UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-Q





(Mark
One)





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





FOR THE
QUARTERLY PERIOD ENDED SEPTEMBER 30, 2009





OR





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





FOR THE
TRANSITION PERIOD FROM ____________ TO ____________





COMMISSION
FILE NUMBER: 333-134568





PEGASI ENERGY RESOURCES
CORPORATION


(Exact
name of registrant as specified in its charter)





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





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





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





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





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





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





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





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





There
were 33,610,801 shares of the registrant's common stock outstanding as of
November 11, 2009.











1








PEGASI
ENERGY RESOURCES CORPORATION


CONSOLIDATED
FINANCIAL STATEMENTS


FOR
THE QUARTER ENDED SEPTEMBER 30, 2009





TABLE
OF CONTENTS





PagePART
      I - FINANCIAL INFORMATIONItem
      1. Financial Statements
            3Item
      2. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
            11Item
      3. Quantitative and Qualitative Disclosures About Market
    Risk
            17Item
      4T. Controls and Procedures
            17PART
      II - OTHER INFORMATIONItem
      1. Legal Proceedings
            18Item
      1A. Risk Factors
            18Item
      2. Unregistered Sales of Equity Securities and Use of
    Proceeds
            18Item
      3. Defaults Upon Senior Securities
            18Item
      4. Submission of Matters to a Vote of Security Holders
            18Item
      5. Other Information
            18Item
      6. Exhibits
            18SIGNATURES
            19








2







PART
I - FINANCIAL INFORMATION





Item
1. Financial Statements.


PEGASI ENERGY
RESOURCES CORPORATION


CONSOLIDATED
BALANCE SHEETS





September
      30,
            
            
            December
      31,2009
            
            
            2008(Unaudited)AssetsCurrent
      assets:Cash
      and cash equivalents
            
            $
            104,764
            
            
            $
            792,255Accounts
      receivable, trade
            
            
            108,654
            
            
            
            249,651Accounts
      receivable, related parties
            
            
            36,256
            
            
            
            69,408Joint-interest
      billings receivable, related parties, net
            
            
            7,825
            
            
            
            58,249Other
      current assets
            
            
            271,643
            
            
            
            166,972Total
      current assets
            
            
            529,142
            
            
            
            1,336,535Property
      and equipment:Equipment
            
            
            597,145
            
            
            
            573,188Pipelines
            
            
            701,806
            
            
            
            701,806Buildings
            
            
            19,916
            
            
            
            19,916Leasehold
      improvements
            
            
            7,022
            
            
            
            7,022Vehicles
            
            
            50,663
            
            
            
            50,663Office
      furniture
            
            
            136,040
            
            
            
            134,407Website
            
            
            15,000
            
            
            
            15,000Total
      property and equipment
            
            
            1,527,592
            
            
            
            1,502,002Less
      accumulated depreciation
            
            
            (478,314
            )
            
            
            (368,878
            )Property
      and equipment, net
            
            
            1,049,278
            
            
            
            1,133,124Oil
      and gas properties:Oil
      and gas properties, proved
            
            
            11,926,381
            
            
            
            11,905,413Oil
      and gas properties, unproved
            
            
            9,087,170
            
            
            
            8,714,577Capitalized
      asset retirement obligations
            
            
            220,237
            
            
            
            220,237Total
      oil and gas properties
            
            
            21,233,788
            
            
            
            20,840,227Less
      accumulated depletion and depreciation
            
            
            (877,798
            )
            
            
            (806,303
            )Oil
      and gas properties, net
            
            
            20,355,990
            
            
            
            20,033,924Total
      assets
            
            $
            21,934,410
            
            
            $
            22,503,583











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




3


PEGASI
ENERGY RESOURCES CORPORATION


CONSOLIDATED
BALANCE SHEETS (CONTINUED)







September
      30,
            
            
            December
      31,2009
            
            
            2008(Unaudited)Liabilities
      and Stockholders' EquityCurrent
      liabilities:Accounts
      payable
            
            $
            115,183
            
            
            $
            202,710Accounts
      payable, related parties
            
            
            831,247
            
            
            
            684,996Revenues
      payable
            
            
            116,224
            
            
            
            194,560Interest
      payable, related party
            
            
            717,878
            
            
            
            385,160Liquidated
      damages payable
            
            
            136,957
            
            
            
            121,579Other
      payables
            
            
            43,092
            
            
            
            54,061Current
      portion of notes payable
            
            
            6,655
            
            
            
            6,575Current
      portion of notes payable, related party
            
            
            5,952,303
            
            
            
            -Total
      current liabilities
            
            
            7,919,539
            
            
            
            1,649,641Notes
      payable
            
            
            6,403
            
            
            
            11,387Notes
      payable, related party
            
            
            -
            
            
            
            4,857,303Asset
      retirement obligations
            
            
            296,060
            
            
            
            283,307Total
      liabilities
            
            
            8,222,002
            
            
            
            6,801,638Commitments
      and contingencies (Note 5)Stockholders'
      equity:Common
      stock; $0.001 par value; 75,000,000 shares authorized;33,610,801
      shares issued and outstandingat
      September 30, 2009 and December 31, 2008
            
            
            33,611
            
            
            
            33,611Additional
      paid-in capital
            
            
            19,673,102
            
            
            
            19,673,102Accumulated
      deficit
            
            
            (5,994,305
            )
            
            
            (4,004,768
            )Total
      stockholders' equity
            
            
            13,712,408
            
            
            
