties, net
            
            
            11,497,542
            
            
            
            7,552,694Total
      assets
            
            $
            14,806,378
            
            
            $
            17,992,873











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











3








PEGASI
ENERGY RESOURCES CORPORATION


CONSOLIDATED
BALANCE SHEETS (CONTINUED)











September
      30,
            
            
            December
      31,2008
            
            
            2007(Unaudited)
            
            
            (Audited)Liabilities
      and Stockholders' EquityCurrent
      liabilities:Accounts
      payable
            
            $
            239,514
            
            
            $
            977,757Accounts
      payable, related parties
            
            
            430,306
            
            
            
            560,095Revenues
      payable
            
            
            397,455
            
            
            
            178,114Interest
      payable
            
            
            1,295,300
            
            
            
            1,003,105Liquidated
      damages payable
            
            
            116,453
            
            
            
            150,756Other
      payables
            
            
            263,167
            
            
            
            57,842Joint-interest
      deposits, related party
            
            
            -
            
            
            
            849,619Line-of-credit,
      related party
            
            
            3,616,214
            
            
            
            4,616,214Current
      portion of notes payable
            
            
            3,937
            
            
            
            4,198Current
      portion of notes payable, related parties
            
            
            -
            
            
            
            20,000Total
      current liabilities
            
            
            6,362,346
            
            
            
            8,417,700Notes
      payable
            
            
            6,767
            
            
            
            9,627Notes
      payable, related parties
            
            
            279,690
            
            
            
            279,691Deferred
      income taxes
            
            
            1,169,558
            
            
            
            1,097,934Asset
      retirement obligations
            
            
            279,298
            
            
            
            271,443Total
      liabilities
            
            
            8,097,659
            
            
            
            10,076,395Commitments
      and contingencies (Note 4)Stockholders'
      equity:Common
      stock; $0.001 par value; 75,000,000 shares authorized;29,410,801
      and 29,378,482 shares issued and outstandingat
      September 30, 2008 and December 31, 2007, respectively
            
            
            29,411
            
            
            
            29,378Additional
      paid-in capital
            
            
            11,277,009
            
            
            
            11,206,945Accumulated
      deficit
            
            
            (4,597,701
            )
            
            
            (3,319,845
            )Total
      stockholders' equity
            
            
            6,708,719
            
            
            
            7,916,478Total
      liabilities and stockholders' equity
            
            $
            14,806,378
            
            
            $
            17,992,873








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








4








PEGASI
ENERGY RESOURCES CORPORATION


CONSOLIDATED
STATEMENTS OF OPERATIONS


(UNAUDITED)











Three
      Months Ended
              September
      30, 2008
            
            
            Three
      Months Ended
              September
      30, 2007
            
            
            Nine
      Months Ended
              September
      30, 2008
            
            
            Nine
      Months Ended
              September
      30, 2007Revenues:Oil
      and gas
            
            $
            491,511
            
            
            $
            188,677
            
            
            $
            1,039,414
            
            
            $
            681,710Condensate
      and skim oil
            
            
            88,282
            
            
            
            17,978
            
            
            
            188,347
            
            
            
            155,483Transportation
      and gathering
            
            
            306,652
            
            
            
            151,619
            
            
            
            746,037
            
            
            
            538,856Saltwater
      disposal income
            
            
            63,700
            
            
            
            62,317
            
            
            
            153,703
            
            
            
            294,620Total
      revenues
            
            
            950,145
            
            
            
            420,591
            
            
            
            2,127,501
            
            
            
            1,670,669Operating
      expenses:Lease
      operating expenses
            
            
            77,508
            
            
            
            29,474
            
            
            
            146,623
            
            
            
            144,342Saltwater
      disposal expenses
            
            
            58,974
            
            
            
            67,977
            
            
            
            159,560
            
            
            
            262,313Pipeline
      operating expenses
            
            
            23,435
            
            
            
            19,639
            
            
            
            123,681
            
            
            
            88,894Cost
      of gas purchased for resale
            
            
            252,463
            
            
            
            130,753
            
            
            
            632,807
            
            
            
            456,109Depletion
      and depreciation
            
            
            2,074
            
            
            
            59,080
            
            
            
            128,045
            
            
            
            212,281General
      and administrative
            
            
            657,740
            
            
            
            94,207
            
            
            
            1,996,526
            
            
            
            274,832Total
      operating expenses
            
            
            1,072,194
            
            
            
            401,130
            
            
            
            3,187,242
            
            
            
            1,438,771Income
      (loss) from operations
            
            
            (122,049
            )
            
            
            19,461
            
            
            
            (1,059,741
            )
            
            
            231,898Other
      income (expenses):Interest
      income
            
            
            9,161
            
            
            
            -
            
            
            
            73,026
            
            
            
            1,618Interest
      expense
            
            
            (98,423
            )
            
            
            (128,016
            )
            
            
            (293,421
            )
            
            
            (378,425
            )Dividend
      income
            
            
            -
            
            
            
            644
            
            
            
            -
            
            
            
            644Loss
      on investment in unconsolidated partnerships
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (20,440
            )Liquidated
      damages
            
            
            185,059
            
            
            
            -
            
            
            
            34,303
            
            
            
            -Other
      income
            
            
            49,163
            
            
            
            6,455
            
            
            
            58,342
            
            
            
            6,455Total
      other income (expenses)
            
            
            144,960
            
            
            
            (120,917
            )
            
            
            (127,750
            )
            
            
            (390,148
            )Income
      (loss) before income tax
              expense
            
            
            22,911
            
            
            
            (101,456
            )
            
            
            (1,187,491
            )
            
            
            (158,250
            )Income
      tax expense
            
            
            (27,613
            )
            
            
            (91,863
            )
            
            
            (90,365
            )
            
            
            (774,720
            )Net
      loss
            
            $
            (4,702
            )
            
            $
            (193,319
            )
            
            $
            (1,277,856
            )
            
            $
            (932,970
            )Basic
      and diluted loss per share
            
            $
            (0.00
            )
            
            $
            (0.06
            )
            
            $
            (0.04
            )
            
            $
            (0.27
            )Weighted
      average shares
              outstanding
            
            
            29,385,912
            
            
            
            3,500,000
            
            
            
            29,378,459
            
            
            
