10QSB 1 basic904.txt 10QSB SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-QSB [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2004 ---------------------------- [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 0-7914 BASIC EARTH SCIENCE SYSTEMS, INC. (Exact name of small business issuer as specified in its charter) Delaware 84-0592823 -------------------------------------------------------------------------------- (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 1801 Broadway, Suite 620, Denver, CO 80202-3835 -------------------------------------------------------------------------------- (Address for principal executive offices) (Zip Code) (303) 296-3076 -------------------------------------------------------------------------------- (Issuer's telephone number) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 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 [ ] Shares of common stock outstanding on November 5, 2004: 16,580,487
BASIC EARTH SCIENCE SYSTEMS, INC. FORM 10-QSB INDEX PART I. FINANCIAL INFORMATION Item 1. Financial Statements............................................. 3 Consolidated Balance Sheets - September 30, 2004 and March 31, 2004............................................... 3 Consolidated Statements of Operations - Quarters and Six Months Ended September 30, 2004 and September 30, 2003.................. 5 Consolidated Statements of Cash Flows - Six Months Ended September 30, 2004 and September 30, 2003........................ 6 Notes to Consolidated Financial Statements....................... 7 Item 2. Management's Discussion and Analysis and Plan of Operation....... 8 Results of Operations............................................ 11 Item 3. Controls and Procedures.......................................... 14 PART II. OTHER INFORMATION Item 1. Legal Proceedings................................................ 15 Item 2. Changes in Securities............................................ 15 Item 3. Defaults Upon Senior Securities.................................. 15 Item 4. Submission of Matters to a Vote of Security Holders.............. 15 Item 5. Other Information................................................ 15 Item 6. Exhibits and Reports on Form 8-K................................. 15 Signatures ................................................................. 16 EXHIBITS ................................................................. 17 2 PART I. FINANCIAL INFORMATION --------------------- ITEM 1. FINANCIAL STATEMENTS ---------------------------- Basic Earth Science Systems, Inc. Consolidated Balance Sheets Page 1 of 2 September 30 March 31 2004 2004 ------------ ------------ (Unaudited) (Audited) Assets Current assets Cash and cash equivalents $ 607,000 $ 424,000 Accounts receivable Oil and gas sales 422,000 438,000 Joint interest and other receivables 331,000 258,000 Less: allowance for doubtful accounts (70,000) (70,000) Other current assets 213,000 173,000 ------------ ------------ Total current assets 1,503,000 1,223,000 ------------ ------------ Property and equipment Oil and gas property (full cost method) 36,757,000 35,865,000 Support equipment 362,000 331,000 ------------ ------------ 37,119,000 36,196,000 Accumulated depletion - FCP (includes cumulative ceiling limitation charges of $15,131,000) (31,763,000) (31,589,000) Accumulated depreciation (300,000) (294,000) ------------ ------------ Net property and equipment 5,056,000 4,313,000 Other non-current assets 199,000 214,000 ------------ ------------ Total non-current assets 5,255,000 4,527,000 ------------ ------------ Total Assets $ 6,758,000 $ 5,750,000 ============ ============ See accompanying notes to consolidated financial statements. 3 Basic Earth Science Systems, Inc. Consolidated Balance Sheets Page 2 of 2 September 30 March 31 2004 2004 ------------ ------------ (Unaudited) (Audited) Liabilities Current liabilities Accounts payable $ 246,000 $ 256,000 Accrued liabilities 999,000 710,000 ------------ ------------ Total current liabilities 1,245,000 966,000 ------------ ------------ Long-term liabilities Long-term debt -- -- Asset retirement obligation 877,000 902,000 ------------ ------------ Total long-term liabilities 877,000 902,000 ------------ ------------ Shareholders' Equity Preferred stock, $.001 par value Authorized - 3,000,000 shares Issued - 0 shares -- -- Common stock, $.001 par value 32,000,000 shares authorized; 16,929,752 shares issued at September 30 and 16,879,752 at March 31 17,000 17,000 Additional paid-in capital 22,695,000 22,692,000 Accumulated deficit (18,053,000) (18,804,000) Treasury stock (349,265 shares at September 30 and March 31); at cost (23,000) (23,000) ------------ ------------ Total shareholders' equity 4,636,000 3,882,000 ------------ ------------ Total Liabilities and Shareholders' Equity $ 6,758,000 $ 5,750,000 ============ ============ See accompanying notes to consolidated financial statements. 