Table of Contents

 

 

 

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**Form 10-Q**

 

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

** **

**For thequarterly period ended March 31, 2010**

** **

**or**

** **

**o****        ****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

** **

**For thetransition period from             to              **

 

**Commissionfile number: 001-33457**

 

**PinnacleGas Resources, Inc.**

(Exactname of registrant as specified in its charter)

 

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

 

**(307)673-9710**

(Registrant’s telephonenumber, including area code)

 

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

 

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

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company. See the definitions of “large accelerated filer,” “acceleratedfiler” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

| Large Accelerated  Filer o |   | Accelerated Filer o     |
|---------------------------------|--------|------------------------------|
|                            |   |                         |
| Non-Accelerated  Filer o   |   | Smaller reporting  company x |

 

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

 

30,319,792 shares of the registrant’s Common Stockwere outstanding as of May 14, 2010.

 

 

 

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**PINNACLE GAS RESOURCES, INC.**

Index to Form 10-Q

 
| ** **                                                                                          | ** ** | **Page** |
|-----------------------------------------------------------------------------------------------------|------------|----------|
| Cautionary Statement Concerning Forward-Looking  Statements                                         |       | 2        |
| Part I.  FINANCIAL INFORMATION                                                                 |       | 4        |
| Item 1. Financial  Statements                                                                       |       | 4        |
| Balance  Sheets as of December 31, 2009 and March 31, 2010 (unaudited)                    |       | 4        |
| Statements of  Operations for the three months ended March 31, 2010 and 2009 (unaudited)       |       | 5        |
| Statements  of Cash Flows for the three months ended March 31, 2010 and 2009  (unaudited)      |       | 6        |
| Statements of  Stockholders’ Equity at March 31, 2010 (unaudited)                         |       | 7        |
| Notes to Financial  Statements (unaudited)                                                          |       | 8        |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations |       | 23       |
| Overview                                                                                            |       | 23       |
| Economic and  Natural Gas Pricing Environment                                                       |       | 23       |
| Credit Facility and Liquidity                                                                       |       | 23       |
| Critical Accounting Policies                                                                        |       | 24       |
| Trends Affecting  Our Business                                                                      |       | 29       |
| Results of Operations                                                                               |       | 30       |
| Liquidity and  Capital Resources                                                                    |       | 32       |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risk                                 |       | 36       |
| Item 4T. Controls  and Procedures                                                                   |       | 37       |
| Part II. OTHER  INFORMATION                                                                    |       | 38       |
| Item 1. Legal  Proceedings                                                                          |       | 38       |
| Item  1A. Risk Factors                                                                              |       | 38       |
| Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds                                |       | 39       |
| Item 3.  Defaults Upon Senior Securities                                                            |       | 39       |
| Item 4.  Submission of Matters to a Vote of Security Holders                                        |       | 39       |
| Item 5. Other  Information                                                                          |       | 39       |
| Item  6. Exhibits                                                                                   |       | 40       |

 

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**CAUTIONARY STATEMENT CONCERNINGFORWARD-LOOKING STATEMENTS**

 

We are including thefollowing discussion to inform you of some of the risks and uncertainties thatcan affect our company and to take advantage of the “safe harbor” protectionfor forward-looking statements that applicable federal securities law affords.Various statements in this quarterly report on Form 10-Q, including thosethat express a belief, expectation, or intention, as well as those that are notstatements of historical fact, are forward-looking statements. These includestatements relating to such matters as:

 

·our financial position or operating results;

 

·projections and estimates concerning the timing and success of specificprojects;

 

·our business strategy;

 

·our budget;

 

·the amount, nature and timing of capital expenditures;

 

·the drilling of wells;

 

·the development of natural gas and oil properties and commercial potential ofthese properties;

 

·the timing and amount of future production of natural gas and oil;

 

·our operating costs and other expenses;

 

·our estimated future net revenues from natural gas and oil reserves and thepresent value thereof;

 

·our cash flow and anticipated liquidity; and

 

· our other plans and objectivesfor future operations.

 

When we use the words “believe,”“intend,” “expect,” “may,” “should,” “anticipate,” “could,” “estimate,” “plan,”“predict,” “project,” their negatives, or other similar expressions, thestatements which include those words are usually forward-looking statements.When we describe strategy that involves risks or uncertainties, we are makingforward-looking statements. The forward-looking statements in this quarterlyreport on Form 10-Q speak only as of the date of this report. We disclaimany obligation to update these statements unless required by securities law,and we caution you not to rely on them unduly. We have based theseforward-looking statements on our current expectations and assumptions aboutfuture events. While our management considers these expectations andassumptions to be reasonable, they are inherently subject to significantbusiness, economic, competitive, regulatory and other risks, contingencies anduncertainties, most of which are difficult to predict and many of which arebeyond our control. These risks, contingencies and uncertainties relate to,among other matters, the following:

 

· the availability ofcapital;

 

· fluctuations in thecommodity prices for natural gas and crude oil and their related effects, includingon cash flows and potential impairments of oil and gas properties;

 

· regional pricedifferentials;

 

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· the extent of oursuccess in discovering, developing and producing reserves, including the risksinherent in exploration and development drilling, well completion andother development activities;

 

· the lack of liquidityof our equity securities;

 

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

 

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

 

·the effects of government regulation and permitting and other legalrequirements;

 

·the uncertainty inherent in estimating future natural gas and oil production orreserves;

 

·production variances from expectations;

 

·our ability to develop and replace reserves;

 

·operating hazards attendant to the natural gas and oil business, includingdown-hole drilling and

 

completion risks that are generally not recoverablefrom third parties or insurance;

 

·potential mechanical failure or under-performance of significant wells;

 

·environmental-related problems;

 

·the availability and cost of materials and equipment;

 

·our dependence upon key personnel;

 

·our ability to find and retain skilled personnel;

 

·delays in anticipated start-up dates;

 

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

 

·land issues and the costs associated with perfecting title for natural gasrights in some of our properties;

 

·our ability to effectively market our production;

 

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

 

· general economic conditions.

 

When you consider theseforward-looking statements, you should keep in mind these factors and the otherfactors discussed under the “Risk Factors” sections of our annual report on Form 10-Kfor the year ended December 31, 2009 and this quarterly report on Form 10-Q.

 

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**PART I. FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**PINNACLEGAS RESOURCES, INC.Balance Sheets**

 
| ** **                                                                                                                                                                           | ** ** | **March 31,  2010**                                                       | ** ** | **December 31,  2009** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                           | ** ** | **(unaudited)**                                                                | ** ** | **(audited)**               | ** ** |
| ** **                                                                                                                                                                           | ** ** | **(in thousands, except  share and  per share data)** | ** ** |
| **Assets**                                                                                                                                                                           |       |                                                                           |       |                        |       |
| Current assets                                                                                                                                                                       |       |                                                                           |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                           |       | $                                                                              | 468        |                        | $          | 175 |   |
| Receivables                                                                                                                                                                          |       |                                                                           |       |                        |       |
| Accrued gas  sales                                                                                                                                                                   |       | 1,326                                                                          |       | 1,240                       |       |
| Joint interest  receivables, net of $14 and $100, respectively, allowance for doubtful  accounts                                                                                     |       | 1,508                                                                          |       | 1,207                       |       |
| Derivative  instruments                                                                                                                                                              |       | 1,513                                                                          |       | —                      |       |
| Inventory of  material held for exploration and development                                                                                                                          |       | 56                                                                             |       | 229                         |       |
| Restricted  certificates of deposits                                                                                                                                                 |       | —                                                                         |       | 142                         |       |
| Prepaid expenses                                                                                                                                                                     |       | 77                                                                             |       | 134                         |       |
| Total current  assets                                                                                                                                                                |       | 4,948                                                                          |       | 3,127                       |       |
| Property and  equipment, at cost, net of accumulated depreciation                                                                                                                    |       | 724                                                                            |       | 1,055                       |       |
| Oil and gas  properties, using full cost accounting, net of accumulated depletion and  impairment                                                                                    |       |                                                                           |       |                        |       |
| Proved                                                                                                                                                                               |       | 9,280                                                                          |       | 9,477                       |       |
| Unproved                                                                                                                                                                             |       | 49,082                                                                         |       | 48,700                      |       |
| Inventory of  material held for exploration and development                                                                                                                          |       | 389                                                                            |       | 223                         |       |
| Deposits                                                                                                                                                                             |       | 57                                                                             |       | 76                          |       |
| Restricted  certificates of deposit                                                                                                                                                  |       | 1,976                                                                          |       | 1,842                       |       |
| Total assets                                                                                                                                                                         |       | $                                                                              | 66,456     |                        | $          | 64,500 |   |
| **Liabilities and Stockholders’  Equity**                                                                                                                                       |       |                                                                           |       |                        |       |
| Current  liabilities                                                                                                                                                                 |       |                                                                           |       |                        |       |
| Long term debt,  current                                                                                                                                                             |       | 5,555                                                                          |       | 6,148                       |       |
| Derivative  instruments, current                                                                                                                                                     |       | —                                                                         |       | 1,375                       |       |
| Trade accounts  payable                                                                                                                                                              |       | 9,809                                                                          |       | 9,058                       |       |
| Revenue  distribution payable                                                                                                                                                        |       | 4,577                                                                          |       | 3,328                       |       |
| Drilling  prepayments from joint interest owners                                                                                                                                     |       | 61                                                                             |       | 63                          |       |
| Asset retirement  obligation, current                                                                                                                                                |       | 710                                                                            |       | 721                         |       |
| Accrued liabilities                                                                                                                                                                  |       | 3,406                                                                          |       | 3,090                       |       |
| Total current  liabilities                                                                                                                                                           |       | 24,118                                                                         |       | 23,783                      |       |
| Asset retirement  obligation, non-current                                                                                                                                            |       | 2,249                                                                          |       | 2,216                       |       |
| Production  taxes, non-current                                                                                                                                                       |       | 665                                                                            |       | 385                         |       |
| Long term debt,  non-current                                                                                                                                                         |       | 748                                                                            |       | 743                         |       |
| Total  liabilities                                                                                                                                                                   |       | 27,780                                                                         |       | 27,127                      |       |
| Commitments and  contingencies                                                                                                                                                       |       |                                                                           |       |                        |       |
| Stockholders’  equity                                                                                                                                                           |       |                                                                           |       |                        |       |
| Common stock,  $0.01 par value; 100,000,000 authorized and 30,320,525 and 30,108,023 shares  issued and outstanding at March 31, 2010 and December 31, 2009,  respectively |       | 289                                                                            |       | 289                         |       |
| Additional  paid-in capital                                                                                                                                                          |       | 151,879                                                                        |       | 151,725                     |       |
| Accumulated  deficit                                                                                                                                                                 |       | (113,492                                                                       | )          | (114,641                    | )          |
| Total  stockholders’ equity                                                                                                                                                     |       | 38,676                                                                         |       | 37,373                      |       |
| Total  liabilities and stockholders’ equity                                                                                                                                     |       | $                                                                              | 66,456     |                        | $          | 64,500 |   |

 

See Notes to Financial Statements (unaudited)

 

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**PINNACLEGAS RESOURCES, INC.**

**Statements of Operations**

**(unaudited)**

 
| ** **                                             | ** ** | **Three Months Ended   March 31,**                             | ** ** |
|--------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **2010**                                                                           | ** ** | **2009** | ** ** |
| ** **                                             | ** ** | **(in thousands, except share and  per share data)** | ** ** |
| Revenues                                               |       |                                                                               |       |   |   |
| Gas sales                                              |       | $                                                                                  | 2,846      |   | $ | 2,766 |   |
| Realized  gain/(loss) on derivatives                   |       | (466                                                                               | )          | 1,457 |   |
| Total revenues                                         |       | 2,380                                                                              |       | 4,223 |   |
| Cost of revenues  and expenses                         |       |                                                                               |       |   |   |
| Lease operating  expenses                              |       | 1,018                                                                              |       | 1,185 |   |
| Production taxes                                       |       | 318                                                                                |       | 279 |   |
| Marketing and  transportation                          |       | 723                                                                                |       | 1,250 |   |
| General and  administrative, net                       |       | 1,407                                                                              |       | 1,031 |   |
| Depreciation,  depletion, amortization and accretion   |       | 715                                                                                |       | 1,828 |   |
| Impairment of  oil and gas properties                  |       | —                                                                             |       | 16,819 |   |
| Total cost of  revenues and expenses                   |       | 4,181                                                                              |       | 22,392 |   |
| Operating loss                                         |       | (1,801                                                                             | )          | (18,169 | ) |
| Other income  (expense)                                |       |                                                                               |       |   |   |
| Unrealized gain  on derivatives                        |       | 2,888                                                                              |       | 571 |   |
| Interest income                                        |       | 14                                                                                 |       | 8 |   |
| Other income                                           |       | 145                                                                                |       | 105 |   |
| Interest expense                                       |       | (97                                                                                | )          | (25 | ) |
| Total other  income                                    |       | 2,950                                                                              |       | 659 |   |
| Net  income/(loss) before income taxes                 |       | 1,149                                                                              |       | (17,510 | ) |
| Income taxes                                           |       | —                                                                             |       | — |   |
| Net  income/(loss) attributable to common stockholders |       | 1,149                                                                              |       | (17,510 | ) |
| Basic and  diluted net income/(loss) per share         |       | $                                                                                  | 0.04       |   | $ | (0.60 | ) |
| Weighted average  shares outstanding — basic      |       | 30,247,330                                                                         |       | 29,191,684 |   |
| Weighted average  shares outstanding — diluted    |       | 31,089,610                                                                         |       | 29,191,684 |   |

 

See Notes to Financial Statements (unaudited)

 

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**PINNACLE GAS RESOURCES, INC.Statements of Cash Flows**

**(unaudited)**

 
| ** **                                                                          | ** ** | **Three  Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                          | ** ** | **2010**                                     | ** ** | **2009** | ** ** |
| Cash flows from  operating activities                                               |       |                                         |       |   |   |
| Net  income/(loss)                                                                  |       | $                                            | 1,149      |   | $ | (17,510 | ) |
| Adjustments to  reconcile net loss to net cash provided by operating activities     |       |                                         |       |   |   |
| Impairment of  oil and gas properties                                               |       | —                                       |       | 16,819 |   |
| Depreciation,  depletion, amortization and accretion                                |       | 715                                          |       | 1,828 |   |
| Gain on  derivatives                                                                |       | (2,422                                       | )          | (2,028 | ) |
| Stock-based  compensation                                                           |       | 154                                          |       | 199 |   |
| Changes in  assets and liabilities                                                  |       |                                         |       |   |   |
| Decrease  (increase) in receivables                                                 |       | (387                                         | )          | 1,257 |   |
| Decrease  (increase) in inventory of material held for exploration and development  |       | 173                                          |       | (1 | ) |
| Asset retirement  obligation settled this period                                    |       | (31                                          | )          | — |   |
| Decrease in  prepaid expenses                                                       |       | 57                                           |       | 86 |   |
| Increase in  trade accounts payable, accrued liabilities and production taxes       |       | 1,095                                        |       | 1,366 |   |
| Increase  (decrease) in revenue distribution payable                                |       | 1,249                                        |       | (1,293 | ) |
| Net cash  provided by operating activities                                          |       | 1,752                                        |       | 723 |   |
| Cash flows from  investing activities                                               |       |                                         |       |   |   |
| Capital  expenditures — exploration and production                             |       | (239                                         | )          | (1,398 | ) |
| Capital  expenditures — property and equipment                                 |       | (27                                          | )          | (1 | ) |
| Decrease  (increase) in purchase of restricted certificates of deposit and deposits |       | 27                                           |       | (5 | ) |
| Increase in  inventory held for exploration and development                         |       | (166                                         | )          | (4 | ) |
| Realized gain  (loss) on derivatives                                                |       | (466                                         | )          | 1,457 |   |
| Net cash (used  in) / provided by investing activities                              |       | (871                                         | )          | 49 |   |
| Cash flows from  financing activities                                               |       |                                         |       |   |   |
| Principal  payments on long term debt                                               |       | (588                                         | )          | (1,007 | ) |
| Net cash used in  financing activities                                              |       | (588                                         | )          | (1,007 | ) |
| Net  increase/(decrease) in cash and cash equivalents                               |       | 293                                          |       | (235 | ) |
| Cash and cash  equivalents at beginning of quarter                                  |       | 175                                          |       | 346 |   |
| Cash and cash  equivalents at end of quarter                                        |       | $                                            | 468        |   | $ | 111 |   |
| Noncash  investing and financing activities                                         |       |                                         |       |   |   |
| Capital  expenditures included in trade accounts payable                            |       | $                                            | 6,659      |   | $ | 6,951 |   |
| Asset retirement  obligations included in oil and gas properties                    |       | 1                                            |       | — |   |
| Supplemental  cash flow information                                                 |       |                                         |       |   |   |
| Cash payments  for interest, net of amount capitalized                              |       | $                                            | 97         |   | $ | 25 |   |

