10QSB 1 basic1204.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 December 31, 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 February 4, 2005: 16,630,487
BASIC EARTH SCIENCE SYSTEMS, INC. FORM 10-QSB INDEX PART I. FINANCIAL INFORMATION Item 1. Financial Statements............................................... 3 Consolidated Balance Sheets - December 31, 2004 and March 31, 2004................................................. 3 Consolidated Statements of Operations - Quarters and Nine Months Ended December 31, 2004 and December 31, 2003...................... 5 Consolidated Statements of Cash Flows - Nine Months Ended December 31, 2004 and December 31, 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............................................ 15 PART II. OTHER INFORMATION Item 1. Legal Proceedings.................................................. 16 Item 2. Changes in Securities.............................................. 16 Item 3. Defaults Upon Senior Securities.................................... 16 Item 4. Submission of Matters to a Vote of Security Holders................ 16 Item 5. Other Information.................................................. 16 Item 6. Exhibits and Reports on Form 8-K................................... 16 Signatures................................................................... 17 EXHIBITS ................................................................... 18 2 PART I. FINANCIAL INFORMATION --------------------- ITEM 1. FINANCIAL STATEMENTS ---------------------------- Basic Earth Science Systems, Inc. Consolidated Balance Sheets Page 1 of 2 December 31 March 31 2004 2004 ------------ ------------ (Unaudited) (Audited) Assets Current assets Cash and cash equivalents $ 98,000 $ 424,000 Accounts receivable Oil and gas sales 510,000 438,000 Joint interest and other receivables 291,000 258,000 Less: Allowance for doubtful accounts (70,000) (70,000) Other current assets 811,000 173,000 ------------ ------------ Total current assets 1,640,000 1,223,000 ------------ ------------ Property and equipment Oil and gas property (full cost method) 37,226,000 35,865,000 Support equipment 372,000 331,000 ------------ ------------ 37,598,000 36,196,000 Accumulated depletion - FCP (includes cumulative ceiling limitation charges of $15,051,000 at March 31 and (31,894,000) (31,589,000) $15,211,000 at December 31) Accumulated depreciation (305,000) (294,000) ------------ ------------ Net property and equipment 5,399,000 4,313,000 Other non-current assets 207,000 214,000 ------------ ------------ Total non-current assets 5,606,000 4,527,000 ------------ ------------ Total Assets $ 7,246,000 $ 5,750,000 ============ ============ See accompanying notes to consolidated financial statements. 3 Basic Earth Science Systems, Inc. Consolidated Balance Sheets Page 2 of 2 December 31 March 31 2004 2004 ------------ ------------ (Unaudited) (Audited) Liabilities Current liabilities Accounts payable $ 383,000 $ 256,000 Accrued liabilities 855,000 710,000 ------------ ------------ Total current liabilities 1,238,000 966,000 ------------ ------------ Long-term liabilities Long-term debt -- -- Asset retirement obligation 881,000 902,000 ------------ ------------ Total long-term liabilities 881,000 902,000 ------------ ------------ 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 December 31 and 16,879,752 at March 31 17,000 17,000 Additional paid-in capital 22,695,000 22,692,000 Accumulated deficit (17,562,000) (18,804,000) Treasury stock (349,265 shares at December 31 and March 31); at cost (23,000) (23,000) ------------ ------------ Total shareholders' equity 5,127,000 3,882,000 ------------ ------------ Total Liabilities and Shareholders' Equity $ 7,246,000 $ 5,750,000 ============ ============ See accompanying notes to consolidated financial statements. 4 Basic Earth Science Systems, Inc. Consolidated Statements of Operations (Unaudited) Nine Months Ended Quarters Ended December 31 December 31 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Revenue Oil and gas sales $ 3,327,000 $ 2,149,000 $ 1,274,000 $ 704,000 Well service revenue 19,000 10,000 2,000 6,000 ------------ ------------ ------------ ------------ Total revenue 3,346,000 2,159,000 1,276,000 710,000 ------------ ------------ ------------ ------------ Expenses Oil and gas production 1,133,000 968,000 403,000 290,000 Production tax 279,000 170,000 108,000 59,000 Well service expenses 20,000 10,000 3,000 5,000 Depreciation and depletion 311,000 181,000 134,000 63,000 Accretion of asset retirement obligation 37,000 54,000 14,000 21,000 Asset retirement expense 43,000 89,000 23,000 51,000 General and administrative 284,000 192,000 102,000 61,000 ------------ ------------ ------------ ------------ Total operating expenses 2,107,000 1,664,000 787,000 550,000 ------------ ------------ ------------ ------------ Income from operations 1,239,000 495,000 489,000 160,000 ------------ ------------ ------------ ------------ Other income (expense) Interest and other income 4,000 2,000 3,000 1,000 Interest and other expenses (1,000) (2,000) (1,000) -- ------------ ------------ ------------ ------------ Total other income 3,000 -- 2,000 1,000 ------------ ------------ ------------ ------------ Income before income taxes and cumulative effect of change in accounting principle 1,242,000 495,000 491,000 161,000 Income taxes -- -- -- -- ------------ ------------ ------------ ------------ Income before cumulative effect of change in accounting principle 1,242,000 495,000 491,000 161,000 Cumulative effect of change in accounting principle -- 562,000 -- -- ------------ ------------ ------------ ------------ Net income $ 1,242,000 $ 1,057,000 $ 491,000 $ 161,000 ============ ============ ============ ============ Weighted average common shares outstanding: Basic 16,572,124 16,530,487 16,580,487 16,530,487 Diluted 17,048,976 16,841,418 17,067,076 16,884,360 Per share amounts: Basic: Before change in accounting principle $ .075 $ .030 $ .030 $ .010 Change in accounting principle -- .034 -- -- ------------ ------------ ------------ ------------ Net income $ .075 $ .064 $ .030 $ .010 ============ ============ ============ ============ Diluted: Before change in accounting principle $ .073 $ .030 $ .029 $ .010 Change in accounting principle -- .033 -- -- ------------ ------------ ------------ ------------ Net income $ .073 $ .063 $ .029 $ .010 ============ ============ ============ ============ See accompanying notes to consolidated financial statements. 5 Basic Earth Science Systems, Inc. Consolidated Statements of Cash Flows (Unaudited) Nine Months Ended December 31 2004 2003 ----------- ----------- Cash flows from operating activities: Net income $ 1,242,000 $ 1,057,000 Adjustments to reconcile net income to net cash provided by operating activities: Cumulative effect of change in accounting principle -- (562,000) Depreciation and depletion 311,000 181,000 Accretion of asset retirement obligation 37,000 54,000 Change in: Accounts receivable, net (105,000) (75,000) Other assets (629,000) (2,000) Accounts payable and accrued liabilities 220,000 191,000 Asset retirement obligation (6,000) -- Other 5,000 5,000 ----------- ----------- Net cash provided by operating activities 1,075,000 849,000 ----------- ----------- Cash flows from investing activities: Capital expenditures Oil and gas property (1,537,000) (950,000) Support equipment (41,000) (9,000) Purchase of lease and well equipment inventory (12,000) (16,000) Proceeds from sale of lease and well equipment inventory 16,000 40,000 Proceeds from sale of oil and gas property and equipment 170,000 168,000 ----------- ----------- Net cash used in investing activities (1,404,000) (767,000) ----------- ----------- Cash flows from financing activities: Proceeds from exercise of common stock options 3,000 -- Proceeds from borrowing 205,000 -- Long-term debt payments (205,000) -- ----------- ----------- Net cash provided by financing activities 3,000 -- ----------- ----------- Cash and cash equivalents: Net increase (decrease) (326,000) 82,000 Balance at beginning of period 424,000 434,000 ----------- ----------- Balance at end of period $ 98,000 $ 516,000 =========== =========== Supplemental disclosure of cash flow information: Cash paid for interest $ 1,000 $ -- See accompanying notes to consolidated financial statements. 6
Basic Earth Science Systems, Inc. Notes to Consolidated Financial Statements December 31, 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 February 4, 2005. WORKING CAPITAL. At December 31, 2004 the Company had a working capital surplus of $402,000 (a current ratio of 1.32:1) compared to a working capital surplus at March 31, 2004 of $257,000 (a current ratio of 1.27:1). The decrease in Cash and Cash Equivalents and a corresponding increase in Other Current Assets reflect cash advances made by Basic to prepay drilling costs on the Halvorsen 31X-1 dual-lateral, horizontal well in Richland County, Montana and the "3-D Bright Spot" test in Liberty County, Texas that were both spud near the end of December 2004. The unused portions of the drilling costs totaling $629,000 at December 31 are included in Other Current Assets. See the Capital Expenditures section below for further discussion. The increase in current liabilities is indicative of a higher level of workover activity at the end of the December 2004 quarter relative to workover activity at the end of the March 2004 quarter. 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 existing loan agreement, Basic has a $1,000,000 line of credit with a current borrowing base of the full $1,000,000. With the present oil and natural gas pricing environment and the new wells the Company has recently brought on production, Basic and American National Bank have begun discussions to increase the Company's borrowing capacity that is more reflective of Basic's current level of estimated oil and gas reserves. 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. 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%. 8 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 nine months ended December 31, 2004 and at December 31, 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. 