PART I
ITEM 1. DESCRIPTION OF BUSINESS
General
We are engaged in the exploration, development and acquisition of oil and gas properties, primarily in the Southwestern region of the United States. We seek to increase reserves and production through internally generated drilling projects, coupled with complementary acquisitions.
At year-end 2007, a certified engineering firm valued our proven reserves at $180,968,260, which reflects the present value of our future net cash flows from reserves, discounted at 10%
At year-end 2007, we owned approximately 23,250 gross (17,950 net) acres of leasehold, which includes 15,250 acres of exploratory and developmental prospects as well as 8,000 acres of enhanced oil recovery prospects. We have built a multi-year inventory of drilling projects and drilling locations and currently have enough acreage to sustain several years of drilling.
ReoStar was incorporated in Nevada on November 29, 2004 under the name Goldrange Resources, Inc. In February, 2007 we changed our name to ReoStar Energy Corporation.
Our corporate offices are located at 5416 Birchman Ave, Fort Worth, Texas 76107. Our telephone number is (817) 989-7367. Effective July 15 , 2007, our corporate offices will be located at 3880 Hulen, Suite 500, Fort Worth, Texas 76107.
Business Strategy
Our objective is to build shareholder value by establishing and consistently growing our reserves and production with a strong emphasis on controlling costs and mitigating risks. Our strategy is (1) to continue to acquire and develop leasehold in key regional resource development plays to utilize our infrastructure and engage in a long-term drilling program, and (2) continue to acquire leasehold in areas of proven reserves to utilize enhanced oil recovery methods. In order to meet our objectives, we mitigate production risk and control costs by selling portions of our working interests in the wells we drill. Although we reduce our upside potential when compared to retaining higher levels of ownerships in the wells we drill, we reduce our exposure and increase our opportunities through more diversified programs. Our strategy to focus on costs requires us to acquire vertically integrated resources by assimilating mineral interests with drilling rigs and other high cost oilfield service equipment into a seamless, efficient, and low-cost operation.
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Significant Accomplishments in Fiscal Year 2007
• Acquire Diversified Asset Base. On February 1, 2007, we completed the acquisition of the following assets:
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Barnett Shale Resource and Exploration Mineral Interests We acquired approximately 9,000 gross acres (approximately 6,750 net acres) in the "oil window" of the Barnett Shale located seventy miles Northwest of Dallas, Texas. The mineral interests included forty-six vertical wells drilled within the last two years and both proven undeveloped reserves (the "resource play" portion of the acquisition) and unproven mineral interests (the high quality "exploratory" portion of the acquisition). The vertical wells are all 9,000 feet deep or less and take an average of 18 days to drill.
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Corsicana Enhanced Oil Recovery (EOR) and Mineral Interests We acquired approximately 4,392 contiguous acres in a mature oil field for the purpose of redevelopment. The field, located 47 miles South of Dallas, Texas, is the oldest commercial field in Texas, with production beginning in the 1890's. An estimated 83% of the original oil in place still remains in the reservoir. These reserves are at depths of 1,000 feet or less, and wells can be drilled and completed quickly at a cost of less than $60,000 per well. An affiliate of the registrant had begun the permitting process to initiate an alkaline-surfactant polymer (ASP) flood pilot project. The Texas regulatory office (RRC - Railroad Commission of Texas) issued the permit for the first Polymer pilot flood in March. Injection into the pilot project commenced in June 2007
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Fayetteville Shale Mineral Interests We acquired approximately 9,492 gross acres (6,537 net acres) in the "fairway" of the Fayetteville Shale located primarily in Conway, Faulkner, and White Counties in Central Arkansas. We expect to initiate drilling operations prior to the end of the next fiscal year. We may dispose of the asset as it is not located in our geographic area of operations..
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Tri-County Gas Gathering System We acquired an undivided thirty percent (30%) joint venture interest in the Tri-County Gas Gathering System, which includes pipeline, compressors, a gas processing plant, and several hundred miles of right-of-ways. The system services the majority of our Barnett gas produced.
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Big Giant Note Receivable We acquired a note receivable from Big Giant, our drilling contractor, in the amount of $2.6 million. The note is secured by the rig dedicated to our Barnett shale acreage.
• Concentrate in Core Operating Areas. We currently focus in one region; the Southwestern United States (which includes the Barnett Shale of North Central Texas, and our Corsicana Enhanced Oil Recovery prospect in East Central Texas). Concentrating our drilling and producing activities in these core areas allows us to develop the regional expertise needed to interpret specific geological and operating trends and develop economies of scale. Operating developmental projects (such as our Barnett Shale prospects) and Enhanced Oil Recovery prospects in the same core area allows us to achieve reserve growth, balance our portfolio between oil and natural gas, and minimize some of the operational risks inherent in our industry.
