ITEM 2
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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Forward-Looking
Information
This
Form 10-Q quarterly report of Houston American Energy Corp. (the “Company”) for the nine months ended September 30,
2017, contains certain 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, which are intended to be covered by the safe harbors created
thereby. To the extent that there are statements that are not recitations of historical fact, such statements constitute forward-looking
statements that, by definition, involve risks and uncertainties. In any forward-looking statement, where we express an expectation
or belief as to future results or events, such expectation or belief is expressed in good faith and believed to have a reasonable
basis, but there can be no assurance that the statement of expectation or belief will be achieved or accomplished.
The
actual results or events may differ materially from those anticipated and as reflected in forward-looking statements included
herein. Factors that may cause actual results or events to differ from those anticipated in the forward-looking statements included
herein include the Risk Factors described in Item 1A herein and in our Form 10-K for the year ended December 31, 2016.
Readers
are cautioned not to place undue reliance on the forward-looking statements contained herein, which speak only as of the date
hereof. We believe the information contained in this Form 10-Q to be accurate as of the date hereof. Changes may occur after that
date, and we will not update that information except as required by law in the normal course of our public disclosure practices.
Additionally,
the following discussion regarding our financial condition and results of operations should be read in conjunction with the financial
statements and related notes contained in Item 1 of Part 1 of this Form 10-Q, as well as the Risk Factors in Item 1A and the financial
statements in Item 7 of Part II of our Form 10-K for the fiscal year ended December 31, 2016.
Critical
Accounting Policies
The
discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements,
which have been prepared in accordance with accounting principles generally accepted in the United States of America. We believe
certain critical accounting policies affect the more significant judgments and estimates used in the preparation of our financial
statements. A description of our critical accounting policies is set forth in our Form 10-K for the year ended December 31, 2016.
As of, and for the nine months ended, September 30, 2017, there have been no material changes or updates to our critical accounting
policies.
Unevaluated
Oil and Gas Properties
Unevaluated
oil and gas properties not subject to amortization, include the following at September 30, 2017:
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September 30, 2017
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Acquisition costs
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$
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141,318
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Development and evaluation costs
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2,161,809
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Total
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$
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2,303,127
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All
of the carrying value of unevaluated oil and gas prospects above was attributable to properties in the South American country
of Colombia. We are maintaining our interest in these properties.
Recent
Developments
Leasing
Activity
During
the nine months ended September 30, 2017, we (i) acquired, for $986,937, a 25% working interest (subject to a proportionate 5%
back-in after payout) in two lease blocks (the Johnson tract and the O’Brien tract) covering 717.25 acres in Reeves County,
Texas; (ii) incurred an additional $11,552 of leasehold cost in Reeves County; and (iii) incurred an additional $1,036 of leasehold
cost in Louisiana.
In
conjunction with the planned drilling and development of our O’Brien tract, and in order to optimize the length of the planned
horizontal leg and anticipated recoveries, our operator entered into a pooling agreement pursuant to which the owner of an adjoining
acreage block contributed a portion of that acreage to the contract area covering our O’Brien tract. As a result, our effective
gross acreage in Reeves County was increased to 960 acres and our average working interest across the acreage was reduced to 18.7%.
Drilling
Activity
During
the nine months ended September 30, 2017, our drilling operations consisted of:
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Johnson
State #1H well, our first well on our Reeves County, Texas acreage was drilled, hydraulic
fracturing operations completed and the well was shut-in pending construction of a gas
sales line; and
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●
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O’Brien
#3H well, our second Reeves County well, was drilled, hydraulic fracturing operations
completed and oil sales began in late September with gas sales delayed pending construction
of a gas sales line.
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Gas
sales lines were under construction to both wells at September 30, 2017. Construction of the gas sales line to the O’Brien
#3H well was completed, and gas sales commenced, during the fourth week of October 2017. Construction of the gas sales line to
the Johnson #1H well is expected to be completed, and sales of oil and gas from the well to commence, by mid-November 2017.