            15,701,945Total
      liabilities and stockholders' equity
            
            $
            21,934,410
            
            
            $
            22,503,583








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




4





PEGASI
ENERGY RESOURCES CORPORATION


CONSOLIDATED
STATEMENTS OF OPERATIONS


(UNAUDITED)





Three Months Ended September 30,
            
            
            Nine
      Months Ended September 30,2009
            
            
            2008
            
            
            2009
            
            
            2008Revenues:Oil
      and gas
            
            $
            141,392
            
            
            $
            491,511
            
            
            $
            387,648
            
            
            $
            1,039,414Condensate
      and skim oil
            
            
            25,469
            
            
            
            88,282
            
            
            
            66,292
            
            
            
            188,347Transportation
      and gathering
            
            
            50,443
            
            
            
            306,652
            
            
            
            187,103
            
            
            
            746,037Saltwater
      disposal income
            
            
            26,368
            
            
            
            63,700
            
            
            
            122,943
            
            
            
            153,703Total
      revenues
            
            
            243,672
            
            
            
            950,145
            
            
            
            763,986
            
            
            
            2,127,501Operating
      expenses:Lease
      operating expenses
            
            
            76,030
            
            
            
            77,508
            
            
            
            282,583
            
            
            
            146,623Saltwater
      disposal expenses
            
            
            38,677
            
            
            
            58,974
            
            
            
            178,950
            
            
            
            159,560Pipeline
      operating expenses
            
            
            16,344
            
            
            
            23,435
            
            
            
            62,632
            
            
            
            123,681Cost of gas
      purchased for resale
            
            
            28,022
            
            
            
            252,463
            
            
            
            114,249
            
            
            
            632,807Depletion
      and depreciation
            
            
            59,039
            
            
            
            2,074
            
            
            
            180,931
            
            
            
            128,045General
      and administrative
            
            
            447,131
            
            
            
            657,740
            
            
            
            1,587,420
            
            
            
            1,996,526Total
      operating expenses
            
            
            665,243
            
            
            
            1,072,194
            
            
            
            2,406,765
            
            
            
            3,187,242Loss
      from operations
            
            
            (421,571
            )
            
            
            (122,049
            )
            
            
            (1,642,779
            )
            
            
            (1,059,741
            )Other
      income (expenses):Interest
      income
            
            
            396
            
            
            
            9,161
            
            
            
            2,223
            
            
            
            73,026Interest
      expense
            
            
            (118,521
            )
            
            
            (98,423
            )
            
            
            (333,941
            )
            
            
            (293,421
            )Liquidated
      damages
            
            
            (5,126
            )
            
            
            185,059
            
            
            
            (15,378
            )
            
            
            34,303Other
      income
            
            
            43
            
            
            
            49,163
            
            
            
            708
            
            
            
            58,342Total
      other income (expenses)
            
            
            (123,208
            )
            
            
            144,960
            
            
            
            (346,388
            )
            
            
            (127,750
            )Income
      (loss) before income tax expense
            
            
            (544,779
            )
            
            
            22,911
            
            
            
            (1,989,167
            )
            
            
            (1,187,491
            )Income
      tax expense
            
            
            -
            
            
            
            (27,613
            )
            
            
            (370
            )
            
            
            (90,365
            )Net
      loss
            
            $
            (544,779
            )
            
            $
            (4,702
            )
            
            $
            (1,989,537
            )
            
            $
            (1,277,856
            )Basic
      and diluted loss per share
            
            $
            (0.02
            )
            
            $
            -
            
            
            $
            (0.06
            )
            
            $
            (0.04
            )Weighted
      average shares outstanding
            
            
            33,610,801
            
            
            
            29,385,912
            
            
            
            33,610,801
            
            
            
            29,378,459








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




5








PEGASI
ENERGY RESOURCES CORPORATION


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(UNAUDITED)










Nine
      Months Ended September 30,2009
            
            
            2008Operating
      ActivitiesNet
      loss
            
            $
            (1,989,537
            )
            
            $
            (1,277,856
            )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depletion
      and depreciation
            
            
            180,931
            
            
            
            128,045Accretion
      of discount on asset retirement obligations
            
            
            12,753
            
            
            
            7,855Stock
      issued for legal services
            
            
            -
            
            
            
            77,000Deferred
      income taxes
            
            
            -
            
            
            
            71,624Liquidated
      damages
            
            
            15,378
            
            
            
            (34,304
            )Other
      income
            
            
            -
            
            
            
            (112,754
            )Changes
      in operating assets and liabilities:Accounts
      receivable, trade
            
            
            140,997
            
            
            
            (253,777
            )Accounts
      receivable, related parties
            
            
            33,152
            
            
            
            44,433Joint-interest
      billings receivable, related parties, net
            
            
            50,424
            
            
            
            (123,420
            )Other
      current assets
            
            
            (104,671
            )
            
            
            130,686Accounts
      payable
            
            
            (87,527
            )
            
            
            (738,243
            )Accounts
      payable, related parties
            
            
            166,251
            
            
            
            128,481Revenues
      payable
            
            
            (78,336
            )
            
            
            219,341Interest
      payable, related party
            
            
            332,718
            
            
            
            14,738Other
      payables
            
            
            (10,969
            )
            
            
            205,325Joint-interest
      deposits, related parties
            
            
            -
            
            
            
            (849,619
            )Net
      cash used in operating activities
            
            
            (1,338,436
            )
            
            
            (2,362,445
            )Investing
      ActivitiesPurchases
      of property and equipment
            
            
            (25,590
            )
            