 

See Notes to Financial Statements (unaudited)

 

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**Statements of Stockholders’ Equity**

 
| ****                                       | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated** | ** ** | ** **  | ** ** |
|--------------------------------------------|------------|-------------------|------------|-------------------------|------------|-----------------|------------|-------------|------------|
| ** **                                 | ** ** | **Shares**        | ** ** | **Amount**              | ** ** | **Capital**     | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| ** **                                 | ** ** | ** **        | ** ** | ** **              | ** ** | ** **      | ** ** | ** **  | ** ** | ** ** | ** ** |
| Balance at December 31, 2009          |       | 30,108,023        |       | $                       | 289        |            | $          | 151,725     |       | $ | (114,641 | ) | $ | 37,373 |   |
| Issuance of restricted share               |       | 212,502           |       |                    |       | $               | 128        |        |       |   | 128 |   |
| Stock-based compensation                   |       |              |       | —                  |       | 26              |       | —      |       | 26 |   |
| Net income                                 |       | —            |       | —                  |       | —          |       | 1,149       |       | 1,149 |   |
| Balance at March 31, 2010 (unaudited) |       | 30,320,525        |       | $                       | 289        |            | $          | 151,879     |       | $ | (113,492 | ) | $ | 38,676 |   |

 

See Notes to FinancialStatements (unaudited)

 

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**Notes to Financial Statements**

**Unaudited**

 

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

 

Pinnacle GasResources, Inc. (the “Company”) was formed as a Delaware corporation in June 2003through a contribution of cash by funds affiliated with DLJ Merchant Bankingand oil and gas reserves and leasehold interests by subsidiaries of Carrizo Oil &Gas, Inc. and U.S. Energy Corporation.

 

The Company’sprimary business is the exploration for, and the acquisition, development andproduction of, coalbed methane natural gas in the United States. The Company isalso engaged in gas property operations and the construction of low pressuregas collection systems which provide transportation for the Company’s coalbedmethane production.

 

Due to the current economic and pricing environment,the Company is actively marketing certain assets to raise additional capitaland is also reviewing alternatives for raising additional capital throughequity and debt financing, capital restructuring and possible mergers.  The Company has executed hedges of its gas tosecure certain operating cash flow levels during the remainder of 2010. From January throughApril 2010, the Company had 5,500 MMbtu per day hedged through fixed priceswaps at a weighted average price of $4.19 per MMbtu.  From May through December 2010, theCompany has 5,500 MMbtu per day hedged through fixed price swaps at a weightedaverage price of $5.08 per MMbtu. The Company has also implemented various costcutting measures, including reducing general and administrative costs throughstaff reductions, wage and benefit cuts and a hiring freeze. The Company hasreduced lease operating expenses by renegotiating water disposal contracts,reducing service costs and temporarily shutting-in marginal wells.

 

The Company continues tocommunicate with key vendors to manage its obligations and payables. TheCompany has entered into agreements with various vendors to make minimummonthly payments ranging from $1,000 to $45,000 at interest rates between 2%and 12% for the remainder of 2010. Management believes that appropriate steps,including cost-cutting measures, are being taken to make operations sustainablein the future.

 

On February 23, 2010,the Company entered into an Agreement and Plan of Merger with Powder Holdings,LLC, a Delaware limited liability company and Powder Acquisition Co., aDelaware corporation and a direct, wholly owned subsidiary of Powder Holdings.  Powder Holdings is controlled by an investorgroup led by Scotia Waterous (USA) Inc. and includes certain members of theCompany’s management team. On April 2, 2010, the Company filed a preliminaryproxy statement relating to the merger, with the U.S. Securities and Exchange Commission.  Although the Company is pursuing variousalternatives to provide additional liquidity, there is no assurance of thelikelihood or timing of any of these transactions.

 

**Note 2 — Basis of Presentation**

 

The accompanyingunaudited financial statements include the Company’s proportionate share ofassets, liabilities, income and expenses from the properties in which theCompany has a participating interest. The Company has no subsidiaries or affiliates with which intercompanytransactions are recorded.

 

The accompanyingfinancial statements are unaudited, and in the opinion of management, reflectall adjustments that are necessary for a fair presentation of the financialposition and results of operations for the periods presented.  All such adjustments are of a normal andrecurring nature. The following Notes describe only the material changes inaccounting policies, account details, or financial statement Notes during thefirst three months of 2010.  The resultsfor the three months ending March 31, 2010 are not necessarily indicativeof the results expected for the entire year. These financial statements should be read in conjunction with theaudited financial statements and the summary of significant accounting policiesfor prior years contained in the reports the Company files with the Securitiesand Exchange Commission, which can be found on the Company’s website at *www.pinnaclegas.com*.

 

*Use of Estimates*

 

The preparation ofthe Company’s financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amount of assets andliabilities, disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period. Actual results could differ from these estimates.Significant estimates with regard to the Company’s financial statements includethe estimated carrying value of unproved properties, the estimate of proved oiland gas reserve volumes and the related present value of estimated future netcash flows, the ceiling test applied to capitalized oil and gas properties, theestimate of the timing and cost of the Company’s future drilling activity,

 

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the estimated cost andtiming related to asset retirement obligations, the estimated fair value of derivativeassets and liabilities, the realizability of deferred tax assets, the estimatesof expenses and timing of exercise of stock options, accrual of operating costsand capital expenditures and revenue.

 

*Oil and Gas Properties*

 

The Company utilizes the full cost method ofaccounting for oil and gas producing activities. Under this method, all costsassociated with property acquisition, exploration and development, includingcosts of unsuccessful exploration, costs of surrendered and abandoned leaseholds,delay lease rentals and the fair value of estimated future costs of siterestoration, dismantlement and abandonment activities are capitalized within acost center. The Company’s oil and gas properties are all located within theUnited States, which constitutes a single cost center. The Company capitalizeslease operating expenses associated with exploration and development ofunevaluated oil and gas properties. No gain or loss is recognized upon the saleor abandonment of undeveloped or producing oil and gas properties unless thesale represents a significant portion of gas properties and the gainsignificantly alters the relationship between capitalized costs and proved gasreserves of the cost center. Expenditures for maintenance and repairs are chargedto lease operating expense in the period incurred.

 

Depreciation, depletion and amortization of oil andgas properties (“DD&A”) is computed on the unit-of-production method basedon proved reserves. Amortizable costs include estimates of future developmentcosts of proved undeveloped reserves and asset retirement obligations. TheCompany invests in unevaluated oil and gas properties for the purpose ofexploration for proved reserves. The costs of such assets, includingexploration costs on properties where a determination of whether proved oil andgas reserves will be established is still under evaluation, and any capitalizedinterest and lease operating expenses are included in unproved oil and gasproperties at the lower of cost or estimated fair market value and are notsubject to amortization. On a quarterly basis, such costs are evaluated forinclusion in the costs to be amortized resulting from the determination ofproved reserves, impairments, or reductions in value. To the extent that theevaluation indicates these properties are impaired, the amount of theimpairment is added to the capitalized costs to be amortized. Abandonment ofunproved properties is accounted for as an adjustment to capitalized costsrelated to proved oil and gas properties, with no losses recognized. TheCompany recorded an impairment of unevaluated properties of $0 million and$36.7 million for the three months ended March 31, 2010 and year ended December 31,2009, respectively. Abandonment of unproved properties is also accounted for asan adjustment to capitalized costs related to proved oil and gas properties. Ifthe adjustment to capitalized costs related to proved oil and gas propertiesresults in the capitalized costs exceeding the full cost ceiling limitations,the excess must be charged to expense.

 

Substantially all of the remaining unproved propertiesare expected to be developed and included in the amortization base over thenext three to five years, based on projected cash flow from operations combinedwith raising additional capital. Salvage value is taken into account indetermining depletion rates and is based on the Company’s estimate of the valueof equipment and supplies at the time the well is abandoned. The estimatedsalvage value of equipment included in determining the depletion rate was $6.8million and $7.2 million as of March 31, 2010 and 2009, respectively.

 

Under the full cost method of accounting rules,capitalized costs less accumulated depletion and related deferred income taxesmay not exceed a ‘‘ceiling’’ value which is the sum of (1) the presentvalue discounted at 10% of estimated future net revenue using current costs andfirst day of the month twelve month average CIG prices, including the effectsof derivative instruments designated as cash flow hedges but excluding thefuture cash outflows associated with settling asset retirement obligations thathave been accrued on the balance sheet, less any related income tax effects;plus (2) the cost of properties not being amortized, if any; plus (3) thelower of costs or estimated fair value of unproved properties; less (4) theincome tax effects related to differences in the book to tax basis of oil andgas properties. This is referred to as the ‘‘full cost ceiling limitation.’’ Ifcapitalized costs exceed the limit, the excess must be charged to expense. Theexpense may not be reversed in future periods. At the end of each quarter, theCompany calculates the full cost ceiling limitation. At March 31, 2010,the full cost ceiling limitation exceeded the capitalized cost of the Company’soil and gas properties by approximately $4.1 million based on the first day ofthe month, twelve month average CIG price of approximately $3.48 per Mcf.Therefore, no impairment was taken for the quarter ended March 31, 2010.An impairment of $16.8 million was taken for the quarter ended March 31,2009 based on a natural gas price of $3.31 per Mcf.

 

*Per Share Information*

 

Basic earnings (loss) per share is computed bydividing net income (loss) from continuing operations attributable to commonstock by the weighted average number of shares of common stock outstandingduring each period. Diluted earnings

 

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per share are computed by adjusting the average numberof shares of common stock outstanding for the dilutive effect, if any, ofcommon stock equivalents such as stock options and warrants. For the threemonths ended March 31, 2010, diluted net income per share was $0.04, andbasic net income per share was $0.04.  During the three months ended March 31,2009, 645,000 options were excluded because they were anti-dilutive.

 

(In thousands except pershare data)

 
| ** **                                                   | ** ** | **For the Three  Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                   | ** ** | **2010**                                        | ** ** | **2009** | ** ** |
| Net  income/(loss)                                           |       | $                                               | 1,149      |   | $ | (17,510 | ) |
| Common  shares outstanding:                                  |       |                                            |       |   |   |
|                                                         |       |                                            |       |   |   |
| Historical  common shares outstanding at beginning of period |       | 30,108                                          |       | 29,194 |   |
| Weighted  average common shares issued                       |       | 139                                             |       | (2 | ) |
| Weighted  average common shares outstanding-basic            |       | 30,247                                          |       | 29,192 |   |
| Effect  of dilution – stock options                     |       | 843                                             |       | — |   |
|                                                         |       |                                            |       |   |   |
| Weighted  average common shares outstanding-diluted          |       | 31,090                                          |       | 29,192 |   |
| Net  income/(loss) per share-basic                           |       | $                                               | .04        |   | $ | (.60 | ) |
| Net  income/(loss) per share-diluted                         |       | $                                               | .04        |   | $ | (.60 | ) |

 

*Income Taxes*

 

The Company uses the asset and liability method ofaccounting for income taxes. Deferred tax assets and liabilities are recognizedfor the expected future tax consequences of temporary differences between thefinancial statement and tax bases of assets and liabilities. If appropriate,deferred tax assets are reduced by a valuation allowance which reflectsexpectations of the extent to which such assets will be realized. As of March 31,2010 and December 31, 2009, the Company had recorded a full valuationallowance for its net deferred tax asset.

 

*New Accounting Pronouncements*

 

In September 2006,the FASB issued accounting guidance related to fair value measurements andrelated disclosures. This new guidance defines fair value, establishes aframework for measuring fair value, and expands disclosures about fair valuemeasurements. The Company adopted this guidance on January 1, 2008, asrequired for its financial assets and financial liabilities. However, the FASBdeferred the effective date of this guidance for one year as it relates to fairvalue measurement requirements for nonfinancial assets and nonfinancialliabilities that are not recognized or disclosed at fair value on a recurringbasis, which include, among others, those nonfinancial long-lived assetsmeasured at fair value for impairment assessment and asset retirementobligations initially measured at fair value. Fair value used in the initialrecognition of asset retirement obligations is determined based on the presentvalue of expected future dismantlement costs incorporating the Company’sestimate of inputs used by industry participants when valuing similarliabilities. Accordingly, the fair value is based on unobservable pricinginputs and therefore, is considered a level 3 value input in the fairvalue hierarchy.

 

In April 2009,the FASB issued accounting guidance relating to determining fair value when thevolume and level of activity for the asset or liability have significantlydecreased and identifying transactions that are not orderly, which providesadditional guidance for estimating fair value. The Company has considered thisguidance provided in its determination of estimated fair values as of December 31,2009.

 

In June 2009,the Financial Accounting Standards Board (“FASB”) issued “FASB AccountingStandards CodificationTM (“Codification”), as the single source of authoritativeUS GAAP” for all non-governmental entities, with the exception of the SECand its staff. The Codification, which became effective July 1, 2009,changes the referencing and organization of accounting guidance and iseffective for interim and annual periods ending after September 15, 2009.The

 

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Company adopted theCodification on July 1, 2009 which provides for changes in references totechnical accounting literature in the accompanying financial statements, butdid not have a material impact on the Company’s financial position, results ofoperations or cash flows.

 

In June 2009,the FASB issued new accounting guidance related to the accounting anddisclosures of subsequent events. This guidance incorporates the subsequentevents guidance contained in the auditing standards literature intoauthoritative accounting literature.

 

In December 2008,the Securities and Exchange Commission (“SEC”) revised its requirements for oiland gas reserves estimation and disclosures and related definitions to alignthem with current practices and changes in technology. In January 2010,the FASB issued Accounting Standards Update (ASU) No. 2010-03 “Oil and GasReserve Estimation and Disclosure,” which aligns the current oil and gasreserve estimation and disclosure requirements with those of the SEC. Asdiscussed earlier, the Company follows the full-cost method of accounting forwhich the SEC provides guidance. Among other things, the SEC and FASBamendments replace the single-day, year-end pricing assumption with atwelve-month average pricing assumption, revise certain definitions and allowthe use of certain technologies to establish reserves.

 

As of December 31,2009, the Company changed its method of determining the quantities of oil andgas reserves which impacted the amount recorded for depreciation, depletion andamortization and the ceiling test calculation for oil and gas properties. Underthe new rules, the Company prepared its oil and gas reserve estimates as of December 31,2009 using the average, first-day-of-the- month price during the 12-monthperiod ending December 31, 2009. In prior years, the Company used theyear-end price. The Company calculates depreciation, depletion and amortizationon a quarterly basis using estimated reserves as of the end of each quarter. Asa result, the new rules impacted the amount of depreciation, depletion andamortization recorded for oil and gas properties and the ceiling testcalculation for the quarter ended December 31, 2009. In addition, underthe new guidance, subsequent price increases cannot be considered in theceiling test calculation.

 

The adoption ofthe new rules is considered a change in accounting principle inseparablefrom a change in accounting estimate. The Company does not believe thatprovisions of the new guidance, other than pricing, significantly impacted thereserve estimates or financial statements. The Company does not believe that itis practicable to estimate the effect of applying the new rules on netloss or the amounts recorded for depreciation, depletion and amortization andceiling impairment for the year ended December 31, 2009.