            3,500,000








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








5








PEGASI
ENERGY RESOURCES CORPORATION


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(UNAUDITED)




Nine
      Months Ended September 30,2008
            
            
            2007Operating
      ActivitiesNet
      loss
            
            $
            (1,277,856
            )
            
            $
            (932,970
            )Adjustments
      to reconcile net loss to netcash
      provided by (used in) operating activities:Depletion
      and depreciation
            
            
            128,045
            
            
            
            212,281Accretion
      of discount on asset retirement obligations
            
            
            7,855
            
            
            
            8,430Deferred
      income taxes
            
            
            71,624
            
            
            
            774,720Liquidated
      damages
            
            
            (34,304
            )
            
            
            -Loss
      on investment in unconsolidated partnerships
            
            
            -
            
            
            
            20,440Stock-based
      compensation
            
            
            77,000
            
            
            
            -Interest
      expense on note payable
            
            
            1,119
            
            
            
            -Other
      income
            
            
            (112,755
            )
            
            
            -Changes
      in operating assets and liabilities:Accounts
      receivable, trade
            
            
            (253,777
            )
            
            
            121,333Accounts
      receivable, related parties
            
            
            44,433
            
            
            
            12,763Joint-interest
      billings receivable, related parties, net
            
            
            (123,420
            )
            
            
            103,082Other
      current assets
            
            
            130,686
            
            
            
            (330,620
            )Accounts
      payable
            
            
            (738,243
            )
            
            
            (218,867
            )Accounts
      payable, related parties
            
            
            128,481
            
            
            
            50,049Revenues
      payable
            
            
            219,341
            
            
            
            52,887Interest
      payable
            
            
            292,195
            
            
            
            344,549Other
      payables
            
            
            205,325
            
            
            
            (2,343
            )Joint-interest
      deposits, related parties
            
            
            (849,619
            )
            
            
            -Net
      cash provided by (used in) operating activities
            
            
            (2,083,870
            )
            
            
            215,734Investing
      ActivitiesPurchases
      of property and equipment
            
            
            (521,548
            )
            
            
            (59,679
            )Purchases
      of oil and gas properties
            
            
            (3,966,560
            )
            
            
            (246,928
            )Net
      cash used in investing activities
            
            
            (4,488,108
            )
            
            
            (306,607
            )Financing
      ActivitiesCapital
      contributions
            
            
            -
            
            
            
            39,759Net
      payments on lines-of-credit
            
            
            -
            
            
            
            (60,000
            )Advances
      on line-of-credit, related party
            
            
            -
            
            
            
            100,000Payments
      on line-of-credit, related party
            
            
            (1,000,000
            )
            
            
            -Payments
      on notes payable
            
            
            (4,240
            )
            
            
            (8,835
            )Proceeds
      from borrowings on notes payable, related party
            
            
            -
            
            
            
            61,772Payments
      on notes payable, related party
            
            
            (20,000
            )
            
            
            -Payments
      for cancelled shares of common stock 1
            
            
            (6,903
            )
            
            
            -Net
      cash provided by (used in) financing activities
            
            
            (1,031,143
            )
            
            
            132,696Net
      increase (decrease) in cash and cash equivalents
            
            
            (7,603,121
            )
            
            
            41,823Cash
      and cash equivalents at beginning of period
            
            
            8,935,283
            
            
            
            359,007Cash
      and cash equivalents at end of period
            
            $
            1,332,162
            
            
            $
            400,830Supplemental
      Disclosure of Cash Flow InformationCash
      paid during the period for interest
            
            $
            1,226
            
            
            $
            33,8761
      2,681 net shares of common stock were cancelled by investors during the
      nine months ended September 30, 2008.






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










6




PEGASI
ENERGY RESOURCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 SEPTEMBER
30, 2008 AND 2007







1.  NATURE
OF OPERATIONS




Pegasi
Energy Resources Corporation (“PERC” or the “Company”) is engaged in the
exploration and production of natural gas and oil through the development of a
repeatable, low geological risk, high potential project in the active East Texas
oil and gas region.  The Company's business strategy, which it
designated as the “Cornerstone Project”, is to identify and exploit resources in
and adjacent to existing or indicated producing areas within the Rodessa field
area.





At
September 30, 2008, the Company had a working capital deficit of $4,007,128 and
an accumulated deficit of $4,597,994.  For the nine month period ended
September 30, 2008 the Company incurred a net loss of
$1,277,856.  These conditions raise substantial doubt about the
Company’s ability to continue as a going concern.  However, at
September 30, 2008, approximately $5,341,820 of the Company’s current
liabilities is due to related parties of the Company that have a vested interest
in the continuation of the Company.  The Company is also in
negotiations with numerous potential funding sources to provide additional
working capital as well as several oil and gas drilling prospects which the
Company anticipates will be online in the near future; however, the Company has
no assurance that these activities will be successfully completed.  If
not successfully completed, additional sources of capital and/or financing may
be required to assist the Company in meeting its future
obligations.  Based upon these conditions any substantial doubt about
the Company’s ability to continue as a going concern has been alleviated for a
reasonable period of time.








2.  SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES







a)  Basis of
Presentation





The
accompanying unaudited interim consolidated financial statements of PERC have
been prepared in accordance with accounting principles generally accepted in the
United States of America and the rules of the Securities and Exchange Commission
(the “SEC”), and should be read in conjunction with PERC’s audited consolidated
financial statements for the year ended December 31, 2007, and notes
thereto, which are included in the Company’s restated annual report on Form
10-KSB/A filed with the SEC on August 8, 2008.  In the opinion of
management, all adjustments, consisting of normal recurring adjustments,
necessary for a fair presentation of consolidated financial position and the
consolidated results of operations for the interim periods presented have been
reflected herein.  The consolidated results of operations for interim
periods are not necessarily indicative of the results to be expected for the
full year.  The notes to consolidated financial statements, which
would substantially duplicate the disclosure required in the Company’s 2007
annual consolidated financial statements, have been omitted.





b)  New
Accounting Pronouncements





In May
2008, the Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standards (“SFAS) No. 162, The Hierarchy of Generally Accepted
Accounting Principles, which identifies a consistent framework for
selecting accounting principles to be used in preparing financial statements for
nongovernmental entities that are presented in conformity with United States
generally accepted accounting principles (“GAAP”). The current GAAP hierarchy
was criticized due to its complexity, ranking position of FASB Statements of
Financial Accounting Concepts and the fact that it is directed at auditors
rather than entities. SFAS No. 162 will be effective 60 days following the SEC’s
approval of the Public Company Accounting Oversight Board amendments to AU
Section 411, The Meaning of
Present Fairly in Conformity with Generally Accepted Accounting
Principles. The FASB does not expect that SFAS No. 162 will have a change
in current practice, and the Company does not believe that SFAS No. 162 will
have an impact on the consolidated operating results, financial position or cash
flows.