            
            (521,548
            )Purchases
      of oil and gas properties
            
            
            (393,561
            )
            
            
            (3,966,560
            )Net
      cash used in investing activities
            
            
            (419,151
            )
            
            
            (4,488,108
            )Financing
      ActivitiesPayments
      on notes payable
            
            
            (4,904
            )
            
            
            (3,121
            )Proceeds
      from borrowing on notes payable, related party
            
            
            1,075,000
            
            
            
            -Payments
      on notes payable, related party
            
            
            -
            
            
            
            (742,544
            )Payments
      for cancelled shares of common stock1
            
            
            -
            
            
            
            (6,903
            )Net
      cash provided by (used in) financing activities
            
            
            1,070,096
            
            
            
            (752,568
            )Net
      decrease in cash and cash equivalents
            
            
            (687,491
            )
            
            
            (7,603,121
            )Cash
      and cash equivalents at beginning of period
            
            
            792,255
            
            
            
            8,935,283Cash
      and cash equivalents at end of period
            
            $
            104,764
            
            
            $
            1,332,162Supplemental
      Disclosure of Cash Flow InformationCash
      paid during the period for interest
            
            $
            1,223
            
            
            $
            278,68312,681 net shares of common stock were cancelled by investors during
      the nine months
              ended
      September 30, 2008.








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




6




PEGASI
ENERGY RESOURCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 SEPTEMBER
30, 2009 AND 2008


1.  NATURE
OF OPERATIONS





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





2.  SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES





a)  Basis of
Presentation





The
accompanying unaudited interim consolidated financial statements of PERC have
been prepared in accordance with accounting principles generally accepted
(“GAAP”) in the United States of America and the rules of the Securities and
Exchange Commission (the “SEC”), and should be read in conjunction with PERC’s
audited consolidated financial statements for the year ended December 31,
2008, and notes thereto, which are included in the Company’s annual report on
Form 10-K filed with the SEC on March 31, 2009.  In the opinion of
management, all adjustments, consisting of normal recurring adjustments,
necessary for a fair presentation of the Company’s consolidated financial
position and the consolidated results of operations for the interim periods
presented have been reflected herein.  The consolidated results of
operations for interim periods are not necessarily indicative of the results to
be expected for the full year.  The notes to consolidated financial
statements, which would substantially duplicate the disclosures required in the
Company’s 2008 annual consolidated financial statements, have been
omitted.





b)  New
Accounting Pronouncements





In July
2009, the Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standards (“SFAS”) No. 168, The FASB Accounting Standards
Codification and the Hierarchy of Generally Accepted Accounting
Principles, which replaces SFAS No, 162, The Hierarchy of Generally Accepted
Accounting Principles.  As of September 15, 2009, the date that
SFAS No. 168 became effective, the new name for this standard is, FASB
Accounting Standards Codification (“ASC”) Topic 105, Generally Accepted Accounting
Principles.  FASB ASC Topic 105 establishes The FASB Accounting Standards
Codification (the “Codification”) as the source of authoritative U.S.
GAAP.  Now that the Codification is in effect, all of its content
carries the same level of authority.  FASB ASC Topic 105 became
effective September 15, 2009.  The FASB does not expect that FASB ASC
Topic 105 will result in a change in current practice, and the Company does not
believe that FASB ASC Topic 105 will have an impact on its consolidated
operating results, financial position or cash flows.





On
December 31, 2008, the SEC issued Modernization of Oil and Gas
Reporting updating its oil and gas reporting requirements. Many of the
revisions are updates to definitions in the existing oil and gas rules to make
them consistent with the petroleum resource management system, which is a widely
accepted standard for the management of petroleum resources that was developed
by several industry organizations. Key revisions include changes to the pricing
used to estimate reserves utilizing a 12-month average price rather than a
single day spot price which eliminates the ability to utilize subsequent prices
to the end of a reporting period when the full-cost ceiling was exceeded and
subsequent pricing exceeds pricing at the end of a reporting period, the ability
to include nontraditional resources in reserves, the use of new technology for
determining reserves, and permitting disclosure of probable and possible
reserves. The SEC will require companies to comply with the amended disclosure
requirements for registration statements filed after January 1, 2010, and
for annual reports on Form 10-K for fiscal years ending on or after
December 15, 2009. Early adoption is not permitted. The Company is
currently assessing the impact that the adoption will have on the Company’s
disclosures, consolidated operating results, financial position and cash
flows.





Effective
in the prior quarter, the Company implemented SFAS No. 165, Subsequent
Events.  As of September 15, 2009, the date that FASB ASC Topic
105 became effective, the new name for SFAS No. 165 is, FASB ASC Topic 855,Subsequent
Events.  This standard establishes general standards of
accounting for and disclosure of events that occur after the balance sheet date
but before financial statements are issued. The adoption of FASB ASC Topic 855
did not impact the Company’s consolidated financial position or results of
operations.  The Company evaluated all events or transactions that
occurred after September 30, 2009 up through November 12, 2009, the date
the Company issued the accompanying consolidated financial statements. 
During this period, the Company did not have any material recognizable
subsequent events, other than the amendments to the notes payable, related party
and the new line of credit agreement with Teton, Ltd. (“Teton”) effective
October 14, 2009 (see Note 6).





c)  Reclassifications





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








7





PEGASI
ENERGY RESOURCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 SEPTEMBER
30, 2009 AND 2008


3.  NOTES
PAYABLE, RELATED PARTY





Notes
payable, related party consisted of the following at:





September
      30,
              2009
            
            
            December 31,
      2008Original
      note payable dated May 21, 2007 to Teton (the “Teton
      Note”).  Additional funds added by  amendments three,
      four and five to the note result in an outstanding balance of $5,952,303,
      including interest at 8%, with an interest payment due on October 21, 2009
      for the period from the date of the note, with all remaining interest and
      principal due on the maturity date of May 21, 2010.
            