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 two quarters ended September 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. On its Indian Hill prospect, the Company participated in drilling the Lynn #1 well in Williams County, North Dakota. Drilling operations were successful and the well was placed on production in August 2004 initially flowing 242 barrels of oil per day. This was followed by a second well, the Lynn #2, which was placed on production in January 2005. Basic also 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. 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. Readers are encouraged to read Basic's SEC reports, particularly the Company's Quarterly Report on Form 10-QSB for the quarters ended June 30 and September 30, 2004 for further details regarding these first and second quarter events. During the third quarter ended December 31, 2004 Basic spent an additional $46,000 for completion and surface equipment costs on the Lynn #2 well for a total investment of $248,000. The Lynn #2, which was placed on production in early January 2005, is producing approximately 50 barrels of oil and 50 barrels of water per day from the Nisku and Duperow formations. However, modifications have recently been made to the artificial lift equipment and the production rate is expected to improve. The Lynn #1 well, which was placed on production last August, continues to produce approximately 135 barrels of oil and 8 barrels of water per day from the Nisku formation. Modifications were also recently made to the artificial lift equipment on this well and the production is expected to improve modestly. Basic has an approximate 18 percent working interest in both the Lynn #1 and #2 wells which are operated by Missouri Basin Well Service, Inc. On the Company's "3-D Bright Spot" test in Wharton County, Texas Basic spent an additional $8,000 on surface facilities in the quarter just ended, for a total investment of $313,000. The well, the Turf Grass #1, is flowing from perforations at 10,898'-10,920' in the Yegua formation. Now in its fourth month of production, although flowing tubing pressures have not yet stabilized, the well is averaging approximately 60 million cubic feet of gas, 13,000 barrels of condensate and 30,000 gallons of propane per month with a flowing tubing pressure of 4,700 psi. The Company has a 5.0 percent working interest (3.55 percent net revenue interest) in the well which is now operated by PetroReal, Inc. As previously disclosed, and 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 due to earlier problems that were encountered while drilling the well. 9 Also in the quarter just ended, the Company participated in a second "3-D Bright Spot" prospect; this one located in Liberty County, Texas. Although the well was started prior to December 31, it did not reach total depth until after the end of the quarter. As previously reported, this effort resulted in a dry hole and the well has been plugged and abandoned. The Company had a 7.5 percent working interest in this venture and now expects prospect fees, acreage and drilling costs to total $195,000, slightly less than the $210,000 that was budgeted. Finally, as previously disclosed, in late-December 2004 the Company began drilling its first dual-lateral, horizontal Bakken formation test, the Halvorsen 31X-1, located in Section 1, T22N-R57E in Richland County, Montana. Total depth was reached subsequent to quarter end and operations are currently suspended while waiting for a completion rig. At this time, the completion plan is to flow test the well unstimulated and hydraulically fracture the well at a later date. Basic has an approximate 26 percent interest in the well and expects to spend $675,000 on drilling and completion costs. The Halvorsen 31X-1 is operated by Headington Oil, L.P. This well is situated in the east half of a 1,280 acre spacing unit such that a second horizontal well may be drilled at a later date. CONTEMPLATED ACTIVITIES. In addition to the capital expenditures described immediately above, the Company anticipates pursuing the following activities. Basic is anticipating notification from the operator of the Indian Hill prospect of plans to drill a third well, a horizontal Nisku test, which is to be initiated this spring or summer. Basic would have an approximate 18 percent working interest in this new well. The Company anticipates its exposure would be approximately $400,000. 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. Although no specific well is identified, in addition to the Halvorsen well discussed above, the Company anticipates participation in other horizontal Bakken wells in this area. Basic's interest in such ventures will be 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. 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. 