4 Basic Earth Science Systems, Inc. Consolidated Statements of Operations (Unaudited) Six Months Ended Quarters Ended September 30 September 30 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Revenue Oil and gas sales $ 2,053,000 $ 1,445,000 $ 1,088,000 $ 717,000 Well service revenue 17,000 4,000 7,000 -- ------------ ------------ ------------ ------------ Total revenue 2,070,000 1,449,000 1,095,000 717,000 ------------ ------------ ------------ ------------ Expenses Oil and gas production 730,000 678,000 350,000 296,000 Production tax 171,000 111,000 89,000 59,000 Well service expenses 17,000 5,000 6,000 -- Depreciation and depletion 177,000 118,000 127,000 58,000 Accretion of asset retirement obligation 23,000 33,000 10,000 17,000 Asset retirement expense 20,000 38,000 11,000 38,000 General and administrative 182,000 131,000 102,000 66,000 ------------ ------------ ------------ ------------ Total operating expenses 1,320,000 1,114,000 695,000 534,000 ------------ ------------ ------------ ------------ Income from operations 750,000 335,000 400,000 183,000 ------------ ------------ ------------ ------------ Other income (expense) Interest and other income 1,000 1,000 -- -- Interest and other expenses -- (2,000) -- (2,000) ------------ ------------ ------------ ------------ Total other expense 1,000 (1,000) -- (2,000) ------------ ------------ ------------ ------------ Income before income taxes and cumulative effect of change in accounting principle 751,000 334,000 400,000 181,000 Income taxes -- -- -- -- ------------ ------------ ------------ ------------ Income before cumulative effect of change in accounting principle 751,000 334,000 400,000 181,000 Cumulative effect of change in accounting principle -- 562,000 -- -- ------------ ------------ ------------ ------------ Net income $ 751,000 $ 896,000 $ 400,000 $ 181,000 ============ ============ ============ ============ Weighted average common shares outstanding: Basic 16,567,918 16,530,487 16,580,487 16,530,487 Diluted 17,040,359 16,814,592 17,061,437 16,816,928 Per share amounts: Basic: Before change in accounting principle $ .045 $ .020 $ .024 $ .011 Change in accounting principle -- .034 -- -- ------------ ------------ ------------ ------------ Net income $ .045 $ .054 $ .024 $ .011 ============ ============ ============ ============ Diluted: Before change in accounting principle $ .044 $ .020 $ .023 $ .011 Change in accounting principle -- .033 -- -- ------------ ------------ ------------ ------------ Net income $ .044 $ .053 $ .023 $ .011 ============ ============ ============ ============ See accompanying notes to consolidated financial statements. 5 Basic Earth Science Systems, Inc. Consolidated Statements of Cash Flows (Unaudited) Six Months Ended September 30 2004 2003 ----------- ----------- Cash flows from operating activities: Net income $ 751,000 $ 896,000 Adjustments to reconcile net income to net cash provided by operating activities: Cumulative effect of change in accounting principle -- (562,000) Depreciation and depletion 177,000 118,000 Accretion of asset retirement obligation 23,000 33,000 Change in: Accounts receivable, net (57,000) 2,000 Other assets (39,000) 9,000 Accounts payable and accrued liabilities 231,000 358,000 Other 3,000 3,000 ----------- ----------- Net cash provided by operating activities 1,089,000 857,000 ----------- ----------- Cash flows from investing activities: Capital expenditures Oil and gas property (983,000) (734,000) Support equipment (31,000) (6,000) Purchase of lease and well equipment inventory (1,000) -- Proceeds from sale of lease and well equipment inventory 12,000 40,000 Proceeds from sale of oil and gas property and equipment 94,000 168,000 ----------- ----------- Net cash used in investing activities (909,000) (532,000) ----------- ----------- Cash flows from financing activities: Proceeds from exercise of common stock options 3,000 -- Long-term debt payments -- -- Proceeds from borrowing -- -- ----------- ----------- Net cash provided by financing activities 3,000 -- ----------- ----------- Cash and cash equivalents: Net increase 183,000 325,000 Balance at beginning of period 424,000 434,000 ----------- ----------- Balance at end of period $ 607,000 $ 759,000 =========== =========== See accompanying notes to consolidated financial statements. 6
Basic Earth Science Systems, Inc. Notes to Consolidated Financial Statements September 30, 2004 The accompanying interim financial statements of Basic Earth Science Systems, Inc. (Basic or the Company) are unaudited. However, in the opinion of management, the interim data includes all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the results for the interim period. The financial statements included herein have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. Management believes the disclosures made are adequate to make the information not misleading and suggests that these condensed financial statements be read in conjunction with the financial statements and notes hereto included in Basic's Form 10-KSB for the year ended March 31, 2004. Forward-Looking Statements -------------------------- This Form 10-QSB includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical fact included in this Form 10-QSB, including, without limitation, the statements under both "Notes To Consolidated Financial Statements" and "Item 2. Management's Discussion and Analysis or Plan of Operation" located elsewhere herein regarding the Company's financial position and liquidity, the amount of and its ability to make debt service payments, its strategies, financial instruments, and other matters, are forward-looking statements. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct. Important factors that could cause actual results to differ materially from the Company's expectations are disclosed in this Form 10-QSB in conjunction with the forward-looking statements included in this Form 10-QSB. Summary of Significant Accounting Policies ------------------------------------------ RECLASSIFICATIONS. Certain prior year amounts may have been reclassified to conform to current year presentation. CASH AND CASH EQUIVALENTS. For purposes of the Consolidated Balance Sheets and Statements of Cash Flows, Basic considers all highly liquid investments with a maturity of ninety days or less when purchased to be cash equivalents. USE OF ESTIMATES. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. There are many factors, including global events, which may influence the production, processing, marketing, and valuation of crude oil and natural gas. A reduction in the valuation of oil and gas properties resulting from declining prices or production could adversely impact depletion rates and ceiling test limitations. 7 Change in Accounting Principle ------------------------------ Effective April 1, 2003 the Company adopted Statement of Financial Accounting Standards No. 143 (SFAS No. 143), "Accounting for Asset Retirement Obligations." SFAS No. 143 requires the fair value of an asset retirement obligation to be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. As such, in the quarter ended June 30, 2003, Basic recorded a net increase in its capitalized oil and gas property cost of $1,686,000, a current asset retirement liability of $106,000, a long-term asset retirement liability of $1,034,000 and a corresponding cumulative effect of change in accounting principle of $562,000. These adjustments not only impact the areas noted above, but also impact areas within the Statement of Operations and Statement of Cash Flows that rely on these balances. As such, because prior periods are not restated, the adjustments made in the quarter ended June 30, 2003 should be taken into account when making comparisons to the financial statements of periods prior to the adoption of SFAS No. 143. Item 2. Management's Discussion and Analysis and Plan of Operation Liquidity and Capital Resources ------------------------------- LIQUIDITY OUTLOOK. The Company's primary source of funding is the net cash flow from the sale of its oil and gas production. The profitability and cash flow generated by the Company's operations in any particular accounting period will be directly related to: (a) the volume of oil and gas produced and then sold, (b) the average realized prices for oil and gas sold, and (c) lifting costs. Assuming that oil prices do not decline significantly from current levels, management believes the cash generated from operations will enable the Company to meet its existing and normal recurring obligations as they become due in fiscal year 2005. In addition, as mentioned in the "Debt" section below, Basic has $1,000,000 of borrowing capacity as of November 5, 2004. WORKING CAPITAL. At September 30, 2004 the Company had a working capital surplus of $258,000 (a current ratio of 1.21:1) compared to a working capital surplus at March 31, 2004 of $257,000 (a current ratio of 1.27:1). DEBT. The Company's current banking relationship, established in March 2002, is with American National Bank (formerly The Bank of Cherry Creek), located in Denver, Colorado. Under the terms of its loan agreement, Basic has a $1,000,000 line of credit with a current borrowing base of the full $1,000,000. Any outstanding loan balance will be due and payable on December 31, 2006. The interest rate on this credit facility is the prime rate plus 2%. As of November 5, 2004 the Company had not yet utilized this facility. If necessary, Basic may borrow funds to reduce payables, finance recompletion or drilling efforts, fund property acquisitions, or pursue other opportunities the Company cannot contemplate at this time but which may arise at a future date. HEDGING. The Company periodically uses hedging techniques to limit its exposure to oil price fluctuations. Typically Basic will utilize either futures or option contracts. The Company did not hedge any of its production during the six months ended September 30, 2004 and at September 30, 2004 the Company had no contracts in place to hedge future production. The Company continues to monitor the futures market in an effort to identify, and participate in, hedging opportunities that the Company views as favorable. 