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 MARCH 31, 2010





OR





 ̈

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





FOR THE TRANSITION PERIOD FROM ____________ TO ____________





COMMISSION FILE NUMBER: 333-134568





PEGASI ENERGY RESOURCES CORPORATION


(Exact name of registrant as specified in its charter)





Nevada

20-4711443(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification Number)





218 N. Broadway, Suite 204

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





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





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





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





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





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





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





There were 33,610,801 shares of the registrant's common stock outstanding as of May 7, 2010.



















PEGASI ENERGY RESOURCES CORPORATION


CONSOLIDATED FINANCIAL STATEMENTS


FOR THE QUARTER ENDED MARCH 31, 2010





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
15Item 4. Controls and Procedures
15PART II - OTHER INFORMATIONItem 1. Legal Proceedings
17Item 1A. Risk Factors
17Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
17Item 3. Defaults Upon Senior Securities
17Item 4. Reserved
17Item 5. Other Information
17Item 6. Exhibits
17SIGNATURES
18








2







PART I - FINANCIAL INFORMATION





Item 1. Financial Statements.


PEGASI ENERGY RESOURCES CORPORATION


CONSOLIDATED BALANCE SHEETS





March 31,


December 31,2010


2009(Unaudited)AssetsCurrent assets:Cash and cash equivalents

$
325,984


$
127,176Accounts receivable, trade


129,287



98,578Accounts receivable, related parties


14,274



13,002Joint-interest billings receivable, related parties, net


21,894



17,983Restricted cash – leasing program


629,884



-Other current assets


26,314



51,288Total current assets


1,147,637



308,027Property and equipment:Equipment


680,927



601,759Pipelines


700,765



700,765Buildings


19,916



19,916Leasehold improvements


7,022



7,022Vehicles


50,663



50,663Office furniture


137,071



137,071Website


15,000



15,000Total property and equipment


1,611,364



1,532,196Less accumulated depreciation


(552,093
)


(515,101
)Property and equipment, net


1,059,271



1,017,095Oil and gas properties:Oil and gas properties, proved


11,926,492



11,928,985Oil and gas properties, unproved


9,171,989



9,150,426Capitalized asset retirement obligations


220,237



220,237Total oil and gas properties


21,318,718



21,299,648Less accumulated depletion and depreciation


(924,275
)


(900,275
)Oil and gas properties, net


20,394,443



20,399,373Other Assets:Certificates of deposit


77,385



77,195Total other assets


77,385



77,195Total assets

$
22,678,736


$
21,801,690





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








3







PEGASI ENERGY RESOURCES CORPORATION


CONSOLIDATED BALANCE SHEETS (CONTINUED)











March 31,


December 31,2010


2009(Unaudited)Liabilities and Stockholders' EquityCurrent liabilities:Accounts payable

$
350,129


$
251,336Accounts payable, related parties


940,926



874,076Revenues payable


118,742



104,366Interest payable, related party


971,098



840,052Liquidated damages payable


147,209



142,083Other payables


23,853



35,795Lease program deposits


629,884



-Current portion of notes payable


5,337



6,570Current portion of notes payable, related party


6,975,303



6,352,303Total current liabilities


10,162,481



8,606,581Notes payable


4,320



4,803Asset retirement obligations


304,817



300,311Total liabilities


10,471,618



8,911,695Commitments and contingencies (Note 5)Stockholders' equity:Common stock; $0.001 par value; 75,000,000 shares authorized;33,610,801 shares issued and outstandingat March 31, 2010 and December 31, 2009


33,611



33,611Additional paid-in capital


19,673,102



19,673,102Accumulated deficit


(7,499,595
)


(6,816,718
)Total stockholders' equity


12,207,118



12,889,995Total liabilities and stockholders' equity

$
22,678,736


$
21,801,690








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 March 31,








2010


2009Revenues:Oil and gas

$
177,716


$
114,807Condensate and skim oil


16,548



21,267Transportation and gathering


67,388



74,831Saltwater disposal income


26,594



71,490Total revenues


288,246



282,395Operating expenses:Lease operating expenses


76,261



76,740Saltwater disposal expenses


99,730



71,732Pipeline operating expenses


19,158



25,314Cost of gas purchased for resale


47,058



50,325Depletion and depreciation


61,017



61,064General and administrative


521,974



683,081Total operating expenses


825,198



968,256Loss from operations


(536,952
)