During
the nine months ended September 30, 2017, our capital investment expenditures for drilling, completion and related operations
totaled $3,284,040.
In
Colombia, our operator is continuing to carry on discussions with federal and local officials in order to overcome opposition
to their efforts to secure necessary permits to commence drilling operations on our Serrania concession. Until a satisfactory
resolution is reached allowing the issuance of necessary permits, substituting equivalent prospects or otherwise compensating
for the value of, and investments in, our Serrania concession, our operator is continuing to defer further efforts to commence
drilling on the Serrania concession.
Our
operator has also deferred commencement of work on the Los Picachos and Macaya concessions until satisfactory resolution of the
permitting issues on the Serrania concession.
Financing
Activity
In
January 2017, we issued 1,200 shares of 12% Series A Convertible Preferred Stock (the “Series A Preferred Stock”)
for aggregate gross proceeds of $1.2 million.
The
Series A Preferred Stock (i) accrues a cumulative dividend, commencing July 1, 2017, at 12% payable, if and when declared, quarterly;
(ii) is convertible at the option of the holder into shares of common stock at a conversion price of $0.20 per share, (iii) has
a liquidation preference of $1,000 per share plus accrued and unpaid dividends; and (iv) is redeemable at our option, commencing
on the second anniversary of the issue date, at a premium to issue price, which premium decreases from 12% to 0% following the
fifth anniversary of the issue date, plus accrued and unpaid dividends. Proceeds from the issuance of the Series A Preferred Stock
were used to acquire our interest in oil and gas properties in Reeves County, Texas and the balance, after offering expenses,
was added to working capital. During the nine months ended September 30, 2017, we paid $36,000 of dividends on our Series A Preferred
Stock.
In
May 2017, we received $909,600 from the sale of 909.6 Units (the “Units”), each Unit consisting of one share of 12.0%
Series B Convertible Preferred Stock (the “Series B Preferred Stock”) and a Warrant (the “Series B Warrant”).
Proceeds from the sale of Units were used to fund our share of drilling costs on a first well on our Reeves County, Texas acreage
with proceeds in excess of such costs, after offering costs, added to working capital.
The
Series B Preferred Stock (i) accrues a cumulative dividend at 12% payable, if and when declared, quarterly; (ii) is convertible
at the option of the holder into shares of common stock at a conversion price of $0.36 per share, (iii) has a liquidation preference
of $1,000 per share plus accrued and unpaid dividends; and (iv) is redeemable at our option, commencing on the second anniversary
of the issue date, at a premium to issue price, which premium decreases from 12% to 0% following the fifth anniversary of the
issue date, plus accrued and unpaid dividends. During the nine months ended September 30, 2017, we paid $44,570 of dividends on
our Series B Preferred Stock.
The
Series B Warrants are exercisable, for a period of nine months, to purchase an aggregate of 3,001,680 shares of common stock at
$0.43 per share. The relative fair value of the warrants were valued on the date of grant at $194,934 using the Black-Scholes
option-pricing model with the following parameters: (1) risk-free interest rate of 1.10%; (2) expected life in years of 0.75;
(3) expected stock volatility of 92.36%; and (4) expected dividend yield of 0%.
In
June 2017, we issued promissory notes (the “Bridge Loan Notes”) in the principal amount of $600,000 and warrants (the
“Bridge Loan Warrants”) to purchase common stock. We received aggregate consideration for the Bridge Loan Notes and
Warrants of $570,000. Proceeds from the issuance of the Bridge Loan Notes were used to fund our share of drilling costs on the
O’Brien #3H well and the balance, after offering expenses, was added to working capital.
The
Bridge Loan Notes were unsecured obligations bearing interest at 12.0% per annum and payable interest only on the last day of
each calendar month with any unpaid principal and accrued interest being payable in full in 120 calendar days.