            $
            5,952,303
            
            
            $
            4,857,303Total
      notes payable, related party
            
            
            5,952,303
            
            
            
            4,857,303Less
      current portion
            
            
            (5,952,303
            )
            
            
            -Total
      long-term notes payable, related party
            
            $
            -
            
            
            $
            4,857,303




In
September 2009, the fifth amendment to the Teton Note, dated May 21, 2007, was
executed.  The amendment defers the September 21, 2009 interest
payment on the Teton Note to October 21, 2009.   In addition, the
amendment added $175,000 of additional funds to the outstanding balance of the
Teton Note.  In May 2009, the third and fourth amendments to the Teton
Note were executed.  The third amendment deferred the May 21, 2009
interest payment to September 21, 2009 and the fourth amendment added $350,000
of additional funds to the outstanding balance of the Teton Note.  On
March 3, 2009, a “Second Amendment to Renewal Promissory Note and Loan
Modification Agreement” (the “Second Amendment”) was executed, which amended the
Teton Note.  This agreement added $550,000 of additional cash proceeds
and $20,000 of advances payable to the outstanding balance of the Teton Note and
pledged substantially all of the Company’s assets to secure repayment of the
note.  On May 1, 2007, a “Memorandum of Understanding” was executed to
grant Teton the right to convert the outstanding balance on the note into shares
of PERC’s common stock at a fixed conversion price of $1.20 per share. The
Second Amendment confirmed that the fixed conversion price of $1.20 per share
would remain for the portion of the note payable balance that existed prior its
execution, and a fixed conversion price of $1.60 was agreed upon for conversion
of the additional funds. Teton has the right, but not the obligation to convert
all or a portion of the indebtedness at any time after May 1, 2008, unless the
debt is repaid before such date. This option will continue in existence as long
as any balance remains outstanding on the note.




8


PEGASI
ENERGY RESOURCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 SEPTEMBER
30, 2009 AND 2008


4.  SEGMENT
INFORMATION





The
following information is presented in accordance with FASB ASC Topic 280, Segment
Reporting.  The Company is engaged in oil and gas exploration
and production, saltwater disposal and pipeline transportation.  PERC
is engaged in the exploration and production of natural gas and
oil.  Pegasi Operating, Inc. (“POI”), a wholly-owned subsidiary of
PERC, conducts the exploration and production operations.  TR Rodessa,
Inc. (“TR Rodessa”) operates a 40-mile gas pipeline and gathering system which
is used to transport hydrocarbons to market to be sold.  59 Disposal,
Inc. (“59 Disposal”) operates a saltwater disposal facility which disposes
saltwater and flow-back waste into subsurface
storage  and  also  sells  the  skim  oil  it  separates  from  the  saltwater.  The
Company identified such segments based on management responsibility and the
nature of their products, services, and costs.  There are no major
distinctions in geographical areas served as all operations are in the United
States.  The Company measures segment profit (loss) as income (loss)
from operations.  Business segment assets are those assets controlled
by each reportable segment.  The following table sets forth certain
information about the financial information of each segment as of September 30,
2009 and December 31, 2008 and for the three and nine months ended September 30,
2009 and 2008:





Three
      Months Ended
              September
      30,
              2009
            
            
            Three
      Months Ended
              September
      30,
              2008
            
            
            Nine
      Months Ended
              September
      30,
              2009
            
            
            Nine
      Months Ended
              September
      30,
              2008Business
      segment revenue:Oil
      and gas
            
            $
            141,392
            
            
            $
            491,511
            
            
            $
            387,648
            
            
            $
            1,039,414Condensate
      and skim oil
            
            
            25,469
            
            
            
            88,282
            
            
            
            66,292
            
            
            
            188,347Transportation
      and gathering
            
            
            50,443
            
            
            
            306,652
            
            
            
            187,103
            
            
            
            746,037Saltwater
      disposal income
            
            
            26,368
            
            
            
            63,700
            
            
            
            122,943
            
            
            
            153,703Total
      revenues
            
            $
            243,672
            
            
            $
            950,145
            
            
            $
            763,986
            
            
            $
            2,127,501Business
      segment profit (loss):Oil
      and gas
            
            $
            (6,677
            )
            
            $
            261,194
            
            
            $
            (287,562
            )
            
            $
            348,995Condensate
      and skim oil
            
            
            25,469
            
            
            
            88,282
            
            
            
            66,292
            
            
            
            188,347Transportation
      and gathering
            
            
            (3,725
            )
            
            
            22,011
            
            
            
            (28,044
            )
            
            
            (56,208
            )Saltwater
      disposal
            
            
            (35,595
            )
            
            
            (26,261
            )
            
            
            (131,248
            )
            
            
            (91,019
            )General
      corporate
            
            
            (401,043
            )
            
            
            (467,275
            )
            
            
            (1,262,217
            )
            
            
            (1,449,856
            )Loss
      from operations
            
            $
            (421,571
            )
            
            $
            (122,049
            )
            
            $
            (1,642,779
            )
            
            $
            (1,059,741
            )Depletion
      and depreciation:Oil
      and gas
            
            $
            25,307
            
            
            $
            (25,345
            )
            