10 Basic anticipates drilling a second test on its Heart River Prospect in Stark County, North Dakota during the summer or fall 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. Results of Operations --------------------- Nine Months Ended December 31, 2004 Compared to Nine Months Ended December 31, 2003 ------------------------------------------------------------------------------ OVERVIEW. Net income from operations for the nine months ended December 31, 2004 (2004) was $1,242,000 compared to net income from operations of $495,000 for the nine months ended December 31, 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 $1,057,000. Net income for the 2004 period was impacted by a $160,000 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 $1,402,000 in 2004. REVENUES. Oil and gas sales revenue increased $1,178,000 (55%) in 2004 over 2003. Oil sales revenue increased $873,000 (48%) as a result of both higher oil sales volume and prices. Higher oil prices contributed $817,000 while the increase in sales volume added $56,000. Gas sales revenue also benefited from increases in both gas sales volume and prices. Higher gas sales volume contributed $180,000 and a jump in natural gas prices added $125,000 to an overall $305,000 (93%) spike in gas sales revenue. VOLUMES AND PRICES. Oil sales volume increased 3%, from 63,700 barrels in 2003 to 65,700 barrels in 2004 while there was a 44% jump in the average price per barrel from $28.56 in 2003 to $41.00 in 2004. Gas sales volume spiked 55%, from 76.8 million cubic feet in 2003 to 119.2 million cubic feet in 2004, while the average price per Mcf rose 25%, from $4.27 in 2003 to $5.32 in 2004. The increase in oil sales volume can be attributed to the addition of 3,500 barrels in 2004 from the Lynn #1 well in Williams County, North Dakota and the Turf Grass #1 well in Wharton County, Texas that were placed on production in late August 2004 and November 2004, respectively. 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 12% from 76,500 BOE in 2003 to 85,600 BOE in 2004. EXPENSES. Oil and gas production expense increased $165,000 (17%) 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. 11 Routine lease operating expense increased $96,000 (12%) from $784,000 in 2003 to $880,000 in 2004 while workover expense increased $69,000 (38%) from $184,000 in 2003 to $253,000 in 2004. As a result of the increase in equivalent barrel sales, routine lease operating expense per BOE decreased slightly from $10.25 in 2003 to $10.14 in 2004. Workover expense per BOE rose 49% from $2.40 in 2003 to $3.58 in 2004. With the current level of oil and natural gas prices and a strong cash flow environment, Basic elected to undertake workovers on a number of its operated properties in attempts to improve operational efficiency, reduce future lifting costs and extend the length of time between subsequent workovers relative to the historical patterns on these particular wells. In general, Basic is experiencing an industry-wide cost increase from service companies that is indicative of the strong demand for general oilfield services within Basic's core operating areas, particularly in the Williston basin in eastern Montana and western North Dakota. This strong demand is a reflection of the historically high level of oil prices that have benefited both the producers and service companies. Primarily as a result of the increase in oil and gas sales revenue, production taxes, which are generally a percentage of sales revenue, increased $109,000 (64%) in 2004 over 2003. Production taxes, as a percent of sales revenue rose from 7.9 percent in 2003 to 8.4 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 was $16.50 in 2004 compared to $14.87 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. Depreciation and depletion expense increased $130,000 (72%) in 2004 over 2003 as a result of the $160,000 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 additional impairment charge in the December 2004 quarter. As a result, after impairment charges of $160,000 during the nine-month period ended December 31, 2004, the carrying value of Legent's Canadian oil and gas property approximated $167,000. Should Legent and its joint venture partners establish production from the Silver Spike wellbore, or on any of its acreage in Saskatchewan, the remaining $167,000 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 $160,000 impairment charge, depreciation and depletion expense in 2004 was $151,000 compared to $181,000 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 53% from $2.34 in 2003 to $3.57 in 2004. Excluding the impairment charge, depreciation and depletion expense per BOE in 2004 was $1.70 reflecting a decrease of 27% from 2003. 12 As a result of implementing SFAS No. 143, the Company recorded a $37,000 expense for the accretion of its asset retirement obligation and an asset retirement expense of $43,000 in 2004. These compare to an accretion expense of $54,000 and an asset retirement expense of $89,000 in 2003. Gross general and administrative (G&A) expense increased $84,000 (24%) while net G&A expense increased $92,000 (48%) 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 44% in 2003. Net general and administrative expense per BOE increased 32% from $2.51 in 2003 to $3.32 in 2004. Quarter Ended December 31, 2004 Compared to Quarter Ended December 31, 2003 --------------------------------------------------------------------------- OVERVIEW. Net income for the quarter ended December 31, 2004 (2004) was $491,000 compared to net income of $161,000 for the quarter ended December 31, 2003 (2003). Net income solely from the Company's core U.S. operations was $571,000 in 2004. REVENUES. Oil and gas sales revenue increased $570,000 (81%) in 2004 over 2003. As a result of both higher oil sales volume and prices, oil sales revenue increased $443,000 (75%). The increase in volume