(Amendment No. 2 )
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
NOTE 1. RESTATEMENT OF PREVIOUSLY REPORTED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
On February 23, 2010, China North East Petroleum Holdings Limited (the “Company) determined that the Company’s financial statements as of March 31, 2009 and for the three months then ended should no longer be relied upon and should be restated as a result of certain non-cash errors contained therein regarding the accounting for: (i) warrants issued in conjunction with a secured debenture on February 28, 2008, which warrants should have been classified according to Emerging Issues Task Force (“EITF”) 00-19 as liability instruments rather than equity instruments; (ii) the change in the fair value of those warrants from the date of issuance through the end of the reporting period; (iii) effective interest expense arising from amortization of the discount to the carrying value of the secured debenture; (iv) the recording of warrants issued to investment consultants in connection with the issuance of the secured debenture as deferred financing costs instead of consulting fees; (v) the rate of amortization of deferred financing costs associated with the issuance of that secured debenture; (vi) compensation issued to employees in the form of stock; (vii) depreciation, depletion and amortization of oil properties; (viii) ceiling test reduction of the net carrying value of oil properties; (ix) income tax expense; (x) non-controlling interests; and (xi) restructuring of the secured debenture on March 5, 2009, treated as an extinguishment of debt.
As a result, the accompanying unaudited condensed consolidated financial statements as of March 31, 2009 and for the three months then ended have been restated from the amounts previously reported. The information in the data below represents only those income statement, balance sheet, cash flow and comprehensive income statement line items affected by the restatement.
STATEMENT OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) INFORMATION
| |
|
Three months ended
March 31, 2009
|
|
| |
|
As
previously
reported
|
|
|
Adjustments |
|
|
As
restated
|
|
|
Cost of Sales:
|
|
|
|
|
|
|
|
|
|
|
Depreciation, depletion and amortization of oil properties
|
|
$ |
2,624,254 |
|
|
$ |
455,376 |
|
|
$ |
3,079,630 |
|
|
Operating Expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Selling, general and administrative expenses
|
|
|
572,583 |
|
|
|
106,292 |
|
|
|
678,875 |
|
|
Professional fees
|
|
|
72,016 |
|
|
|
26,740 |
|
|
|
98,756 |
|
|
Consulting fees
|
|
|
57,680 |
|
|
|
(60,274 |
) |
|
|
(2,594 |
) |
|
Impairment of oil properties
|
|
|
- |
|
|
|
13,825,567 |
|
|
|
13,825,567 |
|
|
Other Income (Expense):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Amortization of deferred financing costs
|
|
|
(74,139 |
) |
|
|
(70,368 |
) |
|
|
(144,507 |
) |
|
Amortization of discount on debenture
|
|
|
(492,703 |
) |
|
|
(177,789 |
) |
|
|
(670,492 |
) |
|
Change in fair value of warrants
|
|
|
- |
|
|
|
653,705 |
|
|
|
653,705 |
|
|
Loss on extinguishment of debt
|
|
|
- |
|
|
|
(8,260,630 |
) |
|
|
(8,260,630 |
) |
|
Income tax expense
|
|
|
(1,419,819 |
) |
|
|
1,419,819 |
|
|
|
- |
|
|
Net income (loss)
|
|
|
2,684,098 |
|
|
|
(20,788,964 |
) |
|
|
(18,104,866 |
) |
|
Non-controlling interests
|
|
|
(412,745 |
) |
|
|
1,286,113 |
|
|
|
(873,368 |
) |
|
Net income (loss) attributable to CNEH common stockholders
|
|
|
2,271,353 |
|
|
|
(19,502,851 |
) |
|
|
(17,231,498 |
) |
|
Foreign currency translation gain
|
|
|
71,045 |
|
|
|
(15,224 |
) |
|
|
55,821 |
|
|
Comprehensive income (loss)
|
|
|
2,342,398 |
|
|
|
(19,518,075 |
) |
|
|
(17,175,677 |
) |
|
Net income (loss) per share -- Basic
|
|
|
0.11 |
|
|
|
(0.94 |
) |
|
|
(0.83 |
) |
|
Net income (loss) per share -- Diluted
|
|
|
0.11 |
|
|
|
(0.94 |
) |
|
|
(0.83 |
) |
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
BALANCE SHEET INFORMATION
| |
|
As of March 31, 2009
|
|
| |
|
As
previously
reported
|
|
|
Adjustments |
|
|
As
restated
|
|
|
Assets:
|
|
|
|
|
|
|
|
|
|
|
Oil properties, net
|
|
$ |
67,671,268 |
|
|
$ |
30,170,385 |
|
|
$ |
37,500,883 |
|
|
Deferred financing costs, net
|
|
|
864,959 |
|
|
|
(864,959 |
) |
|
|
- |
|
|
Deferred tax assets
|
|
|
- |
|
|
|
4,719,562 |
|
|
|
4,719,562 |
|
|
Total Assets
|
|
|
95,485,927 |
|
|
|
(26,315,782 |
) |
|
|
69,170,145 |
|
|
Current Liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Current portion of secured debenture
|
|
|
3,917,726 |
|
|
|
2,807,274 |
|
|
|
6,725,000 |
|
|
Other payables and accrued liabilities
|
|
|
1,023,285 |
|
|
|
68,060 |
|
|
|
1,091,345 |
|
|
Total current liabilities
|
|
|
19,302,262 |
|
|
|
2,875,334 |
|
|
|
22,177,596 |
|
|
Long-term Liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Secured debenture, net of discount
|
|
|
4,296,391 |
|
|
|
3,078,609 |
|
|
|
7,375,000 |
|
|
Deferred tax liabilities
|
|
|
590,266 |
|
|
|
(590,266 |
) |
|
|
- |
|
|
Warrants
|
|
|
- |
|
|
|
6,897,094 |
|
|
|
6,897,094 |
|
|
Total long-term liabilities
|
|
|
18,938,566 |
|
|
|
9,385,437 |
|
|
|
28,324,003 |
|
|
Stockholders' Equity:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Additional paid-in capital
|
|
|
21,831,732 |
|
|
|
(8,242,683 |
) |
|
|
13,589,049 |
|
|
Deferred stock compensation
|
|
|
(1,046,250 |
) |
|
|
1,046,250 |
|
|
|
- |
|
|
Retained earnings (deficit), unappropriated
|
|
|
26,807,432 |
|
|
|
(28,774,307 |
) |
|
|
(1,966,875 |
) |
|