• Manage Our Risk Exposure. We continue to sell working interests in the development wells we drill. Currently, we sell our working interests on a turn-key basis, which helps us to save costs. Due to our focus on controlling costs, we are able to extend economic considerations to not only our third-party working interest investors, but to ourselves in the form of a higher retained interest.
• Production and reserve growth - During the fourth quarter we completed and brought online five Barnett Shale wells that were in various stages of completion when we acquired them in February. We also began drilling three additional wells. The three additional wells were in process at year end and have been brought online in the first fiscal quarter. We have one drilling rig dedicated full-time to our Barnett Shale properties.
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• Continued expansion of drilling inventory and emerging plays - To continue to grow, the size of our prospect inventory must also increase. We will continue to search for high quality prospects that fit our corporate strategy. The company is well positioned to acquire additional acreage as we have minimal debt in relation to our reserve base.
Plans for 2008
With the majority of the necessary funds coming from third-parties, we expect to drill a minimum of 20 wells in our Barnett Shale acreage before the end of our fiscal year while retaining an average of 25% in each of the wells. In addition, we plan to initiate a re-completion program on some of our older wells utilizing an adjusted "mighty acid" fracture stimulation. The initial data indicates that the change in methodology has been effective. We will continue to analyze the results and adjust our methods with an eye to improving the long-term decline curves.
Our Corsicana properties were studied and a pilot injection area was chosen. Corsicana Polymer studies have been carried out by several laboratories over the years. Pilot floods were carried out in the 1980's but they were curtailed due to reduced oil prices.
Thirteen new wells were drilled, 6 of which are injectors and 7 of which are producers. The wells were drilled in a pattern where each injector has approximately four producers surrounding it.
We will begin injection in our Polymer pilot project in the early summer of 2007. The polymer mixing plant has been designed and built and is ready to begin the injection process into our pilot injection wells. Numerous source water lines, injection and production lines have been installed. Our plans have been supported by various labs. Following initiation of injection we anticipate increased production in less than a year. We anticipate many additional injection projects in the ensuing years.
We have begun acquiring deeper rights in the area and plan on initiating a seismic program in order to drill deep tests. The Corsicana area is in an oil and gas province with many potential deeper reservoirs.
During the last portion of 2006, we had considered purchasing a local contract drilling company as there was concern regarding the availability of quality rigs. In our desire to continue operations without being uninterrupted, we entered into a letter of intent to purchase the above mentioned contractor. Due to the inability to have access to audited financial statements and solidify future drilling commitments, we withdrew from the transaction. However, in the ensuing months, the market for quality drilling rigs has softened and we feel confident we will have access to quality drilling rigs in the near future. We continue to have a financial interest in the drilling contractor in the form of a secured note receivable.
In late March the operator and majority owner of the Tri-County Gas Gathering System (TCGGS) announced they had been sold to another pipeline operator. Effective May 1, 2007, our joint venture partners and ReoStar sold our collective interest in the TCGGS for $15 million. The purchase price is subject to certain post closing adjustments which could reduce the sales proceeds by as much as $900,000.
Production, Revenues and Price History
The following table sets forth information regarding oil and gas production, and revenues.
Years Ending December 31
2006
2005
Production
Oil (Bbl)
34,019
7,262
Gas (Mcf)
177,016
77,650
Total (BOE)
64,555
20,650
Revenues
Crude Oil
1,777,716
555,900
Gas
1,096,575
553,299
Total
2,874,291
1,109,199
Average Sale Price (per BOE)
44.52
53.71
Direct Operating Costs (per BOE)
17.53
27.01
(a) Natural Gas was converted to BOE at the rate of 1 barrel equals 5.8 MCF.
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Competition
We encounter substantial competition in developing and acquiring oil and gas properties, securing and retaining personnel, conducting drilling and field operations and marketing production. Competitors in exploration, development, acquisitions and production include the major oil companies as well as numerous independent oil companies, individual proprietors and others. Although our sizable acreage position and core-area concentration provide some competitive advantages, many competitors have financial and other resources substantially exceeding ours. Therefore, competitors may be able to pay more for desirable leases and to evaluate, bid for and purchase a greater number of properties or prospects than our financial or personnel resources allow. Our ability to replace and expand our reserve base depends on our ability to attract and retain quality personnel and identify and acquire suitable producing properties and prospects for future drilling.