8 The continuation of hedging activities may vary or change due to change of circumstances, unforeseen opportunities, inability to fund margin requirements, lending institution requirements and other events which the Company is not able to anticipate. CAPITAL EXPENDITURES. To summarize capital expenditures during the Company's first quarter ended June 30, 2004, Basic re-entered the Antenna Federal #13-36 and #31-36 wells on the Company's Antenna Federal property in Weld County, Colorado to remove temporary seals separating the Codell and J-Sand formations in order to commingle production from these formations. The Company also participated in drilling the Lynn #1 well in Williams County, North Dakota. Drilling operations were successful and the well was placed on production in late July 2004 initially flowing 242 barrels of oil per day. Finally, Basic participated in drilling a "3-D Bright Spot" test of the Yegua formation in Wharton County, Texas. As previously disclosed, numerous problems were encountered in the well and drilling operations were not finalized until late July 2004. Readers are encouraged to read Basic's SEC reports, particularly the Company's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2004 for further details regarding these first quarter events. During the second quarter ended September 30, 2004 the Company spent an additional $58,000 on completion and surface equipment costs on the Lynn #1 well. To date the Company has spent approximately $285,000 on this well. The well continues to flow approximately 100 barrels of oil per day (BOPD) from the Nisku formation. Basic had planned to commingle the existing Nisku production with the previously completed and tested Duperow formation. However, the operator of the well now plans to employ a previously installed pumping unit to artificially lift the well and continue to produce solely from the Nisku formation. This is being done to evaluate the pressure and reservoir potential for a third well in the Nisku. The Company expects the artificial lift equipment to increase production from the Nisku formation to approximately 200 BOPD and expects to spend an additional $8,000 on this conversion. In addition, the Company previously disclosed the successful drilling of the Lynn #2 on this prospect and that the Company has been sufficiently encouraged by the results of surveys to install casing. The Lynn #2, operated by Missouri Basin Well Service, Inc., is located near the Lynn #1 in the Indian Hills Field in northwest North Dakota. Basic has an approximate 18 percent interest in the well. At September 30, 2004 Basic estimates having spent approximately $202,000 for its portion of the drilling and completion costs and expects to spend an additional $75,000 in efforts to place the Lynn #2 on production. Completion operations have not commenced. The operator of the well has reported a shortage of completion rigs in the area and hopes to begin operations within the next two weeks. On the Company's "3-D Bright Spot" test in Wharton County, Texas Basic spent an additional $33,000 on completion and equipment costs in the quarter just ended, for a total of $305,000 on the well. While not confirmed, a portion of the drilling costs, possibly $100,000 to Basic's interest, may be recoverable from insurance coverage held by all the working interest owners. Subsequent to September 30, a gas sales contract was secured and surface facilities and pipeline connections were constructed. The well was placed on production and began selling gas and condensate approximately November 1. However, due to the complexity of the surface facilities that has hampered efforts to stabilize production, Basic has not yet finalized its estimate of initial production rates, or the impact of this well on the Company's revenues and reserves. Finally, the Company reported that through Legent Resources Corporation (Legent), its wholly-owned Canadian subsidiary, it drilled its Silver Spike prospect in Alberta, Canada. The initial well, the Westerose 6-6-46-1W5, was drilled to 2,486 meters (8,100 feet). While Legent did not encounter a Devonian LeDuc reef, the Company is evaluating other alternatives that may be available to it and its partners, including drilling to deeper horizons. Legent has a 7.8125 percent interest in the well and has spent approximately $54,000 on prospect, acreage, and licensing costs and approximately $65,000 on drilling. 