Accumulated other comprehensive income
|
|
|
3,324,113 |
|
|
|
(182,589 |
) |
|
|
3,141,524 |
|
|
Total stockholders’ equity
|
|
|
52,310,810 |
|
|
|
(36,153,329 |
) |
|
|
16,157,481 |
|
|
Total liabilities and stockholders’ equity
|
|
|
95,485,927 |
|
|
|
(26,315,782 |
) |
|
|
69,170,145 |
|
STATEMENT OF CASH FLOWS INFORMATION
| |
|
Three months ended
March 31, 2009
|
|
| |
|
As
previously
reported
|
|
|
Adjustments |
|
|
As
restated
|
|
|
Net income (loss)
|
|
$ |
2,271,353 |
|
|
$ |
(19,502,851 |
) |
|
$ |
(17,231,498 |
) |
|
Adjustments to reconcile net income to cash provided by operating activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Depreciation, depletion and amortization of oil properties
|
|
|
2,624,254 |
|
|
|
455,376 |
|
|
|
3,079,630 |
|
|
Amortization of deferred financing costs
|
|
|
74,139 |
|
|
|
70,368 |
|
|
|
144,507 |
|
|
Amortization of discount on debenture
|
|
|
492,703 |
|
|
|
177,789 |
|
|
|
670,492 |
|
|
Amortization of stock option compensation
|
|
|
173,576 |
|
|
|
106,292 |
|
|
|
279,868 |
|
|
Change in fair value of warrants
|
|
|
- |
|
|
|
(653,706 |
) |
|
|
(653,705 |
) |
|
Impairment of oil properties
|
|
|
- |
|
|
|
13,825,567 |
|
|
|
13,825,567 |
|
|
Loss on extinguishment of debt
|
|
|
- |
|
|
|
8,260,630 |
|
|
|
8,260,630 |
|
|
Warrants issued for services
|
|
|
48,680 |
|
|
|
(21,940 |
) |
|
|
26,740 |
|
|
Noncontrolling interests
|
|
|
412,745 |
|
|
|
(1,286,113 |
) |
|
|
(873,368 |
) |
|
Other payables and accrued liabilities
|
|
|
281,021 |
|
|
|
(11,594 |
) |
|
|
269,427 |
|
|
Deferred liabilities
|
|
|
(172,139 |
) |
|
|
(1,424,904 |
) |
|
|
(1,597,043 |
) |
|
Net cash provided by operating activities
|
|
|
5,790,716 |
|
|
|
(5,085 |
) |
|
|
5,785,631 |
|
|
Effect of exchange rate on cash
|
|
|
(11,922 |
) |
|
|
5,085 |
|
|
|
(6,837 |
) |
NOTE 2. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
In the opinion of management, the unaudited condensed consolidated financial statements contain all adjustments consisting only of normal recurring accruals considered necessary to present fairly the Company's financial position at March 31, 2009, the results of operations and cash flows for the three months ended March 31, 2009 and 2008. The results for the three months ended March 31, 2009 are not necessarily indicative of the results to be expected for the entire fiscal year ending December 31, 2009.
These financial statements should be read in conjunction with the Company's annual report on Form 10-K as filed with the Securities and Exchange Commission.
NOTE 3. ORGANIZATION
China North East Petroleum Holdings Limited (“North East Petroleum”) was incorporated in Nevada on August 20, 1999 under the name of Draco Holding Corporation (“Draco”).
Hong Xiang Petroleum Group Limited ("Hong Xiang Petroleum Group") was incorporated in the British Virgin Islands (“BVI”) on August 28, 2003 as an investment holding company.
Song Yuan City Hong Xiang Petroleum Technical Services Co., Ltd. (“Hong Xiang Technical”) was incorporated in the People’s Republic of China (“PRC”) on December 5, 2003 to provide technical advisory services to oil and gas exploration companies in the PRC.
During 2004, Hong Xiang Petroleum Group acquired a 100% ownership of Hong Xiang Technical.
During 2004, Hong Xiang Technical acquired a 100% interest in Song Yuan City Yu Qiao Qianan Hong Xiang Oil and Gas Development Co., Ltd. (“Hong Xiang Oil Development”) which is engaged in the exploration and production of crude oil in the Jilin Oil Region, of the PRC. In December 2002, Hong Xiang Oil Development entered into an oil lease agreement with Song Yuan City Yu Qiao Oil and Gas Development Limited Corporation (“Yu Qiao”) to develop the proven reserves in the Qian’an Oil Field Zone 112 (Qian’an 112) in Jilin Oil Region for 20 years.
During 2004, Draco executed a Plan of Exchange to acquire 100% of Hong Xiang Petroleum Group.
On July 26, 2006, the Company entered into a Joint Venture Agreement (the “JV Agreement”) with a principal stockholder and a related party, hereafter referred to as the “Related Parties,” to acquire oil and gas properties for the exploration of crude oil in the PRC. Pursuant to the JV Agreement, the Company and the Related Parties are obligated to contribute $1 million and $121,000, respectively, to the registered capital of Song Yuan North East Petroleum Technical Service Co., Ltd. (“Song Yuan Technical”), and the Company and the Related Parties will each share 90% and 10% respectively of the equity and profit interests of Song Yuan Technical.
On June 1, 2005, Song Yuan Technical acquired from third parties 100% equity interest of LongDe Oil & Gas Development Co. Ltd. (“LongDe”) at a consideration of $120,773 in cash. LongDe is engaged in the exploration and production of crude oil in the Jilin Oil Region of the PRC.
On January 26, 2007, Song Yuan Technical acquired 100% of the equity interest of Yu Qiao for 10,000,000 shares of the Company’s common stock having a fair value of $3,100,000. Yu Qiao is engaged in the extraction and production of crude oil in Jilin Province, PRC and operates 3 oilfields with a total exploration area of 39.2 square kilometers. Pursuant to a 20-year exclusive Cooperative Exploration Contract (the “Oil Lease”) which was entered into on May 28, 2002 with PetroChina Group, a corporation organized and existing under the laws of PRC (“PetroChina”), the Company has the right to explore, develop and extract oil at Qian’an 112, Da 34 and Gu 31 area.