 

TheCompany adopted FASB ASC Update 2010-06, “Fair Value Measurements andDisclosures” which amends ASC Update 2010-06 to require additional disclosuresconcerning transfers between Levels 1 and 2, inputs and valuation techniquesused to value Level 2 and 3 measurements, and push down of previouslyprescribed fair value disclosures to each class of asset and liability forLevels 1, 2, and 3.  These disclosures were effective for the Company forthe quarter ended March 31, 2010.  The adoption of thispronouncement did not have a material impact on the Company’s consolidatedfinancial statements.

 

Inaddition, ASC Update 2010-06 requires that purchases, sales, issuances, andsettlements for Level 3 measurements be disclosed.  This portion of thenew authoritative guidance is effective for interim and annual reportingperiods beginning after December 15, 2010.  As such, the Company willapply this new authoritative guidance in the Company’s March 31, 2011,Quarterly Report on Form 10-Q.  The adoption of ASC Update 2010-06will not have a material impact on the Company’s financial statements.

 

TheCompany adopted FASB ASC Update 2010-09, “Amendments to Certain Recognition andDisclosure Requirements,*”* whicheliminates the requirement for SEC filers to disclose the date through which anentity has evaluated subsequent events.  ASU No. 2010-09 waseffective upon issuance and its adoption had no impact on the Company’s financialposition, results of operations or cash flows.

 

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

 

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

 

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A liability forthe fair value of an asset retirement obligation with a corresponding increaseto the carrying value of the related long-lived asset is recorded at the time awell is completed or acquired. The increased carrying value is depleted usingthe units-of-production method, and the discounted liability is increasedthrough accretion over the remaining life of the respective oil and gasproperties.

 

The estimatedliability is based on historical gas industry experience in abandoning wells,including estimated economic lives, external estimates as to the cost toabandon the wells in the future and federal and state regulatory requirements.The Company’s liability is discounted using its best estimate of itscredit-adjusted risk-free rate. Revisions to the liability could occur due tochanges in estimated abandonment costs, changes in well economic lives or iffederal or state regulators enact new requirements regarding the abandonment ofwells.

 

The following is asummary of the Company’s asset retirement obligation activity for the threemonths ended March 31, 2010 and 2009 (in thousands):

 
| ** **                                      | ** ** | **Three  Months Ended  March 31,** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                      | ** ** | **2010**                                     | ** ** | **2009** | ** ** |
| ** **                                      | ** ** | **(unaudited)**                              | ** ** |
| Beginning  balance asset retirement obligations |       | $                                            | 2,937      |   | $ | 3,366 |   |
| Additional  obligation added during the period  |       | 1                                            |       | — |   |
| Obligations  settled during the period          |       | (31                                          | )          | — |   |
| Accretion  expense                              |       | 52                                           |       | 56 |   |
| Ending balance  of asset retirement obligations |       | $                                            | 2,959      |   | $ | 3,422 |   |

 

**Note 4****— Restricted Assets (Certificates of Deposit) and Deposits**

 

*Certificates of Deposit.*

 

The Company holdsa certificate of deposit (“CD”), which expires in July 2010, totaling$160,000. The CD is collateral for bonding required by the State of Wyoming,the State of Montana and the Federal Bureau of Land Management. Because theCompany intends to renew the CD in order to maintain its bonding requirements,the Company has included the CD in other non-current assets as of March 31,2010. The issuer of the bonds has commenced litigation against the Company toincrease its collateral position, although this litigation has now been resolved(see Note 9). Additionally, the Company holds two CDs for $604,000 and $964,000which were issued in February 2006 and renewed annually.  The $604,000 CD expired on February 14,2010; a new CD in the amount of $513,000 was obtained on February 19, 2010and will expire in February 2011. The $964,000 CD expires in May, 2010. These CDs collateralize letters ofcredit in favor of Powder River Energy Corporation, a local rural electricassociation, in order to secure power lines to the Kirby, Deer Creek and CabinCreek areas. The Company has included these amounts in non-current assets as ofMarch 31, 2010 because the Company also intends to renew the CDs in orderto maintain power supply on a long-term basis. In March 2010 the Company also posted a security deposit to PowderRiver Energy Corp. of approximately $225,000 to collateralize electrical usagein its Kirby, Deer Creek and Cabin Creek areas. In April 2007, the Companyissued a $1,000,000 letter of credit (“LOC”), which was collateralized by a CDin favor of Bitter Creek Pipelines, LLC to secure the construction of ahigh pressure pipeline and related compression facilities to the Company’s DeerCreek and Kirby areas. Bitter Creek Pipelines, LLC has drawn approximately$858,000 on this LOC for compression services provided to the Company in thethird and fourth quarters of 2009. In January of 2010, Bitter CreekPipelines, LLC drew the remaining balance of the CD collateralizing thisLOC.

 

*SuretyBonds.*

 

From June 2009through March 31, 2010, the Company posted idle well surety forapproximately $64,000 to the Wyoming Oil and Gas Conservation Commission. TheCommission has requested the Company make 18 monthly installments of$12,777 for surety on wells that will need to be plugged by the Company. Thesurety amount may be adjusted downward by the Commission if the Companysuccessfully plugs the proposed wells in question. In addition, the Company hasincluded a $50,000 payment for bonding requirements in the Company’s KirbyMontana area.

 

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*Deposits.*

 

The Company hasincluded approximately $57,000 related to royalty payments in deposits. Theseamounts are included in Deposits in the accompanying balance sheet at March 31,2010.

 

**Note 5 — Derivatives**

 

The Company haselected not to designate its derivatives as cash flow hedges underauthoritative guidance prescribed by the FASB. These derivative instruments aremarked to market at the end of each reporting period and changes in the fairvalue are recorded in the accompanying statements of operations. The aggregatefair values of these contracts were estimated to be an asset totaling$1,513,000 and an asset of $4,916,000 at March 31, 2010 and 2009, respectively.The Company realized a hedging loss of $466,000 and a hedging gain of$1,457,000 for the quarters ended March 31, 2010 and 2009, respectively. As aresult of the change in the fair value of the commodity derivatives, theCompany had an unrealized gain of $2,889,000 for the quarter ended March 31,2010 and unrealized gain of $571,000 for the quarter ended March 31, 2009.Unrealized and realized gains and losses are included in gains or losses onderivatives in the statement of operations. As of March 31, 2010 and 2009, theCompany had natural gas hedges in place as follows:

 
| **Product and Type of Hedging Contract** | ** ** | **MMbtu Per  Day** | ** ** | **Fixed Price  Range  CIG Index Price** | ** ** | **Time  Period** | ** **  |
|-------------------------------------------------------------------|------------|-------------------------|------------|--------------------------------------------------------|------------|------------------|-------------|
| March 31,  2010 (unaudited)                                  |       |                    |       |                                                   |       |             |        |
| Natural Gas—Swap                                             |       | 2,500                   |       | $                                                      | 3.45       |             | 01/10-04/10 |   |
| Natural Gas—Swap                                             |       | 2,000                   |       | $                                                      | 4.48       |             | 01/10-12/10 |   |
| Natural Gas—Swap                                             |       | 1,000                   |       | $                                                      | 5.50       |             | 01/10-1210  |   |
| Natural Gas—Swap                                             |       | 2,500                   |       | $                                                      | 5.40       |             | 05/10-12/10 |   |
| March 31,  2009 (unaudited)                                  |       |                    |       |                                                   |       |             |        |
| Natural  Gas—Collar                                          |       | 2,000                   |       | $                                                      | 6.50-$7.50 |             | 01/09-12/09 |   |
| Natural  Gas—Swap                                            |       | 2,500                   |       | $                                                      | 7.17       |             | 01/09-12/09 |   |
| Natural  Gas—Swap                                            |       | 2,500                   |       | $                                                      | 3.45       |             | 05/09-04/10 |   |
| Natural  Gas—Swap                                            |       | 2,000                   |       | $                                                      | 4.48       |             | 01/10-12/10 |   |

 
| ** **                    | ** ** | **Location on  Consolidated Balance  Sheets** | ** ** | **Fair Value at  March 31, 2010** | ** ** |
|-------------------------------|------------|-----------------------------------------------|------------|----------------------------------------|------------|
| ** **                    | ** ** | ** **                                    | ** ** | **(In thousands)**                     | ** ** |
| Derivative  Assets:           |       |                                          |       |                                   |       |
| Natural  gas, commodity swaps |       | Current asset                                 |       | $                                      | 1,513      |   |
|                          |       |                                          |       |                                   |       |
| Total  derivative assets      |       |                                          |       | $                                      | 1,513      |   |

 

The Company isexposed to credit risk to the extent of nonperformance by the counterparties inthe derivative contracts discussed above; however, the Company does notanticipate such nonperformance.

 

**Note 6 — Stock Based Compensation**

 

*Options under Employee Option Plans*

 

TheCompany has adopted a stock incentive plan authorizing the grant of bothincentive and non-statutory stock options. All options allow for the purchaseof common stock at prices not less than the fair market value of such stock atthe date of grant. If the option holder owns more than 10% of the totalcombined voting power of all classes of the Company’s stock, the exercise pricecannot be less than 110% of the fair market value of such stock at the date ofgrant.

 

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Optionsgranted under the plan become vested as directed by the Company’s Board ofDirectors and generally expire seven or ten years after the date of grant,unless the option holder owns more than 10% of the total combined voting powerof all classes of the Company’s stock, in which case the non-statutory stockoptions must be exercised within five years of the date of grant. At March 31,2010, there were options to purchase 640,000 shares granted under the plan.

 

The options granted sinceformation in June 2003 vest as follows:

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

 

At March 31, 2010,the Company had unvested options to purchase 12,500 shares with a weightedaverage grant date fair value of $5,600. During the three months ended March 31,2010, the Company did not grant any options to purchase common stock. TheCompany will recognize compensation expense relating to nonvested optionsgranted after January 1, 2007 ratably over the next three years. TheCompany recognized an expense of approximately $19,000 for the three monthsended March 31, 2010, based on the fair value of the vested options.

 

The followingtable summarizes stock option activity for the three months ended March 31,2010:

 
| ** **                                    | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price  Per Share** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Aggregate  Intrinsic value** | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding,  December 31, 2009          |       | 640,000                    |       | $                                                              | 5.81       |                                                    |       |                                |       |   |
| Canceled or  forfeited                        |       | —                     |       | —                                                         |       |                                                    |       |                                |       |
|                                          |       |                       |       |                                                           |       |                                                    |       |                                |       |
| Outstanding,  March 31, 2010 (unaudited) |       | 640,000                    |       | $                                                              | 5.81       |                                                    | 2.08       |                                | $          | — |   |
|                                          |       |                       |       |                                                           |       |                                                    |       |                                |       |
| Exercisable,  March 31, 2010 (unaudited) |       | 627,500                    |       | $                                                              | 5.76       |                                                    | 2.04       |                                | $          | — |   |

 

The following table summarizes information about stockoptions outstanding at March 31, 2010:

 
| ** **          | ** ** | **Options Outstanding**           | ** ** | **Options Exercisable**                           | ** ** |
|---------------------|------------|-----------------------------------|------------|---------------------------------------------------|------------|
| **Exercise Prices** | ** ** | **Number of Shares  Outstanding** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** | **Number  Exercisable** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Fair Value  Determination** | ** ** |
| $4.00               |       | 137,500                           |       | 0.5 years                                    |       | 137,500 |   | $ | 4.00 |   | Black-Scholes  (minimum value) |   |
| $4.80               |       | 265,000                           |       | 2.0 years                                    |       | 265,000 |   | $ | 4.80 |   | Black-Scholes  (minimum value) |   |
| $5.20               |       | 112,500                           |       | 2.8 years                                    |       | 112,500 |   | $ | 5.20 |   | Black-Scholes |   |
| $8.40               |       | 25,000                            |       | 4.2 years                                    |       | 12,500 |   | $ | 8.40 |   | Black-Scholes |   |
| $11.00              |       | 100,000                           |       | 3.2 years                                    |       | 100,000 |   | $ | 11.00 |   | Black-Scholes |   |
|                |       | 640,000                           |       |                                              |       | 627,500 |   |   |   |   |   |

 

*StockAppreciation Rights under Stock Incentive Plan*

 

The Company has adopted a stock incentive planauthorizing the grant of Stock Appreciation Rights (“SARs”). A SAR confers onthe participant a right to receive, upon exercise, the excess of the fairmarket value of a share of Common Stock on the date of the exercise over $1.00.Such excess shall be paid in cash or common stock or a combination thereof tothe participant. On June 1, 2009, 202,280 SARs were granted and currentlyoutstanding as of March 31, 2010. The SARs granted since 2009 vest asfollows:

 

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| Year  1 |   | 33.33 | % |
|---------|--------|-------|---|
| Year  2 |   | 33.33 | % |
| Year  3 |   | 33.34 | % |
|    |   | 100   | % |

 

As of March 31, 2010, the Company hadapproximately $55,000 of unrecognized compensation expense related to nonvestedSAR awards.

 

The following table summarizes stock appreciationactivity for the three months ended March 31, 2010:

 
| ** **                                      | ** ** | **Shares** | ** ** | **Weighted  Average Grant  Date Fair Value** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** |
|-------------------------------------------------|------------|------------|------------|----------------------------------------------|------------|-----------------------------------------------------|------------|
| Outstanding as of  December 31, 2009       |       | 202,280    |       | $                                            | 0.41       |                                                | 6.42       |   |
| Granted                                         |       | —     |       | —                                       |       | —                                              |       |
| Canceled  or forfeited                          |       | —     |       | —                                       |       | —                                              |       |
| Outstanding at  March 31, 2010 (unaudited) |       | 202,280    |       | $                                            | 0.41       |                                                | 6.17       |   |

 

During the three months ended March 31, 2010, theCompany recognized compensation expense of approximately $6,000 based on the fairvalue of the vested shares using a Black-Scholes model.

 

*RestrictedStock*

 

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

 

The Company recognized acompensation expense of approximately $128,000 for the quarter ended March 31,2010 based on the fair value of the vested shares during that period.

 

A summary of the status and activity of the restrictedstock for the three months ended March 31, 2010 is presented   below.

 
| ** **                                   | ** ** | **Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|----------------------------------------------|------------|------------|------------|---------------------------------------------------|------------|
| Unvested at  December 31, 2009          |       | 342,993    |       | $                                                 | 2.18       |   |
| Granted                                      |       | 212,502    |       | $                                                 | 0.31       |   |
| Vested                                       |       | (215,002   | )          | $                                                 | 0.43       |   |
| Unvested at  March 31, 2010 (unaudited) |       | 340,493    |       | $                                                 | 2.12       |   |

 

As of March 31,2010, the Company had approximately $0.5 million of unrecognized share-basedcompensation expense related to unvested stock awards, which is expected to beamortized over the remaining vesting periods of three years.

 

**Note 7 —Line of Credit and Long Term Debt**

 

*CreditFacility*

 

Effective February 12,2007, the Company entered into a credit facility which permits borrowings up tothe borrowing base as designated by the administrative agent. As of March 31,2010 and December 31, 2009, the Company had $5.5 million and$6.1 million, respectively, of debt outstanding under the facility. Asdescribed below, the Company is currently unable to borrow additional amountsunder the credit facility due to covenant limitations and may be furtherlimited in the future based on borrowing base limitations.

 

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As of December 31,2008, the borrowing base under the credit facility was approximately$13.2 million. The borrowing base was subject to automatic reductions for approximately$666,667 per month until it reached $10.5 million on April 1, 2009.As of April 14, 2009, the borrowing base was further reduced to$9.0 million, subject to automatic reductions of $500,000 per month untilit reached $6.5 million on October 1, 2009. As of October 20,2009, the borrowing base was subject to automatic reductions of $200,000 permonth until it reaches maturity or until a redetermination is received.