9 CONTEMPLATED ACTIVITIES. In addition to the capital expenditures described immediately above, the Company anticipates pursuing the following activities. By virtue of its acquisitions in the mid- and late-1990s, Basic has interests in the heart of the developing horizontal Bakken play in Richland County, Montana. With interests in five different sections, Basic is exposed to several significant drilling opportunities. The Company is currently finalizing its participation on one of two tracts in anticipation of eventually drilling at least two separate horizontal wells. Basic's interest is dependant upon the size of the approved well spacing unit and could range from a 6.25 percent to 25.0 percent working interest in each well. At these levels, Basic's financial commitment could vary from $170,000 to $680,000 per well. Following the success of its "3-D Bright Spot" test of the Yegua formation in Wharton County, Texas, Basic is finalizing plans to participate in a similar prospect in Liberty County, Texas. This "3-D Bright Spot" test of the Cook Mountain formation was generated by the same company that produced the Wharton County prospect. The Company expects to have a 7.5 percent working interest and spend approximately $200,000 for land, prospect and drilling costs. Management believes that this effort will be undertaken in the fourth quarter of this fiscal year ending March 31, 2005. The Company also envisions further development on its Antenna Federal property in Weld County, Colorado. Basic has received proposals from its joint venture partner to deepen three additional Codell formation wells to the J-Sand formation. The Company originally anticipated having completed this effort by the quarter ending December 31, 2004. These efforts have been delayed by federal permitting approvals and a corporate merger involving the operator of the property. Basic has been assured that one of the wells will be drilled in the quarter ending March 31, 2005 and the remaining two in the subsequent quarter. Basic currently has a 5 percent overriding royalty interest in these Codell wells and will earn a 60 percent working interest in the J-Sand once the wells are deepened to that formation. The Company estimates the total cost to deepen all three wells to be approximately $380,000. Basic had received proposals to drill two additional horizontal wells in the TR-Madison Unit in Billings County, North Dakota. The TR-Madison Unit, previously operated by Westport Oil and Gas Company, L.P., is now operated by Kerr-McGee Rocky Mountain Corporation. The Company recently learned that these wells have been delayed until the spring of 2005 following the merger of Westport and Kerr-McGee. Basic has a 1.075 percent working interest in the entire TR-Madison Unit and has budgeted $30,000 for these two wells. Basic anticipates drilling a second test on its Heart River Prospect in Stark County, North Dakota during the summer of 2005. This project is expected to test the Cambrian Winnipeg formation at approximately 11,500 feet. The Company expects to incur $150,000 in drilling costs on this second test well. The Company may alter or vary, all or part of, these contemplated activities based upon changes in circumstances, unforeseen opportunities, inability to negotiate favorable acquisition, farmout, joint venture or loan terms, lack of cash flow, lack of funding and/or other events which the Company is not able to anticipate. DIVESTITURES/ABANDONMENTS. The Company has previously disclosed that it holds a number of marginal, operated and non-operated properties that provide minimal impact to the Company's operations. The adoption of SFAS No. 143 has caused management to carefully quantify and evaluate the Company's asset retirement liability and the possibility of realizing salvage value from equipment in excess of plugging costs. As a result, management intends to more actively direct and exploit these assets in the future. 10 Results of Operations --------------------- Six Months Ended September 30, 2004 Compared to Six Months Ended September 30, 2003 ------------------------------------------------------------------------------ OVERVIEW. Net income from operations for the six months ended September 30, 2004 (2004) was $751,000 compared to net income from operations of $334,000 for the six months ended September 30, 2003 (2003). Including the cumulative effect of change in accounting principle due to the implementation of Statement of Financial Accounting Standard No. 143 (SFAS No. 143), net income for 2003 was $896,000. Net income for the 2004 period was impacted by an $80,000 impairment charge to recognize the potentially diminished value of its Canadian assets (see further discussion in Expenses section below). Net income solely from the Company's core U.S. operations was $831,000 in 2004. REVENUES. Oil and gas sales revenue increased $608,000 (42%) in 2004 over 2003. Oil sales revenue increased $430,000 (35%). A positive variance of $437,000 from higher oil prices was reduced by a $7,000 negative variance from lower oil sales volumes. Gas sales revenue increased $178,000 (82%) in 2004 over 2003 as a result of both higher gas sales volume and prices. The increase in gas sales volume contributed $121,000 while higher natural gas prices added $57,000. VOLUMES AND PRICES. Oil sales volume slipped less than 1%, from 43,200 barrels in 2003 to 43,000 barrels in 2004 while there was a 36% increase in the average price per barrel from $28.42 in 2003 to $38.60 in 2004. Gas sales volume jumped 56%, from 50.8 million cubic feet in 2003 to 79.2 million cubic feet in 2004, while the average price per Mcf