After the acquisition of Yu Qiao, the oil lease agreement between Yu Qiao and Hong Xiang Oil Development was rescinded and Hong Xiang Technical and Hong Xiang Oil Development were dissolved in March 2007.
North East Petroleum, Hong Xiang Petroleum Group, Song Yuan Technical, LongDe and Yu Qiao are hereinafter referred to as (“the Company”).
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
NOTE 4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of consolidation
The accompanying unaudited condensed consolidated financial statements include the unaudited financial statements of North East Petroleum and its wholly owned subsidiary, Hong Xiang Petroleum Group and 90% equity interest owned subsidiaries, Song Yuan Technical, LongDe and Yu Qiao (collectively, “the Company”). The noncontrolling interests represent the minority shareholders’ 10% share of the results of Song Yuan Technical, LongDe and Yu Qiao.
All significant inter-company accounts and transactions have been eliminated in consolidation.
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 and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates include the value of the Company’s oil reserve quantities which are the basis for the calculation of the depletion, depreciation and amortization of oil properties and impairments of oil properties and estimates of the fair value of warrants. Actual results could differ from those estimates.
Foreign currency translation and other comprehensive income
The reporting currency of the Company is the US dollar. The functional currency of Song Yuan Technical, LongDe and Yu Qiao is the Chinese Renminbi (RMB).
For the subsidiaries whose functional currencies are other than the US dollar, all assets and liabilities accounts were translated at the exchange rate on the balance sheet date; stockholder's equity is translated at the historical rates and items in the statement of operations items and statement of cash flows are translated at the average rate for the year. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the statement of stockholders’ equity. The resulting translation gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.
Accumulated other comprehensive income in the consolidated statement of stockholders’ equity amounted to $3,141,524 and $3,085,703 as of March 31, 2009 and December 31, 2008, respectively. The balance sheet amounts with the exception of equity at March 31, 2009,were translated at 6.8456 RMB to $1.00 USD. The average translation rates applied to income statement amounts for the three months ended March 31, 2009 was 6.84659 RMB to $1.00 USD.
Cash and concentration of risk
The Company considers all highly liquid investments with original maturities of three months or less at the time of purchase to be cash equivalents, for statement of cash flows purposes. Cash includes cash on hand and demand deposits in accounts maintained with state owned banks within the PRC and with banks the US.
The Company’s cash equivalents are exposed to concentration of credit risk. The Company maintains balances at financial institutions which, from time to time, may exceed Federal Deposit Insurance Corporation insured limits for the banks located in the United States. Balances at financial institutions or state owned banks within the PRC are not covered by insurance. As of March 31, 2009 and December 31, 2008, the Company had deposits in excess of federally insured limits totaling $915,764 and $1,016,733, respectively. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant risks on its cash in bank accounts.
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
Substantially all of the Company's operations are carried out in the PRC. Accordingly, the Company's business, financial condition and results of operations may be influenced by the political, economic and legal environments in that country, and by the general state of that country’s economy. The Company's operations in the PRC are subject to specific considerations and significant risks not typically associated with companies in the United States. These include risks associated with, among others, the political, economic and legal environments and foreign currency exchange. The Company's results may be adversely affected by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation, among other things.
Revenue Recognition
The Company records revenues from the sales of oil on a net basis when delivery to its sole customer (PetroChina) has occurred and title has transferred. This occurs when oil has been delivered to a PetroChina depot.
Pursuant to the Oil Leases entered into in 2002 and 2003 with PetroChina, each with twenty year-terms, the Company is entitled to 80% of the Company’s oil production for the first ten years and 60% of the Company’s oil production for the remaining ten years. The Company receives payment for the net physical volume of oil delivered (either 80% or 60% by volume, depending upon the lease terms that are current at that point in time). The Company only records revenue for the production that the Company is entitled to.
Major customers
We have only one customer – PetroChina’s Jilin Refinery branch, located in Song Yuan City, Jilin Province, PRC. Pursuant to our lease agreements with PetroChina we are unable to sell our oil production to any other customer.
Accounts receivables and allowance for doubtful accounts
The Company bills PetroChina on a monthly basis, at month-end, for the oil that we delivered to PetroChina during that month. We receive payment from PetroChina approximately 10 to 20 days following the end of each month. We receive payment in full for the prior month, less a holdback in the first and second months of each calendar quarter for the amount of oil surcharge tax (if any) due the PRC government for the respective month’s oil sales. These oil surcharge tax holdbacks are paid to the Company with the normal monthly payment for the third month of each quarter, and therefore are timed to be received by us shortly before we are responsible for remitting the quarterly oil surcharge tax to the PRC government. Therefore, the amount we show as accounts receivable at the end of each reporting period will include the amounts due to us for sales in the prior month, as well as lesser amounts due from the two preceding months equal to the amount of oil surcharge tax payable by us. We do not recognize any allowance for doubtful accounts, as PetroChina has always paid our invoices on a correct, consistent and timely basis.
Long-lived assets
Long-lived assets to be held and used in the Company's operations are reviewed for impairment whenever events or changes in circumstances indicate that the related carrying amount may not be recoverable. When the carrying amounts of long-lived assets exceed the fair value, which is generally based upon discounted future cash flows the Company records an impairment. Impairment loss recognized for the 3 months ended March 31, 2009 was $13,825,567.
Financial instruments
The Company analyzes all financial instruments with features of both liabilities and equity under Statement of Financial Accounting Standards (“SFAS”) No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity,” SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.” The warrants issued in conjunction with the issuance of the secured debenture in February, 2008 are treated as liability instruments and will be marked to fair value as of each reporting date. Additionally, the Company analyzes registration rights agreements associated with any equity instruments issued to determine if penalties triggered for late filing should be accrued under FSP EITF 00-19-2, “Accounting for Registration Payment Arrangements.” (See Note 8, Registration Payment Arrangements, below).