 

The borrowing baseis determined on a semi-annual basis and at such other additional times, up totwice yearly, as may be requested by either the Company or the administrativeagent and is determined by the administrative agent in accordance withcustomary practices and standards for loans of a similar nature, although suchdetermination is at the administrative agent’s discretion as the creditagreement does not provide a specific borrowing base formula.

 

Borrowings underthis credit facility may be used solely to acquire, explore or develop oil andgas properties and for general corporate purposes. The credit facility matures June 15,2010.

 

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

 

Borrowings underthe Company’s credit facility, as amended, bear interest either: (i) atthe greater of the one month London Interbank Offered Rate, or LIBOR, plus1.00% or a domestic bank rate, plus in either case an applicable margin of 0.75%to 1.75% based on utilization, or (ii) on a sliding scale from the one,two, three or six month LIBOR, plus an applicable margin of 2.00% to 3.00%based on utilization. The weighted average interest rate as of March 31,2010 was 5.0%. The credit agreement provides for various fees, including aquarterly commitment fee of 0.5% per annum and engineering fees to theadministrative agent in connection with a borrowing base determination. Inaddition, the credit facility provided for an up front fee of $27,000, whichwas paid on the closing date of the credit facility, and an additionalarrangement fee of 1% based on utilization. Borrowings under this creditfacility may be prepaid without premium or penalty, except on Eurodollaradvances.

 

The credit agreement, asamended contains covenants that, among other things, restrict the Company’sability, (subject to certain exceptions) to do the following:

 

·**               **incur liens;

 

·**               **incur debt;

 

·**               **make investments in other persons;

 

·**               **declare dividends or redeem or repurchase stock;

 

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

 

·**               **enter into certain hedging arrangements;

 

·**               **amend material contracts; and

 

·**               **enter into related party transactions.

 

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

 

The creditagreement, as amended, also requires the Company satisfy certain affirmativecovenants, meet certain financial tests, maintain certain financial ratios andmake certain customary indemnifications to lenders and the 

 

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administrative agent. Thefinancial covenants include requirements to maintain: (i) a ratio ofEBITDA to cash interest expense of not less than 3.00 to 1.00, (ii) aratio of current assets to current liabilities of not less than 1.00 to 1.00, (iii) atotal debt to annualized EBITDA ratio of not more than 3.0 to 1.0, (iv) aquarterly total senior debt to annualized EBITDA ratio equal to or less than3.0 to 1.0, and (v) a total proved PV-10 value to total debt ratio of atleast 1.50 to 1.00.

 

The creditagreement, as amended, contains customary events of default, including paymentdefaults, covenant defaults, certain events of bankruptcy and insolvency,defaults in the payment of other material debt, judgment defaults, breaches ofrepresentations and warranties, loss of material permits and licenses and achange in control. The credit agreement requires any wholly-owned subsidiariesto guarantee the obligations under the credit agreement.

 

After an event ofdefault, the outstanding debt bears interest at the default rate under theterms of the credit agreement. The default rate is (i) with respect toprincipal, 2% over the otherwise applicable rate and (ii) with respect tointerest, fees and other amounts, the Base Rate (as defined in the creditfacility), plus the Applicable Margin (as defined in the credit agreement),plus 2%. Any default interest is payable on demand. Failure to pay the defaultinterest when the administrative agent demands, would be another default. Thelenders’ remedies for defaults under the credit agreement are to terminatefurther borrowings, accelerate the repayment of indebtedness and/or ultimatelyforeclose on the collateral property.

 

Effective August 4,2008, the Company and the administrative agent and lender entered into thesecond amendment to the credit agreement (the “second amendment”). The second amendmentprovided, among other things, for (i) an increase in the total quarterlysenior debt to annualized EBITDA ratio from 2.0 to 1.0, to 3.0 to 1.0, (ii) anincrease in interest at each utilization level for LIBOR borrowings, (iii) theamendment of the utilization calculation to be determined as the greater of (x) thepercentage of credit exposure over the borrowing base or (y) thepercentage of credit exposure over three times EBITDA minus permittedsubordinated debt, and (iv) the payment of an amendment fee.

 

Effective December 31,2008, the Company and the administrative agent and lender entered into thethird amendment to the credit agreement (the “third amendment”). In addition towaiving compliance with the current ratio covenant as of December 31,2008, the third amendment, among other things, required that immediately priorto any additional borrowings under the credit agreement, the ratio of currentassets to current liabilities be not less than 1.00 to 1.00. As a result ofthis new condition to additional borrowings, the Company is currently unable toborrow additional amounts under the credit agreement. The third amendment alsoincreased the interest rate payable under the credit agreement to either (i) thegreater of the one month LIBOR plus 1.00% or a domestic bank rate, plus ineither case an applicable margin of 0.75% to 1.75% based on utilization, or (ii) asliding scale from the one, two, three or six month LIBOR, plus an applicablemargin of 2.00% to 3.00% based on utilization, and provided for the payment ofan amendment fee.

 

On April 14,2009, the Company and the administrative agent entered into the fourthamendment to the credit agreement which reduced the borrowing base as describedabove and waived compliance with the current ratio financial covenant as of December 31,2008 and March 31, 2009 and with the restrictive covenants related toaccounts payable, permitted liens and permitted debt until the current ratiofinancial covenant and next borrowing base redetermination, subject to certainfinancial caps. On August 19, 2009, the lenders waived compliance with thecurrent ratio financial covenant under the credit agreement for the periodending August 26, 2009 and the quarter ending June 30, 2009.

 

On August 26,2009, the Company entered into a fifth amendment to the credit agreement whichprovided a waiver of the current ratio covenant through October 26, 2009and for the quarter ending June 30, 2009. The fifth amendment to thecredit agreement also extended restrictive covenants related to accountspayable, permitted liens and permitted debt, until October 26, 2009,subject to certain financial caps.

 

On October 20,2009, the Company and the Lenders executed the sixth amendment to the creditagreement. This amendment established the Borrowing Base for the followingamounts in the following applicable periods:

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

 

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Each Calendarmonth thereafter commenced May 1, 2010; the Borrowing Base for thepreceding calendar month reduced by $200,000.

 

On October 26,2009, the lenders provided a waiver effectively extending the terms of thefifth amendment to the credit agreement through November 16, 2009. On November 16,2009, the lenders provided an additional waiver effectively extending the termsof the fifth amendment to the credit agreement through November 23, 2009.

 

On November 23,2009, the lenders provided an additional waiver extending the terms of thefifth amendment to the credit agreement through December 1, 2009 and forthe quarter ended December 31, 2009.

 

On December 1,2009 the lenders provided an additional waiver extending the terms of the fifthamendment to the credit agreement through January 5, 2010.

 

On January 5,2010 the lenders provided an additional waiver extending the terms of the fifthamendment to the credit agreement through January 12, 2010.

 

On January 13,2010, the Company entered into a seventh amendment and waiver to creditagreement (“*waiver agreement*”)with the lenders party thereto. The waiver agreement provided that the lenderswould waive (i) its compliance with certain restrictions based on thecurrent ratio in the credit agreement, (ii) certain requirementspertaining to the aging of certain accounts payable, and (iii) certainrestrictions regarding the amount of liens the Company has. Default remediesavailable to the lenders under the credit agreement include acceleration of allprincipal and interest amounts due under the credit agreement. The waiveragreement extends the waiver period for these items until the earlier of June 15,2010 and the date of any default arising out of a breach or non-compliance withthe credit agreement not expressly waived in the waiver agreement or a breachof the waiver agreement.

 

In addition, thewaiver agreement amends the definition of “Final Maturity Date” under thecredit agreement to the earlier of (i) June 15, 2010 or (ii) thedate that is thirty days following the earlier of (A) the date the mergeris withdrawn or terminated in whole or in part or (B) the date that thelenders have been advised that the merger will not proceed.

 

*OfficeBuilding Loan.*

 

On November 15,2005, the Company entered into a mortgage loan secured by its office buildingin Sheridan, Wyoming in the aggregate principal amount of $829,000. Thepromissory note provides for monthly payments of principal and interest in theinitial amount of $6,400 and unpaid principal that bore interest at 6.875%until November 15, 2008, currently bears interest at a variable base rateplus 0.5% and will bear interest at 18% upon a default. The variable base rateis based on the lender’s base rate. The maturity date of this mortgage is November 15,2015, at which time a principal and interest payment of $520,800 will becomedue. As of March 31, 2010, the Company had $725,000 outstanding inprincipal on this mortgage. On November 15, 2008, the interest rate on themortgage loan changed from a fixed rate of 6.875% to a variable rate. As of March 31,2010, the variable rate was 4.0%.

 

**Note 8 —Fair Value Measurements**

 

Effective January 1,2008, the Company adopted the authoritative guidance that applies to allfinancial assets and liabilities required to be measured and reported on a fairvalue basis. Beginning January 1, 2009, the Company also applied theguidance to non-financial assets and liabilities measured at fair value on anonrecurring basis, including proved oil and gas properties and otherlong-lived assets and asset retirement obligations initially measured at fairvalue. The guidance defines fair value as the price that would be received tosell an asset or paid to transfer a liability (an exit price) in an orderlytransaction between market participants at the measurement date. The guidanceestablishes a hierarchy for inputs used in measuring fair value that maximizesthe use of observable inputs and minimizes the use of unobservable inputs byrequiring that the most observable inputs be used when available. Observableinputs are inputs that market participants would use in pricing the asset orliability developed based on market data obtained from sources independent ofthe Company. Unobservable inputs are inputs that reflect the Company’sassumptions of what market participants would use in pricing the asset orliability based on the best information available in the circumstances. Thefinancial and nonfinancial assets and liabilities are classified based on thelowest level of input that is significant to the fair value measurement. Thehierarchy is broken down into three levels based on the reliability of theinputs as follows:

 

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·                  Level 1—Quoted prices in active markets for identical assets orliabilities;

 

·                  Level 2—Quoted prices in active markets for similar assets andliabilities, that are observable for the asset or liability; or

 

·                  Level 3—Unobservable pricing inputs that are generally lessobservable from objective sources, such as discounted cash flow models orvaluations.

 

The following is alisting of the Company’s assets and liabilities required to be measured at fairvalue on a recurring basis and where they are classified within the hierarchyas of March 31, 2010 (in thousands):

 
| ** **                          | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|-------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|-----------|------------|
| Assets                              |       |             |       |             |       |             |       |      |       |
| Oil and gas  derivative instruments |       | $                | —     |             | $          | 1,513            |       | $         | —     |   | $ | 1,513 |   |
| Total                               |       | $                | —     |             | $          | 1,513            |       | $         | —     |   | $ | 1,513 |   |

 

As of March 31,2010, the Company’s derivative financial instruments are comprised of fournatural gas swap agreements. The fair values of the swap agreements aredetermined based primarily on inputs that are derived from observable data atcommonly quoted intervals for the full term of the derivatives and aretherefore considered Level 2 in the fair value hierarchy.

 

The Company adopted FASBASC Update 2010-06, “Fair Value Measurements and Disclosures” which amends ASCUpdate 2010-06 to require additional disclosures concerning transfers betweenLevels 1 and 2, inputs and valuation techniques used to value Level 2 and 3measurements, and push down of previously prescribed fair value disclosures toeach class of asset and liability for Levels 1, 2, and 3. The Companydetermines the fair value of these swap contracts under the income approachusing a discounted cash flow model.  Thevaluation model requires a variety of inputs, including contractual terms,projected gas market prices, discount rate, and credit risk adjustments, as appropriate.  The Company has consistently applied thisvaluation technique in all periods presented and believes it has obtained themost accurate information available for the types of derivative instruments itholds. These disclosures were effective for the Company for the quarter ended March 31, 2010. The adoption of this pronouncement did not have a material impact on theCompany’s consolidated financial statements.

 

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

 

**Note 9 —Commitments and Contingencies**

 

*OperatingLease*

 

Upon purchase ofthe building in August 2005, the Company was assigned the lease agreementsfor existing tenants in the building. The leases expire from January 2010to January 2013. Future minimum lease income under noncancelable operatingleases is as follows:

 
| **Year Ending December 31,** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|
| 2010                              |       | $          | 79,000     |   |
| 2011                              |       | 60,000     |       |
| 2012                              |       | 44,000     |       |
| 2013                              |       | 44,000     |       |
| Total  minimum lease payments     |       | $          | 227,000    |   |

 

*Gas Gathering Contracts*

 

The Company has enteredinto gas gathering and compression agreements with service providers in orderto compress and transport its gas to the point of sale. Compression agreementsand gathering agreements are based on a fee per 

 

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Mcf either compressed orgathered. The Company accounts for these fees as a marketing and transportationexpense. The Company does not pay or charge marketing fees associated with themovement and sale of natural gas.

 

*Litigation*

 

From time to time,the Company is subject to legal proceedings and claims that arise in theordinary course of its business. In addition, like other natural gas and oilproducers and marketers, the Company’s operations are subject to extensive andrapidly changing federal and state environmental, health and safety and otherlaws and regulations governing air emissions, wastewater discharges, and solidand hazardous waste management activities. As a result, it is extremelydifficult to reasonably quantify future environmental and regulatory relatedexpenditures.

 

The followingrepresent legal actions in which the Company is involved. No assurance can begiven that these legal actions will be resolved in the Company’s favor.However, the Company’s management believes, based on its experiences to date,that these matters will not have a material adverse impact on the Company’sbusiness, financial position or results of operations.

 

The Company,together with the State of Montana, the Montana Department of EnvironmentalQuality, the Montana Board of Oil and Gas Conservation and the Department ofNatural Resources, were named as defendants in a lawsuit (Civil Cause No. DV-05-27)filed on May 19, 2005 in the Montana 22nd Judicial District Court,Bighorn County by Diamond Cross Properties, LLC relating to the Coal CreekPOD. The plaintiff is a surface owner with properties located in Big HornCounty and Rosebud County, Montana where the Company has a lease forapproximately 10,300 acres, serves as operator and owns a working interest inthe minerals under lease. The plaintiff sought to permanently enjoin the Stateof Montana and its administrative bodies from issuing licenses or permits, or authorizingthe removal of ground water from under the plaintiff’s ranch. In addition, theplaintiff further sought to preliminarily and permanently enjoin the Company onthe basis that the Company’s operations lacked adequate safeguards requiredunder the Montana state constitution. On August 25, 2005, the districtjudge issued an order denying without prejudice the application for temporaryrestraining order and preliminary injunction requested by the plaintiff. Thecase was appealed by the plaintiff to the Montana Supreme Court. On November 16,2005, the Montana Supreme Court issued an order that denied enjoining the CoalCreek POD, and subsequently, the Montana Supreme Court remanded the case backto the district court for a decision on the merits.

 

The Company,together with the defendants above, was also named as defendants in a relatedlawsuit (Civil Cause No. DV-05-70) filed on September 21, 2005 in theMontana 22nd Judicial District Court, Bighorn County by Diamond CrossProperties, LLC relating to the Dietz POD. The plaintiff sought similarrelief as in the Coal Creek POD suit. The two cases were combined.

 

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

 

In April and September 2005,the U.S. Bureau of Land Management in Miles City, Montana issued suspensions ofoperations for the majority of the Company’s federal leases in Montana. Thesuspensions were issued based upon a court order issued on April 5, 2005by the U.S. District Court of Montana that required the BLM to complete aSupplemental Environmental Impact Statement (SEIS) to address phaseddevelopment of coal bed natural gas. The U.S. Ninth Circuit Court of Appealsalso issued an order on May 31, 2005 which enjoined the BLM from approvingcoal bed natural gas production projects in the Powder River Basin of Montana.Both of these actions placed limitations on lease development until completionof the SEIS.

 

The 2005injunction was lifted by the Ninth Circuit Court of Appeals on October 29,2007. The record of decision (ROD) for the SEIS was signed by the BLM on December 30,2008 and went into effect on January 14, 2009. The Suspension ofOperations and Production for the suspended leases was terminated effective February 1,2009. The Company has received letters from the BLM with amended lease terms ofthe affected leases. Leases that were suspended have been placed back into anactive lease status with the primary term increasing for approximately three tofive years based on the time period the leases were in suspension.