In March
2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities—an amendment of FASB Statement No. 133. SFAS No. 161 requires entities that utilize derivative instruments to
provide qualitative disclosures about their objectives and strategies for using
such instruments, as well as any details of credit-risk-related contingent
features contained within derivatives. SFAS No. 161 also requires entities to
disclose additional information about the amounts and location of derivatives
located within the financial statements, how the provisions of SFAS No. 133 have
been applied, and the impact that hedges have on an entity’s operating results,
financial position or cash flows. SFAS No. 161 is effective for fiscal years and
interim periods beginning after November 15, 2008, with early application
encouraged. The Company is currently assessing the impact, if any, that the
adoption of this pronouncement will have on the Company’s
disclosures.







7






PEGASI
ENERGY RESOURCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 SEPTEMBER
30, 2008 AND 2007





2.  SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)





b)  New Accounting
Pronouncements (Continued)





SFAS No.
141R (revised 2007), Business
Combinations,amends SFAS No. 141, Business Combinations, by
requiring an acquirer to recognize: (i) the assets acquired, liabilities
assumed, and any non-controlling interest in the acquiree at fair value as of
the acquisition date, (ii) a gain attributable to any “negative goodwill” in a
bargain purchase, and (iii) an expense related to acquisition
costs.  SFAS No. 141R is effective for fiscal years beginning on
or after December 15, 2008.  The Company does not expect the adoption
of SFAS No. 141R to have a material impact on its consolidated financial
position or results of operations.





In
December 2007, the FASB issued SFAS No. 160,Noncontrolling Interests in
Consolidated Financial Statements, which amends Accounting Research
Bulletin ("ARB") No. 51, Consolidated Financial
Statements, to establish accounting and reporting standards for the
non-controlling interest in a subsidiary and for the deconsolidation of a
subsidiary.  SFAS No. 160 is effective for fiscal years beginning on
or after December 15, 2008.  The Company does not expect the adoption
of SFAS No. 160 to have a material impact on its consolidated financial
position or results of operations.





c)  Reclassifications





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





3.  SEGMENT
INFORMATION





The
following information is presented in accordance with SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information.  The Company is engaged in
oil and gas exploration and production, saltwater disposal and pipeline
transportation.  Pegasi Operating, Inc. (“POI”), a wholly-owned
subsidiary of PERC, conducts the exploration and production
operations.  TR Rodessa, Inc. (“TR Rodessa”) owns a 70% undivided
interest in and operates a 40-mile gas pipeline and gathering system which is
used to transport hydrocarbons to market to be sold.  59 Disposal,
Inc. (“59 Disposal”) owns a 70% undivided interest in and operates a saltwater
disposal facility which disposes saltwater and flow back waste into subsurface
storage  and  also  sells  the  skim  oil  it  separates  from  the  saltwater.  Management
has identified such segments based on management responsibility and the nature
of their products, services, and costs.  There are no major
distinctions in geographical areas served as all operations are in the United
States.  The Company measures segment profit (loss) as income (loss)
from operations.  Business segment assets are those assets controlled
by each reportable segment.  The following table sets forth certain
information about the financial information of each segment for the three and
nine months ended September 30, 2008 and 2007 and as of September 30, 2008 and
December 31, 2007:








8








PEGASI
ENERGY RESOURCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 SEPTEMBER
30, 2008 AND 2007


3.  SEGMENT
      INFORMATION (CONTINUED)





Three
      Months Ended September 30, 2008
            
            
            Three
      Months Ended September 30, 2007
            
            
            Nine
      Months Ended September 30, 2008
            
            
            Nine
      Months Ended September 30, 2007Business
      segment revenue:Oil
      and gas
            
            $
            491,511
            
            
            $
            188,677
            
            
            $
            1,039,414
            
            
            $
            681,710Condensate
      and skim oil
            
            
            88,282
            
            
            
            17,978
            
            
            
            188,347
            
            
            
            155,483Transportation
      and gathering
            
            
            306,652
            
            
            
            151,619
            
            
            
            746,037
            
            
            
            538,856Saltwater
      disposal income
            
            
            63,700
            
            
            
            62,317
            
            
            
            153,703
            
            
            
            294,620Total
      revenues
            
            $
            950,145
            
            
            $
            420,591
            
            
            $
            2,127,501
            
            
            $
            1,670,669Business
      segment profit (loss):Oil
      and gas
            
            $
            261,194
            
            
            $
            112,314
            
            
            $
            348,995
            
            
            $
            370,042Condensate
      and skim oil
            
            
            88,282
            
            
            
            17,978
            
            
            
            188,347
            
            
            
            155,483Transportation
      and gathering
            
            
            22,011
            
            
            
            (6,785
            )
            
            
            (56,208
            )
            
            
            (21,386
            )Saltwater
      disposal
            
            
            (26,261
            )
            
            
            (20,559
            )
            
            
            (91,019
            )
            
            
            (7,948
            )General
      corporate
            
            
            (467,275
            )
            
            
            (83,487
            )
            
            
            (1,449,856
            )
            
            
            (264,293
            )Income
      (loss) from operations
            
            $
            (122,049
            )
            
            $
            19,461
            
            
            $
            (1,059,741
            )
            
            $
            231,898Depreciation
      and depletion:Oil
      and gas
            
            $
            (25,345
            )
            
            $
            37,227
            
            
            $
            27,724
            
            
            $
            147,234Transportation
      and gathering
            
            
            (815
            )
            
            
            5,395
            
            
            
            17,085
            
            
            
            16,185Saltwater
      disposal
            
            
            20,660
            
            
            
            13,263
            
            
            