Employees
Non-publicly traded affiliates operate our oil and gas properties. The affiliated operating companies are owned and managed by ReoStar shareholders that own more than 50% of our stock. As of April 1, 2007, the aggregate number of employees and affiliated employees totaled fifty-five.
All of ReoStar's full-time employees are eligible to receive equity awards approved by the Compensation Committee of the Board of Directors. No employees are covered by a labor union or other collective bargaining arrangement. We believe that the relationship with our employees is excellent. We regularly utilize independent consultants and contractors to perform various professional services, particularly in the areas of drilling, completion, field and on-site production operation services.
Available Information
We maintain an internet website under the name "www.reostarenergy.com." We make available, free of charge, on our website, the annual report on Form 10-KSB, quarterly reports on Form 10-QSB, current reports on Form 8-K and amendments to those reports, as soon as reasonably practicable after providing such reports to the SEC. Also, our Corporate Governance Guidelines, the Code of Ethics, Insider Trading Policy and Guidelines, and Corporate Disclosure Policy are available on our website and in print to any stockholder who provides a written request to Investor Relations at 5416 Birchman Avenue, Fort Worth, Texas 76107.
We file annual reports on Form 10-KSB, quarterly reports on Form 10-QSB and current reports on Form 8-K, proxy statements and other documents with the SEC under the Securities Exchange Act of 1934. The public may read and copy any materials that we file with the SEC at the SEC's Public Reference Room at 100 F Street, N.E., Washington DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an internet website that contains reports, proxy and information statements, and other information regarding issuers, including REOSTAR, that file electronically with the SEC. The public can obtain any document we file with the SEC at "www.sec.gov." Information contained on or connected to our website is not incorporated by reference into this Form 10-KSB and should not be considered part of this report or any other filing that we make with the SEC.
Effective February 1, 2007 three entities under common control, Benco Operating, Inc. ("Benco); JMT Resources Ltd ("JMT"); and REO Energy Ltd ("REO") contributed certain assets to Goldrange Resources, Inc. ("Goldrange") in exchange for stock. The contributing entities were under common control prior to the transaction, and immediately after the transactions, the former shareholders of the contributing entities owned 80.4% of the issued and outstanding stock of Goldrange. The contribution has been accounted for as a reverse merger.
The predecessor entities kept accounting records based on a calendar year end. Goldrange's fiscal year end is March 31, 2007. Therefore, for prior years, all data presented reflects data using a calendar year end.
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Marketing and Customers
We market nearly all of our oil and gas production from the properties we operate for both our interest and that of the other working interest owners and royalty owners. All of our gas produced from the Barnett Shale is sold pursuant to a gas contract with Cimmarron Gathering, L.P. The contract term is ten years and provides for a two tier system of charging for gathering natural gas. Currently, none of our gas is sold under long-term fixed price contracts. Our Barnett oil is currently sold to Cimmarron Gathering, LP under contract through June 15th, 2007 continuing thereafter month to month until such time as either party cancels by providing thirty (30) days advance written notice to the other party of intent to cancel. The contract pays Platts P+ minus $1.00 based on Plains - North Texas Sweet posted price.
Oil and gas purchasers are selected on the basis of price, credit quality and service. For a summary of purchasers of our oil and gas production that accounted for 10% or more of consolidated revenue, see Note 10 to our financial statements. Because alternative purchasers of oil and gas are usually readily available, we believe that the loss of any of these purchasers would not have a material adverse effect on us.
We have not entered into hedging transactions in the past, but may enter into hedging transactions with unaffiliated third parties for portions of our production to achieve more predictable cash flows and to reduce our exposure to short-term fluctuations in oil and gas prices in the future.
Proximity to local markets, availability of competitive fuels and overall supply and demand are factors affecting the prices for which our production can be sold. Market volatility due to international political developments, overall energy supply and demand, fluctuating weather conditions, economic growth rates and other factors in the United States and worldwide has had, and will continue to have, a significant effect on energy prices.
We incur gathering and transportation expenses to move our natural gas from the wellhead and tanks to purchaser specified delivery points. These expenses vary based on volume and the fee charged by the third-party transporters. Our natural gas production is transported through the Tri-County Gas Gathering System. Our oil production is transported primarily through third-party trucks. We are an owner of the Tri-County Gas Gathering System. Our ownership interests in the system have varied from 33.33% in 2005 to 30.00% at March 31, 2007.
For additional information, see "Risk Factors".