 

On July 6,2009, the Company filed suit (Cause No. DV09-35) against Big SkyEnergy LLC and Quaneco L.L.C., in the Twenty-Second Judicial DistrictCourt, Big Horn County, Montana alleging claims for breach of contract, breachof 

 

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implied covenant of goodfaith and fair dealing, tortuous interference with business, tortuousinterference with contractual relations and slander of title. The Company isamending the complaint to add a foreclosure action against Big SkyEnergy LLC’s and Quaneco L.L.C.’s collective interest in the developedproperties in Montana for non payment of invoices in the amount of $298,689.

 

The Company willcontinue to vigorously pursue payment of the amounts owed including interestand attorney’s fees along with foreclosure proceedings and any other rights andremedies available to us pursuant to the Joint Operating Agreement dated June 23,2003, as amended.

 

The Company wasnamed as a defendant in litigation brought by RLI Insurance Company (CivilCause No. 09-CV-157-J) filed in United States District Court for theDistrict of Wyoming on July 6, 2009. The complaint alleges that theCompany failed to provide $1,439,360 in additional collateral requested byplaintiff to secure certain bonds issued by plaintiff on behalf of the Company.Plaintiff seeks the additional bond collateral plus attorney’s fees and costs.On March 18, 2010, Pinnacle Gas Resources, Inc. and RLI Insurance Companyentered into a Tolling Agreement. The agreement stipulates that the partiesagree to drop all claims and counter claims in the litigation captioned RLIInsurance Company v. Pinnacle Gas Resources, Inc., Case No. 09-CV-157-J(D. Wyo.), without prejudice. The agreement further stipulates that each partywill extend the period within which either party may institute a claim,counterclaim, action or proceeding up to and including June 16, 2010. Theagreement also obligates The Company to continue to solicit market quotes forthe purpose of replacing all bonds or bonding relationships which exist betweenthe Company and RLI Insurance Company.

 

Two putativestockholder class action lawsuits related to the Merger have been filed in theDelaware Court of Chancery since the announcement of the execution of theMerger Agreement described in our Proxy Statement filed April 2,2010. On March 24, 2010, the Delaware Court of Chancery entered an orderconsolidating the two actions under the caption *In re Pinnacle Gas Resources Shareholder Litigation,*C.A. No. 5313-CC(Del. Ch.) and appointing co-lead counsel.

 

The consolidatedcomplaint generally alleges that our directors breached their fiduciary dutiesby, among other things, taking actions designed to deter higher offers fromother potential acquirers and failing to maximize the value of Pinnacle to itsstockholders. In addition, the lawsuit alleges that DLJ, as a controllingstockholder of Pinnacle, violated fiduciary duties to Pinnacle stock holdersand that Powder and Merger Sub aided and abetted the alleged breaches offiduciary duties by the other defendants.  The lawsuit seeks, among otherrelief, injunctive relief prohibiting the Merger, and costs of the actionincluding reasonable attorneys’ fees.

 

The Company believes thatthese lawsuits are without merit and intends to vigorously defend against them.

 

*Regulations*

 

The Company’s oiland gas operations are subject to various federal, state and local laws andregulations. The Company could incur significant expense to comply with the newor existing laws and non-compliance could have a material adverse effect on theCompany’s operations.

 

*Environmental*

 

The Companyproduces significant amounts of water from its wells. If future wells producewater of a lesser quality than allowed under state laws or if water is producedat rates greater than the Company can dispose of, the Company could incuradditional costs to dispose of the water.

 

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**Note 10— Recent Developments**

 

***NASDAQ Delisting***

 

On March 16,2010, The NASDAQ Stock Market notified the Company of its failure to complywith Listing Rule 5450(a)(1). This rule subjects a company’s stock todelisting on the NASDAQ exchange if its stock price closes below $1 over theprevious 30 consecutive business days and then, after notification, failsto regain compliance within the subsequent 180 days. Accordingly, unlessthe Company appealed this determination, the trading of the Company’s stock wouldhave been suspended on March 25, 2010. The Company filed an appeal,pursuant to NASDAQ listing rule series 5800 on March 22, 2010.

 

On April 29, 2010,the Company met with representatives of NASDAQ to formally request a 180 dayextension to allow implementation of certain strategies to regain compliance.

 

On May 10, 2010, theCompany received a determination letter from the NASDAQ hearings panel grantingthe Company’s request for continued listing subject to a proxy being filedwhich included a proposal for a reverse stock split and a closing bid price of$1.00 or more for a minimum of ten consecutive trading days prior to September 13,2010.

 

********

 

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

 

*Thediscussion and analysis that follows should be read together with theaccompanying financial statements and notes related thereto that are includedelsewhere in this quarterly report on Form 10-Q. It includesforward-looking statements that may reflect our estimates, beliefs, plans andexpected performance. The forward-looking statements are based upon events,risks and uncertainties that may be outside our control. Our actual resultscould differ significantly from those discussed in these forward-lookingstatements. Factors that could cause or contribute to these differencesinclude, but are not limited to, market prices for natural gas and oil,regulatory changes, estimates of proved reserves, economic conditions,competitive conditions, development success rates, capital expenditures andother uncertainties, as well as those factors discussed below and elsewhere inthis quarterly report on Form 10-Q and in our annual report on Form 10-Kfor the year ended December 31, 2009, including in “Risk Factors” and “CautionaryStatement Concerning Forward-Looking Statements,” all of which are difficult topredict. As a result of these assumptions, risks and uncertainties, theforward-looking matters discussed may not occur.*

 

**Overview**

 

We are anindependent energy company engaged in the acquisition, exploration anddevelopment of domestic onshore natural gas reserves. We primarily focus ourefforts on the development of CBM properties located in the Powder River Basinin northeastern Wyoming and southern Montana. In addition, in April 2006,we acquired properties located in the Green River Basin in southern Wyoming. Asof December 31, 2009, we owned natural gas and oil leasehold interests inapproximately 424,000 gross (308,000 net) acres, approximately 90% of whichwere undeveloped. As of December 31, 2009, we had estimated net provedreserves of approximately 15.0 Bcf based on the first day of the month, twelvemonth average CIG index price of approximately $3.04 per Mcf.

 

The continuedcredit crisis and related turmoil in the global financial system have had anadverse impact on our business and financial condition. In addition, the pricesof oil and natural gas declined significantly in 2008 and have remained low in2009 and during the first three months of 2010. Therefore, total capitalexpenditures were limited to $4.2 million in 2009. As a result of low CIGindex prices, the economic climate and our limited capital resources, we expectto continue operating during 2010 with a reduced capital expenditure plan.Under our plan, we will generally make expenditures only as necessary to securedrilling permits in strategic areas, drill wells that secure leaseholdpositions and construct the necessary infrastructure to complete and hook-upwells that have already been drilled. Our capital expenditure budget for 2010will be dependent upon CIG index prices, our cash flows and the availability ofadditional capital resources.  We hadtotal capital expenditures of $0.2 million for the three months ended March 31,2010.

 

Shares of ourcommon stock are traded on the NASDAQ Global Market under the symbol “PINN.”

 

**Economic and Natural Gas Pricing Environment**

 

During 2009, theglobal economy experienced a significant downturn. The downturn, which beganover concerns related to the U.S. financial markets, spread to otherindustries, including the energy industry. The initial effects of the downturnrestricted the capital and credit markets to a degree that has not been seen ina number of decades in the United States. We have been able to partiallymitigate the constraints imposed by the current economic climate throughutilization of cash flows from operations.

 

The fear of globalrecession led to an immediate drop in demand for natural gas, primarily byindustrial users, which in turn led to a significant reduction in natural gasprices. The natural gas index price in the Rocky Mountain region averaged $6.24per Mcf for the twelve months ended December 31, 2008 but only $3.07 perMcf for the twelve months ended December 31, 2009. For the first quarterof 2010, the price averaged $5.14.  This volatilityin price has caused us to reevaluate our 2010 business plan. We have curtaileddrilling, except for wells that will hold significant blocks of acreage, andhave also reduced administrative, operating and transportation costs. Even withcost reductions and a flexible capital spending budget, the current natural gaspricing and economic environment remains challenging. We are exploringstrategic alternatives to increase our capital resources.

 

**Credit Facility and Liquidity**

 

Inthe past, our primary sources of liquidity have been private and public salesof our equity securities, cash provided by operating activities, and debtfinancing. All of these sources have been negatively impacted by the current 

 

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economicclimate, its impact on our industry, and by significant fluctuations in oil andgas prices, operating costs, and volumes produced. We have no control over themarket prices for oil and natural gas, although we are able to influence theamount of our net realized revenues related to gas sales through the use ofderivative contracts. A decrease in market prices would reduce expected cashflow from operating activities and could reduce the borrowing base of ourcredit facility as well as the value of assets we might consider selling.Historically, decreases in the market prices have limited our industry’s accessto the capital markets. During these challenging times, we have reduced ouradministrative, operating and transportation costs. We are also activelymarketing asset sales and exploring other strategic alternatives and capitalrestructuring options.

 

OnJanuary 13, 2010, we entered into a seventh amendment and waiver to creditagreement (“*waiver agreement*”)with the lenders party thereto. The waiver agreement provided that the lenderswould waive (i) our compliance with certain restrictions based on thecurrent ratio in the credit agreement, (ii) certain requirementspertaining to the aging of certain accounts payable, and (iii) certainrestrictions regarding the amount of liens we have. Default remedies availableto the lenders under the credit agreement include acceleration of all principaland interest amounts due under the credit agreement. The waiver agreementextends the waiver period for these items until the earlier of June 15,2010 and the date of any default arising out of a breach or non-compliance withthe credit agreement not expressly waived in the waiver agreement or a breachof the waiver agreement.

 

Inaddition, the waiver agreement amends the definition of “Final Maturity Date”under the credit agreement to the earlier of (i) June 15, 2010 or (ii) thedate that is thirty days following the earlier of (A) the date the merger(please see Note 10 in the notes to the financial statements) is withdrawn orterminated in whole or in part or (B) the date that the lenders have beenadvised that the merger will not proceed.

 

OnFebruary 23, 2010, we entered into an Agreement and Plan of Merger withPowder Holdings, LLC, a Delaware limited liability company, and PowderAcquisition Co., a Delaware corporation and a direct, wholly ownedsubsidiary of Powder Holdings. Powder Holdings is controlled by an investorgroup led by Scotia Waterous (USA) Inc. and includes certain members ofthe Company’s management team.

 

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

 

**CriticalAccounting Policies**

 

The most subjective andcomplex judgments used in the preparation of our financial statements are:

 

·                  Reserve evaluation anddetermination;

 

·                  Estimates of the timing and cost ofour future drilling activity;

 

·                  Estimates of the fair valuation ofhedges in place;

 

·                  Estimates of timing and cost ofasset retirement obligations;

 

·                  Estimates of the expense and timingof exercise of stock options;

 

·                  Accruals of operating costs,capital expenditures and revenue; and

 

·                  Estimates for litigation.

 

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***Oil and Gas Properties***

 

We use the fullcost method of accounting for oil and gas producing activities. Under thismethod, all costs associated with property acquisition, exploration anddevelopment, including costs of unsuccessful exploration, costs of surrenderedand abandoned leaseholds, delay lease rentals and the fair value of estimatedfuture costs of site restoration, dismantlement and abandonment activities, arecapitalized within a cost center. Our oil and gas properties are all locatedwithin the United States, which constitutes a single cost center. We capitalizecertain lease operating expenses associated with exploration and development ofunevaluated oil and gas properties. No gain or loss is recognized upon the saleor abandonment of undeveloped or producing oil and gas properties unless thesale represents a significant portion of gas properties and the gainsignificantly alters the relationship between capitalized costs and proved gasreserves of the cost center. Expenditures for maintenance and repairs arecharged to lease operating expense in the period incurred.

 

Depreciation,depletion and amortization of oil and gas properties are computed on theunit-of-production method based on proved reserves. Amortizable costs includeestimates of future development costs of proved undeveloped reserves and assetretirement obligations. We invest in unevaluated oil and gas properties for thepurpose of exploration for proved reserves. The costs of such assets, includingexploration costs on properties where a determination of whether proved oil andgas reserves will be established is still under evaluation, and any capitalizedinterest and lease operating expenses, are included in unproved oil and gasproperties at the lower of cost or estimated fair market value and are notsubject to amortization. On a quarterly basis, such costs are evaluated forinclusion in the costs to be amortized resulting from the determination ofproved reserves, impairments, or reductions in value. To the extent that theevaluation indicates these properties are impaired, the amount of theimpairment is added to the capitalized costs to be amortized. We recorded animpairment of unevaluated properties of $0 million and $36.7 million during thethree months ended March 31, 2010 and the year ended December 31,2009, respectively. Abandonment of unproved properties is also accounted for asan adjustment to capitalized costs related to proved oil and gas properties,with no losses recognized.

 

Substantially allremaining unproved property costs are expected to be developed and included inthe amortization base ratably over the next three to five years. Salvage valueis taken into account in determining depletion rates and is based on ourestimate of the value of equipment and supplies at the time the well isabandoned. As of March 31, 2010 and March 31, 2009, the estimatedsalvage value of equipment was $6.8 million and $7.2 million, respectively.

 

Under the full costmethod of accounting rules, capitalized costs less accumulated depletion andrelated deferred income taxes may not exceed a “ceiling” value which is the sumof (1) the present value discounted at 10% of estimated future net revenueusing current costs and the first day of the month, twelve month average CIGprice, including the effects of derivative instruments designated as cash flowhedges but excluding the future cash outflows associated with settling assetretirement obligations that have been accrued on the balance sheet, less anyrelated income tax effects; plus (2) the cost of properties not beingamortized, if any; plus (3) the lower of costs or estimated fair value ofunproved properties; less (4) the income tax effects related todifferences in the book to tax basis of oil and gas properties. This isreferred to as the “full cost ceiling limitation.” If capitalized costs exceedthe limit, the excess must be charged to expense. The expense may not bereversed in future periods. At the end of each quarter, we calculate the fullcost ceiling limitation. At March 31, 2010, the full cost ceilinglimitation exceeded the capitalized cost of the Company’s oil and gasproperties by approximately $4.1 million based on the first day of the month,twelve month average CIG price of approximately $3.48 per Mcf. Therefore, noimpairment was taken for the quarter ended March 31, 2010. An impairmentof $16.8 million was taken for the quarter ended March 31, 2009 based on anatural gas price of $3.31 per Mcf. A decline in gas prices or an increase inoperating costs subsequent to the measurement date or reductions ineconomically recoverable quantities could result in the recognition ofadditional impairments of our oil and gas properties in future periods.

 

***Gas Sales***

 

We use the sales methodfor recording natural gas sales. Sales of gas applicable to our interest inproducing natural gas and oil leases are recorded as revenues when the gas ismetered and title transferred pursuant to the gas sales contracts covering ourinterest in gas reserves. During such times as our sales of gas exceed our prorata ownership in a well, such sales are recorded as revenues unless totalsales from the well have exceeded our share of estimated total gas reservesunderlying the property at which time such excess is recorded as a gasimbalance liability. At March 31, 2010 and December 31, 2009, therewas no such liability recorded. Although there was no such liability recordedfor prior periods, gas reserves are an estimate and are updated on an annualand interim basis. Gas pricing, expenses and production may impact future gasreserves remaining which, in turn, could impact the recording of liabilities inthe future. Gas sales accruals at March 31, 2010, and December 31,

 

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2009 were based on theactual volume statements from our purchasers and distribution process. Ifaccruals were to change by 10% at March 31, 2010 and at December 31,2009, the impact would have been a change of $133,000 and $124,000,respectively.