(685,861
)Other income (expenses):Interest income


191



1,416Interest expense


(135,267
)


(102,831
)Liquidated damages


(5,126
)


(5,126
)Other income


(5,723
)


606Total other income (expenses)


(145,925
)


(105,935
)Loss before income tax expense


(682,877
)


(791,796
)Income tax expense


-



(370
)Net loss

$
(682,877
)

$
(792,166
)Basis and diluted loss per share

$
(0.02
)

$
(0.02
)Weighted average shares outstanding


33,610,801



3,610,801








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









5





PEGASI ENERGY RESOURCES CORPORATION


CONSOLIDATED STATEMENTS OF CASH FLOWS


(UNAUDITED)


Three Months Ended March 31,








2010


2009Operating ActivitiesNet loss

$
(682,877
)

$
(792,166
)Adjustments to reconcile net loss to net cash used in operating activities:Depletion and depreciation


61,017



61,064Accretion of discount on asset retirement obligations


4,506



4,251Liquidated damages


5,126



5,126Loss on abandonment of equipment


5,727



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


(30,709
)


115,767Accounts receivable, related parties


(1,272
)


13,499Joint-interest billings receivable, related parties, net


(3,911
)


4,619Other current assets


24,974



(68,470
)Accounts payable


98,793



160,087Accounts payable, related parties


66,850



35,638Revenues payable


14,376



(24,490
)Interest payable, related party


131,046



102,562Other payables


(11,942
)


(1,586
)Net cash used in operating activities


(318,296
)


(384,099
)Investing ActivitiesAdditions to certificate of deposit


(190
)


-Purchases of property and equipment


(84,920
)


(10,634
)Purchases of oil and gas properties


(19,070
)


(336,640
)Net cash used in investing activities


(104,180
)


(347,274
)Financing ActivitiesPayments on notes payable


(1,716
)


(1,611
)Proceeds from borrowing on notes payable, related party


623,000



570,000Net cash provided by financing activities


621,284



568,389Net increase (decrease) in cash and cash equivalents


198,808



(162,984
)Cash and cash equivalents at beginning of period


127,176



792,255Cash and cash equivalents at end of period

$
325,984


$
629,271Supplemental Disclosure of Cash Flow InformationCash paid during the period for interest

$
4,221


$
269








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








6




PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010 AND 2009







1.  NATURE OF OPERATIONS





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





2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





a)  Basis of Presentation





The accompanying unaudited interim consolidated financial statements of PERC have been prepared in accordance with accounting principles generally accepted (“GAAP”) in the United States of America and the rules of the Securities and Exchange Commission (the “SEC”), and should be read in conjunction with PERC’s audited consolidated financial statements for the year ended December 31, 2009, and notes thereto, which are included in the Company’s annual report on Form 10-K filed with the SEC on March 29, 2010.  In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the Company’s consolidated financial position and the consolidated results of operations for the interim periods presented have been reflected herein.  The consolidated results of operations for interim periods are not necessarily indicative of the results to be expected for the full year.  The notes to consolidated financial statements, which would substantially duplicate the disclosures required in the Company’s 2009 annual consolidated financial statements, have been omitted.





b)  New Accounting Pronouncements





In January 2010, the FASB issued Accounting Standards Update (ASU) No. 2010-03, Extractive Industries – Oil and Gas, (Topic 932): Oil and Gas Reserve Estimation and Disclosure, which aligned U.S. GAAP with the SEC’s updated reporting and disclosure requirements for energy companies that went into effect on January 1, 2010, effective for annual reporting periods ending on or after December 31, 2009.  The Company included the required disclosures in the Form 10-K filed with the SEC on March 29, 2010 under the guidance of the Modernization of Oil and Gas Reporting update issued by the SEC on December 31, 2008.