The
Bridge Loan Notes were subject to mandatory prepayment from and to the extent of (i) 100% of net proceeds we receive from any
sales, for cash, of equity or debt securities (other than Bridge Loan Notes), (ii) 100% of net proceeds we receive from the sale
of assets (other than sales in the ordinary course of business); and (iii) 75% of net proceeds we receive from the sale of oil
and gas produced from our Reeves County, Texas properties. Additionally, we had the option to prepay the Bridge Loan Notes, at
its sole election, without penalty.
The
Bridge Loan Warrants are exercisable, for a period of one year, to purchase an aggregate of 600,000 shares of common stock at
$0.50 per share.
The
holders of $300,000 in the face amount of the Bridge Loan Notes waived mandatory prepayment at both July 31, 2017 and August 31,
2017 and the holders of the remaining $300,000 in face amount of the Bridge Loan Notes were repaid in full pursuant to the mandatory
prepayment provision. The balance of the Bridge Loan Notes, in the amount of $300,000, were repaid in full as of September 30,
2017.
In
July 2017, we entered into an At-the-Market Issuance Sales Agreement (the “Sales Agreement”) with WestPark Capital,
Inc. (“WestPark Capital”) pursuant to which we may sell, at our option, up to an aggregate of $5 million in shares
of our common stock through WestPark Capital, as sales agent. Sales of shares under the Sales Agreement (the “ATM Offering”)
will be made, in accordance with one or more placement notices we may deliver to WestPark Capital, which notices shall set parameters
under which shares may be sold. The ATM Offering will be made pursuant to a shelf registration statement by methods deemed to
be “at the market,” as defined in Rule 415 promulgated under the Securities Act of 1933. We will pay WestPark a commission
in cash equal to 3% of the gross proceeds from the sale of shares in the ATM Offering. Additionally, we reimbursed WestPark Capital
for $25,000 of expenses incurred in connection with the ATM Offering. Proceeds from the ATM Offering have been used to repay the
Bridge Loan Notes, to pay drilling and development costs and for working capital.
As
of September 30, 2017, we had sold an aggregate of 5,522,874 shares in the ATM Offering and had received proceeds, net of commissions
and expenses, of $3,049,515.
Subsequent
to September 30, 2017, through the date hereof, we sold an aggregate of 913,702 shares in the ATM Offering and received proceeds,
net of commissions and expenses, of $467,874.
Employment
Arrangements
During
the quarter ended March 31, 2017, our compensation committee approved revised employment terms of John Boylan, our Chairman, CEO
and President, and we hired a Vice President – Business Development to assist in implementation of our growth plan.
The
principal terms of Mr. Boylan’s compensation, as revised during the quarter, include (i) an annual base salary of $250,000,
effective January 1, 2017, with $10,000 per month being payable on a current basis, and full salary and accrued unpaid salary
being payable at such time as the compensation committee determines that the Company has sufficient financial capability to pay
such amounts; (ii) annual bonuses as determined by the compensation committee; (iii) grant, pursuant to our Production Incentive
Compensation Plan, of a 1% interest in our revenues from all wells drilled on our Reeves County, Texas acreage; and (iv) grant
of a stock option to purchase 500,000 shares of common stock.
During
the six months ended June 30, 2017, we terminated our newly hired Vice President – Business Development and options granted
pursuant to the terms of employment expired unvested and unexercised.
Results
of Operations
Oil
and Gas Revenues.
Total oil and gas revenues increased by 181% to $111,741 in the three months ended September 30, 2017 compared
to $39,738 in the three months ended September 30, 2016. Oil and gas revenues increased 77% to $215,649 in the nine months ended
September 30, 2017 compared to $121,885 in the nine months ended September 30, 2016.