 

***Asset Retirement Obligations***

 

We follow certainaccounting provisions that apply to legal obligations associated with theretirement of long-lived assets that result from the acquisition, construction,development and/or the normal operation of a long-lived asset. These provisionsrequire us to recognize an estimated liability for costs associated with theabandonment of our oil and gas properties.

 

A liability for the fairvalue of an asset retirement obligation with a corresponding increase to thecarrying value of the related long-lived asset is recorded at the time a wellis completed or acquired. The increased carrying value is depleted using theunits-of-production method, and the discounted liability is increased throughaccretion over the remaining life of the respective oil and gas properties.

 

The estimated liabilityis based on historical gas industry experience in abandoning wells, includingestimated economic lives, external estimates as to the cost to abandon thewells in the future and federal and state regulatory requirements. Ourliability is discounted using our best estimate of our credit-adjustedrisk-free rate. Revisions to the liability could occur due to changes inestimated abandonment costs, changes in well economic lives or if federal orstate regulators enact new requirements regarding the abandonment of wells. Forexample, a 10% change in our estimated retirement costs would have had a$296,000 effect on our asset retirement obligation liability at March 31,2010.

 

The following is asummary of our asset retirement obligation activity for the three months ended March 31,2010 and 2009 (in thousands):

 
| ** **                                      | ** ** | **Three  Months Ended  March 31,** | ** ** | **Three  Months Ended  March 31,** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                      | ** ** | **2010**                                     | ** ** | **2009**                                     | ** ** |
| ** **                                      | ** ** | **(unaudited)**                              | ** ** | **(unaudited)**                              | ** ** |
| Beginning  balance asset retirement obligations |       | $                                            | 2,937      |                                         | $          | 3,366 |   |
| Additional  obligation added during the period  |       | 1                                            |       | —                                       |       |
| Obligations  settled during the period          |       | (31                                          | )          | —                                       |       |
| Accretion  expense                              |       | 52                                           |       | 56                                           |       |
| Ending balance  of asset retirement obligations |       | $                                            | 2,959      |                                         | $          | 3,422 |   |

 

***Inventory***

 

We have acquiredinventory of oil and gas equipment, primarily tubulars, to take advantage ofquantity pricing and to secure a readily available supply. Inventory is valuedat the lower of average cost or market. Inventory is used in the development ofgas properties and to the extent it is estimated that it will be billed toother working interest owners during the next year, it is included in currentassets. Otherwise, it is recorded in non-current assets. The price of steel isa primary factor in valuing our inventory. Under the valuation method of lowerof average cost or market, a 10% reduction in the price of steel would havecaused a $44,000 reduction in our inventory valuation as of March 31,2010. The market price of steel is evaluated each quarter using prices quotedby authorized vendors in the area.

 

***Property and Equipment***

 

Property and equipment iscomprised primarily of a building, computer hardware and software, vehicles andequipment, and is recorded at cost. Renewals and betterments that substantiallyextend the useful lives of the assets are capitalized. Maintenance and repairsare expensed when incurred. Depreciation and amortization are provided usingthe straight-line method over the estimated useful lives of the assets, rangingas follows: buildings—30 years, computer hardware and software—3 to5 years, machinery, equipment and vehicles—5 years, and officefurniture and equipment—3 to 5 years.

 

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***Long-Lived Assets***

 

Long-lived assets to beheld and used in our business are reviewed for impairment whenever events orchanges in circumstances indicate that the related carrying amount may not berecoverable. When the carrying amounts of long-lived assets exceed the fairvalue, which is generally based on discounted expected future cash flows, werecorded an impairment. No impairments were recorded during the three monthsended March 31, 2010 and the year ended December 31, 2009.

 

***General and Administrative Expenses***

 

General andadministrative expenses are reported net of amounts allocated and billed toworking interest owners of gas properties operated by us. The administrativeexpenses billed to working interest owners may change in accordance with theterms of the joint operating agreements. Administrative expenses are charged toworking interest owners based on productive well counts.  A 10% change in well counts for the threemonths ended March 31, 2010 would have increased or decreased our expensesbilled to working interest owners by approximately $29,000. As we operate anddrill additional wells in the future, additional administrative expenses willbe charged to the working interest owners when the wells become productive.

 

***Income Taxes***

 

We use the asset andliability method of accounting for income taxes. Deferred tax assets andliabilities are recognized for the expected future tax consequences oftemporary differences between the financial statement and tax bases of assetsand liabilities. If appropriate, deferred tax assets are reduced by a valuationallowance which reflects expectations of the extent to which such assets willbe realized. As of March 31, 2010 and December 31, 2009, we recordeda full valuation allowance for our net deferred tax asset.

 

On January 1,2007, we adopted accounting provisions that prescribe a recognition thresholdand measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.This provision requires that we recognize in our consolidated financialstatements only those tax positions that are “more-likely-than-not” of beingsustained as of the adoption date, based on the technical merits of theposition. As a result of the implementation of the provision, we performed acomprehensive review of our material tax positions in accordance with theserecognition and measurement standards. As a result of this review, we did notidentify any material deferred tax assets that required adjustment. As of March 31,2010 and December 31, 2009, we had not recorded any material uncertain taxpositions.

 

Our policy is torecognize interest and penalties related to uncertain tax benefits in incometax expense. As of March 31, 2010 and 2009, we had not recognized anyinterest or penalties in our statement of operations or statement of financialposition.

 

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

 

***Derivatives***

 

We use derivativeinstruments to manage our exposure to fluctuating natural gas prices throughthe use of natural gas swap and option contracts. We account for derivativeinstruments or hedging activities under authoritive guidance prescribed by FASBthat requires us to record derivative instruments at their fair value. If thederivative is designated as a fair value hedge, the changes in the fair valueof the derivative and of the hedged item attributable to the hedged risk arerecognized in earnings. If the derivative is designated as a cash flow hedge,the effective portions of changes in the fair value of the derivative arerecorded in other comprehensive income (loss) and are recognized in thestatement of operations when the hedged item affects earnings. Ineffectiveportions of changes in the fair value of cash flow hedges, if any, arerecognized in earnings. Changes in the fair value of derivatives that do notqualify for hedge treatment are recognized in earnings.

 

We periodicallyhedge a portion of our oil and gas production through swap and collaragreements. The purpose of the hedges is to provide a measure of stability toour cash flows in an environment of volatile oil and gas prices and to managethe exposure to commodity price risk. Our management decided not to use hedgeaccounting for these agreements. Therefore, in accordance with certainaccounting provisions, the changes in fair market value are recognized inearnings.

 

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***Stock-Based Compensation***

 

Effective January 1,2006, we adopted accounting provisions, which require companies to recognizecompensation expense for share-based payments based on the estimated fair valueof the awards. We recognized an expense of approximately $19,000 for the threemonths ended March 31, 2010, based on the fair value of vested options.  We recognized an expense of approximately$129,000 for the three months ended March 31, 2010, based on the fair value ofrestricted stock that vested during the quarter.  We recognized an expense of approximately$6,000 for the three months ending March 31, 2010, based on the fair marketvalue of stock appreciation rights. This accounting provision also requiresthat the benefits of tax deductions in excess of compensation cost recognizedfor stock awards and options (“excess tax benefits”) be presented as financingcash inflows in the Statement of Cash Flows.

 

***Accounts Receivable***

 

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

 

***Transportation Costs***

 

We account fortransportation costs under authoritative guidance prescribed by the FASBrelated to the accounting for shipping and handling fees and costs, wherebyamounts paid for transportation are classified as operating expenses.

 

***Legal Estimates***

 

From time to time,we are subject to legal proceedings and claims that arise in the ordinarycourse of business. We account for these costs under an accounting provision,which states that a loss contingency be recorded if it is probable that aliability has been incurred and it is reasonably estimatable. At March 31,2010 and 2009, we recorded no expenses for legal proceedings.

 

***Per Share Information***

 

Basicearnings (loss) per share is computed by dividing net income (loss) fromcontinuing operations attributable to common stock by the weighted averagenumber of shares of common stock outstanding during each period. Dilutedearnings per share are computed by adjusting the average number of shares ofcommon stock outstanding for the dilutive effect, if any, of common stockequivalents such as stock options and warrants. For the three months ended March 31,2010, diluted net income per share was $0.04 and basic net income per share was$0.04. During the three months ended March 31, 2009, 645,000 options wereexcluded because they were anti-dilutive.

 

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***Recent Accounting Pronouncements***

 

For informationconcerning recent accounting pronouncements, please see Note 2 in the notes tothe audited financial statements appearing elsewhere in this report.

 

**TrendsAffecting Our Business**

 

Thecontinued credit crisis and related turmoil in the global financial system havehad an adverse impact on our business and financial condition. In addition, theprices of oil and natural gas declined significantly in 2008 and have remainedlow in 2009 and the first quarter of 2010. As a result of low CIG index prices,the economic climate and our limited capital resources, we expect to continueoperating during 2010 with a reduced capital expenditure plan for 2010. Underour plan, we will generally make expenditures only as are necessary to securedrilling permits in strategic areas, drill wells that secure leaseholdpositions and construct the necessary infrastructure to complete and hook-upwells that have already been drilled.

 

Historically,natural gas prices have been extremely volatile, and we expect that volatilityto continue. For example, during the three months ended March 31, 2010,the NYMEX natural gas index price ranged from a high of $6.00 per MMBtu to alow of $3.84 per MMBtu, while the CIG natural gas index price ranged from ahigh of $6.08 per MMBtu to a low of $3.41 per MMBtu. During the year ended December 31,2009, the NYMEX natural gas index price ranged from a high of $6.07 per MMBtuto a low of $2.51 per MMBtu, while the CIG natural gas index price ranged froma high of $5.75 per MMBtu to a low of $1.33 per MMBtu. Changes in natural gaspricing have impacted our revenue streams, production taxes, prices used inreserve calculations, borrowing base calculations and the carrying value of ourproperties and the valuation of potential property acquisitions. During thethree months ended March 31, 2010, estimated future gas prices had animpact on both our revenues and the costs attributable to our futureoperations. We expect that changing natural gas prices will continue to impactour operations and financial results in the future.

 

Transportation of natural gas and access to throughputcapacity have a direct impact on natural gas prices in the Rocky Mountainregion, where our operations are concentrated. As drilling activity increasesthroughout the Rocky Mountain region, additional production may come on line,which could cause bottlenecks or capacity constraints. Generally speaking, asurplus of natural gas production relative to available transportation capacityhas a negative impact on prices. Conversely, as capacity increases, andbottlenecks are eliminated, prices generally increase. Although there iscurrently adequate transportation capacity out of the Powder River Basin, asurplus of natural gas arriving at key marketing hubs from the Powder RiverBasin and elsewhere relative to available takeaway capacity from these hubs hascaused Rocky Mountain gas to generally trade at a discount to the NYMEX naturalgas index price. For example, from January 1, 2010 through March 31,2010, Rocky Mountain gas traded at a differential to the NYMEX natural gasindex price that ranged from a premium of $0.27 per Mcf to a discount of $0.64per Mcf, with an average differential of a discount of $0.24 per Mcf. TheRockies Express Pipeline which was completed and placed into service in early2008, has increased takeaway capacity by approximately 1.5 Bcf per day fromthese hubs. We expect that the completion of additional proposed pipelines willhelp reduce the differential between gas produced in the Rocky Mountain regionand the NYMEX natural gas index price. Additional proposed pipelines arescheduled to be completed in late 2010 and 2011. General economic conditionsand the future demand for natural gas may change the development schedule ofproposed pipelines.

 

The U.S. House ofRepresentatives recently passed the American Clean Energy and Security Act of2009 which, if passed into law, will establish a federal cap-and-trade system.Under this system, major producers of greenhouse gas emissions would berequired to acquire emission allowances, either through purchases at auctionsor through trades with other allowance holders, and then surrender theallowances to the government. If a regulated party could not acquire sufficientallowances or reduce its emissions to the level of the allowances that it didacquire, the party would face regulatory penalties. This legislation wouldinitially cover electrical generation facilities and would phase in coverage ofother industrial sources of emissions and natural gas and fossil fueldistribution. If this or similar legislation is enacted into law, it could havea material adverse effect on our operations through significant increases inoperating costs and decreases in the demand for natural gas.

 

The U.S. Congressis currently considering legislation that would amend the Safe Drinking WaterAct to eliminate an existing exemption from federal regulation of hydraulicfracturing activities. Hydraulic fracturing is a common process in our industryof creating artificial cracks or fractures in deep underground formationsthrough the pressurized injection of water or other materials. The resultingfractures allow natural gas and oil to flow more freely to a producing well.This 

 

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process is oftennecessary to produce economically viable quantities of oil and natural gas frommany reservoirs. Currently, regulation of hydraulic fracturing is primarilyconducted at the state level through permitting and other compliancerequirements. If adopted, the proposed amendment to the Safe Drinking Water Actcould result in additional regulations and permitting requirements at thefederal level. These additional regulations and permitting requirements couldlead to significant operational delays and increased operating costs as well asencumbering field enhancements through fracturing.

 

**Resultsof Operations**

 

Net income attributableto stockholders for the quarter ended March 31, 2010 was $1.1 million, or$0.04 per diluted share, on total revenues of $2.8 million. Other income forthe quarter ended March 31, 2010 included a $2.9 million unrealized gainassociated with the change in the fair valuation of our natural gas hedges inplace in accordance with certain accounting provisions. Absent such change inthe valuation of hedges, we would have shown a loss of $1.7 million Thiscompares to a net loss attributable to stockholders of $17.5 million for thequarter ended March 31, 2009 on total revenue of $2.8 million. Adjustedfor an unrealized gain in the fair valuation of our natural gas hedges in placeof $0.6 million shown in other income, our results for the quarter ended March 31,2009 would have been a net loss attributable to common stockholders of $18.1million.

 

In order toprovide a measure of stability to the cash flow in an environment of volatileoil and gas prices and to manage the exposure to commodity price risk, we choseto periodically hedge a portion of our oil and gas production using swap andcollar agreements. We account for our derivative instruments under certainaccounting provisions which require us to record derivative instruments attheir fair value. Management has chosen not to use hedge accounting for thesearrangements. Therefore, in accordance with these provisions, changes in thefair market value are recognized in earnings.

 

***Three Months Ended March 31,2010 Compared To Three Months Ended March 31, 2009***

 

*Gassales volume.*

 

Gas sales volumedecreased 27%, from 813 MMcf in the three months ended March 31, 2009 to594 MMcf in the three months ended March 31, 2010. Daily sales volume was6.6 MMcf for the three months ended March 31, 2010 as compared to 9.0 MMcffor the three months ended March 31, 2009, a 2.4 MMcf per day decrease.The decrease resulted primarily from shutting in wells due to low natural gasprices, reductions in volumes due to compression maintenance and repairs, andweather related downtime.

 

*Gassales revenue.*

 

Revenue from gas salesincreased approximately $80,000 during the three months ended March 31,2010, to approximately $2.8 million, a 3% increase compared to the three monthsended March 31, 2009. This increase was primarily due to an increase inthe average realized price per Mcf but was partially offset by a decrease involume. The average realized price per Mcf increased approximately 41%, from$3.40 per Mcf in the three months ended March 31, 2009 to $4.79 per Mcf inthe three months ended March 31, 2010.

 

*Derivatives.*

 

For the threemonths ended March 31, 2010, we had an unrealized gain of $2.9 millioncompared to an unrealized gain of $0.6 million for the three months ended March 31,2009. The unrealized gains are non-cash income based primarily on theBlack-Scholes model for valuing future cash flows utilizing price volatilitywith a normal discount rate for our costless collars in place and an intrinsicmodel for our swaps in place. Hedges settled during the three months ended March 31,2010 resulted in a realized loss of $0.5 million compared to a realized hedgegain of approximately $1.5 million during the three months ended March 31,2009. The unrealized hedge gain for the three months ended March 31, 2010,was due to future gas prices being lower than the weighted average price of ourfuture hedge positions.