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
Fair value of financial instruments
On January 1, 2008, the Company adopted SFAS No. 157. SFAS No. 157, “Fair Value Measurements”, defines fair value, establishes a three-level valuation hierarchy for disclosures of fair value measurement and enhances disclosures requirements for fair value measures. The three levels are defined as follow:
| |
·
|
Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
|
| |
·
|
Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the assets or liability, either directly or indirectly, for substantially the full term of the financial instruments.
|
| |
·
|
Level 3 inputs to the valuation methodology are unobservable and significant to the fair value.
|
The financial assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect the valuation of the fair value of assets and liabilities and their placement within the fair value hierarchy levels
Assets and liabilities measured at fair value on a recurring basis as of March 31, 2009 are summarized as follows (unaudited):
| |
Fair value measurement using inputs
|
| |
Level 1
|
|
Level 2
|
|
Level 3
|
| |
|
|
|
|
|
Liabilities:
|
|
|
|
|
|
|
Derivative instruments − Warrants
|
$
|
- |
|
$
|
- |
|
$
|
|
|
Total
|
$
|
-
|
|
$
|
-
|
|
$
|
|
The Company determines the fair value of the warrants using a Black-Scholes option model using inputs that are derived from observable and unobservable data and are therefore considered Level 3 in the fair value hierarchy. See Note 5 for further information.
The carrying values of cash and cash equivalents, trade receivables, non-current trade payables, and short-term bank loans and debts approximate their fair values due to the short maturities of these instruments. The Company believes that the carrying value of its non-current trade payables and the secured debenture at March 31, 2009 approximates fair value, after considering the various attributes of the debt and the Company’s current credit standing (see Note 5, “Secured Debenture,” for additional information regarding the carrying value of the secured debenture).
Stock-Based Compensation
The Company follows SFAS No. 123R, “Share-Based Payments”. This Statement requires a company to measure the cost of services provided by employees in exchange for an award of equity instruments to be based on the grant-date fair value of the award. That cost will be recognized over the period during which services are received. Stock compensation for stock granted to non-employees has been determined in accordance with SFAS No. 123R and EITF No. 96-18, "Accounting for Equity Instruments that are issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods or Services", as the fair value of the consideration received or the fair value of equity instruments issued, whichever is more reliably measured.
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
Property and equipment, net
The Company uses the full cost method of accounting for oil properties. As the Company currently maintains oil operations in only one country (the PRC), the Company has only one cost center. All costs incurred in the acquisition, exploration, and development of properties (including costs of surrendered and abandoned leaseholds, delay lease rentals, dry holes and overhead related to exploration and development activities) and the fair value of estimated future costs of site restoration, dismantlement, and abandonment activities are capitalized.
Investments in unproved properties, including capitalized interest costs, are not depleted pending determination of the existence of proved reserves. Unproved reserves are assessed periodically to ascertain whether impairment has occurred. Unproved properties whose costs are individually significant are assessed individually by considering the primary lease terms of the properties, the holding periods of the properties, and geographic and geologic data obtained relating to the properties. Where it is not practicable to assess individually the amount of impairment of properties for which costs are not individually significant, such properties are grouped for purposes of assessing impairment. The amount of impairment assessed is added to the costs to be amortized, or is reported as a period expense, as appropriate. As of March 31, 2009, the Company did not have any investment in unproved oil properties.
Pursuant to full cost accounting rules, the Company must perform a ceiling test each quarter on its proved oil assets within each separate cost center. The ceiling test provides that capitalized costs less related accumulated depletion and deferred income taxes for each cost center may not exceed the sum of (1) the present value of future net revenue from estimated production of proved oil reserves using current prices, excluding the future cash outflows associated with settling asset retirement obligations that have been accrued on the balance sheet, at a discount factor of 10%; plus (2) the cost of properties not being amortized, if any; plus (3) the lower of cost or estimated fair value of unproved properties included in the costs being amortized, if any; less (4) income tax effects related to the differences in the book and tax basis of oil properties. Should the net capitalized costs for a cost center exceed the sum of the components noted above, an impairment charge would be recognized to the extent of the excess capitalized costs. Due to the significant decline in oil prices during the fourth quarter of 2008 and the continued decline in prices for the first quarter of 2009, the net capitalized costs of our oil properties exceeded the sum of the components noted above by $13,184,103 on December 31, 2008 and by $13,825,567 on March 31, 2009, and therefore the Company has recognized impairment charges and corresponding reductions in the carrying value of those net capitalized costs of $13,184,103 and $13,825,567, as of December 31, 2008 and March 31, 2009, respectively. For additional details regarding net carrying value of oil properties and the calculations used to derive the value of the impairment, please see Note 12, “Oil Properties.” below.
Gain or loss is not recognized on the sale of oil properties unless the sale significantly alters the relationship between capitalized costs and estimated proved oil reserves attributable to a cost center.
Depletion of proved oil properties is computed on the unit-of-production method, whereby capitalized costs, as adjusted for future development costs and asset retirement obligations, net of salvage, are amortized over the total estimated proved reserves. Furniture and fixtures, leasehold improvements, computer hardware and software, and other equipment are depreciated on the straight-line method, based upon estimated useful lives of the assets ranging from three to fifteen years.
Asset Retirement Obligations
SFAS No. 143, “Accounting for Asset Retirement Obligations” requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred with a corresponding increase in the carrying amount of the related long-lived asset. Subsequent to initial measurement, the asset retirement liability is required to be accreted each period to its present value. Capitalized costs are depleted as a component of the full cost pool using the unit-of-production method. Pursuant to our lease agreements with PetroChina, which terminate in 2022 and 2023, we do not recognize any asset retirement obligations, because at the end of the lease term we are obligated to hand over to PetroChina all of the physical assets we have erected on the leased properties, including all wells, facilities and equipment.
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
Earnings per share
The Company reports earnings per share in accordance with the provisions of SFAS No. 128, "Earnings Per Share." SFAS No. 128 requires presentation of basic and diluted earnings per share in conjunction with the disclosure of the methodology used in computing such earnings per share. Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average common shares outstanding during the period. Diluted earnings per share takes into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock using the treasury method.
Income taxes
Income taxes are accounted for under the asset and liability method in accordance with SFAS No. 109, “Accounting for Income Taxes.” Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company provides valuation allowances against the net deferred tax asset for amounts that are not considered more likely than not to be realized.
The Company adopted FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), on January 1, 2007. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The adoption had no effect on the Company’s financial statements.
Deferred tax is accounted for using the balance sheet liability method in respect of temporary differences arising from differences between the carrying amount of assets and liabilities in the financial statements and the corresponding tax basis used in the computation of assessable tax profit. In principle, deferred tax liabilities are recognized for all taxable temporary differences, and deferred tax assets are recognized to the extent that it is probably that taxable profit will be available against which deductible temporary differences can be utilized. Deferred tax is calculated at the tax rates that are expected to apply to the period when the asset is realized or the liability is settled. Deferred tax is charged or credited in the income statement, except when it related to items credited or charged directly to equity, in which case the deferred tax is also dealt with in equity. Deferred tax assets and liabilities are offset when they relate to income taxes levied by the same taxation authority and the Company intends to settle its current tax assets and liabilities on a net basis. As of March 31, 2009, the Company’s deferred tax assets amounted to $4,719,562.