rose 17%, from $4.26 in 2003 to $4.98 in 2004. The decrease in oil sales volume can be attributed to normal production decline that was partially offset by the addition of 1,300 barrels from the Lynn #1 well that was placed on production in late July 2004. The increase in gas sales volume is primarily due to the successful enhanced recovery techniques employed to-date on some of the Company's natural gas wells in Weld County, Colorado. On an equivalent barrel (BOE) basis, sales increased 9% from 51,700 BOE in 2003 to 56,200 BOE in 2004. EXPENSES. Oil and gas production expense increased $52,000 (8%) in 2004 over 2003. Oil and gas production expense is comprised of two components: routine lease operating expenses and workovers. Routine expenses typically include such items as daily well maintenance, utilities, fuel, water disposal and minor surface equipment repairs. Workovers, on the other hand, which primarily include downhole repairs, are generally random in nature. Although workovers are expected, they can be much more frequent in some wells than others and their cost can be significant. Therefore, workovers account for more dramatic fluctuations in oil and gas production expense from period to period. Routine lease operating expense increased $43,000 (8%) from $539,000 in 2003 to $582,000 in 2004 while workover expense increased $9,000 (6%) from $139,000 in 2003 to $148,000 in 2004. As a result of the increase in equivalent barrel sales, routine lease operating expense per BOE decreased slightly from $10.42 in 2003 to $10.36 in 2004 and workover expense per BOE declined 2% from $2.69 in 2003 to $2.64 in 2004. Primarily as a result of the increase in oil and gas sales revenue, production taxes, which are generally a percentage of sales revenue, increased $60,000 (54%) in 2004 over 2003. Production taxes, as a percent of sales revenue rose from 7.7 percent in 2003 to 8.3 percent in 2004. This percent increase is attributed to the elimination of severance tax incentives in Montana triggered by the higher oil price level in 2004 relative to the 2003 price level. The overall lifting cost per BOE is $16.05 in 2004 compared to $15.26 in 2003. Management cautions that this cost per BOE is not indicative of all wells, and that certain high cost wells could be shut in should oil prices drop significantly. 11 Depreciation and depletion expense increased $59,000 (50%) in 2004 over 2003 as a result of the $80,000 impairment charge related to the Canadian oil and gas assets owned by Legent Resources Corporation, a wholly-owned subsidiary of Basic. Even though Basic is a "full-cost pool" reporting company, SEC regulations require the Company to evaluate its Canadian assets separately from its U.S. properties. In this regard, Legent is still evaluating alternatives with respect to the initial well on its Silver Spike prospect and believes viable opportunities exist in this wellbore. However, Legent is a minority owner in this well and in the joint venture in Saskatchewan. As a result it has little ability to dictate future drilling plans and is unable to pursue development of the area on its own. While the majority owner may propose additional operations, at this time Legent is unaware of any such plans. Therefore, in assessing its acreage position with respect to possible future drilling plans and expiring leases, management felt it was appropriate to take an impairment charge in the quarter just ended. As a result, at September 30, 2004, following the $80,000 charge, the carrying value of Legent's Canadian oil and gas property approximated $247,000. Should Legent and its joint venture partners establish production from the Silver Spike wellbore, or on any of its acreage in Saskatchewan, the remaining $247,000 Canadian full cost pool would be depleted on a units-of-production basis in accordance with full cost pool accounting rules over the life of the reserves. However, should Legent and its joint venture partners not establish production or decide to forego drilling and allow the leases to expire, Legent would be required to write-off the remaining carrying value of its Canadian assets. Excluding the $80,000 impairment charge, depreciation and depletion expense in 2004 was $97,000 compared to $118,000 in 2003. This decrease was due to a revision upward of estimated oil and gas reserves at September 30, 2004 based on higher commodity prices, especially with respect to oil prices. Including the impairment charge, depreciation and depletion expense per BOE increased 37% from $2.26 in 2003 to $3.09 in 2004. Excluding the impairment charge, depreciation and depletion expense per BOE in 2004 was $1.66 reflecting a decrease of 27% from 2003. As a result of implementing SFAS No. 143, the Company recorded a $23,000 expense for the accretion of its asset retirement obligation and an asset retirement expense of $20,000 in 2004. These compare to an accretion expense of $33,000 and an asset retirement expense of $38,000 in 2003. Gross general and administrative (G&A) expense increased $43,000 (18%) while net G&A expense increased $51,000 (39%) in 2004 over 2003. Gross G&A expense differs from net G&A expense in that the Company is allowed to recover an overhead fee on wells that it operates. This fee is applied against, and serves to reduce, gross G&A expense. The increase in net G&A expense in 2004 over 2003 is indirectly related to the enhanced drilling and recompletion activity in 2004 relative to 2003, a reduction in the amount of G&A that Basic was able to charge out to Company-operated properties, and an increase in employee benefits. The percentage of gross G&A expense that the Company was able to charge out was 35% in 2004 compared to 45% in 2003. Net general and administrative expense per BOE increased 28% from $2.54 in 2003 to $3.25 in 2004. Quarter Ended September 30, 2004 Compared to Quarter Ended September 30, 2003 ----------------------------------------------------------------------------- OVERVIEW. Net income for the quarter ended September 30, 2004 (2004) was $400,000 compared to net income of $181,000 for the quarter ended September 30, 2003 (2003). Net income solely from the Company's core U.S. operations was $480,000 in 2004. REVENUES. Oil and gas sales revenue increased $371,000 (52%) in 2004 over 2003. As a result of both higher oil sales volume and prices, oil sales revenue increased $296,000 (49%). The increase in volume contributed $29,000 while higher oil prices added $267,000. In addition, gas sales revenue increased $75,000 (64%) in 2004 over 2003. Of this amount, higher gas sales volume contributed $47,000 while an increase in the average price per Mcf in 2004 over 2003 added $28,000. VOLUMES AND PRICES. Oil sales volume increased 5%, from 20,600 barrels in 2003 to 21,700 barrels in 2004 while there was a 42% jump in the average price per barrel from $29.06 in 2003 to $41.41 in 2004. Gas sales volume rose 40%, from 26.7 million cubic feet in 2003 to 37.5 million cubic feet in 2004, while the average price per Mcf increased 17%, from $4.36 in 2003 to $5.11 in 2004. The increase in oil sales volume can be attributed to the addition of 1,300 barrels from the Lynn #1 well that began production in late July 2004 while the increase in gas sales volume is primarily due to enhanced production from the Company's Weld County, Colorado natural gas wells. On an equivalent barrel (BOE) basis, sales increased 11% from 25,100 BOE in 2003 to 27,900 BOE in 2004. 12 EXPENSES. Oil and gas production expense increased $54,000 (18%) in 2004 over 2003. Routine lease operating expense increased $38,000 (16%) from $251,000 in 2003 to $289,000 in 2004 while workover expense increased $16,000 (37%) from $45,000 in 2003 to $61,000 in 2004. On an BOE basis, routine lease operating expense rose from $10.02 in 2003 to $10.35 in 2004 and workover expense increased from $1.78 in 2003 to $2.20 in 2004. Again, as a result of the increase in oil and gas sales revenue, production taxes increased $30,000 (51%) in 2004 over 2003. Production taxes were 8.2 percent of oil and gas sales revenue in both 2004 and 2003. The overall lifting cost per equivalent barrel increased 12% from $14.14 in 2003 to $15.77 in 2004. Management cautions that this cost per equivalent barrel is not indicative of all wells, and that certain high cost wells could once again be shut in should oil prices drop significantly. As a result of the $80,000 impairment charge related to the Canadian oil and gas property owned by Legent Resources discussed above, depreciation and depletion expense increased $69,000 (119%) in 2004 over 2003. Excluding the impairment, depreciation and depletion expense was $47,000 in 2004, a decrease of $11,000 (19%) from 2003. This decrease was again due to an upward revision of estimated oil and gas reserves at September 30, 2004 based on higher commodity prices, especially with respect to oil prices. Including the impairment charge, depletion expense per BOE increased 96% from $2.27 in 2003 to $4.45 in 2004. Excluding the impairment charge, depletion and depreciation expense per BOE in 2004 was $1.58 reflecting a 30% decrease from 2003. Related to the adoption of SFAS No. 143, the accretion of the present value of Basic's estimated asset retirement exposure was $10,000 in 2004 compared to $17,000 in 2003 while the asset retirement expense dropped from $38,000 in 2003 to $11,000 in 2004. Gross general and administrative (G&A) expense increased $31,000 (26%) while net G&A expense increased $36,000 (55%) in 2004 over 2003. The increase in net G&A expense was primarily the result of an increase in employee benefits and a reduction in the amount of G&A that Basic was able to charge out to Company-operated properties. Net G&A expense per BOE increased 39% from $2.64 in 2003 to $3.66 in 2004. (Intentionally left blank.) 13 Liquids and Natural Gas Production, Sales Price and Production Costs -------------------------------------------------------------------- The following table shows selected financial information for the six months and quarter ended September 30 in the current and prior year. Certain prior year amounts may have been reclassified to conform to current year presentation.