Also, in January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.  This standard requires reporting entities to provide information about movements of assets among Levels 1 and 2 of the three-tier fair value hierarchy established by SFAS No. 157 (FASB ASC 820).  The guidance is effective for any interim and annual reporting periods  that  begin after December 15, 2009.  The Company adopted ASU No. 2010-06 in the first quarter of 2010 and the adoption did not have a material impact on the Company’s disclosures.  The standard also requires entities to provide a reconciliation of purchases, sales, issuance, and settlements of anything valued with a Level 3 method.  This guidance is effective for fiscal years beginning after December 15, 2010, and for interim and periods within those fiscal years. The Company is currently assessing the impact that the adoption will have on their disclosures.





c)  Reclassifications





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








7








PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010 AND 2009





3.  NOTES PAYABLE, RELATED PARTY





Notes payable, related party consisted of the following at:

March 31,

2010


December 31, 2009Original note payable dated May 21, 2007 to Teton (the “Teton Note”).  Additional funds added by amendments three, four, five to the note result in an outstanding balance of $5,952,303, including interest at 8%, with all interest and principal due on the maturity date of May 21, 2010.  Substantially all of the Company’s assets are pledged as collateral on the note.

$
5,952,303


$
5,952,303Original unsecured promissory note payable in the amount of $1 million dated October 14, 2009 to Teton (the “Teton Promissory”).  Additional funds added by amendment two to the note result in funds available of $1.5 million.  Accrued interest of 6.25% per annum on the principal amount, which is the sum of all advances made, is due July 1, 2010.  The remaining interest and outstanding principal balance are due on the maturity date of October 14, 2010.


1,023,000



400,000Total notes payable, related party


6,975,303



6,352,303Less current portion


(6,975,303
)


(6,352,303
)Total long-term notes payable, related party

$
-


$
-





In the fourth quarter of 2009, the Teton Promissory was amended to eliminate the requirement of interest payments to be made on January 1, 2010; April 1, 2010; July 1, 2010; and October 1, 2010.  In May 2010, a second amendment was executed which increased the available balance to $1,500,000 effective March 2, 2010.





On May 1, 2007, a “memorandum of Understanding” was executed to grant Teton the right to convert the outstanding balance on the Teton Note into shares of PERC’s common stock at a fixed conversion price of $1.20 per share.  Teton has the right, but not the obligation to convert all or a portion of the indebtedness at any time after May 1, 2008, unless the debt is repaid before such date.  This option will continue in existence as long as any balance remains outstanding on the note.





On March 3, 2009, a “Second Amendment to Renewal Promissory Note and Loan Modification Agreement” (the “Second Amendment”) was executed, which amended the Teton Note.  This agreement added $550,000 of additional cash proceeds and $20,000 of advances payable to the outstanding balance of the Teton Note and pledged substantially all of the Company’s assets to secure repayment of the note.  The Second Amendment confirmed that the fixed conversion price of $1.20 per share would remain for the portion of the note payable balance that existed prior to its execution, and a fixed conversion price of $1.60 was agreed upon for conversion of the additional funds.





In May 2009, the third and fourth amendments to the Teton Note were executed.  The third amendment deferred the May 21, 2009 interest payment to September 21, 2009 and the fourth amendment added $350,000 of additional funds to the outstanding balance of the Teton Note.  In September 2009, the fifth amendment was executed, which added $175,000 of additional funds to the outstanding balance of the Teton Note and deferred the interest payment due date from September 21, 2009 to October 21, 2009.  In February 2010, the seventh amendment to the Teton Note, dated May 21, 2007, was executed.  This amendment amended the sixth amendment, executed in October 2009, to defer the October 21, 2009 interest payment to February 21, 2010.  The seventh amendment eliminated the February 21, 2010 interest payment.  The final maturity date of the Teton Note was unchanged and remains May 21, 2010.  The Company is currently negotiating an amendment to the note to extend the maturity date.