Value Added Tax
Sales revenue represents the invoiced value of oil, net of a value-added tax (“VAT”). All of the Company’s oil that is sold in the PRC is subject to a Chinese value-added tax at a rate of 17% of the gross sales price. This VAT may be offset by VAT paid by the Company on investment and operating costs associated with oil production. The Company records its net VAT Payable or VAT Recoverable balance in the financial statements. As of March 31, 2009 the Company had a net VAT Payable liability balance of $469,905, compared with a net VAT Recoverable asset balance of $311,240 as of December 31, 2008.
Recently issued accounting pronouncements
In February 2007, the Financial Accounting Standards Board (FASB) issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115”. This statement permits entities to choose to measure many financial instruments and certain other items at fair value. Most of the provisions of SFAS No. 159 apply only to entities that elect the fair value option. However, the amendment to SFAS No. 115 “Accounting for Certain Investments in Debt and Equity Securities” applies to all entities with available-for-sale and trading securities. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided the entity also elects to apply the provision of SFAS No. 157, “Fair Value Measurements”. The adoption of this statement did not have a material effect on the Company's financial statements.
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51”. This statement improves the relevance, comparability, and transparency of the financial information that a reporting entity provides in its consolidated financial statements by establishing accounting and reporting standards that require; the ownership interests in subsidiaries held by parties other than the parent and the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income, changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary be accounted for consistently, when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary be initially measured at fair value, entities provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS No. 160 affects those entities that have an outstanding noncontrolling interest in one or more subsidiaries or that deconsolidate a subsidiary. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Early adoption is prohibited. The adoption of this statement will result in the reclassification of “Minority interests” to equity as “Noncontrolling interests” and separate disclosures in the statements of operations.
In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations – a replacement of FASB Statement No. 141,” which significantly changes the principles and requirements of how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This statement is effective prospectively, except for certain retrospective adjustments to deferred tax balances, for fiscal years beginning after December 15, 2008. This statement will be effective for the Company beginning in fiscal 2010. The adoption of SFAS No. 141(R) will only impact future acquisitions.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133”. This statement amends and expands the disclosure requirements of SFAS No. 133 to require qualitative disclosure about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. The statement will be effective for the Company beginning in fiscal 2009. We are currently evaluating the disclosure implications of this statement.
In May 2008, the FASB released SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that presented in conformity with generally accepted accounting principles in the United States of America. SFAS No. 162 will be effective 60 days following the SEC’s approval of the PCAOB amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. The Company does not believe SFAS 162 will have a significant impact on the Company’s consolidated financial statements.
In May 2008, the FASB issued SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of FASB Statement No.60.” The scope of this Statement is limited to financial guarantee insurance (and reinsurance) contracts, as described in this Statement, issued by enterprises included within the scope of Statement 60. Accordingly, this Statement does not apply to financial guarantee contracts issued by enterprises excluded from the scope of Statement 60 or to some insurance contracts that seem similar to financial guarantee insurance contracts issued by insurance enterprises (such as mortgage guaranty insurance or credit insurance on trade receivables). This Statement also does not apply to financial guarantee insurance contracts that are derivative instruments included within the scope of FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities.” The Company does not believe SFAS 163 will have a significant impact on the Company’s consolidated financial statements.
On December 31, 2008, the SEC adopted a final rule that amends its oil and gas reporting requirements. The revised rules change the way oil and gas companies report their reserves in the financial statements. The rules are intended to reflect changes in the oil and gas industry since the original disclosures were adopted in 1978. Definitions were updated to be consistent with Petroleum Resource Management System (PRMS). Other key revisions include a change in pricing used to prepare reserve estimates, the inclusion of non-traditional resources in reserves, the allowance for use of new technologies in determining reserves, optional disclosure of probable and possible reserves and significant new disclosures. The revised rules will be effective for our annual report on Form 10-K for the fiscal year ending December 31, 2009. The SEC is precluding application of the new rules in quarterly reports prior to the first annual report in which the revised disclosures are required and early adoption is not permitted. We are currently evaluating the effect the new rules will have on our financial reporting and anticipate that the following rule changes could have a significant impact on our results of operations as follows:
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
| |
•
|
|
The price used in calculating reserves will change from a single-day closing price measured on the last day of the company’s fiscal year to a 12-month average price, and will affect our depletion and ceiling test calculations.
|
| |
|
|
|
| |
•
|
|
Several reserve definitions have changed that could revise the types of reserves that will be included in our year-end reserve report.
|
| |
|
|
|
| |
•
|
|
Many of our financial reporting disclosures could change as a result of the new rules.
|
Reclassifications
Certain prior period amounts have been reclassified to conform to the current period presentation. These reclassifications have no effect on net income or cash flows.