Six Months Ended Quarters Ended September 30 September 30 2004 2003 2004 2003 ---------- ---------- ---------- ---------- Sales volume Oil (barrels) 43,000 43,200 21,700 20,600 Gas (mcf) 79,200 50,800 37,500 26,700 Revenue Oil $1,658,000 $1,228,000 $ 896,000 $ 600,000 Gas 395,000 217,000 192,000 117,000 ---------- ---------- ---------- ---------- 2,053,000 1,445,000 1,088,000 717,000 Total production expense(1) 901,000 789,000 439,000 355,000 ---------- ---------- ---------- ---------- Gross profit $1,152,000 $ 656,000 $ 649,000 $ 362,000 ========== ========== ========== ========== Depletion expense $ 174,000 $ 117,000 $ 125,000 $ 57,000 Average sales price(2) Oil (per barrel) $ 38.60 $ 28.42 $ 41.41 $ 29.06 Gas (per mcf) $ 4.98 $ 4.26 $ 5.11 $ 4.36 Average production expense(1,2,3) $ 16.05 $ 15.26 $ 15.77 $ 14.14 Average gross profit(2,3) $ 20.50 $ 12.69 $ 23.23 $ 14.40 Average depletion expense(2,3) $ 3.09 $ 2.26 $ 4.45 $ 2.27 Average general and administrative expense(2,3) $ 3.25 $ 2.54 $ 3.66 $ 2.64 ---------------------------- (1) Operating expenses, including production tax (2) Averages calculated based upon non-rounded figures (3) Per equivalent barrel (6 Mcf of gas is equivalent to 1 barrel of oil)
ITEM 3. Controls and Procedures The Company's chief executive officer and chief financial officer evaluated the Company's disclosure controls and procedures within 90 days prior to the filing date of this report. Based on this evaluation, Basic's chief executive officer and chief financial officer concluded that the disclosure controls and procedures are effective in connection with the Company's filing of its quarterly report on Form 10-QSB for the quarter ended September 30, 2004. Subsequent to the evaluation through the date of this filing, there have been no significant changes in the Company's internal controls or in other factors that could significantly affect these controls, including any significant deficiencies or material weaknesses of internal controls that would require corrective action. 14 PART II. OTHER INFORMATION ----------------- (Cumulative from March 31, 2004) Item 1. Legal Proceedings ------------------------- None. Item 2. Changes in Securities ----------------------------- None. Item 3. Defaults Upon Senior Securities --------------------------------------- None. Item 4. Submission of Matters to a Vote of Security Holders ----------------------------------------------------------- During the six months ended September 30, 2004 there were no meetings of Basic's shareholders nor were any matters submitted to a vote of security holders through the solicitation of consents, proxies or otherwise. Item 5. Other Information ------------------------- None. Item 6. Exhibits and Reports on Form 8-K ---------------------------------------- (a) Exhibits Exhibit No. Document ----------- -------- 31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (Ray Singleton, Chief Executive Officer). 31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (David Flake, Chief Financial Officer). 32.1 Certification Pursuant to 18 U.S.C. ss.1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Ray Singleton, Chief Executive Officer). 32.2 Certification Pursuant to 18 U.S.C. ss.1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (David Flake, Chief Financial Officer). Other exhibits and schedules are omitted because they are not applicable, not required or the information is included in the financial statements or notes thereto. 15 (b) Reports on Form 8-K Date Document ---- -------- August 16, 2004 The Company announced earnings results for the first quarter ended June 30, 2004 and provided an update of its exploration results for both the Lynn #1 well in Williams County, North Dakota and its Wharton County, Texas discovery. In addition Basic announced that Legent Resources Corporation (Legent), its wholly-owned Canadian subsidiary, was drilling ahead on its Westerose 6-6-46-1W5 well in Alberta, Canada. August 26, 2004 The Company announced that Legent did not encounter a Devonian LeDuc reef that it was targeting and had suspended drilling operations on its Westerose well. September 1, 2004 The Company announced that it had commenced drilling the Lynn #2 well, a direct offset to the Lynn #1, in Williams County, North Dakota. Also, Basic provided a production update on the Lynn #1. September 28, 2004 The Company announced that it was installing production casing in the Lynn #2. Basic also provided a production update on the Lynn #1 and reported that completion operations were progressing as scheduled on its Wharton County, Texas discovery. Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed by the following authorized persons on behalf of Basic. BASIC EARTH SCIENCE SYSTEMS, INC. /s/ Ray Singleton ----------------- Ray Singleton President /s/ David Flake --------------- David Flake Chief Financial Officer and Principal Accounting Officer Date: November 5, 2004 16