4.  SEGMENT INFORMATION





The following information is presented in accordance with FASB ASC Topic 280, Segment Reporting.  The Company is engaged in oil and gas exploration and production, saltwater disposal and pipeline transportation.  PERC is engaged in the exploration and production of natural gas and oil.  Pegasi Operating, Inc. (“POI”), a wholly-owned subsidiary of PERC, conducts the exploration and production operations.  TR Rodessa, Inc. (“TR Rodessa”) 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”) 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.  The Company identified such segments based on management responsibility and the nature of their products, services, and costs.  There are no major distinctions in geographical areas served as all operations are in the United States.  The Company measures segment profit (loss) as income (loss) from operations.  Business segment assets are those assets controlled by each reportable segment.  The following table sets forth certain information about the financial information of each segment as of March 31, 2010 and December 31, 2009 and for the three months ended March 31, 2010 and 2009.






8




PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010 AND 2009





Three Months Ended

March 31,

2010


Three Months Ended

March 31,

2009Business segment revenue:Oil and gas

$
177,716


$
114,807Condensate and skim oil


16,548



21,267Transportation and gathering


67,388



74,831Saltwater disposal income


26,594



71,490Total revenues

$
288,246


$
282,395Business segment profit (loss):Oil and gas

$
15,633


$
(197,296
)Condensate and skim oil


16,548



21,267Transportation and gathering


(19,910
)


(17,271
)Saltwater disposal


(99,618
)


(27,351
)General corporate


(449,605
)


(465,210
)Loss from operations

$
(536,952
)

$
(685,861
)Depletion and depreciation:Oil and gas

$
25,940


$
27,752Transportation and gathering


7,492



7,599Saltwater disposal


19,822



16,604General corporate


7,763



9,109Total depletion and depreciation

$
61,017


$
61,064








Three Months Ended

March 31,

2010


Three Months Ended

March 31,

2009Capital expenditures:Oil and gas

$
19,070


$
336,640Transportation and gathering


-



-Saltwater disposal


84,920



10,634General corporate


-



-Total capital expenditures

$
103,990


$
347,274March 31,


December 31,2010



2009Business segment assets:Oil and gas

$
20,623,984


$
20,508,595Transportation and gathering


649,752



664,306Saltwater disposal


379,822



294,086General corporate


1,025,178



334,703Total assets

$
22,678,736


$
21,801,690











9





PEGASI ENERGY RESOURCES CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 MARCH 31, 2010 AND 2009





5. COMMITMENTS AND CONTINGENCIES





Along with the Company's counsel, management monitors developments related to legal matters and, when appropriate, makes adjustments to record liabilities to reflect current facts and circumstances.  Management has recorded a liability related to its registration rights agreement with investors that provides for the filing of a registration statement for the registration of the shares issued in the offering in December 2007, as well as the shares issuable upon exercise of related warrants.  The Company failed to meet the deadline for the effectiveness of the registration statement and therefore was required to pay liquidated damages of approximately $100,000 on the first day of effectiveness failure, or July 18, 2008.  An additional $100,000 penalty was required to be paid by the Company every thirty days thereafter, prorated for periods totaling less than thirty days, until the effectiveness failure was cured, up to a maximum of 18% of the aggregate purchase price, or approximately $1,800,000.  The Company’s registration became effective on August 21, 2008.  At March 31, 2010, management reevaluated the status of the registration statement and determined an accrual of $147,209 was sufficient to cover any potential payments for liquidated damages.  The damages are reflected as liquidated damages payable of $147,209 and $142,083 in the accompanying consolidated balance sheets as of March 31, 2010 and December 31, 2009, respectively.




6.  FAIR VALUE OF FINANCIAL INSTRUMENTS





In accordance with the reporting requirements of FASB ASC Topic 825-10-50, Disclosures about Fair Value of Financial Instruments, the Company calculates the fair value of its assets and liabilities which qualify as financial instruments under this topic and includes this additional information in the notes to consolidated financial statements when the fair value is different than the carrying value of these financial instruments.  The estimated fair values of accounts receivable, accounts payable, and other current assets and accrued liabilities approximate their carrying amounts due to the relatively short maturity of these instruments.  The carrying value of long-term debt approximates market value due to the use of market interest rates.