The
following table sets forth the gross and net producing wells, net oil and gas production volumes and average hydrocarbon sales
prices for the quarter and nine months ended September 30, 2017 and 2016:
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Three Months Ended
September 30,
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Nine Months Ended
September 30,
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2017
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2016
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2017
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2016
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Gross producing wells
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11
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9
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12
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9
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Net producing wells
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0.99
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0.47
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1.0
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0.47
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Net oil production (bbl)
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2,310
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690
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3,888
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2,218
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Net gas production (mcf)
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3,450
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4,172
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11,479
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16,126
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Average sales price – oil (per barrel)
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$
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43.45
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$
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45.61
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$
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45.69
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$
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38.97
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Average sales price – natural gas (per mcf)
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$
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3.29
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$
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1.98
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$
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3.31
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$
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2.20
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The
increase in oil production reflects sales of initial production, during well-testing, from our first two Reeves County wells and
the commencement of production from one of those wells late in the quarter. The decline in gas production reflects natural decline
rates, partially offset by resumption of production from a well that had been off line. The change in average sales prices realized
reflects a partial recovery in global commodity prices following a steep drop in prices beginning in late 2014 and continuing
to mid-2016.
With
the commencement of oil production from our O’Brien #3H well late the quarter and natural gas production following quarter
end and the anticipated commencement of production from our Johnson #1H well by mid-November 2017, we anticipate that production
levels and revenues will increase substantially beginning in the fourth quarter of 2017.
Oil
and gas sales revenues by region were as follows:
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Colombia
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U.S.
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Total
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2017 First Nine Months
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Oil sales
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$
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—
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$
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177,678
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$
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177,678
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Gas sales
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—
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37,971
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37,971
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2016 First Nine Months
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Oil sales
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$
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—
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$
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86,420
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$
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86,420
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Gas sales
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—
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35,465
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35,465
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Lease
Operating Expenses.
Lease operating expenses increased by 140% to $55,245 during the three months ended September 30, 2017
from $23,054 during the three months ended September 30, 2016. During the nine months ended September 30, 2017, lease operating
expenses increased by 58% to $95,260 from $60,416 during the nine months ended September 30, 2016. The change in total lease operating
expenses was attributable to the resumption of production from a well that had been offline, increased salt water disposal fees
and the commencement of production from the first of our Reeves County wells.
Following
is a summary comparison of lease operating expenses, by region, for the periods.
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Colombia
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U.S.
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Total
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Quarter ended September 30,
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-2017
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$
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—
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$
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55,245
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$
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55,245
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-2016
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$
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—
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$
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23,054
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$
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23,054
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Nine Months ended September 30,
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-2017
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$
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—
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$
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95,260
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$
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95,260
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-2016
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$
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—
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$
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60,416
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$
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60,416
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Consistent
with our business model and operating history, we experience steep declines in lease operating expenses following strategic divestitures
and anticipate lease operating expenses to ramp up to levels consistent with regional costs as new wells are brought on line.
With
the commencement of production in Reeves County late in the quarter, we experienced an increase in lease operating expense during
the third quarter of 2017 and expect substantial increases in lease operating expenses commencing in the fourth quarter of 2017.
General
and Administrative Expenses.
General and administrative expense increased by 72% to $622,994 during the three months ended
September 30, 2017 from $362,807 during the three months ended September 30, 2016, and increased 36% to $1,627,433 during the
nine months ended September 30, 2017 from $1,194,223 during the nine months ended September 30, 2016. The change in general and
administrative expense was primarily attributable to (i) an increase in the base salary of our principal officer effective January
1, 2017, including deferred and accrued salary totaling $32,500 for the current quarter and $97,500 for the nine months ended
September 30, 2017, which will not be paid until our compensation committee determines that we have sufficient financial capacity
to pay the same, (ii) hiring of a non-executive officer for a two-month period, (iii) increased legal, professional and other
costs associated with our efforts to finalize the acquisition of our Reeves County acreage, increase investor visibility, maintain
our exchange listing and secure funding to satisfy our financial commitments with respect to the Reeves County acreage, (iv) increased
stock compensation expense associated with 2017 option grants, and (v) increased insurance costs; all partially offset by select
salary reductions and timing related decreases in director fees.
Depreciation
and Depletion Expense.
Depreciation and depletion expense was $55,280 and $25,069 for the three months ended September 30,
2017 and 2016, respectively, and $86,486 and $74,333 for the nine months ended September 30, 2017 and 2016, respectively. The
increase was due to the commencement, late in the quarter, of production from the first of our Reeves County wells.