            61,162
            
            
            
            39,789General
      corporate
            
            
            7,574
            
            
            
            3,195
            
            
            
            22,074
            
            
            
            9,073Total
      depreciation and depletion
            
            $
            2,074
            
            
            $
            59,080
            
            
            $
            128,045
            
            
            $
            212,281





Nine
      Months Ended September 30, 2008
            
            
            Nine
      Months Ended September 30, 2007Capital
      expenditures:Oil
      and gas
            
            $
            3,966,560
            
            
            $
            246,927Transportation
      and gathering
            
            
            427,370
            
            
            
            432Saltwater
      disposal
            
            
            15,061
            
            
            
            48,747General
      corporate
            
            
            79,117
            
            
            
            10,500Total
      capital expenditures
            
            $
            4,488,108
            
            
            $
            306,606September
      30,
            
            
            December
      31,2008
            
            
            2007Business
      segment assets:Oil
      and gas
            
            $
            12,716,360
            
            
            $
            16,281,398Transportation
      and gathering
            
            
            881,669
            
            
            
            322,588Saltwater
      disposal
            
            
            296,090
            
            
            
            599,794General
      corporate
            
            
            912,259
            
            
            
            789,093Total
      assets
            
            $
            14,806,378
            
            
            $
            17,992,873









9






PEGASI
ENERGY RESOURCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 SEPTEMBER
30, 2008 AND 2007





4.
COMMITMENTS AND CONTINGENCIES





Along
with the Company's counsel, management monitors developments related
to legal matters and, when appropriate, makes adjustments to record liabilities
to reflect current facts and circumstances.  Management has recorded a
liability related to its registration rights agreement with investors that
provides for the filing of a registration statement for the registration of the
shares issued in the offering, as well as the shares issuable upon exercise of
related warrants.  The Company failed to meet the deadline for the
effectiveness of the registration statement and therefore was required to
pay liquidated damages of approximately $100,000 on the first day of
effectiveness failure, or July 18, 2008.  An additional $100,000
penalty was required to be paid by the Company every thirty days
thereafter, pro rated for periods totaling less than thirty days, until the
effectiveness failure is cured, up to a maximum of 18% of the aggregate purchase
price, or approximately $1,800,000.  The Company’s registration became
effective on August 21, 2008.  At September 30, 2008, management
reevaluated the status of the registration statement and determined an accrual
of $116,453 was sufficient to cover any potential payments for liquidated
damages.  The damages are reflected as liquidated damages payable in
the accompanying consolidated balance sheets as of September 30, 2008 and
December 31, 2007.




5.
STOCK-BASED COMPENSATION




In August
2008, the Company issued 35,000 shares of its common stock to a Director of the
Company for services rendered by the Director to the Company. Such shares were
valued at $2.20 per share, the value of the shares on the date of issuance, for
total stock-based compensation of $77,000, which is included in general and
administrative expenses in the accompanying consolidated statements of
operations.


6.
SUBSEQUENT EVENTS





On
October 7, 2008 (with an effective date of October 1, 2008), the Company entered
into and completed the transactions contemplated by an agreement with TR Energy,
Inc. (“TR Energy”), a related party, providing for the sale by TR Energy to the
Company of a portion of TR Energy’s interests in certain assets that are
co-owned by the Company as follows:





1.
            10%
      right, title, and interest in and to the lands, oil and gas leases and
      leasehold interests of TR Energy (the “Leases”), as well as 10% right,
      title, and interest in the equipment, materials, personal property,
      fixtures and improvements associated with the
  Leases.





2.
            10%
      right, title, and interest of TR Energy in the pipeline assets, including
      the pipe and associated compressor stations and production equipment
      associated with the relevant pipeline rights-of-way and surface
      agreements.





3.
            10%
      right, title, and interest of TR Energy in the saltwater disposal
      facility, and 10% right, title, and interest in all equipment, both
      surface and subsurface, appurtenant thereto or used in connection with the
      disposal of saltwater and other water from production or any other
      oilfield related activities.





As a
result of the completion of the transactions contemplated under the agreement,
the Company now owns 80% of the assets with the balance owned by TR
Energy.





The
consideration for the purchase of the TR Energy interests consisted of the
issuance to TR Energy of 4,200,000 shares of common stock of the Company at
$1.90 per share.  TR Energy is owned by Michael Neufeld, a Director of
the Company and its President and Chief Executive Officer, and William Sudderth,
the Company’s Executive Vice President.  Mr. Neufeld did not
participate in the deliberations by the Company’s Board of Directors and
abstained from voting on the transactions contemplated by the purchase agreement
(the “Agreement”).





The
issuance of the shares was exempt from registration under the Securities Act of
1933, as amended, as an issuance to accredited investors since TR Energy is
owned solely by two of the Company executive officers.






10







Item
2. Management’s Discussion and Analysis of Financial Condition and Results of
Operations.





Forward Looking Statements





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





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





Company
Overview





We are an
organic growth-oriented independent energy company engaged in the exploration
and production of natural gas and oil through the development of a repeatable,
low geological risk, high potential project in the active East Texas oil and gas
region.  We currently hold interests in properties located in Marion
and Cass County, Texas, home to the Rodessa oil field, which has produced
approximately 2.3 trillion cubic feet of gas and approximately 400 million
barrels of oil.  The field has historically been the domain of small
independent operators and is not a legacy field for any major oil
company.





Our
Cornerstone Project is to identify and exploit resources in and adjacent to
existing or indicated producing areas within the Rodessa field
area.  We intend to quickly develop and produce reserves at a low cost
and will take an aggressive approach to exploiting our contiguous acreage
position through utilization of “best in class” drilling, (i.e. using the
latest drilling techniques available and seismic technology).  We
believe that we are uniquely familiar with the history and geology of the
Cornerstone Project area based on our collective experience in the region as
well as through our ownership of a large proprietary database which details the
drilling history of the Cornerstone Project area over the previous 28
years.  We believe implementing our drilling strategy and using new
drilling and completion techniques will enable us to find significant gas and
oil reserves in the Cornerstone Project area.




We
conduct our main exploration and production operations through our wholly-owned
subsidiary, Pegasi Operating Inc.  We conduct additional operations
through two other wholly-owned subsidiaries: (i) TR Rodessa, Inc ("TR Rodessa").
and (ii) 59 Disposal, Inc ("59 Disposal").