NOTE 5. SECURED DEBENTURE
The following is a summary of secured debenture at March 31, 2009 and December 31, 2008:
|
|
|
March 31,
|
|
|
December 31,
|
|
|
|
|
2009
|
|
|
2008
|
|
|
|
|
(Unaudited)
|
|
|
(Audited)
|
|
| |
|
(Restated)
|
|
|
(Restated)
|
|
|
|
|
|
|
|
|
|
8% Secured Debenture, at 8% interest
|
|
|
|
|
|
|
|
per annum, secured by 66% of the Company's equity interest
|
|
|
|
|
|
|
|
in Song Yuan Technical and certain properties of the Company
|
|
|
|
|
|
|
|
and 6,732,000 shares of common stock of the Company
|
|
|
|
|
|
|
|
owned by a stockholder, due on February 28, 2012
|
|
$
|
14,100,000
|
|
|
$
|
7,375,765
|
|
|
|
|
|
|
|
|
|
|
|
|
Less: current maturities
|
|
|
(6,725,000)
|
|
|
|
(2,625,000
|
)
|
|
Long-term portion
|
|
$
|
7,375,000
|
|
|
$
|
4,750,765
|
|
On February 28, 2008, the Company entered into a Securities Purchase Agreement (the “Purchase Agreement”) with Lotusbox Investments Limited (the "Investor"). Pursuant to the Purchase Agreement, the Company agreed to issue to the Investor an 8% Secured Debenture due 2012 (the "Debenture") in the aggregate principal amount of $15,000,000, and agreed to issue to the Investor five-year warrants exercisable for up to (i) 1,200,000 shares of the Company's common stock at an initial exercise price equal to $0.01 per share ("Class A Warrants"), (ii) 1,500,000 shares of the Company's common stock at an initial exercise price equal to $3.20 per share ("Class B Warrants") and (iii) 2,100,000 shares of the Company's common stock at an initial exercise price equal to $3.45 per share (“Class C Warrants”), with all warrant exercise prices being subject to certain adjustments. The Class B Warrants are subject to certain call rights by the Company. As additional security provided to the Investor, the Company also granted the Investor the right to purchase up to 24% of the registered capital of Song Yuan Technical at fair market value which right shall only become enforceable immediately on the date following the occurrence of an event of a payment default. Pursuant to the Purchase Agreement, the exercise price of the Series B and C Common Stock Purchase Warrants issued on February 28, 2008 (the “B Warrants” and “C Warrants”) for the purchase of 3,600,000 shares of common stock of the Company, have been reset to $2.35 per share.
The Company accounts for these warrants as liability instruments in accordance with paragraph 8 of EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and potentially settled in, a Company’s Own Stock.” Upon issuance, the warrants were recorded at fair value of $10,268,321, which was recognized as a discount to the carrying value of the debenture. The initial carrying value of the debenture, net of discount, was $4,731,679.
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
On March 5, 2009, the Company and the Investor entered into Agreement No.1 to 8% Secured Debenture (the "Amendment" or the “restructuring”) which amended the Debenture issued to the Investor on February 28, 2008 for the principal amount of $15,000,000. Pursuant to the Amendment, the Investor agreed to extend the Company's requirement to effect a listing of its common stock on either the NYSE Alternext US LLC or NASDAQ until August 30, 2010, and the Company issued four-year warrants to the Investor to purchase up to (i) 250,000 shares of common stock at an exercise price of $2 per share and (ii) 250,000 shares of common stock at an exercise price of $2.35 per share. Also pursuant to the Amendment, the parties have agreed to amend the monthly principal repayment schedule of the Debenture. The net present value of cash flows projected to be paid by the Company to the Investor as a result of this Amendment exceed the net present value of cash flows projected to be paid by the Company to the Investor pursuant to the previously existing repayment schedule by greater than 10%. Therefore, the Company has accounted for this Amendment as an extinguishment and reissue of debt. Accordingly, the Company has recognized a loss on extinguishment of debt, effective March 5, 2009, of $8,260,630, which is comprised of the remaining unamortized discount on the secured debenture prior to the Amendment date, plus the unamortized deferred financing fees on the secured debenture prior to the Amendment date, plus the fair value of the warrants issued to the Investor in conjunction with the Amendment.
As the restructuring is presumed to have the effect of reflecting fair market terms and conditions for the Amended secured debenture, the carrying value of the debenture is the remaining principal balance of the debenture and no discount is recognized. Changes in the fair value of the warrants will be recognized as gain or loss in the period incurred.
Interest expense and discount amortized on the debenture for the three months ended March 31, 2009 were $280,000 and $670,492 respectively.
NOTE 6. NET INCOME (LOSS) PER SHARE
The following is a reconciliation of the numerators and denominators used in computing basic and diluted net income per share (in thousands, except per share amounts):
|
|
|
Three months ended March 31,
|
|
|
|
|
2009
|
|
|
2008
|
|
| |
|
(Restated)
|
|
|
(Restated)
|
|
|
Numerator:
|
|
|
|
|
|
|
|
Net (loss) income attributable to CNEH common stockholders
|
|
|
|
|
|
|
|
used in computing basis net (loss) income per share
|
|
$
|
(17,231)
|
|
|
$
|
1,005
|
|
|
Net (loss) income attributable to CNEH common stockholders
|
|
|
|
|
|
|
|
|
|
used in computing diluted net (loss) income per share
|
|
$
|
(17,231)
|
|
|
$
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Denominator:
|
|
|
|
|
|
|
|
|
|
Shares used in the computation of basic net (loss) income per share
|
|
|
|
|
|
|
(weighted average common stock outstanding)
|
|
|
20,784
|
|
|
|
19,224
|
|
|
Dilutive potential common stock:
|
|
|
|
|
|
|
|
|
|
Options and warrants
|
|
|
-
|
|
|
|
1,314
|
|
|
Shares used in the computation of diluted net (loss) income per share
|
|
|
|
|
|
|
20,538
|
|
|
Basic net (loss) income per share
|
|
$
|
(0.83)
|
|
|
$
|
0.05
|
|
|
Diluted net (loss) income per share
|
|
$
|
(0.83)
|
|
|
$
|
0.05
|
|
For the three months ended March 31, 2009, options and warrants to purchase shares of common stock were not included in the calculation because the effect is anti-dilutive.
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
NOTE 7. COMMITMENTS AND CONTINGENCIES
(A) Lease commitment
The Company leases office spaces from a stockholder, land and office spaces from third parties under four operating leases which expire on September 20, 2023, June 30, 2015, January 20, 2011 and September 14, 2009 at annual rental of $183, $14,024, $18,990 and $37,200 respectively.
As of March 31, 2009, the Company had outstanding commitments with respect to the above operating leases, which are due as follows:
|
2009
|
|
$
|
41,948
|
|
|
2010
|
|
|
33,197
|
|
|
2011
|
|
|
15,789
|
|
|
2012
|
|
|
14,207
|
|
|
Thereafter
|
|
|
37,028
|
|
|
|
|
$
|
142,169
|
|
(B) Capital commitments
As of March 31, 2009, the Company had commitments for capital expenditure of $784,000 with a contractor to complete the drilling of 7 oil wells under construction.