7.  RESTRICTED CASH – LEASING PROGRAM





During the first quarter of 2010, we executed agreements with two independent oil and gas companies regarding leasing specific areas on the Cornerstone project.  The agreements include both extensions and renewals of existing leaseholds that we currently hold and acquisitions of new leaseholds in order to expand our acreage position.  Funds received from these companies are restricted to the leasing programs and are considered released when they are spent in accordance with the agreements.  Total funds of $750,000 were received on these programs and $120,116 was spent on leasing activities leaving a balance of $629,884 in restricted cash and lease program deposits at March 31, 2010.








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 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 not  currently  known  to management  could  cause  actual  results  to differ  materially  from  those in forward-looking  statements.  We undertake no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes in the future operating results over time. We believe that our assumptions are based upon reasonable data derived from and 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.  The field has historically been the domain of small independent operators and is not a legacy field for any major oil company.





Our business strategy, which we 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. 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 since 1980.  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, POI.  We conduct additional operations through two other wholly-owned subsidiaries: (i) TR Rodessa and (ii) 59 Disposal.





TR Rodessa owns an 80% 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.  TR Rodessa expanded the capacity of its system through the construction of a new 9,238 foot 8” trunkline in 2008. A total in excess of one mile of 4” laterals were constructed to the Childers #2, Harris #2, Huntington #4 and Childers # 3 well sites. These gathering lines have been tied into the central gathering point at the Huntington location.





59 Disposal owns an 80% 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. (“Maple Mountain”).  On December 12, 2007, Maple Mountain entered into a Share Exchange with the shareholders of PERC, a Texas corporation, pursuant to which Maple Mountain purchased from PERC’s shareholders all issued and outstanding shares of PERC’s common stock in consideration for the issuance of 17,500,000 shares of Maple Mountain’s 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 shotgun dual or sawtooth production technique. We will also implement the latest drilling, fracturing, and completion techniques, including shotgun duals, to develop our properties as well as horizontal drilling.  These horizontal wells will primarily target the Bossier formation and we anticipate these wells will 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.





In order to implement our strategy, we will first need to raise additional capital to develop our properties.   We may also consider farmout agreements, whereby we would lease parts of our properties to other operators for drilling purposes and we would receive payment based on the production.  We anticipate the cost of a horizontal oil well will be approximately $5 million and a vertical shallow gas well to be approximately $0.8 million.





Our oil and gas assets are located in Cass and Marion counties in northeast Texas.  As of March 31, 2010, we operated nine wells.  We did have a major work over on the 59 Disposal plant disposal well where the tubing was replaced and the well refurbished.  The work began in early December 2009 and was completed in January 2010.





As of March 31, 2010, our leasehold position is approximately 22,000 gross acres and 15,000 net acres.  We have an 80% working interest in the acreage.  We have an ongoing leasing program whereby expiring leases are being renewed and previously unleased acreage is being leased. We began discussions with two independent oil and gas companies during the first quarter of 2010 regarding leasing specific areas on the Cornerstone project.  Agreements were finalized in the middle of February and late March 2010 and could result in up to $4,000,000 and $4,700,000, respectively, in lease acquisitions.  Both agreements have been partially funded and an aggressive leasing program is underway.  This includes both extensions and renewals of existing leasehold that we currently hold and acquisitions of new leaseholds in order to expand our acreage position.  The participating companies are paying 100% of the cost for a 50% interest in the acreage, resulting in no cost to us.  We believe that this will result in follow-up drilling opportunities.  We plan on drilling several vertical wells with the first location being built in preparation of spudding the Norbord #1 well to be followed up by development drilling if successful.  We have a signed farmout commitment for 50% of the cost of drilling the Norbord #1 on a promoted basis.





In addition to the operating of the wells, we own an 80% undivided interest in approximately 40 miles of natural gas pipeline as well as an 80% undivided interest in a saltwater and drilling fluid disposal system.