TR
Rodessa owns a 70% undivided interest in and operates a 40-mile natural gas
pipeline and gathering system which we currently use to transport our
hydrocarbons to market.  Excess capacity on this system is used to
transport third-party hydrocarbons.





59
Disposal owns a 70% undivided interest in and operates a saltwater disposal
facility which disposes saltwater and flow-back waste into subsurface
storage.





We
previously operated under the name Maple Mountain Explorations
Inc.  On December 12, 2007, we entered into a Share Exchange Agreement
with the shareholders of Pegasi Energy Resources Corporation, a Texas
corporation, pursuant to which we purchased from Pegasi Energy Resources
Corporation’s shareholders all issued and outstanding shares of Pegasi Energy
Resources Corporation common stock in consideration for the issuance of
17,500,000 shares of our common stock. Effective January 23, 2008, we changed
our name to Pegasi Energy Resources Corporation.






11





Plan
of Operations





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





·
            Develop the Cornerstone
      Project in East Texas through an aggressive drilling
      program.We will focus our near-term efforts on
      development drilling on existing acreage.  We expect this
      drilling program to increase our proved reserve and cash flow
      profile.·
            Apply management expertise in
      the Cornerstone Project area and recent developments in drilling and
      completion technology to identify new drilling opportunities and enhance
      production.We plan to maximize the present value of our
      vertical wells by utilizing a “Sawtooth” production
      technique.  This technique is characterized by sequentially
      completing multiple geologic horizons in a single wellbore in order to
      maximize well economics.  We will also implement the latest
      drilling, fracturing, and completion techniques to develop our properties
      including horizontal drilling.  These horizontal wells will
      primarily target the Bossier formation and we expect these wells to yield
      significantly higher hydrocarbon flow rates than our vertical
      wells.·
            Continue to lease
      underdeveloped acreage in the Cornerstone Project
      area.We plan to use our extensive proprietary database
      to help optimize additional drilling locations and to acquire additional
      acreage.  We intend to target acreage with exploitation and
      technology upside within the Cornerstone Projectarea.  Most
      properties in the project area are held by smaller independent companies
      that lack the resources to exploit them fully.  We intend to
      pursue these opportunities to selectively expand our portfolio of
      properties.  These acreage additions will complement our
      existing substantial acreage position in the area and provide us with
      significant additional drilling inventory.·
            Maintain a conservative and
      flexible financial strategy.We intend to continue to
      focus on maintaining a low level of corporate overhead expense in addition
      to continued utilization of outsourcing, when appropriate, to maximize
      cash flow.  We believe this internally generated cash flow,
      coupled with reserve-based debt financing when appropriate, will provide
      the optimal capital structure to fund our future drilling
      activity.





Our oil
and gas assets are located in Cass and Marion counties in northeast
Texas.  As of September 30, 2008, we operated nine
wells.  The Harris #2 well was completed in January 2008 and the
Childers #2 well was completed in February 2008.  Both wells were
logged to total depth and production casing set.





The first
fracture treatment stage of the Cotton Valley Group in the Harris #2 and
Childers #2 wells occurred in June 2008.    Permanent
facilities have been installed and the wells have been placed on production.
Additional stages of fracture treatment are planned for the fourth quarter of
2008. As of September 30, 2008, our leasehold position is approximately 20,000
gross acres and 14,000 net acres.  We have a 70% working interest in
the acreage. We have an ongoing leasing program whereby expiring leases are
being renewed and previously unleased acreage is being leased.





In
addition to the operating of the wells, we own a 70% undivided interest in
approximately 40 miles of natural gas pipeline as well as a saltwater and
drilling fluid disposal system.  The pipeline system is being extended to
connect to the Harris #2 and the Childers #2.  We expanded our
pipeline system by 9,238 feet, by building a new eight-inch high pressure line
to accommodate our production. Additional work is being conducted on the
pipeline to enhance transportation of third-party gas.





In
October 2008, we issued 4.2 million shares of our common stock to TR Energy in
exchange for a net 10% interest in the Cornerstone Project.  The
acquisition increased our interest in the Cornerstone Project to 80% and TR
Energy retains a 20% interest.





Results
of Operations





Three Months Ended September
30, 2008 Compared to Three Months Ended September 30, 2007





Summarized Results of Operations





2008
            
            
            2007
            
            
            Increase
      (Decrease)Total
      revenues
            
            $
            950,145
            
            
            $
            420,591
            
            
            $
            529,554Total
      operating expenses
            
            
            1,072,194
            
            
            
            401,130
            
            
            
            671,064Income
      (loss) from operations
            
            
            (122,049
            )
            
            
            19,461
            
            
            
            (141,510
            )Total
      other income (expenses)
            
            
            144,960
            
            
            
            (120,917
            )
            
            
            265,877Income
      (loss) before income tax expense
            
            
            22,911
            
            
            
            (101,456
            )
            
            
            124,367Income
      tax expense
            
            
            (27,613
            )
            
            
            (91,863
            )
            
            
            (64,250
            )Net
      loss
            
            $
            (4,702
            )
            
            $
            (193,319
            )
            
            $
            (188,617
            )





Revenues:  Total
revenues for the three months ended September 30, 2008 totaled $950,145,
compared to $420,591 for the three months ended September 30,
2007.  Production revenues of oil and gas increased $302,834 for the
three months ended September 30, 2008 compared to the three months ended
September 30, 2007.  This increase in revenues reflects the impact of
higher sales volume for natural gas as well as an increase in sales prices for
natural gas of about 62%.  In addition, we completed a rework of the
Bramlett well in the second quarter which resulted in a significant increase in
its production, and, consequently, an increase in revenue during the three
months ended September 30, 2008 of approximately $146,000 from that
well.  Also during the three months ended September 30, 2008, the
Childers #2 and Harris #2 wells began production.  This also resulted
in a significant increase in production and an increase in revenue of
approximately $206,000.  Transportation and gathering revenue
increased $155,033 in the three months ended September 30, 2008, compared to the
three months ended September 30, 2007 due to an overall increase in gas produced
by third-party operators in the area during that time period.