 

*Leaseoperating expenses.*

 

Leaseoperating expenses decreased $0.2 million in the three months ended March 31,2010 to $1.0 million, a 14% decrease compared to the three months ended March 31,2009. This decrease resulted primarily from a reduction in contract services,fuel, and water management related costs offset partially by an increase insurface use expenses in the productive 

 

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cycle during the threemonths ended March 31, 2010. On a Mcf basis, lease operating expensesincreased 18% from $1.46 per Mcf in the three months ended March 31, 2009to $1.71 per Mcf in the three months ended March 31, 2010. The increaseper Mcf was primarily due to a number of shut-in wells in the Kirby area beingturned back on in the first quarter of 2010 that have not yet begun producinggas.

 

*Production taxes.*

 

Production taxesincreased $40,000 in the three months ended March 31, 2010 to $0.3million, a 14% increase from the three months ended March 31, 2009.Production taxes generally correlate to gross sales revenue because productiontaxes are based on a percentage of sales value. In Wyoming, the percentageaverages 11% to 13%, depending on rates in effect for the respective year,while in Montana the percentage averages 9%. The decrease in production taxesfor the three months ended March 31, 2010 was primarily due to decreasedrevenues associated with decreased volume and realized pricing. On a Mcf basis,production taxes were $0.54 per Mcf for the three months ended March 31,2010 and $0.34 per Mcf for the three months ended March 31, 2009, a 56%increase, which correlates to the increase in the price per Mcf received in thethree months ended March 31, 2010 from the three months ended March 31,2009.

 

*Marketingand transportation.*

 

Marketing andtransportation expenses decreased approximately $0.5 million in the threemonths ended March 31, 2010 to approximately $0.7 million, a 42% decreasefrom the three months ended March 31, 2009. The decrease related primarilyto a decrease in transportation fees and compression due to lower production volumes.On a Mcf basis, marketing and transportation expenses decreased 21% to $1.22per Mcf in the three months ended March 31, 2010 from $1.54 per Mcf in thethree months ended March 31, 2009.

 

*Generaland administrative expenses, net.*

 

General and administrativeexpenses are offset by operating income from drilling and production activitiesfor which we can charge an overhead fee to nonoperating working interestowners. These well operating overhead fees were $289,000 in the three monthsended March 31, 2010 compared to $325,000 for the three months ended March 31,2009, an 11% decrease. General and administrative expenses net increased $0.4million in the three months ended March 31, 2010 to $1.4 million. On a Mcfbasis, general and administrative expenses, net increased 87%, from $1.27 perMcf in the three months ended March 31, 2009 to $2.37 per Mcf in the threemonths ended March 31, 2010. General and administrative expenses, for thequarter ended March 31, 2010, include $0.7 million of professional servicesexpense for restructuring under the potential merger agreement with ScotiaWaterous signed February 23, 2010.

 

*Depreciation,depletion, amortization and accretion.*

 

Depreciation, depletion,amortization and accretion expense decreased $1.1 million for the three monthsended March 31, 2010 to $0.7 million, a 61% decrease compared to the threemonths ended March 31, 2009. The decrease was primarily due to a decreasein the capitalized basis in our full cost pool. On a Mcf basis, thedepreciation, depletion, amortization and accretion rate decreased to $1.20 perMcf in the three months ended March 31, 2010, from $2.25 per Mcf in thethree months ended March 31, 2009.

 

*Impairment.*

 

At March 31, 2010,the full cost ceiling limitation of our oil and gas properties exceeded thecapitalized cost by approximately $4.1 million based upon a natural gas priceof approximately $3.48 per Mcf (based on the first day of the month, twelvemonth average per Mcf on the Colorado Interstate Gas Rocky Mountain Index) ineffect at that date. Therefore, no impairment was taken for the quarter ended March 31,2010. An impairment of approximately $16.8 million was taken for the quarterended March 31, 2009.  For furtherinformation regarding this impairment, please see Note 2 — “Basis ofPresentation” in the Notes to the unaudited financial statements appearingelsewhere in this quarterly report. A decline in natural gas prices or anincrease in operating costs in economically recoverable quantities could resultin the recognition of additional impairments of our oil and gas properties infuture periods.

 

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**Liquidityand Capital Resources**

 

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

 

*Credit Facility.*

 

Effective February 12, 2007, we entered into acredit facility which permits borrowings up to the borrowing base as designatedby the administrative agent. As of March 31, 2010 and December 31,2009, we had $5.5 million and $6.1 million, respectively, of debt outstandingunder the facility. As described below, we are currently unable to borrowadditional amounts under the credit facility due to covenant limitations andmay be further limited in the future based on borrowing base limitations.

 

As of December 31, 2008, the borrowing base underthe credit facility was approximately $13.2 million. The borrowing base wassubject to automatic reductions of approximately $666,667 per month until itreached $10.5 million on April 1, 2009. As of April 14, 2009, ourborrowing base was reduced to $9.0 million, subject to automatic reductions of$500,000 per month until it reaches $6.5 million on October 1, 2009, whereit will remain until the next borrowing base redetermination. If natural gasprices do not improve, we expect that our borrowing base could be furtherreduced in the future.

 

The borrowing base is determined on a semi-annualbasis and at such other additional times, up to twice yearly, as may berequested by either us or the administrative agent and is determined by theadministrative agent in accordance with customary practices and standards forloans of a similar nature, although such determination is at the administrativeagent’s discretion as the credit agreement does not provide a specificborrowing base formula.

 

Borrowings under this credit facility may be usedsolely to acquire, explore or develop oil and gas properties and for generalcorporate purposes. The credit facility matures February 12, 2011.

 

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

 

Borrowings under our credit facility, as amended, bearinterest either: (i) at the greater of the one month London InterbankOffered Rate, or LIBOR, plus 1.00% or a domestic bank rate, plus in either casean applicable margin of 0.75% to 1.75% based on utilization, or (ii) on asliding scale from the one, two, three or six month LIBOR, plus an applicablemargin of 2.00% to 3.00% based on utilization. The weighted average interestrate as of March 31, 2010 was 5.0%. The credit agreement provides for various fees, including a quarterlycommitment fee of 0.5% per annum and engineering fees to the administrativeagent in connection with a borrowing base determination. In addition, thecredit facility provided for an up front fee of $27,000, which was paid on theclosing date of the credit facility, and an additional arrangement fee of 1%based on utilization. Borrowings under this credit facility may be prepaidwithout premium or penalty, except on Eurodollar advances.

 

The credit agreement, as amended, contains covenantsthat among other things restrict our ability (subject to certain exceptions) todo the following:

 

· incur liens;

 

· incur debt;

 

· make investments in other persons;

 

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· declare dividends or redeem or repurchase stock;

 

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

 

· enter into certain hedging arrangements;

 

· amend material contracts; and

 

· enter into related party transactions.

 

With regard to hedging arrangements, our creditagreement provides that acceptable commodity hedging arrangements cannot covergreater than 80 to 85%, depending on the measurement date, of our monthlyproduction from our hydrocarbon properties that are used in the borrowing basedetermination, and that the fixed or floor price of our hedging arrangementsmust be equal to or greater than the gas price used by the lenders indetermining the borrowing base.

 

The credit agreement, as amended, also requires thatwe satisfy certain affirmative covenants, meet certain financial tests,maintain certain financial ratios and make certain customary indemnificationsto lenders and the administrative agent. The financial covenants includerequirements to maintain: (i) a ratio of EBITDA to cash interest expense ofnot less than 3.00 to 1.00, (ii) a ratio of current assets to currentliabilities of not less than 1.00 to 1.00, (iii) a total debt toannualized EBITDA ratio of not more than 3.0 to 1.0, (iv) a quarterlytotal senior debt to annualized EBITDA ratio equal to or less than 3.0 to 1.0,and (v) a total proved PV-10 value to total debt ratio of at least 1.50 to1.00.

 

The credit agreement, as amended, contains customaryevents of default, including payment defaults, covenant defaults, certainevents of bankruptcy and insolvency, defaults in the payment of other materialdebt, judgment defaults, breaches of representations and warranties, loss ofmaterial permits and licenses and a change in control. The credit agreementrequires any wholly-owned subsidiaries to guarantee the obligations under thecredit agreement.

 

After an event of default, the outstanding debt bearsinterest at the default rate under the terms of the credit agreement. Thedefault rate is (i) with respect to principal, 2% over the otherwise applicablerate and (ii) with respect to interest, fees and other amounts, the BaseRate (as defined in the credit facility), plus the Applicable Margin (asdefined in the credit agreement), plus 2%. Any default interest is payable ondemand. Failure to pay the default interest when the administrative agentdemands would be another default. The lenders’ remedies for defaults under thecredit agreement are to terminate further borrowings, accelerate the repaymentof indebtedness and/or ultimately foreclose on the collateral property.

 

Effective August 4, 2008, we and theadministrative agent and lender entered into the second amendment to the creditagreement (the “second amendment”). The second amendment provided, among otherthings, for (i) an increase in the total quarterly senior debt toannualized EBITDA ratio from 2.0 to 1.0, to 3.0 to 1.0, (ii) an increasein interest at each utilization level for LIBOR borrowings, (iii) theamendment of the utilization calculation to be determined as the greater of (x) thepercentage of credit exposure over the borrowing base or (y) thepercentage of credit exposure over three times EBITDA minus permittedsubordinated debt, and (iv) the payment of an amendment fee.

 

Effective September 30, 2008, we and theadministrative agent and lender entered into the third amendment to the creditagreement (the “third amendment”). In addition to waiving compliance with thecurrent ratio covenant as of September 30, 2008, the third amendment,among other things, required that immediately prior to any additionalborrowings under the credit agreement, our ratio of current assets to currentliabilities be not less than 1.00 to 1.00. As a result of this new condition toadditional borrowings, we are currently unable to borrow additional amountsunder the credit agreement. The third amendment also increased the interestrate payable under the credit agreement to either (i) the greater of theone month LIBOR plus 1.00% or a domestic bank rate, plus in either case anapplicable margin of 0.75% to 1.75% based on utilization, or (ii) asliding scale from the one, two, three or six month LIBOR, plus an applicablemargin of 2.00% to 3.00% based on utilization, and provided for the payment ofan amendment fee.

 

On April 14,2009, we and the administrative agent entered into the fourth amendment to thecredit agreement which reduced the borrowing base as described above and waivedcompliance with the current ratio financial covenant as of December 31,2008 and March 31, 2009 and with the restrictive covenants related toaccounts payable, permitted liens and permitted debt until the current ratiofinancial covenant and next borrowing base redetermination, subject to certainfinancial 

 

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caps. On August 19,2009, the lenders waived compliance with the current ratio financial covenantunder the Credit Agreement for the period ending August 26, 2009 and thequarter ending June 30, 2009.

 

On August 26,2009, we entered into a fifth amendment to the credit agreement which provideda waiver of the current ratio covenant through October 26, 2009 and forthe quarter ending June 30, 2009. The fifth amendment to the credit agreementalso extended restrictive covenants related to accounts payable, permittedliens and permitted debt, until October 26, 2009, subject to certainfinancial caps.

 

On October 20,2009, we and the Lenders executed the sixth amendment to the credit agreement.This amendment established the borrowing base for the following amounts in thefollowing applicable periods:

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

 

Each Calendarmonth thereafter commencing May 1, 2010; the borrowing base for thepreceding calendar month reduced by $200,000.

 

On October 26,2009, the lenders provided a waiver effectively extending the terms of thefifth amendment to the credit agreement through November 16, 2009. On November 16,2009, the lenders provided an additional waiver effectively extending the termsof the fifth amendment to the credit agreement through November 23, 2009.

 

On November 23,2009, the lenders provided an additional waiver extending the terms of thefifth amendment to the credit agreement through December 1, 2009 and forthe quarter ended December 31, 2009.

 

On December 1,2009 the lenders provided an additional waiver extending the terms of the fifthamendment to the credit agreement through January 5, 2010.

 

On January 5,2010 the lenders provided an additional waiver extending the terms of the fifthamendment to the credit agreement through January 12, 2010.

 

On January 13,2010, we entered into a seventh amendment and waiver to credit agreement (“*waiver agreement*”) with the lenders partythereto. The waiver agreement provided that the lenders would waive (i) ourcompliance with certain restrictions based on the current ratio in the creditagreement, (ii) certain requirements pertaining to the aging of certainaccounts payable, and (iii) certain restrictions regarding the amount ofliens we have. Default remedies available to the lenders under the creditagreement include acceleration of all principal and interest amounts due underthe credit agreement. The waiver agreement extends the waiver period for theseitems until the earlier of June 15, 2010 and the date of any defaultarising out of a breach or non-compliance with the credit agreement notexpressly waived in the waiver agreement or a breach of the waiver agreement.

 

In addition, thewaiver agreement amends the definition of “Final Maturity Date” under thecredit agreement to the earlier of (i) June 15, 2010 or (ii) thedate that is thirty days following the earlier of (A) the date the mergeris withdrawn or terminated in whole or in part or (B) the date that thelenders have been advised that the merger will not proceed.

 

*OfficeBuilding Loan.*

 

On November 15, 2005, we entered into a mortgageloan secured by our office building in Sheridan, Wyoming in the aggregateprincipal amount of $829,000. The promissory note provides for monthly paymentsof principal and interest in the initial amount of $6,400, and unpaid principalthat bore interest at 6.875% until November 15, 2008, currently bearsinterest at a variable base rate plus 0.5% and will bear interest at 18% upon adefault. The variable base rate is based on the lender’s base rate. Thematurity date of this mortgage is November 15, 2015, at which time aprincipal and interest payment of $520,800 will become due. As of March 31,2010, we had $725,000 outstanding in principal on this mortgage. On November 15,2008, the interest rate on our mortgage loan changed from a fixed rate of6.875% to a variable rate. As of March 31, 2010, the variable rate was4.00%.

 

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*CapitalExpenditure Budget*.

 

The continuedcredit crisis and related turmoil in the global financial system have had anadverse impact on our business and financial condition. In addition, the pricesof oil and natural gas declined significantly in 2008 and remained low in 2009and the first quarter of 2010. Therefore, total capital expenditures werelimited to $4.2 million in 2009. As a result of low CIG index prices, theeconomic climate and our limited capital resources, we expect to continueoperating during 2010 with a reduced capital expenditure plan. Under our plan,we will generally make expenditures only as necessary to secure drillingpermits in strategic areas, drill wells that secure leasehold positions andconstruct the necessary infrastructure to complete and hook-up wells that havealready been drilled. Our capital expenditure budget for 2010 will be dependentupon CIG index prices, our cash flows and the availability of additionalcapital resources. We had total capital expenditures of $0.7 million for thethree months ended March 31, 2010.

 

***Cash Flow from Operating Activities***

 

Net cash providedby operating activities was $1.8 million for the three months ended March 31,2010, compared to $0.7 million for the three months ended March 31, 2009.The change was primarily due to an increase in accounts payable, an increase inaccrued liabilities, and an increase in revenue distribution payables.

 

***Cash Flow from Investing Activities***

 

Net cash used ininvesting activities was approximately $0.9 million for the three monthsended March 31, 2010, compared to net cash provided by operatingactivities of $49,000 for the three months ended March 31, 2009. Thechange in 2010 was primarily due to a realized loss on derivatives.

 

***CashFlow from Financing Activities***

 

Net cash used infinancing activities was $0.6 million for the three months ended March 31,2010, compared to $1.0 million for the three months ended March 31, 2009.The change in 2010 was primarily due to a reduction in the balance owed on theline of credit for the quarter ended March 31, 2010.

 

There have been noissuances of shares of common stock since our initial public offering except toemployees, executive officers and directors pursuant to our incentive stockplan.

 

***Contractual Obligations***

 

Please see Notes 3 and 7of the Notes to the unaudited financial statements appearing elsewhere in thisquarterly report for information regarding our credit facility and other indebtedness.