NOTE 8. REGISTRATION PAYMENT ARRANGEMENTS
In conjunction with the March 5, 2009 modification of the terms of the Company’s secured debenture issued on February 28, 2008 (see Note 5, Secured Debenture, above) and the original issuance of the secured debenture, the Company entered into two Registration Rights Agreements which cover stock to be issued underlying warrants associated with both the modification and the issuance of the second debenture. These Registration Rights Agreements provide for financial penalties in certain circumstances, including (i) if the registration statement covering the shares of common stock underlying the Original Warrants is not declared effective within 180 days of the date of the Registration Rights Agreement or (ii) after effectiveness, the registration statement ceased to remain continuously effective for more than 10 consecutive calendar days or more than 30 calendar days in any 30 calendar day period. The financial penalty equals to 1% of the aggregate purchase price paid for the Original Warrants subject to the registration rights up to a maximum of 10% of the principal amount of the debenture.
The Company analyzes these Registration Rights Agreements to determine if penalties triggered for late filing should be accrued under FSP EITF 00-19-2, “Accounting for Registration Payment Arrangements” The Company evaluates the potential likelihood of incurring these financial penalties, and the magnitude of the associated costs, on a probabilistic basis, as required under EITF 00-19-2. For the reporting period ended June 30, 2009, the Company estimates that no financial penalties are likely to be incurred as a result of any of its Registration Rights Agreements, and therefore no expense has been accrued for anticipated future registration payments.
NOTE 9. STOCK-BASED COMPENSATION
During 2008, the Company granted to its employees, stock options qualified under the Company’s 2006 Stock Option/Stock Issuance Plan to purchase Common Stock. As of March 31, 2009, stock options granted under the Company’s 2006 Stock Option/Stock Issuance Plan to purchase 410,000 shares of its Common Stock (the “Options”) at an exercise price from $4.05 to $4.50 per share were outstanding. 25% of the 100,000 stock options shall vest upon grant and 25% shall vest every three months thereafter, and these stock options granted shall expire ten years after the grant date if unexercised at that time. 50% of the 310,000 stock options shall vest upon grant and 50% shall vest on the first anniversary of the grant date.
The fair value of stock options granted was estimated at the date of grant using the Black-Scholes option-pricing model with the following assumptions:
|
Expected
|
Expected
|
|
Dividend
|
|
Risk Free
|
|
Grant Date
|
|
|
Life
|
Volatility
|
|
Yield
|
|
Interest Rate
|
|
Fair Value
|
|
|
5 years
|
292% to 308%
|
|
0
|
%
|
|
3.25% to 3.42%
|
|
$
|
4.05 to $4.50
|
|
|
|
-
|
Dividend Yield: The expected dividend yield is zero. The Company has not paid a dividend and does not anticipate paying dividends in the foreseeable future.
|
|
|
-
|
Risk Free Rate: Risk-free interest rate of 3.25% to 3.42% was used. The risk-free interest rate was based on U.S. Treasury yields with a remaining term that corresponded to the expected term of the option calculated on the granted date.
|
|
|
-
|
Expected Life: Because the Company has no historical share option exercise experience to estimate future exercise patterns, the expected life was determined using the simplified method as these awards meet the definition of "plain-vanilla" options under the rules prescribed by Staff Accounting Bulletin No. 107.
|
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
Stock compensation expense is recognized based on awards expected to vest. There was no estimated forfeiture as the Company has a short history of issuing options. SFAS No. 123R requires forfeiture to be estimated at the time of grant and revised in subsequent periods, if necessary, if actual forfeitures differ from those estimates.
As of March 31, 2009, 410,000 stock options with a fair value of approximately $1,816,267 were issued to staff, of which the Company recognized $279,868 as staff compensation expenses included in selling, general and administrative expenses for the three months ended March 31, 2009.
As of March 31, 2009, the total compensation cost related to stock options not yet recognized was $992,945 and this will be recognized over the next year.
The following is a summary of the stock options activity:
|
|
|
Number of
Options
Outstanding
|
|
|
Weighted-
Average
Exercise
Price
|
|
|
Balance, December 31, 2008
|
|
|
-
|
|
|
|
-
|
|
|
Granted
|
|
|
410,000
|
|
|
$
|
4.43
|
|
|
Forfeited
|
|
|
-
|
|
|
|
-
|
|
|
Exercised
|
|
|
-
|
|
|
|
-
|
|
|
Balance, March 31, 2009
|
|
|
410,000
|
|
|
$
|
4.43
|
|
The following is a summary of the status of options outstanding at March 31, 2009:
|
Outstanding Options
|
|
|
Exercisable Options
|
|
Exercise Price
|
|
Number
|
|
Average
Remaining
Contractual
Life
|
|
Average
Exercise
Price
|
|
Number
|
|
Weighted
Average
Exercise Price
|
|
$4.05
|
|
60,000
|
|
9.17 years
|
|
$4.05
|
|
60,000
|
|
$4.05
|
|
$4.50
|
|
310,000
|
|
9.29 years
|
|
$4.50
|
|
155,000
|
|
$4.50
|
|
$4.50
|
|
40,000
|
|
|
|
$4.50
|
|
30,000
|
|
$4.50
|
Stock Grants
On July 18, 2008, the Company issued 360,000 shares of common stock to two executive officers and three engineers as bonuses for a period of two years. The stock was valued at the closing price on the date of grant of $4.50 per share, yielding an aggregate value of $1,620,000. The Company recognized expense of $202,500 during the three months ended March 31, 2009.
NOTE 10. STOCKHOLDERS’ EQUITY
On February 28, 2008, the Company issued three tranches of warrants in conjunction with the issuance of a secured debenture as discussed in Note 5. In addition, the Company issued an additional three tranches of warrants to investment consultants in conjunction with the issuance of the secured debenture. On March 5, 2009, the Company issued two tranches of warrants in conjunction with the Amendment to the secured debenture as discussed in Note 5. The Company analyzes all financial instruments with features of both liabilities and equity under SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity,” SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”
The Company treats these warrants as liabilities under EITF 00-19 and accordingly records the warrants at fair value with changes in fair values recorded in the profit or loss until such time as the warrants are exercised or expire. The fair values were $12,014,990 at issuance and $6,897,094 at March 31, 2009. For the three months ended March 31, 2009, the Company recorded gains of $653,705 in changes in the fair value of the warrants in earnings.