12






Expenses:  Total
operating expenses for the three months ended September 30, 2008 were
$1,072,194, compared to $401,130 in the three months ended September 30,
2007.  This change is comprised of increases in general and
administrative expenses and cost of gas purchased for resale.





·
            General and Administrative
      Expense:  The $563,533 increase in general and
      administrative expense to $657,740 for the three months ended September
      30, 2008 from $94,207 for the three months ended September 30, 2007 is
      primarily due to payroll expenses.  The current officer
      employment agreements were executed on May 1, 2007; however, the officers
      waived their salaries for the period May to November
      2007.  Therefore, we did not pay officer salaries during the
      three months ended September 30, 2007.  In addition, increased
      legal, accounting and regulatory filing expenses have been incurred as a
      result of going public in late
2007.





·
            Cost of Gas Purchased for
      Resale:The $121,710 increase in cost of gas purchased
      for resale to $252,463 for the three months ended September 30, 2008 from
      $130,753 for the three months ended September 30, 2007 is due to an
      increase in the gas produced by third-party operators in the area and is
      consistent with the increase in the related transportation and gathering
      revenue.





Other Income
(Expenses):Total other income for the three months ended
September 30, 2008 was $144,960, compared to $120,917 of other expenses for the
three months ended September 30, 2007.  The primary reason for this
$265,877 change was due to the reevaluation of the liquidated damages expense
and an adjustment of $185,059 during the three months ended September 30,
2008.  At the end of the second quarter of 2008, we had accrued
approximately $300,000.  During the third quarter the registration
effectiveness date was extended to July 17, 2008 from May 18, 2008 (See Note
4).  In the three months ended September 30, 2008, we recognized
$9,161 in interest income, primarily from our interest-bearing bank
accounts.  In the three months ended September 30, 2007, we did not
have interest-bearing bank accounts.  We also had a $29,593 decrease
in our interest expense to $98,423 for the three months ended September 30, 2008
from $128,016 for the three months ended September 30, 2007 primarily due to the
$1 million principal payment made on the note payable to Teton, Ltd. in January
2008.





Income Tax
Expense:In the three months ended September 30, 2008, we
recognized deferred income tax expense of $27,613 and recognized deferred income
tax expense of $91,863 in the third quarter of 2007.  The $64,250
difference is primarily due to our election to capitalize intangible drilling
and completion costs for tax purposes as of January 1, 2008.





Operating Loss:As
a result of the above described revenues and expenses, we incurred a net
operating loss of $4,702 in the three months ended September 30, 2008 as
compared to an operating loss of $193,319 in the three months ended September
30, 2007.





Nine Months Ended September
30, 2008 Compared to Nine Months Ended September 30, 2007





Summarized
Results of Operations





2008
            
            
            2007
            
            
            Increase
      (Decrease)Total
      revenues
            
            $
            2,127,501
            
            
            $
            1,670,669
            
            
            $
            456,832Total
      operating expenses
            
            
            3,187,242
            
            
            
            1,438,771
            
            
            
            1,748,471Income
      (loss) from operations
            
            
            (1,059,741
            )
            
            
            231,898
            
            
            
            (1,291,639
            )Total
      other income (expenses)
            
            
            (127,750
            )
            
            
            (390,148
            )
            
            
            262,398Income
      (loss) before income tax expense
            
            
            (1,187,491
            )
            
            
            (158,250
            )
            
            
            1,029,241Income
      tax expense
            
            
            (90,365
            )
            
            
            (774,720
            )
            
            
            (684,355
            )Net
      loss
            
            $
            (1,277,856
            )
            
            $
            (932,970
            )
            
            $
            344,886





Revenues:  Total
revenues for the nine months ended September 30, 2008 totaled $2,127,501,
compared to $1,670,669 for the nine months ended September 30,
2007.  Production revenues of oil and gas increased $357,704 for the
nine months ended September 30, 2008 compared to the nine months ended September
30, 2007.  This increase in revenues reflects the impact of higher
sales volume for natural gas as well as an increase in sales prices for natural
gas of about 68%.  In addition, we completed a rework of the Bramlet
well during the nine months ended September 30, 2008 which resulted in a
significant increase in the production, and, consequently, an increase in
revenue from the well of approximately $437,000 for the nine months ended
September 30, 2008.  Also during the nine months ended September 30,
2008, the Childers #2 and Harris #2 wells began production.  This also
resulted in a significant increase in production and an increase in revenue of
approximately $206,000.  The increase in production from the Bramlet,
Childers #2 and Harris #2 wells were partially offset by a decrease in
production from the Childers #1 and the Huntington #3 wells.  Both
wells stopped producing in 2008.  Overall, oil prices during the nine
months ended September 30, 2008 also increased about 53% from the nine months
ended September 30, 2007.  Transportation and gathering revenue
increased $207,181 for the nine months ended September 30, 2008, compared to the
nine months ended September 30, 2007 due to an overall increase in gas produced
by third-party operators in the area during that time
period.  Saltwater disposal income decreased by $140,917 for the nine
months ended September 30, 2008 as compared to the nine months ended September
30, 2007.  Many of 59 Disposal’s customers have opened their own
non-commercial disposal systems, and therefore no longer require outside
disposal services.  This is a growing trend for hauling companies in
the area, and could continue to impact disposal revenues.






13






Expenses:  Operating
expenses increased to $3,187,242 in the nine months ended September 30, 2008
from $1,438,771 in the nine months ended September 30, 2007.  This
change is comprised of increases in general and administrative expenses and the
cost of gas purchased for resale, partially offset by reductions in saltwater
disposal expenses and depreciation and depletion expense.





·
            General and Administrative
      Expense:  The $1,721,694 increase in general and
      administrative expense to $1,996,526 for the nine months ended September
      30, 2008 from $274,832 for the nine months ended September 30, 2007 is
      primarily due to payroll expenses.  The current officer
      employment agreements were executed on May 1, 2007; however, the officers
      waived their salaries for the period May to November
      2007.  Therefore, we did not pay officer salaries during the
      nine months ended September 30, 2007.  Total salaries for the
      nine months ended September 30, 2008 were approximately $747,692 as
      compared to approximately $82,330 for the nine months ended September 30,
      2007.  In addition, increased legal, accounting and regulatory
      filing expenses have been incurred in the nine months ended September 30,
      2008 as a result of going public in late
2007.