With
drilling operations and the commencement of production in Reeves County, we anticipate that depreciation and depletion expenses
will increase beginning in the fourth quarter of 2017.
Other
Income (Expense)
. Other income/expense, net, totaled $164,500 of expense during the three months ended September 30, 2017
as compared to $849 of income during the three months ended September 30, 2016 and totaled $161,421 of expense during the nine
months ended September 30, 2017 as compared to $6,887 of income during the nine months ended September 30, 2016. Other income,
net, consisted of a one-time lease participation fee of $10,000 received from a third-party during the 2017 nine-month period
and interest income net of interest expense. Interest expense during the three and nine months ended September 30, 2017, totaled
$164,503 and $171,605, respectively, all relating to the issuance of Bridge Loan Notes and associated Warrants during 2017, and
consisted of $12,131 and $12,871, respectively, of cash interest paid; plus $152,372 and $158,734, respectively, of amortization
of debt discount of $128,734 attributable to the Bridge Loan Warrants and the $30,000 excess of the face amount of the Bridge
Loan Notes over the consideration paid for the Bridge Loan Notes.
Financial
Condition
Liquidity
and Capital Resources.
At September 30, 2017, we had a cash balance of $409,606 and a deficit in working capital of $100,170,
compared to a cash balance of $481,172 and working capital of $423,795 at December 31, 2016. The change in working capital during
the period was primarily attributable to investments in acquiring and commencement of drilling on the Reeves County acreage and
the operating loss for the first nine months of 2017, partially offset by equity capital raising efforts.
Operating
activities used cash of $1,241,127 during the nine months ended September 30, 2017 compared to $1,023,200 used during the nine
months ended September 30, 2016. The change in operating cash flow was primarily attributable to an increase in our net loss,
reflecting increased compensation and legal, professional and other costs associated with increased investor visibility activities
and regulatory matters, partially offset by the accrual of deferred salary and additional non-cash charges during 2017.
Investing
activities used cash of $3,878,984 during the nine months ended September 30, 2017 compared to $92,217 used during the nine months
ended September 30, 2016. The increase in funds used by investing activities during 2017 reflects the acquisition of our Reeves
County acreage ($999,525) and investments in drilling and related operations on the Reeves County acreage ($3,284,040) and preparation
and evaluation costs in Colombia ($18,941).
Financing
activities provided cash of $5,048,545 during the nine months ended September 30, 2017 compared to $135,973 used during the nine
months ended September 30, 2016. The change in cash flow from financing activity reflects the receipt of gross funds totaling
$5,729,115 from the sale, during 2017, of Common Stock under our ATM Offering, Series A Preferred Stock, Series B Preferred and
Series B Warrants, and Bridge Loan Notes and Bridge Loan Warrants, partially offset by the payment of dividends on the Series
A and Series B Preferred Stock ($80,570) and repayment of Bridge Loan Notes ($600,000), while funds were used during 2016 for
the purchase of treasury stock.
Long-Term
Liabilities
. At September 30, 2017, we had long-term liabilities of $76,302 compared to $27,444 at December 31, 2016. Long-term
liabilities consisted of deferred rent obligation and a reserve for plugging costs at September 30, 2017 and consisted of a reserve
for plugging costs at December 31, 2016.
Capital
and Exploration Expenditures and Commitments.
Our principal capital and exploration expenditures relate to ongoing efforts
to acquire, drill and complete prospects, in particular our Reeves County acreage.
During
the nine months ended September 30, 2017, we invested $4,302,506 for the acquisition and development of oil and gas properties,
consisting of (1) cost of acquisition of U.S. properties $999,525, principally attributable to acreage acquired in Reeves County,
Texas, (2) cost of drilling and hydraulic fracturing of, and construction of gas sales lines to, our Johnson State #1H well and
O’Brien #3H well, totaling in the aggregate $3,284,040, and (3) preparation and evaluation costs in Colombia of $18,941.