We are seeking to raise additional capital.  However, we currently do not have any other contracts or commitments for funding and there are no guarantees that we will be able to raise funds on terms acceptable to us.  Effective March 1, 2010, we executed an agreement with an independent investor relations consultant.  In return for the consultant’s services, he will receive Director and Officer insurance as our spokesperson, 20,000 shares of our common stock, and a monthly fee of $3,500 plus any approved expenses incurred related to work performed on our behalf.  One half of the shares pursuant to this agreement are due August 1, 2010 and the remaining shares are due on March 1, 2011.





If we are able to obtain funding, our main emphasis will be to explore for oil with horizontal drilling.  The present discussions are based on pursuing an aggressive drilling program where we would be carried for an interest in any wells at no cost to us.  In addition, any funds could be used to apply fracture treatment to the Harris #2 and Childers #2 as well as deepening the Childers #1 and Harris #1.  The deepening will be to a minimum depth to complete the wells in the Cotton Valley formation and possibly deeper in order to evaluate the Cotton Valley Lime formation.





12





Results of Operations





Three Months Ended March 31, 2010 Compared to Three Months Ended March 31, 2009.





Summarized Results of Operations





2010


2009


Increase (Decrease)Total revenues

$
288,246


$
282,395



5,851Total operating expenses


825,198



968,256



(143,058
)Loss from operations


(536,952
)


(685,861
)


(148,909
)Total other income (expenses)


(145,925
)


(105,935
)


39,990Loss before income tax expense


(682,877
)


(791,796
)


(108,919
)Income tax expense


-



(370
)


(370
)Net loss

$
(682,877
)

$
(792,166
)


109,289





Revenues:  Total revenues for the three months ended March 31, 2010 totaled $288,246, compared to $282,395 for the three months ended March 31, 2009.  Production revenues of oil and gas increased $62,909 to $177,716 for the three months ended March 31, 2010 compared to $114,807 for the three months ended March 31, 2009.  The increase in production revenues reflects the impact of an increase in sales prices for natural gas of about 26% and oil of about 52%.  Saltwater disposal revenue decreased $44,896 to $26,594 for the three months ended March 31, 2010, compared to $71,490 for the three months ended March 31, 2009 due to a work over on the disposal well that began in December 2009 and was not completed until the first quarter of 2010 as well as an overall decrease in drilling activity starting in mid-2009 that lead to a decrease in disposal services needed.





Expenses:  Total operating expenses for the three months ended March 31, 2010 were $825,198, compared to $968,256 for the three months ended March 31, 2009.  This decrease is comprised mainly of a decrease in general and administrative expenses.





General and Administrative Expense:  The $161,107 decrease in general and administrative expense to $521,974 for the three months ended March 31, 2010 from $683,081 for the three months ended March 31, 2009 was primarily due to decrease in legal and accounting fees of $134,727.  The decrease was due to continued efficiencies in the accounting work performed in the quarter ended March 31, 2010 related to the preparation of the 2009 10-K.    An additional $12,000 decrease in regulatory filing files was due to lower audit fees in the first quarter of 2010 for the 2009 10-K as compared to fees in the first quarter of 2009 for the audit of the 2008 10-K.





Other Income (Expenses):Total other expenses for the three months ended March 31, 2010 were $145,925, compared to $105,935 of other expenses for the three months ended March 31, 2009.  The primary reason for this $39,990 increase was due to the increase in the balance of the line of credit.





Net Loss:As a result of the above described revenues and expenses, we incurred a net loss of $682,877 for the three months ended March 31, 2010 as compared to a net loss of $792,166 for the three months ended March 31, 2009.





Liquidity and Capital Resources





We ended the first quarter of 2010 with $325,984 in cash and cash equivalents, compared to $127,176 at December 31, 2009.  The increase in cash and cash equivalents is related to proceeds received from notes payable during the first quarter of 2010.  The increase was offset by purchases of lease and well equipment and oil and gas properties and using cash to cover operating expenses.