·
            Cost of Gas Purchased for
      Resale:The $176,698 increase in cost of gas purchased
      for resale to $632,807 for the nine months ended September 30, 2008 from
      $456,109 for the nine months ended September 30, 2007 is due to an
      increase in the gas produced by third-party operators in the area and is
      consistent with the increase in the related transportation and gathering
      revenue.





·
            Saltwater Disposal
      Expenses:The decrease in saltwater disposal expenses to
      $159,560 for the nine months ended September 30, 2008 from $262,313 for
      the nine months ended September 30, 2007 corresponds to the decrease in
      saltwater disposal income.





Other Income
(Expense):Total other expenses for the nine months ended
September 30, 2008 were $127,750, compared to $390,148 for the nine months ended
September 30, 2007.  The primary reason for this $262,398 change was
due to the reevaluation of the liquidated damages expense and an adjustment of
$185,059 during the three months ended September 30, 2008.  At the end
of the second quarter of 2008, we had accrued approximately
$300,000.  During the three months ended September 30, 2008 the
registration effectiveness date was extended to July 17, 2008 from May 18, 2008
(See Note 4). In the nine months ended September 30, 2008, we recognized $73,026
in interest income, primarily from our interest-bearing bank
accounts.  In the nine months ended September 30, 2007, we did not
have interest-bearing bank accounts.  We also had an $85,004 decrease
in our interest expense to $293,421 for the nine months ended September 30, 2008
from $378,425 for the nine months ended September 30, 2007 primarily due to the
$1 million principal payment made on the note payable to Teton, Ltd. in January
2008.





Income Tax
Expense:In the nine months ended September 30, 2008, we
recognized deferred income tax expense of $90,365 and recognized deferred income
tax expense of $774,720 during the nine months ended September 30,
2007.  The $684,355 difference is primarily the result of First
Southern Crown, Inc., 59 Disposal, and TR Rodessa converting from partnerships
to taxable corporations in 2007 and represents temporary differences primarily
created by oil and gas properties as well as property and
equipment.  Our election to capitalize our intangible drilling and
completion costs for income tax purposes as of January 1, 2008 also resulted in
a lower deferred tax expense for 2008.





Operating Loss:As
a result of the above described revenues and expenses, we incurred a net
operating loss of $1,277,856 for the nine months ended September 30, 2008 as
compared to an operating loss of $932,970 for the nine months ended September
30, 2007.





Liquidity and Capital Resources





We ended
the third quarter of 2008 with approximately $1.3 million in cash and cash
equivalents, compared to approximately $8.9 million at December 31,
2007.  The decrease in cash and cash equivalents is related to
drilling and completion work performed on the Harris #2 and Childers #2 wells in
January 2008 and February 2008, respectively, fracture treatment on the Harris
#2 and Childers #2 in June 2008, purchases of lease and well equipment and oil
and gas properties, a payment made on our line-of-credit with Teton, Inc., a
related party, and payments made on operating liabilities.





Cash
Flows





The
following table summarizes our cash flows for the nine months ended September
30, 2008 and 2007:





Nine
      Months Ended September 30,2008
            
            
            2007Total
      cash provided by (used in):Operating
      activities
            
            $
            (2,083,870
            )
            
            $
            215,734Investing
      activities
            
            
            (4,488,108
            )
            
            
            (306,607
            )Financing
      activities
            
            
            (1,031,143
            )
            
            
            132,696Increase
      (decrease) in cash and cash equivalents
            
            $
            (7,603,121
            )
            
            $
            41,823








14





Cash used
in operating activities in the nine months ended September 30, 2008 totaled
$2,083,870, compared to $215,733 provided by operating activities in the nine
months ended September 30, 2007.  The change is primarily due to an
increase in cash used by changes in connection with operating assets and
liabilities, and by an increase in the net loss.  The net loss was
$1,277,856 in the nine months ended September 30, 2008, an increase from the net
loss of $932,970 in the nine months ended September 30, 2007.  The
changes in operating assets and liabilities are primarily due to changes in
related party joint-interest deposits payable and accounts payable.





Cash used
in investing activities in the nine months ended September 30, 2008 was
$4,488,108, compared to $306,606 in the nine months ended September 30,
2007.  The change is due primarily to increased drilling activities in
nine months ended September 30, 2008.  Drilling and completion of the
Harris #2 and Childers #2 wells were finished in January 2008 and February 2008,
respectively.  In addition, fracture treatment of the two wells began
in June 2008.  We spent in excess of $3.9 million on lease and well
equipment, leasehold costs and intangible drilling and completion costs in the
first nine months of 2008, compared to $246,927 in the first nine months of
2007.  Finally, property and equipment purchases were approximately
$522,000 in the first nine months of 2008 compared to $60,000 in the first nine
months of 2007.





Cash used
in financing activities in the nine months ended September 30, 2008 totaled
$1,031,143, compared to $132,696 of cash provided by financing activities in the
nine months ended September 30, 2007.  This change is due primarily to
the payment of $1,000,000 on a related party line-of-credit in January
2008.





Sources
of Liquidity





Our most
significant source of liquidity continues to be the funds generated in the
public offering in December 2007.  We believe that the proceeds from
the offering will be sufficient to finance our operations for the remainder of
2008.  However, future acquisitions and future exploration,
development, production and marketing activities, as well as administrative
requirements (such as salaries, insurance expenses, general overhead expenses,
legal compliance costs and accounting expenses) will require a substantial
amount of additional capital and cash flow.





We plan to pursue sources of additional
capital through various financing transactions or arrangements, including joint
venturing of projects, debt financing, equity financing or other
means.  We entered into a credit agreement with lenders led by Amegy
Bank, N.A. in November 2007.  Pursuant to the terms of the credit
agreement, the aggregate commitment is $50 million, with no initial borrowing
base or borrowing base reduction under the agreement.  Upon
satisfaction of various conditions precedent to the initial credit extension,
the borrowing base will be $5 million and the initial monthly borrowing base
reduction will be determined on the initial funding date.  As of
September 30, 2008, we have not drawn any funds on the line-of-credit, but may
choose to do so in the future.