            $
            80,294
            
            
            $
            27,724Transportation
      and gathering
            
            
            7,599
            
            
            
            (815
            )
            
            
            22,797
            
            
            
            17,085Saltwater
      disposal
            
            
            16,996
            
            
            
            20,660
            
            
            
            50,465
            
            
            
            61,162General
      corporate
            
            
            9,137
            
            
            
            7,574
            
            
            
            27,375
            
            
            
            22,074Total
      depletion and depreciation
            
            $
            59,039
            
            
            $
            2,074
            
            
            $
            180,931
            
            
            $
            128,045





9




PEGASI
ENERGY RESOURCES CORPORATION
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 SEPTEMBER
30, 2009 AND 2008


4.  SEGMENT
INFORMATION (CONTINUED)





Nine
      Months Ended
                September
      30,
                2009
              
              
              Nine
      Months Ended
                September
      30,
                2008Capital
      expenditures:Oil
      and gas
              
              $
              393,561
              
              
              $
              3,966,560Transportation
      and gathering
              
              
              -
              
              
              
              427,370Saltwater
      disposal
              
              
              23,197
              
              
              
              15,061General
      corporate
              
              
              2,393
              
              
              
              79,117Total
      capital expenditures
              
              $
              419,151
              
              
              $
              4,488,108
  September
      30,
              
              
              December
      31,2009
              
              
              
              2008Business
      segment assets:Oil
      and gas
              
              $
              20,628,354
              
              
              $
              20,921,001Transportation
      and gathering
              
              
              642,425
              
              
              
              773,767Saltwater
      disposal
              
              
              303,660
              
              
              
              344,113General
      corporate
              
              
              359,971
              
              
              
              464,702Total
      assets
              
              $
              21,934,410
              
              
              $
              22,503,583





5.
COMMITMENTS AND CONTINGENCIES





Along
with the Company's counsel, management monitors developments related
to legal matters and, when appropriate, makes adjustments to record liabilities
to reflect current facts and circumstances.  Management has recorded a
liability related to its registration rights agreement with investors that
provides for the filing of a registration statement for the registration of the
shares issued in the offering in December 2007, as well as the shares issuable
upon exercise of related warrants.  The Company failed to meet the
deadline for the effectiveness of the registration statement and therefore was
required to pay liquidated damages of approximately $100,000 on the first day of
effectiveness failure, or July 18, 2008.  An additional $100,000
penalty was required to be paid by the Company every thirty days thereafter,
prorated for periods totaling less than thirty days, until the effectiveness
failure was cured, up to a maximum of 18% of the aggregate purchase price, or
approximately $1,800,000.  The Company’s registration became effective
on August 21, 2008.  At September 30, 2009, management reevaluated the
status of the registration statement and determined an accrual of $136,957 was
sufficient to cover any potential payments for liquidated
damages.  The damages are reflected as liquidated damages payable of
$136,957 and $121,579 in the accompanying consolidated balance sheets as of
September 30, 2009 and December 31, 2008, respectively.





6.  SUBSEQUENT
EVENTS





Effective
October 21, 2009, a sixth amendment to the Teton Note was executed, which
deferred the October 21, 2009 interest payment on the note to February 21,
2010.  The final maturity date of the Teton Note is unchanged and
remains May 21, 2010. In addition, effective October 14, 2009, the Company
entered into a $1.0 million line of credit agreement with Teton with interest of
6.25% per year.  Quarterly payments of all accrued interest will be
payable on January 1, 2010, April 1, 2010, July 1, 2010, and October 1,
2010.  Principal shall be the sum of all advances made to the Company
and is due and payable on October 14, 2010.





Management
has evaluated and disclosed subsequent events up to and including November 12,
2009 which is the date the accompanying consolidated financial statements were
available for issuance.





7.  FAIR VALUE OF FINANCIAL
INSTRUMENTS





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




10




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





Forward
Looking Statements





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





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





Company
Overview





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





Our
business strategy, which we designated as the “Cornerstone Project”, is to
identify and exploit resources in and adjacent to existing or indicated
producing areas within the Rodessa field area. We intend to quickly develop and
produce reserves at a low cost and will take an aggressive approach to
exploiting our contiguous acreage position through utilization of “best in
class” drilling, (i.e. using the latest drilling techniques available and
seismic technology).  We believe that we are uniquely familiar with
the history and geology of the Cornerstone Project area based on our collective
experience in the region as well as through our ownership of a large proprietary
database which details the drilling history of the Cornerstone Project area over
the previous 29 years.  We believe implementing our drilling strategy
and using new drilling and completion techniques will enable us to find
significant gas and oil reserves in the Cornerstone Project area.





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





TR
Rodessa owns an 80% undivided interest in and operates a 40-mile natural gas
pipeline and gathering system which we currently use to transport our
hydrocarbons to market.  Excess capacity on this system is used to
transport third-party hydrocarbons.  TR Rodessa expanded the capacity
of its system through the construction of a new 9,238 foot 8” trunkline in 2008.
A total in excess of one mile of 4” laterals were constructed to the Childers
#2, Harris #2, Huntington #4 and Childers # 3 well sites. These gathering lines
have been tied into the central gathering point at the Huntington
location.





59
Disposal owns an 80% undivided interest in and operates a saltwater disposal
facility which disposes saltwater and flow-back waste into subsurface
storage.





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





11





Plan
of Operations





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





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





Our oil
and gas assets are located in Cass and Marion counties in northeast
Texas.  As of September 30, 2009, we operated nine
wells.  In addition, we are actively maintaining our producing wells
with necessary workover procedures, however, no workovers were conducted in the
third quarter beyond normal maintenance.