contributed $64,000 while higher oil prices added $379,000. In addition, gas sales revenue increased $127,000 (113%) in 2004 over 2003. Of this amount, higher gas sales volume contributed $60,000 while an increase in the average price per Mcf in 2004 over 2003 added $67,000. VOLUMES AND PRICES. Oil sales volume increased 11%, from 20,500 barrels in 2003 to 22,700 barrels in 2004 while there was a 58% jump in the average price per barrel from $28.87 in 2003 to $45.54 in 2004. Gas sales volume rose 54%, from 26.0 million cubic feet in 2003 to 40.0 million cubic feet in 2004, while the average price per Mcf increased 39%, from $4.30 in 2003 to $5.98 in 2004. The increase in oil sales volume can be attributed to the addition of 2,200 barrels from the Lynn #1 well that began production in August 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 19% from 24,800 BOE in 2003 to 29,400 BOE in 2004. EXPENSES. Oil and gas production expense increased $113,000 (39%) in 2004 over 2003. Routine lease operating expense increased $52,000 (21%) from $246,000 in 2003 to $298,000 in 2004 while workover expense increased $61,000 (139%) from $44,000 in 2003 to $105,000 in 2004. On a BOE basis, routine lease operating expense rose from $9.90 in 2003 to $10.14 in 2004 and workover expense increased from $1.79 in 2003 to $3.58 in 2004. Again, as a result of the increase in oil and gas sales revenue, production taxes increased $49,000 (83%) in 2004 over 2003. Production taxes were 8.4 percent of oil and gas sales revenue in both 2004 and 2003. The overall lifting cost per equivalent barrel increased 24% from $14.06 in 2003 to $17.37 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. 13 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 $71,000 (113%) in 2004 over 2003. Excluding the impairment, depreciation and depletion expense was $54,000 in 2004, a decrease of $9,000 (14%) 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 80% from $2.50 in 2003 to $4.50 in 2004. Excluding the impairment charge, depletion and depreciation expense per BOE in 2004 was $1.77 reflecting a 29% 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 $14,000 in 2004 compared to $21,000 in 2003 while the asset retirement expense dropped from $51,000 in 2003 to $23,000 in 2004. Gross general and administrative (G&A) expense increased $41,000 (36%) while net G&A expense increased $41,000 (67%) in 2004 over 2003. The increase in net G&A expense was primarily the result of an increase in employee benefits. Net G&A expense per BOE increased 43% from $2.44 in 2003 to $3.48 in 2004. (Intentionally left blank.) 14 Liquids and Natural Gas Production, Sales Price and Production Costs -------------------------------------------------------------------- The following table shows selected financial information for the nine months and quarter ended December 31 in the current and prior year. Certain prior year amounts may have been reclassified to conform to current year presentation.
Nine Months Ended Quarters Ended December 31 December 31 2004 2003 2004 2003 ---------- ---------- ---------- ---------- Sales volume Oil (barrels) 65,700 63,700 22,700 20,500 Gas (mcf) 119,200 76,800 40,000 26,000 Revenue Oil $2,693,000 $1,820,000 $1,035,000 $ 592,000 Gas 634,000 329,000 239,000 112,000 ---------- ---------- ---------- ---------- 3,327,000 2,149,000 1,274,000 704,000 Total production expense(1) 1,412,000 1,138,000 511,000 349,000 ---------- ---------- ---------- ---------- Gross profit $1,915,000 $1,011,000 $ 763,000 $ 355,000 ========== ========== ========== ========== Depletion expense $ 305,000 $ 179,000 $ 131,000 $ 62,000 Average sales price(2) Oil (per barrel) $ 41.00 $ 28.56 $ 45.54 $ 28.87 Gas (per mcf) $ 5.32 $ 4.27 $ 5.98 $ 4.30 Average production expense(1,2,3) $ 16.50 $ 14.87 $ 17.37 $ 14.06 Average gross profit(2,3) $ 22.39 $ 13.20 $ 25.99 $ 14.27 Average depletion expense(2,3) $ 3.57 $ 2.34 $ 4.50 $ 2.50 Average general and administrative expense(2,3) $ 3.32 $ 2.51 $ 3.48 $ 2.44 ---------------------------- (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 December 31, 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. 15 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 nine months ended December 31, 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. 16 (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. January 17, 2005 The Company announced that its Liberty County, Texas "3-D Bright Spot" test well was a dry hole. It also provided a drilling progress report on its Halvorsen 31X-1 dual-lateral, horizontal well in Richland County, Montana and disclosed that the recently completed Lynn #2 well in Williams County, North Dakota had begun producing from both the Nisku and Duperow formations. February 7, 2005 The Company announced that it had completed drilling operations on the Halvorsen 31X-1 dual-lateral, horizontal well and was currently waiting on a completion rig. It also provided production updates on the Lynn #1 and Lynn #2 wells and the Turf Grass #1 well in Wharton County, Texas, all three of which have been completed and placed on production during the current fiscal year ending March 31, 2005. 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: February 4, 2005 17