 

The following tablesummarizes by period our contractual obligations as of March 31, 2010:

 
| ** **                                               | ** ** | **Total**          | ** ** | **2010** | ** ** | **2011–2012** | ** ** | **2013–2014** | ** ** | **Thereafter** | ** ** |
|----------------------------------------------------------|------------|--------------------|------------|----------|------------|--------------------|------------|--------------------|------------|----------------|------------|
| ** **                                               | ** ** | **(In Thousands)** | ** ** |
| Notes  payable in connection with mortgage and equipment |       | $                  | 749        |     | $          | 31                 |       | $                  | 89         |           | $          | 76 |   | $ | 553 |   |
| Capital  lease                                           |       | 55                 |       | 11       |       | 34                 |       | 10                 |       | —         |       |
| Asset  retirement obligations                            |       | 2,959              |       | 710      |       | 752                |       | 395                |       | 1,102          |       |
| Production  and property taxes                           |       | 3,656              |       | 2,991    |       | 665                |       | —             |       | —         |       |
| Total                                                    |       | $                  | 7,419      |     | $          | 3,743              |       | $                  | 1,540      |           | $          | 481 |   | $ | 1,655 |   |

 

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

 

The primary objective ofthe following information is to provide forward-looking quantitative andqualitative information about our potential exposure to market risk. The term “marketrisk” refers to the risk of loss arising from adverse changes in natural gasprices or interest rates. This forward-looking information provides indicatorsof how we view and manage our ongoing market risk exposure. All of our marketrisk sensitive instruments were entered into for purposes other thanspeculative trading.

 

**Commodity Price Risk**

 

Our major market risk exposure is in the pricingapplicable to our natural gas production. The prices we receive for ourproduction depend on many factors beyond our control. We seek to reduce ourexposure to unfavorable changes in natural gas prices, which are subject tosignificant and often volatile fluctuation, through the use of fixed-pricecontracts. Our fixed-price contracts are comprised of energy swaps and collars.Fixed price contracts allow us to predict with greater certainty the effectivenatural gas prices to be received for hedged production and benefit operatingcash flows and earnings when market prices are less than the fixed pricesprovided by the contracts. However, we will not benefit from market prices thatare higher than the fixed prices in the contracts for hedged production. Collarstructures provide for participation in price increases and decreases to theextent of the ceiling prices and floors provided in those contracts. Withregard to hedging arrangements, our credit facility provides that acceptablecommodity hedging arrangements cannot cover greater than 80 to 85%, dependingon the measurement date, of our monthly production from our hydrocarbonproperties that are used in the borrowing base determination, and that thefixed or floor price of our hedging arrangements must be equal to or greaterthan the gas price used by the lenders in determining the borrowing base.

 

The following table summarizes the estimated volumes,fixed prices, fixed price sales and fair value attributable to the fixed pricecontracts as of March 31, 2010. At March 31, 2010, we had hedgedvolumes through December 2010. Please see Note 5 of the Notes to theunaudited financial statements appearing elsewhere in this quarterly report forfurther information regarding our derivatives.

 
| ** **                                       | ** ** | **Year Ending  December 31, 2010** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                       | ** ** | **(Unaudited)**                                   | ** ** |
| **Natural Gas Swaps:**                           |       |                                              |       |
| Contract  volumes (MMBtu)                        |       | 1,512,500                                         |       |
| Weighted-average  fixed price sales per MMBtu(1) |       | $                                                 | 4.98       |   |
| Fair  value, net (thousands)(2)                  |       | $                                                 | 1,513      |   |
| **Total Natural Gas Contracts:**                 |       |                                              |       |
| Contract  volumes (MMBtu)                        |       | 1,512,500                                         |       |
| Fixed-price  sales                               |       | $                                                 | 4.98       |   |
| Fair  value, net (thousands)(2)                  |       | $                                                 | 1,513      |   |

 

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(1)             Volumes hedged using the CIG index pricepublished in the first issue of Inside FERC’s Gas Market Report for each calendarmonth of the derivative transaction.

 

(2)             Fair value based on CIG index price ineffect for each month as of March 31, 2010.

 

**Interest Rate Risk**

 

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

 

As of March 31,2010, we had $5.5 million in outstanding indebtedness under our creditfacility. Borrowings under the credit facility bear interest either: (i) atthe greater of the one month LIBOR plus 1.00% or a domestic bank rate, plus ineither case an applicable margin of 0.75% to 1.75% based on utilization, or (ii) ona sliding scale from one, two, three, or six month LIBOR, plus an applicablemargin of 2.00% to 3.00% based on utilization. The weighted average interestrate for borrowings under our credit facility was 5.0% for the three monthsended March 31, 2010 and for the year ended December 31, 2009,respectively. In light of the current economic climate, we expect that interestrates on alternative financing options to range from 8% to 12%. Theavailability of alternative financing arrangements and the interest rates 

 

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thereof would depend onthe type of financing and our ability to restructure our current indebtnessoutstanding under our credit facility. Due to covenant restrictions in ourcredit facility, we are currently unable to borrow additional amounts.

 

A hypothetical change of1% in either the domestic bank rate or the LIBOR interest rates would increaseor decrease gross interest expense approximately $55,000 per year based on ouroutstanding indebtness at March 31, 2010.

 

**ITEM 4T. CONTROLS AND PROCEDURES**

 

**Disclosure Controls and Procedures**

 

Our principal executive officer and principalfinancial officer are responsible for establishing and maintaining adequatedisclose controls and procedures.  Basedon their evaluation as of the end of the period covered by this quarterlyreport, our principal executive officer and principal financial officer haveconcluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (theExchange Act)) are effective to ensure that information required to bedisclosed in reports that we file or submit under the Exchange Act arerecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms.

 

**Changes in Internal Control OverFinancial Reporting**

 

During the most recent fiscal quarter, there has beenno change in our internal control over financial reporting that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

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**PART II. OTHER INFORMATION**

 

**ITEM1. LEGAL PROCEEDINGS**

 

From time to time, we aresubject to legal proceedings and claims that arise in the ordinary course ofour business. While the outcome of these proceedings cannot be predicted withcertainty, we do not currently expect them to have a material adverse effect onthe financial statements.

 

There has been nomaterial developments during the quarter ended March 31, 2010 regardingour currently pending legal proceedings. For a discussion of certain of ourcurrent legal proceedings, please see Note 9 — “Commitments and Contingencies”of the Notes to the unaudited financial statements appearing elsewhere in thisquarterly report.

 

**ITEM1A. RISK FACTORS**

 

The followingdiscussion supplements or updates the risk factors set forth under the heading “RiskFactors” in our annual report on Form 10-K for the year ended December 31,2009.

 

***Due to the recentfinancial and credit crisis, we may not be able to obtain funding, or obtainfunding on acceptable terms, to meet our future capital needs, which couldnegatively affect our business, results of operations and financial condition.***

 

The continuedcredit crisis and the related turmoil in the global financial system have hadan adverse impact on our business and financial condition, and we may facemajor challenges if conditions in the financial markets do not improve.Currently, we are not able to borrow additional amounts under our creditfacility. As a result, we curtailed substantially all new drilling in 2009 andif our operating cash flow is not sufficient to carry out our drilling plansfor 2010, we will be required to reduce the number of wells we drill or seekalternative sources of financing. However, due to the financial crisis,financing through the capital markets or otherwise may not be available to uson acceptable terms or at all. If additional funding is not available, or isavailable only on unfavorable terms, we may be unable to implement our drillingplans, make capital expenditures, withstand a further downturn in our businessor the economy in general, or take advantage of business opportunities that mayarise. Any further curtailment of our operations would have an additionaladverse effect on our revenues and results of operations. In addition, currenteconomic conditions have led to reduced demand for, and lower prices of, oiland natural gas, and a sustained decline the price of natural gas wouldadversely affect our business, results of operations and financial condition.Please read “The volatility of natural gas and oil prices could have a materialadverse effect on our business” below. Further, the economic situation couldhave an impact on our lenders or customers, causing them to fail to meet theirobligations to us, and on the liquidity of our operating partners, resulting indelays in operations or their failure to make required payments. Also, marketconditions could have an impact on our natural gas and oil derivativestransactions if our counterparties are unable to perform their obligations orseek bankruptcy protection.

 

***Our contemplated mergeragreement may not be consummated.***

 

We have entered anAgreement and Plan of Merger, as further described in Note 10 in the notesto the unaudited financial statements herein and in the proxy statement filed April 2,2010. There can be no assurances that the contemplated merger transaction willoccur. If the merger is not consummated, we will continue to need additionalcapital to remain a going concern and successfully operate our business.

 

***Our credit facility has substantial restrictions andfinancial covenants that may affect our ability to successfully operate ourbusiness. In addition, we may have difficulty returning to compliance withcertain financial covenants.***

 

Our creditfacility imposes certain operational and financial restrictions on us. Theserestrictions, among other things, limit our ability to:

 

·                  incur additional indebtedness;

 

·                  create liens;

 

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

 

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·                  make investments and other restricted payments, including dividends;and

 

·                  engage in transactions with affiliates.

 

These limitationsare subject to a number of important qualifications and exceptions. Inaddition, our credit facility requires us to maintain certain financial ratiosand to satisfy certain financial conditions which may require us to reduce ourdebt or to take some other action in order to comply with them. These restrictionsin our credit facility could also limit our ability to obtain futurefinancings, make needed capital expenditures, withstand a downturn in ourbusiness or the economy in general, or otherwise conduct necessary corporateactivities. We also may be prevented from taking advantage of businessopportunities that arise because of the limitations imposed on us by therestrictive covenants under our credit facility.

 

We were not incompliance with the current ratio financial covenant and certain other covenantsrelated to accounts payable, permitted liens and permitted debt under ourcredit facility, and would be in default absent a waiver or amendment. On January 13,2010, the lenders waived compliance with the current ratio as of December 31,2009 through June 15, 2010, and with such other restrictive covenants,subject to certain financial caps. We have also not been in compliance withcertain financial covenants for the last seven quarters, but obtained waiversand/or amendments in each instance. In addition, the final maturity date of thefunds outstanding under our credit facility has accelerated to June 15,2010. As a result of such non-compliance, we are unable to borrow additionalfunds under our credit agreement.

 

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

 

**ITEM 2. UNREGISTERED SHARES OF EQUITYSECURITIES AND USE OF PROCEEDS**

 

Notapplicable.

 

**ITEM 3. DEFAULTS UPON SENIOR SECURITIES**

** **

Notapplicable.

 

**ITEM 4. SUBMISSION OF MATTERS TOA VOTE OF SECURITY HOLDERS**

 

Notapplicable.

 

**ITEM 5. OTHER INFORMATION**

 

Not applicable.

 

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**ITEM 6. EXHIBITS**

 
| **Exhibit****No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                              |
|--------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                |       | Amended and Restated  Agreement and Plan of Merger, dated as of February 23, 2010, among  Powder Holdings, LLC, Pinnacle Gas Resources, Inc. and Powder  Acquisition, Co. (incorporated by reference to Exhibit 2.1 to the  Current Report on Form 8-K (File No. 001-33457) filed by Pinnacle  Gas Resources, Inc. on February 26, 2010). |
| 3.1                | —     | Second Amended and Restated Certificate of  Incorporation of Pinnacle Gas Resources, Inc. (incorporated herein by  reference to Exhibit 3.1 to the Registration Statement on Form S-1  (File No. 333-133983) filed by Pinnacle Gas Resources, Inc. on  May 10, 2006).                                                                          |
| 3.2                | —     | Amended and Restated Bylaws of Pinnacle Gas  Resources, Inc. (incorporated herein by reference to Exhibit 3.2 to  the Registration Statement on Form S-1 (File No. 333-133983) filed  by Pinnacle Gas Resources, Inc. on May 10, 2006).                                                                                                        |
| 4.1                | —     | Amended and Restated Securityholders Agreement,  dated February 16, 2006 (incorporated herein by reference to  Exhibit 4.1 to the Registration Statement on Form S-1 (File  No. 333-133983) filed by Pinnacle Gas Resources, Inc. on  May 10, 2006).                                                                                           |
| 4.2                | —     | Registration Rights Agreement, dated April 11,  2006 (incorporated herein by reference to Exhibit 4.2 to the  Registration Statement on Form S-1 (File No. 333-133983) filed by  Pinnacle Gas Resources, Inc. on May 10, 2006).                                                                                                                |
| 10.21              | —     | Fourth Amendment to  Credit Agreement, dated as of April 14, 2009 (incorporated herein by  reference to Exhibit 10.21 to the Annual Report on Form 10-K (File  No. 001-33457) filed by Pinnacle Gas Resources, Inc. on  April 15, 2009).                                                                                                       |
| 10.22              |       | Waiver to Credit  Agreement, dated as of August 19, 2009 (incorporated herein by reference  to Exhibit 10.2 to the Quarterly Report on Form 10-Q filed by  Pinnacle Gas Resources on August 19, 2009).                                                                                                                                                   |
| 10.23              |       | Fifth Amendment to the  Credit Agreement, dated August 26, 2009 (incorporated herein by  reference to Exhibit 10.1 to the 8-K filed by Pinnacle Gas  Resources, Inc. on August 27, 2009).                                                                                                                                                                |
| 10.24              |       | Sixth Amendment to the  Credit Agreement, dated October 20, 2009 (incorporated herein by  reference to Exhibit 10.1 to the 8-K filed by Pinnacle Gas  Resources, Inc. on October 22, 2009).                                                                                                                                                              |
| 10.25              |       | Waiver and Amendment,  dated October 26, 2009 (incorporated herein by reference to  Exhibit 10.1 to the 8-K filed by Pinnacle Gas Resources, Inc. on  October 29, 2009).                                                                                                                                                                                 |
| 10.26              |       | Waiver and Amendment,  dated November 16, 2009 (incorporated herein by reference to  Exhibit 10.1 to the 8-K filed by Pinnacle Gas Resources, Inc. on  November 19, 2009).                                                                                                                                                                               |
| 10.27              |       | Waiver and Amendment,  dated November 23, 2009 (incorporated herein by reference to  Exhibit 10.1 to the 8-K filed by Pinnacle Gas Resources, Inc. on  November 23, 2009).                                                                                                                                                                               |
| 10.28              |       | Waiver and Agreement  dated as of January 5, 2010 (incorporated herein by reference to  Exhibit 10.1 to the 8-K filed by Pinnacle Gas Resources, Inc. on  January 8, 2010).                                                                                                                                                                              |
| 10.29              |       | Seventh Amendment and  Waiver to the Credit Agreement dated as of January 13, 2010  (incorporated herein by reference to Exhibit 10.1 to the 8-K filed by  Pinnacle Gas Resources, Inc. on January 19, 2010).                                                                                                                                            |
| *31.1              | —     | Certification of President and Chief Executive  Officer of Pinnacle Gas Resources, Inc. pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                |
| *31.2              | —     | Certification of Senior Vice President, Chief  Financial Officer and Secretary of Pinnacle Gas Resources, Inc. pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                         |
| *32.1              | —     | Certification of President and Chief Executive  Officer of Pinnacle Gas Resources, Inc. pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                           |
| *32.2              | —     | Certification of Senior Vice President, Chief  Financial Officer and Secretary of Pinnacle Gas Resources, Inc. pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002.                                                                                                                                    |

 

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*              Filedherewith

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|       | PINNACLE GAS RESOURCES, INC. |
|------------|------------------------------|
| ** ** | ** **                   |
|       | By:                          | /s/ Peter G.  Schoonmaker |
|       | Name:                        | Peter G. Schoonmaker |
|       | Title:                       | *President,  Chief Executive* |
| * *   | * *                     | *Officer  and Director* |
|       |                         | (Principal Executive  Officer) |
|       |                         |   |
|       | Date:                        | May 14, 2010 |
|       |                         |   |
|       | By:                          | /s/ Ronald T. Barnes |
|       | Name:                        | Ronald T. Barnes |
|       | Title:                       | *Senior  Vice President, Chief Financial* |
| * *   | * *                     | *Officer  and Secretary* |
|       |                         | (Principal Financial  Officer and |
|       |                         | Principal Accounting  Officer) |
|       |                         |   |
|       | Date:                        | May 14, 2010 |

 

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