As of
September 30, 2009, our leasehold position is approximately 21,000 gross acres
and 14,000 net acres.  We have an 80% working interest in the
acreage.  We continue to maintain our acreage position by having an
ongoing leasing program whereby expiring leases are being renewed and previously
unleased acreage is being leased.





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





In
January 2009, we engaged an exclusive financial advisor to assist us in securing
additional capital.  In conjunction with our financial advisor and our
management team, we have aggressively contacted many potential investors both
within the industry and institutional investors.  We have had
discussions with several potential investors, which, if successful, could result
in drilling opportunities on our leaseholds in the near
future.  However, we currently do not have any contracts or
commitments for funding and there are no guarantees that we will be able to
raise funds on terms acceptable to us, if any at all.





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





12





Results
of Operations





Three Months Ended September
30, 2009 Compared to Three Months Ended September 30, 2008.





Summarized Results of Operations





2009
            
            
            2008
            
            
            Increase
              (Decrease)Total
      revenues
            
            $
            243,672
            
            
            $
            950,145
            
            
            $
            (706,473
            )Total
      operating expenses
            
            
            665,243
            
            
            
            1,072,194
            
            
            
            (406,951
            )Loss
      from operations
            
            
            (421,571
            )
            
            
            (122,049
            )
            
            
            299,522Total
      other income (expenses)
            
            
            (123,208
            )
            
            
            144,960
            
            
            
            (268,168
            )Income
      (loss) before income tax expense
            
            
            (544,779
            )
            
            
            22,911
            
            
            
            (567,690
            )Income
      tax expense
            
            
            -
            
            
            
            (27,613
            )
            
            
            (27,613
            )Net
      loss
            
            $
            (544,779
            )
            
            $
            (4,702
            )
            
            $
            540,077





Revenues:  Total
revenues for the three months ended September 30, 2009 totaled $243,672,
compared to $950,145 for the three months ended September 30,
2008.  Production revenues of oil and gas decreased $350,119 to
$141,392 for the three months ended September 30, 2009 compared to $491,511 for
the three months ended September 30, 2008.  The decrease in production
revenues reflects the impact of a drop in sales prices for natural gas of about
72% and oil of about 45%.  Transportation and gathering revenue
decreased $256,209 to $50,443 for the three months ended September 30, 2009,
compared to $306,652 for the three months ended September 30, 2008 due to the
drop in sales price for natural gas.





Expenses:  Total
operating expenses for the three months ended September 30, 2009 were $665,243,
compared to $1,072,194 for the three months ended September 30,
2008.  This decrease is comprised of decreases in cost of gas
purchased for resale and general and administrative expenses offset by an
increase in depletion and depreciation.





·
            Depletion and
      Depreciation:The $56,965 increase in depletion and
      depreciation to $59,039 for the three months ended September 30, 2009 from
      $2,074 for the three months ended September 30, 2008 was primarily due to
      a correction made to the depletion calculation in the third quarter of
      2008.  The adjustment was for the first three quarters of 2008
      and related to using the undiscounted estimated future expenditures
      instead of the discounted estimated future expenditures in the
      calculation. The remaining difference was due to the addition of equipment
      and a pipeline in 2009 resulting in higher
  depreciation.





·
            General and Administrative
      Expense:  The $210,609 decrease in general and
      administrative expense to $447,131 for the three months ended September
      30, 2009 from $657,740 for the three months ended September 30, 2008 was
      primarily due to decreased audit and accounting fees.   The
      large part of the audit and accounting fees decrease is due to work
      performed during 2008 related to the 2007 10-K and S-1 registration
      statement preparation.





·
            Cost of Gas Purchased for
      Resale:The $224,441 decrease in cost of gas purchased
      for resale to $28,022 for the three months ended September 30, 2009 from
      $252,463 for the three months ended September 30, 2008 was due to a drop
      in the purchase price for natural gas purchased from
      operators.





Other Income
(Expenses):Total other expenses for the three months ended
September 30, 2009 were $123,208, compared to $144,960 of other income for the
three months ended September 30, 2008.  The primary reason for this
$268,168 increase was due to an over accrual in 2008 of liquidated damages
expense that was corrected in the third quarter of 2008.





Income Tax
Expense:For the three months ended September 30, 2009, we
recognized no income tax expense compared to income tax expense of $27,613 in
the third quarter of 2008.  The $27,613 decrease is due to our
position that we are not likely to realize our deferred tax assets or
liabilities, and therefore, a valuation allowance was recorded to offset these
amounts.





Operating Loss:As
a result of the above described revenues and expenses, we incurred a net
operating loss of $544,779 for the three months ended September 30, 2009 as
compared to a net operating loss of $4,702 for the three months ended September
30, 2008.








13














Nine Months Ended September
30, 2009 Compared to Nine Months Ended September 30, 2008.