Governmental Regulation
Our operations are substantially affected by federal, state and local laws and regulations. In particular, oil and gas production and related operations are, or have been, subject to price controls, taxes and numerous other laws and regulations. All of the jurisdictions in which we own or operate producing crude oil and natural gas properties have statutory provisions regulating the exploration for and production of crude oil and natural gas, including provisions related to permits for the drilling of wells, bonding requirements in order to drill or operate wells, the location of wells, the method of drilling and casing wells, the surface use and restoration of properties upon which wells are drilled, and the abandonment of wells. Our operations are also subject to various conservation laws and regulations. These include the regulation of the size of drilling and spacing units or proration units, the number of wells which may be drilled in an area, and the unitization or pooling of crude oil and natural gas wells, generally prohibit the venting or flaring of natural gas, and impose certain requirements regarding the ratability or fair apportionment of production from fields and individuals wells.
In August 2005, Congress enacted the Energy Policy Act of 2005 ("EPAct 2005"). Among other matters, the EPAct 2005 amends the Natural Gas Act ("NGA"), to make it unlawful for "any entity", including otherwise non-jurisdictional producers such as ReoStar, to use any deceptive or manipulative device or contrivance in connection with the purchase or sale of natural gas or the purchase or sale of transportation services subject to regulation by the Federal Energy Regulatory Commission ("FERC"), in contravention of rules prescribed by the FERC. On January 20, 2006, the FERC issued rules implementing this provision. The rules make it unlawful in connection with the purchase or sale of natural gas subject to the jurisdiction of FERC, or the purchase or sale of transportation services subject to the jurisdiction of FERC, for any entity, directly or indirectly, to use or employ any device, scheme or artifice to defraud; to make any untrue statement of material fact or omit to make any such statement necessary to make the statements made not misleading; or to engage in any act or practice that operates as a fraud or deceit upon any person. EPAct 2005 also gives the FERC authority to impose civil penalties for violations of the NGA up to $1,000,000 per day per violation.
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The new anti-manipulation rule does not apply to activities that relate only to intrastate or other non-jurisdictional sale or gathering, but does apply to activities or otherwise non-jurisdictional entities to the extent the activities are conducted "in connection with" gas sales, purchases or transportation subject to FERC jurisdiction. It therefore reflects a significant expansion of FERC's enforcement authority. ReoStar does not anticipate it will be affected any differently than other producers of natural gas.
Failure to comply with applicable laws and regulations can result in substantial penalties. The regulatory burden on the industry increases the cost of doing business and affects profitability. Although we believe we are in substantial compliance with all applicable laws and regulations, such laws and regulations are frequently amended or reinterpreted. Therefore, we are unable to predict the future costs or impact of compliance. Additional proposals and proceedings that affect the oil and gas industry are regularly considered by Congress, the states, the FERC, and the courts. We cannot predict when or whether any such proposals may become effective.
Environmental Matters
Our operations are subject to stringent federal, state and local laws governing the discharge of materials into the environment or otherwise relating to environmental protection. Numerous governmental departments such as the Environmental Protection Agency ("EPA") issue regulations to implement and enforce such laws, which are often difficult and costly to comply with and which carry substantial civil and criminal penalties for failure to comply. These laws and regulations may require the acquisition of a permit before drilling commences, restrict the types, quantities and concentrations of various substances that can be released into the environment in connection with drilling, production and transporting through pipelines, limit or prohibit drilling activities on certain lands lying within wilderness, wetlands, frontier and other protected areas, require some form of remedial action to prevent pollution from former operations such as plugging abandoned wells, and impose substantial liabilities for pollution resulting from operations. In addition, these laws, rules and regulations may restrict the rate of production. The regulatory burden on the oil and gas industry increases the cost of doing business, affecting growth and profitability. Changes in environmental laws and regulations occur frequently, and changes that result in more stringent and costly waste handling, disposal or clean-up requirements could adversely affect our operations and financial position, as well as the industry in general. We believe we are in substantial compliance with current applicable environmental laws and regulations. Although we have not experienced any material adverse effect from compliance with environmental requirements, there is no assurance that this will continue. We did not have any material capital or other non-recurring expenditures in connection with complying with environmental laws or environmental remediation matters in 2006, nor do we anticipate that such expenditures will be material in 2007.
The Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), known as the "Superfund" law, imposes liability, without regard to fault or the legality of the original conduct, on certain classes of persons who are considered to be responsible for the release of a "hazardous substance" into the environment. These persons include owners or operators of the disposal site or sites where the release occurred and companies that disposed of or arranged for the disposal of the hazardous substances at the site where the release occurred. Under CERCLA, such persons may be subject to joint and several liability for the costs of cleaning up the hazardous substances that have been released into the environment, for damages to natural resources and for the costs of certain health studies. Furthermore, although petroleum, including crude oil and natural gas, is not a "hazardous substance" under CERCLA, at least two courts have ruled that certain wastes associated with the production of crude oil may be classified as "hazardous substances" under CERCLA and that such wastes may therefore give rise to liability under CERCLA. Beyond CERCLA, state laws regulate the disposal of oil and gas wastes, and periodically new state legislative initiatives are proposed that could have a significant impact on us. In addition, it is not uncommon for neighboring landowners and other third parties to file claims for personal injury and property damages allegedly caused by the release of hazardous substances or other pollutants into the environment pursuant to environmental statutes, common law or both.
The Federal Water Pollution Control Act ("FWPCA") imposes restrictions and strict controls regarding the discharge of produced waters and other oil and gas wastes into waters of the United States. Permits must be obtained to discharge pollutants into state and federal waters. The FWPCA and analogous state laws provide for civil, criminal and administrative penalties for any unauthorized discharges of oil and other hazardous substances in reportable quantities and may impose substantial potential liability for the costs of removal, remediation and damages. State water discharge regulations and Federal National Pollutant Discharge Elimination System permits applicable to the oil and gas industry generally prohibit the discharge of produced water, sand and some other substances into coastal waters. The cost to comply with zero discharges mandated under federal and state law has not had a material adverse impact on our financial condition and results of operations.
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Some oil and gas exploration and production facilities are required to obtain permits for their storm water discharges. Costs may be incurred in connection with treatment of wastewater or developing and implementing storm water pollution prevention plans. The Resource Conservation and Recovery Act ("RCRA") as amended, generally does not regulate most wastes generated by the exploration and production of oil and gas. RCRA specifically excludes from the definition of hazardous waste "drilling fluids, produced waters, and other wastes associated with the exploration, development, or production of crude oil, natural gas or geothermal energy." However, these wastes may be regulated by the EPA or state agencies as non-hazardous solid waste. Moreover, ordinary industrial wastes, such as paint wastes, waste solvents, laboratory wastes and waste compressor oils, can be regulated as hazardous wastes. Although the costs of managing wastes classified as hazardous waste may be significant, we do not expect to experience more burdensome costs than similarly situated companies.
The Oil Pollution Act ("OPA") requires owners and operators of facilities that could be the source of an oil spill into "waters of the United States" (a term defined to include rivers, creeks, wetlands and coastal waters) to adopt and implement plans and procedures to prevent any spill of oil into any waters of the United States. OPA also requires affected facility owners and operators to demonstrate that they have sufficient financial resources to pay for the costs of cleaning up an oil spill and compensating any parties damaged by an oil spill. Substantial civil and criminal fines and penalties can be imposed for violations of OPA and other environmental statutes.
Stricter standards in environmental legislation may be imposed on the oil and gas industry in the future. For instance, legislation has been proposed in Congress from time-to-time that would alter the RCRA exemption by reclassifying certain oil and gas exploration and production wastes as "hazardous wastes" and make the waste subject to more stringent handling, disposal and clean-up restrictions. If such legislation were enacted, it could have a significant impact on our operating costs, as well as the industry in general. Compliance with environmental requirements generally could have a material adverse effect on our capital expenditures, earnings or competitive position. Although we have not experienced any material adverse effect from compliance with environmental requirements, no assurance may be given that this will continue.
RISK FACTORS
We are subject to various risks and uncertainties in the course of our business. The following summarizes some, but not all, of the risks and uncertainties which may adversely affect our business, financial condition or results of operations.
Volatility of oil and natural gas prices significantly affects our cash flow and capital resources and could hamper our ability to produce oil and gas economically
Oil and natural gas prices are volatile, and a decline in prices would adversely affect our profitability and financial condition. The oil and natural gas industry is typically cyclical, and prices for oil and natural gas have been highly volatile. Historically, the industry has experienced severe downturns characterized by oversupply and/or weak demand. In recent years, higher oil and natural gas prices have contributed to increased earnings industry wide. However, long-term supply and demand for oil and natural gas is uncertain and subject to a myriad of factors such as:
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the domestic and foreign supply of oil and gas;
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the price and availability of alternative fuels;
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weather conditions;
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the level of consumer demand;
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the price of foreign imports;
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world-wide economic conditions;
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political conditions in oil and gas producing regions; and
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domestic and foreign governmental regulations.