Off
Balance Sheet Arrangements





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





Critical
Accounting Policies




Our
critical accounting policies, including the assumptions and judgments underlying
them, are disclosed in the notes to consolidated financial statements which
accompany the consolidated financial statements.  These policies have
been consistently applied in all material respects and address such matters as
revenue recognition and depreciation methods.  The preparation of
consolidated financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the consolidated financial statements and the recorded amounts of revenues and
expenses during the reporting period.  Actual results could differ
from these estimates.




Accounts
Receivable





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





Property
and Equipment





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






15







Oil
and Gas Properties





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





All
capitalized costs of oil and gas properties, including the estimated future
costs to develop proved reserves, are amortized on the units-of-production
method using estimates of proved reserves.  Investments in unproved
properties and major development projects are not amortized until proved
reserves associated with the projects can be determined or until impairment
occurs.  If the results of an assessment indicate that the properties
are impaired, the amount of the impairment is removed from the capitalized costs
to be amortized.




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





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





Abandonment
of properties is recognized as an expense in the period of abandonment and
accounted for as an adjustment of capitalized costs.





Revenue
Recognition





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





Gas
imbalances are accounted for using the sales method.  Under this
method, revenues are recognized based on actual volumes of oil and gas sold to
purchasers.  However, we have no history of significant gas
imbalances.





Income
Taxes





Deferred
income taxes are determined using the “liability method” in accordance with SFAS
No. 109, Accounting for Income
Taxes.Deferred tax assets and liabilities are recognized for
the future tax consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases.




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





Item
3. Quantitative and Qualitative Disclosures about Market Risk





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





Item
4T.  Controls and Procedures.





(a)
Evaluation of disclosure controls and procedures.





Our
management, with the participation of our Chief Executive Officer and Chief
Financial Officer, evaluated the effectiveness of our disclosure controls and
procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934
(the "Exchange Act")  as of September 30, 2008. In designing and
evaluating the disclosure controls and procedures, management recognizes that
any controls and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving the desired control objectives.
In addition, the design of disclosure controls and procedures must reflect the
fact that there are resource constraints and that management is required to
apply its judgment in evaluating the benefits of possible controls and
procedures relative to their costs.





Based
on our evaluation, our Chief Executive Officer and Chief Financial Officer
concluded that, as a result of the material weaknesses described below, our
disclosure controls and procedures are not designed at a reasonable assurance
level and are ineffective to provide reasonable assurance that information we
are required to disclose in reports that we file or submit under the Exchange
Act is recorded, processed, summarized and reported within the time periods
specified in SEC rules and forms, and that such information is not
accumulated nor communicated to our management, including our Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow timely decisions
regarding required disclosure. In the course of responding to comments issued by
the SEC on our registration statement, a number of material weaknesses were
brought to our attention that needed to be addressed.  The material
weaknesses, which relate to internal control over financial reporting, that were
identified are:






16







a)
            We
      did not maintain sufficient personnel with an appropriate level of
      technical accounting knowledge, experience, and training in the
      application of US GAAP commensurate with our complexity and our financial
      accounting and reporting requirements. This control deficiency is
      pervasive in nature and specifically resulted in us restating previously
      filed annual and quarterly consolidated financial statements as a result
      of errors in the accounting for minority interests in our subsidiary as
      well as improperly accounting for receivables as contributions. Further,
      there is a reasonable possibility that material misstatements of the
      consolidated financial statements including disclosures will not be
      prevented or detected on a timely basis as a result;
  and





b)
            We
      improperly accounted for reserves discovered after the proper cut-off date
      for reserve reporting requirements.





We are
committed to improving our financial organization. As part of this commitment,
we will look to increase our personnel resources and technical accounting
expertise within the accounting function by the end of fiscal 2009 to resolve
non-routine or complex accounting matters. In addition, when funds are
available, which we expect to occur by the end of fiscal 2009, we will take the
following action to enhance our internal controls: Hiring additional
knowledgeable personnel with technical accounting expertise to further support
our current accounting personnel, which management estimates will cost
approximately $100,000 per annum. We currently engage an outside accounting firm
to assist us in the preparation of our consolidated financial
statements. As necessary, we will engage consultants in the future as necessary
in order to ensure proper accounting for our consolidated financial
statements.





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





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





Our subsidiary, 59 Disposal, is now
wholly-owned by us and there is no longer a minority interest in such subsidiary
or any of our other subsidiaries.  As a result, we believe that this
material weakness has been resolved.





We will
continue to monitor and evaluate the effectiveness of our disclosure controls
and procedures and our internal controls over financial reporting on an ongoing
basis and are committed to taking further action and implementing additional
enhancements or improvements, as necessary and as funds allow.





(b)
Changes in internal control over financial reporting.





We regularly
review our system of internal control over financial reporting and make changes
to our processes and systems to improve controls and increase efficiency, while
ensuring that we maintain an effective internal control environment. Changes may
include such activities as implementing new, more efficient systems,
consolidating activities, and migrating processes.





There
were no changes in our internal control over financial reporting that occurred
during the period covered by this Quarterly Report on Form 10-Q that have
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.








17











PART
II - OTHER INFORMATION





Item
1. Legal Proceedings.





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





Item
1A. Risk Factors.





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





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




None.





Item
3. Defaults Upon Senior Securities.





None.





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





None.





Item
5. Other Information.





None.





Item
6. Exhibits.




31.1
            Certification
      of Chief Executive Officer pursuant to Rule 13a-14 and Rule 15d-14(a),
      promulgated under the Securities and Exchange Act of 1934, as
      amended





31.2
            Certification
      of Chief Financial Officer pursuant to Rule 13a-14 and Rule 15d 14(a),
      promulgated under the Securities and Exchange Act of 1934, as
      amended





32.1
            Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 (Chief Executive
  Officer)





32.2
            Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002 (Chief Financial
  Officer)







18





SIGNATURES





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




PEGASI
      ENERGY RESOURCES CORPORATIONDate:  November
      13, 2008
            By:/s/ MICHAEL NEUFELDMichael
      NeufeldChief
      Executive Officer (Principal Executive Officer)Date:  November
      13, 2008
            By:/s/ RICHARD LINDERMANISRichard
      LindermanisChief
      Financial Officer (Principal Financial Officer and Principal Accounting
      Officer)












19