Summarized
Results of Operations





2009
            
            
            2008
            
            
            Increase
              (Decrease)Total
      revenues
            
            $
            763,986
            
            
            $
            2,127,501
            
            
            $
            (1,363,515
            )Total
      operating expenses
            
            
            2,406,765
            
            
            
            3,187,242
            
            
            
            (780,477
            )Loss
      from operations
            
            
            (1,642,779
            )
            
            
            (1,059,741
            )
            
            
            583,038Total
      other expenses
            
            
            (346,388
            )
            
            
            (127,750
            )
            
            
            218,638Loss
      before income tax expense
            
            
            (1,989,167
            )
            
            
            (1,187,491
            )
            
            
            801,676Income
      tax expense
            
            
            (370
            )
            
            
            (90,365
            )
            
            
            (89,995
            )Net
      loss
            
            $
            (1,989,537
            )
            
            $
            (1,277,856
            )
            
            $
            711,681





Revenues:  Total
revenues for the nine months ended September 30, 2009 totaled $763,986, compared
to $2,127,501 for the nine months ended September 30,
2008.  Production revenues of oil and gas decreased $651,766 to
$387,648 for the nine months ended September 30, 2009 compared to $1,039,414 for
the nine months ended September 30, 2008.  The decrease in production
revenues reflects the impact of a drop in sales prices for natural gas of about
66% and oil of about 54%.  Transportation and gathering revenue
decreased $558,934 to $187,103 for the nine months ended September 30, 2009,
compared to $746,037 for the nine months ended September 30, 2008 due to the
drop in sales price for natural gas.





Expenses:  Total
operating expenses for the nine months ended September 30, 2009 were $2,406,765,
compared to $3,187,242 for the nine months ended September 30,
2008.  This decrease is comprised of decreases in cost of gas
purchased for resale and general and administrative expenses offset by an
increase in the lease operating expenses.





·
            Lease Operating
      Expense:  The $135,960 increase in lease operating
      expense to $282,583 for the nine months ended September 30, 2009 from
      $146,623 for the nine months ended September 30, 2008 is primarily due to
      workover costs on the Bramlett and Ralph 1 wells and the operating costs
      of the Childers #2 and Harris #2 wells.  The Childers #2 and
      Harris #2 were not operating during the first six months of
      2008.





·
            General and Administrative
      Expense:  The $409,106 decrease in general and
      administrative expense to $1,587,420 for the nine months ended September
      30, 2009 from $1,996,526 for the nine months ended September 30, 2008 is
      primarily due to decreased audit and accounting fees.   The
      decrease in audit and accounting fees of $206,000 was mainly due to work
      performed during the first nine months of 2008 related to the preparation
      of the S-1 registration statement, the 2007 10-K, and restatement of the
      Form 10-Q for the three-month period ended March 31, 2008.  In
      addition, due to the decrease in revenue during 2009, we made a concerted
      effort to decrease expenses such as automobile, travel and contract
      labor.





·
            Cost of Gas Purchased for
      Resale:The $518,558 decrease in cost of gas purchased
      for resale to $114,249 for the nine months ended September 30, 2009 from
      $632,807 for the nine months ended September 30, 2008 is due to a drop in
      the purchase price for natural gas purchased from
    operators.





Other Income
(Expenses):Total other expenses for the nine months ended
September 30, 2009 was $346,388, compared to $127,750 of other expenses for the
nine months ended September 30, 2008.  The increase of $49,681 was
partially due to an over accrual in 2008 of the liquidated damages expense that
was corrected in the third quarter of 2008.  There was also a decrease
of $70,803 in interest income from $73,026 for the nine months ended September
30, 2008 to $2,223 for the nine months ended September 30, 2009 due to the
significant decrease in cash and lower interest rates.  In addition,
interest expense increased $40,520 to $333,941 for the nine months ended
September 30, 2009 from $293,421 for the nine months ended September 30, 2008
due to an increase in the note payable, related party balance.





Income Tax
Expense:For the nine months ended September 30, 2009, we
recognized income tax expense of $370 compared to income tax expense of $90,365
for the nine months ended September 30, 2008.  The $89,995 decrease is
primarily due to our position that we are not likely to realize our deferred tax
assets or liabilities, and therefore, a valuation allowance was recorded to
offset these amounts.





Operating Loss:As
a result of the above described revenues and expenses, we incurred a net
operating loss of $1,989,537 for the nine months ended September 30, 2009 as
compared to an operating loss of $1,277,856 for the nine months ended September
30, 2008.





14





Liquidity
and Capital Resources





We ended
the third quarter of 2009 with $104,764 in cash and cash equivalents, compared
to $792,255 at December 31, 2008.  The decrease in cash and cash
equivalents is related to purchases of lease and well equipment and oil and gas
properties and using cash to cover operating expenses.  The decrease
is partially offset by additional proceeds received from notes payable during
2009.





Cash
Flows





The
following table summarizes our cash flows for the nine months ended September
30, 2009 and 2008:





Nine
      Months Ended September 30,2009
            
            
            2008Total
      cash provided by (used in):Operating
      activities
            
            $
            (1,338,436
            )
            
            $
            (2,362,445
            )Investing
      activities
            
            
            (419,151
            )
            
            
            (4,488,108
            )Financing
      activities
            
            
            1,070,096
            
            
            
            (752,568
            )Decrease
      in cash and cash equivalents
            
            $
            (687,491
            )
            
            $
            (7,603,121
            )





Cash used
in operating activities for the nine months ended September 30, 2009 totaled
$1,338,436, compared to $2,362,445 used in operating activities for the nine
months ended September 30, 2008.  The decrease of $1,024,009 in cash
used is primarily due to additional cash provided by changes in connection with
operating assets and liabilities offset by an increase in the net
loss.  The net loss was $1,989,537 for the nine months ended September
30, 2009, an increase from the net loss of $1,277,856 for the nine months ended
September 30, 2008.  The changes in operating assets and liabilities
are primarily due to changes in accounts receivable, related parties, other
current assets, accounts payable, related parties, joint-interest deposits,
related parties, and interest payable, related party.