Of the amount invested, we capitalized $18,941 to oil and gas properties not subject to amortization and $4,283,565 to oil and
gas properties subject to amortization.
We
do not presently expect to drill any additional wells during 2017. For the balance of 2017, we have not budgeted any capital expenditures,
although we may make some capital expenditures relating to costs incurred, after September 30, 2017, in bringing our initial Reeves
County wells on line. We expect to drill two additional wells on our Reeves County acreage in the first quarter of 2018. With
the construction of substantial field infrastructure in connection with drilling and completion of our first two Reeves County
wells, which infrastructure will support future drilling operations, we anticipate that future well costs on those blocks will
decline.
Capital
expenditure plans for the balance of 2017 and early 2018 may change depending on (1) our ability to fund our share of drilling
and completion costs on wells on our Reeves County acreage, (2) the results of drillings on our Reeves County acreage, (3) the
schedule of future drilling operations on our Reeves County acreage, (4) the timing and ultimate resolution of permitting issues
at Serrania, and (5) field conditions and other factors beyond our control or the control of the operators of our prospects. Accordingly,
there can be no assurance as to the timing of these operations or the amount actually spent on such operations.
Financing
Requirements
. Our cash holdings, taking into account $467,874, net, raised from the sale of common stock subsequent to September
30, 2017, are expected to be adequate to support operations over the balance of 2017 but are not adequate to fund our share of
drilling and completion costs on wells anticipated to be drilled in Reeves County in 2018. While we expect to realize a significant
increase in revenues from initial production in Reeves County commencing during the fourth quarter of 2017, those revenues will
not be adequate to fund our drilling budget.
In
order to fully fund our estimated drilling and completion budget and support operations through early 2018, and beyond, we expect
that we will be required to raise additional capital. While we may, among other efforts, pursue additional sales of shares in
our ATM Offering, private sales of equity and debt securities and may realize up to $1.59 million of additional funding from exercise
of outstanding warrants, we presently have no commitments to provide additional funding, through the exercise of warrants or otherwise,
and there can be no assurance that we can secure the necessary capital to support such plans and operations on acceptable terms
or at all. If, for any reason, we are unable to fully fund our drilling budget and fail to satisfy commitments reflected therein,
we may be subject to penalties or to the possible loss of some of our rights and interests in prospects with respect to which
we fail to satisfy funding commitments and we may be required to curtail operations and forego opportunities.
Outlook
Continued low oil and natural
gas prices during 2015 and 2016 and recurring delays in drilling of our Serrania prospect in Colombia had a significant adverse
impact on our business. Our financial statements include a “going concern” qualification reflecting substantial doubt
as to our ability to continue as a going concern. We will continue to operate at a loss absent substantial increases in production,
pricing or both. Our present focus in addressing our recurring operating losses is drilling on our Reeves County acreage. Even
with the commencement of cash flow from our initial Reeves County wells in the fourth quarter of 2017, in order to achieve
profitability and sustain positive operating cash flow, we will need to continue to drill successful wells on our Reeves County
acreage, or elsewhere. While we have secured the necessary capital to support drilling operations to date in Reeves County, we
have not yet secured financing to fund our share of estimated costs to support planned operations in Reeves County through early
2018 and beyond. We can provide no assurance as to our ultimate ability to fully fund our share of estimated drilling and completion
costs, as to the ultimate success of those wells or of the ultimate production rates, if any, of those wells. If, for any reason,
we are unable to finance our portion of drilling and completion costs on our planned Reeves County wells, or if one or more of
those wells is not successful or if production rates are less than anticipated, we may continue to operate at a loss and may lack
the financial resources to continue as a going concern and may be required to divest certain assets or pursue other strategic
alternatives to support operations.
Off-Balance
Sheet Arrangements
We
had no off-balance sheet arrangements or guarantees of third party obligations at September 30, 2017.
Inflation
We
believe that inflation has not had a significant impact on operations since inception.