Cash Flows





The following table summarizes our cash flows for the three months ended March 31, 2010 and 2009:





Three Months Ended March 31,2010


2009Total cash provided by (used in):Operating activities


(318,296
)

$
(384,099
)Investing activities


(104,180
)


(347,274
)Financing activities


621,284



568,389Increase (decrease)  in cash and cash equivalents


198,808


$
(162,984
)











13








Cash used in operating activities for the three months ended March 31, 2010 totaled $318,296, compared to $384,099 used in operating activities for the three months ended March 31, 2009.  The decrease of $65,803 in cash used is primarily due to additional cash provided by changes in connection with operating assets and liabilities and a decrease in the net loss.  The net loss was $682,877 for the three months ended March 31, 2010, a decrease from the net loss of $792,166 for the three months ended March 31, 2009.  The changes in operating assets and liabilities are primarily due to changes in accounts receivable, related parties, joint interest deposits – prepayments, other current assets, accounts payable, related parties, and interest payable, related party.





Cash used in investing activities for the three months ended March 31, 2010 was $104,180, compared to $347,274 for the three months ended March 31, 2009.  The change is due primarily to decreased drilling activities for the three months ended March 31, 2010.   We spent $336,640 on leasehold costs, lease and well equipment, and intangible drilling and completion costs in the first three months of 2009 compared to $19,070 in the first three months of 2010.  This was partially offset by an increase in property and equipment purchases from $10,634 in the first three months of 2009 compared to $84,920 in the first three months of 2010.





Cash provided by financing activities for the three months ended March 31, 2010 totaled $621,284, compared to $568,389 of cash provided by financing activities for the three months ended March 31, 2009.  During the first three months of 2010, we received proceeds of $623,000 on a related party note payable compared to proceeds of $570,000 for the first three months of 2009.





Sources of Liquidity





Our main source of liquidity continues to be from funds generated by production from our wells.  Any short fall in revenue to cover costs has been covered by utilizing financing from a related party in the form of notes payable.  We believe that the proceeds from production and financing available from related parties will be sufficient to finance our operations for the remainder of 2010.  However, we have no commitments from related parties to provide additional financing. In addition, 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 have aggressively contacted many potential investors both within the industry as well as institutional investors to secure additional financing.  Additional financing would be used for drilling opportunities and additional lease funding in the near future, along with working capital purposes.  We do not have any commitments or agreements for financing, and we cannot assure you that additional funding will be available on terms acceptable to us, if at all.





We also entered into a credit agreement with various 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 March 31, 2010, these conditions had not been met.





Off Balance Sheet Arrangements





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





Critical Accounting Policies





Our critical accounting policies, including the assumptions and judgments underlying them, are disclosed in the notes to consolidated financial statements which accompany the consolidated financial statements included in our annual report on Form 10-K filed with the SEC on March 29, 2010.  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.








14







Property and Equipment





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





Oil and Gas Properties





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





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





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





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





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 interests in the wells.  Crude oil inventories are immaterial and are not recorded.





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





Income Taxes





Deferred income taxes are determined using the “liability method” in accordance with FASB ASC Topic 740, Income Taxes.Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.





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





Item 3.   Quantitative and Qualitative Disclosures about Market Risk





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





Item 4.  Controls and Procedures.





MANAGEMENT’S EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES





Disclosure controls and procedures have been designed to ensure that information required to be disclosed by the Company is collected and communicated to management to allow timely decisions regarding required disclosures.  The Chief Executive Officer and the Chief Financial Officer have concluded, based on their evaluation as of March 31, 2010 that, as a result of the following material weaknesses in internal control over financial reporting, disclosure controls and procedures were ineffective in providing reasonable assurance that material information is made known to them by others within the Company:








15





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





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





Changes to Internal Controls and Procedures Over Financial Reporting





There have been no changes to our internal control in the quarter ended March 31, 2010.





Management’s Remediation Plans





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 2010 to resolve non-routine or complex accounting matters. In addition, when funds are available, which we expect to occur by the end of 2010, 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 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.








16








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, consolidated 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. Reserved





Item 5. Other Information.





None.





Item 6. Exhibits.





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





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





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








17





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:  May 14, 2010
By:/s/ MICHAEL NEUFELDMichael NeufeldChief Executive Officer (Principal Executive Officer)Date:  May 14, 2010
By:/s/ RICHARD LINDERMANISRichard LindermanisChief Financial Officer (Principal Financial Officer and Principal Accounting Officer)