Cash used
in investing activities for the nine months ended September 30, 2009 was
$419,151, compared to $4,488,108 for the nine months ended September 30,
2008.  The change is due primarily to decreased drilling activities
for the nine months ended September 30, 2009.  Drilling and completion
of the Harris #2 and Childers #2 wells were finished in January 2008 and
February 2008, respectively.  We spent $3,966,560 on lease and well
equipment, leasehold costs and intangible drilling and completion costs in the
first nine months of 2008, compared to $393,561 in the first nine months of
2009.  Finally, property and equipment purchases were $25,590 in the
first nine months of 2009 compared to $521,548 in the first nine months of
2008.





Cash
provided by financing activities for the nine months ended September 30, 2009
totaled $1,070,096, compared to $752,568 of cash used in financing activities
for the nine months ended September 30, 2008.  During the first nine
months of 2009, we received proceeds of $1,075,000 on a related party note
payable.  In January 2008, we made a payment of $742,544 of principal
on that same related party note payable.





Sources
of Liquidity





Our main
source of liquidity continues to be from funds generated by production from our
wells.  Any short fall in revenue to cover costs has been covered by
utilizing financing from a related party in the form of notes
payable.  We believe that the proceeds from production and financing
available from related parties will be sufficient to finance our operations for
the remainder of 2009.  However, future acquisitions and future
exploration, development, production and marketing activities, as well as
administrative requirements (such as salaries, insurance expenses, general
overhead expenses, legal compliance costs and accounting expenses) will require
a substantial amount of additional capital and cash flow.





We plan to pursue sources of additional
capital through various financing transactions or arrangements, including joint
venturing of projects, debt financing, equity financing or other
means.  In January 2009, we engaged an exclusive financial advisor to
assist us in securing additional capital.  In conjunction with our
financial advisor and our management team, we have aggressively contacted many
potential investors both within the industry and institutional
investors.  We have had discussions with several potential investors,
which, if successful, could result in drilling opportunities on our leasehold in
the near future.  However, we currently do not have any contracts or
commitments for funding and there are no guarantees that we will be able to
raise funds on terms acceptable to us, if any at all.





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




15





We
also entered into a credit agreement with various lenders led by Amegy Bank,
N.A. in November 2007.  Pursuant to the terms of the credit agreement,
the aggregate commitment is $50 million, with no initial borrowing base or
borrowing base reduction under the agreement.  Upon satisfaction of
various conditions precedent to the initial credit extension, the borrowing base
will be $1.3 million and the initial monthly borrowing base reduction will be
determined on the initial funding date.  As of September 30, 2009,
these conditions had not been met.





Off
Balance Sheet Arrangements





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





Critical
Accounting Policies





Our
critical accounting policies, including the assumptions and judgments underlying
them, are disclosed in the notes to consolidated financial statements which
accompany the consolidated financial statements included in our annual report on
Form 10-K filed with the SEC on March 31, 2009.  These policies have
been consistently applied in all material respects and address such matters as
revenue recognition and depreciation methods.  The preparation of
consolidated financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the consolidated financial statements and the recorded amounts of revenues and
expenses during the reporting period.  Actual results could differ
from these estimates.





Accounts
Receivable





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





Property
and Equipment





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





Oil
and Gas Properties





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





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





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





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





Revenue
Recognition





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





16





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





Income
Taxes





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





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





Item
3.   Quantitative and Qualitative Disclosures about Market
Risk





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





Item
4T.  Controls and Procedures.





MANAGEMENT’S
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES





Disclosure
controls and procedures have been designed to ensure that information required
to be disclosed by the Company is collected and communicated to management to
allow timely decisions regarding required disclosures.  The Chief
Executive Officer and the Chief Financial Officer have concluded, based on their
evaluation as of September 30, 2009 that, as a result of the following material
weaknesses in internal control over financial reporting, disclosure controls and
procedures were ineffective in providing reasonable assurance that material
information is made known to them by others within the Company:





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





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





Changes
to Internal Controls and Procedures Over Financial Reporting





There
have been no changes to our internal control in the quarter ended September 30,
2009.





Management’s
Remediation Plans





We are
committed to improving our financial organization. As part of this commitment,
we will look to increase our personnel resources and technical accounting
expertise within the accounting function by the third quarter of 2010 to resolve
non-routine or complex accounting matters. In addition, when funds are
available, which we expect to occur by the third quarter of 2010, we will take
the following action to enhance our internal controls: Hiring additional
knowledgeable personnel with technical accounting expertise to further support
our current accounting personnel, which management estimates will cost
approximately $100,000 per annum. We currently engage an outside accounting firm
to assist us in the preparation of our consolidated financial
statements. As necessary, we will engage consultants in the future as necessary
in order to ensure proper accounting for our consolidated financial
statements.





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





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




17







PART
II - OTHER INFORMATION





Item
1. Legal Proceedings.





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





Item
1A. Risk Factors.





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





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





None.





Item
3. Defaults Upon Senior Securities.





None.





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





None.





Item
5. Other Information.





None.





Item
6. Exhibits.





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





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





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





18








SIGNATURES





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





PEGASI
      ENERGY RESOURCES CORPORATIONDate:  November
      12, 2009
            By:/s/ MICHAEL NEUFELDMichael
      NeufeldChief
      Executive Officer (Principal Executive Officer)Date:  November
      12, 2009
            By:/s/ RICHARD LINDERMANISRichard
      LindermanisChief
      Financial Officer (Principal Financial Officer and Principal Accounting
      Officer)