CHINA NORTH EAST PETROLEUM HOLDINGS LIMITED
AND SUBSIDIARIES
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS AS OF MARCH 31, 2009
(UNAUDITED)
The Company estimates the fair value of these warrants using the Black-Scholes option pricing model using the following assumptions:
| |
March 31, 2009
|
|
February 28, 2008
|
|
Market price and estimated fair value of common stock:
|
$1.52
|
|
$2.14
|
|
Exercise price:
|
$0.01 - $2.35
|
|
$0.01 - $3.45
|
|
Remaining contractual life (years):
|
3.92
|
|
5
|
|
Dividend yield:
|
–
|
|
–
|
|
Expected volatility:
|
268%
|
|
316%
|
|
Risk-free interest rate:
|
1.15%
|
|
2.73%
|
Also on February 28, 2008, the Company issued warrants to purchase 100,000 shares of Common Stock to a professional service provider in conjunction with a two year service agreement. The Company treats these warrants as equity instruments and is accordingly recognizing the grant date fair value of the warrants as professional fee expense ratably over the two year term. For the three months ended March 31, 2009, the Company recognized $26,740 of expense associated with these warrants.
(B) Stock issuances
On August 26, 2008, Class A warrants to purchase 1,200,000 shares of the Company’s common stock at an exercise price of $0.01 per share were exercised.
NOTE 11 RELATED PARTY TRANSACTIONS
|
|
a)
|
As of March 31, 2009, the Company owed a stockholder of $965,162 which is repayable on demand. Imputed interest is computed at 5% per annum on the amount due.
|
|
|
b)
|
As of March 31, 2009, the Company owed a related party of $14,608 which is repayable on demand. Imputed interest is computed at 5% per annum on the amount due.
|
|
|
c)
|
Total imputed interest expenses recorded as additional paid-in capital amounted to $12,248 for the three months ended March 31, 2009.
|
|
|
d)
|
The Company paid a stockholder $3,505 for leased office spaces for the three months ended March 31, 2009.
|
NOTE 12. OIL PROPERTIES
As of March 31, 2009, the Company’s full cost pool exceeded the ceiling limitation, based on oil prices of $40.64 per barrel, by $13,825,567. Therefore, impairment expense related to our oil and gas properties of $13,825,567 was recorded during the three months ended March 31, 2009. For the year ended December 31, 2008 we recognized impairment to the value of our oil properties of $13,184,103.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion and analysis of financial condition and results of operations should be read in conjunction with our financial statements and related notes included elsewhere in this report. This discussion contains forward-looking statements that involve risks, uncertainties and assumptions. Forward-looking statements can be identified by the fact that they do not relate strictly to historic or current facts. They use words such as “anticipate,” “estimate,” “project,” “intend,” “plan,” “believe” and other words and terms of similar meaning in connection with any discussion of future operating or financial performance. In particular, these include statements relating to:
|
|
·
|
Deviations in and volatility of the market price of crude oil produced by us;
|
|
|
·
|
Uncertainties in the estimation of proved reserves and in the projection of future rates of production;
|
|
|
·
|
Timing and amount of production;
|
|
|
·
|
The availability of, and our ability to raise additional capital resources and provide liquidity to meet cash flow needs;
|
|
|
·
|
Fluctuations in foreign currency exchange rates and interest rates;
|
|
|
·
|
Our ability to find, acquire, lease, develop, and produce from new properties; and
|
|
|
·
|
The other risks and uncertainties which are described below under “RISK FACTORS.”
|
Overview
We are engaged in the exploration and production of crude oil in Northern China. We have an arrangement with the Jilin Refinery of PetroChina Group to sell our crude oil production for use in the China marketplace. We currently operate 247 producing wells located in four oilfields in Northern China and have plans for additional drilling projects.
In particular, through two of our subsidiaries, Song Yuan City Yu Qiao Oil and Gas Development Co. Ltd. (“Yu Qiao”) and Chang Ling Longde Oil and Gas Development Co. Ltd. (“LongDe”), we have entered into binding sales agreements with the PetroChina Group, whereby we sell our crude oil production for use in the China marketplace.
We currently operate 4 oilfields located in Northern China, which include:
Details of Oil and Gas Properties and Activities
|
Field
|
Acreage
|
Producing wells #
|
Proven Reserves (bbls)
|
|
Qian112
|
5,115
|
219
|
5,292,591
|
|
Da34
|
2,298
|
7
|
13,240
|
|
Gu31
|
1,779
|
7
|
95,729
|
|
He301
|
2,471
|
14
|
52,232
|
|
Total
|
11,663
|
247
|
5,453.792
|
Organizational History
We were incorporated in the State of Nevada on August 20, 1999 under the name Draco Holding Corporation. On March 29, 2004, we executed an Agreement for Share Exchange with Hong Xiang Petroleum Group Limited, a corporation organized and existing under the laws of the British Virgin Islands (“Hong Xiang”), and the individual shareholders owning 100% of the outstanding common shares of Hong Xiang (the “Hong Xiang Shareholders”).
Pursuant to the Agreement for Share Exchange, we issued 18,700,000 shares of our common stock to the Hong Xiang Shareholders in exchange for all of the shares of capital stock of Hong Xiang owned by the Hong Xiang Shareholders at closing, and Hong Xiang became our wholly-owned subsidiary. On June 28, 2004, we changed our name to China North East Petroleum Holdings Ltd.
During 2004, we acquired a 100% ownership in Song Yuan City Hong Xiang Petroleum Technical Services Co., Ltd. (“Hong Xiang Technical”), and Hong Xiang Technical in turn acquired a 100% interest in Song Yuan City Yu Qiao Qianan Hong Xiang Oil and Gas Development Co., Ltd. (“Hong Xiang Oil Development”), which was engaged in the exploration and production of crude oil in the Jilin region of the PRC.
As a result of the Yu Qiao acquisition discussed below, all operations, assets and liabilities of the Company’s subsidiary Hong Xiang Oil Development were transferred to Yu Qiao on March 19, 2007. Since Hong Xiang Oil Development and Hong Xiang Technical were no longer necessary elements of the Company’s corporate structure, and they were liquidated and dissolved.
PetroChina Oil Leases
Pursuant to a 20-year exclusive Cooperative Oil Lease (the “Oil Lease”), among PetroChina Group, Yu Qiao and the Company, entered into in May 2002, the Company has the right to explore, develop and produce oil at Qian’an 112 Oilfield. Pursuant to the Oil Lease, (i) PetroChina is entitled to 20% of the Company’s oil production for the first ten years of the Oil Lease term and 40% of the Company’s oil production for the remaining ten years of the Oil Lease term; and (ii) Yu Qiao is entitled to 2% of the Company’s oil production as a management fee. The payment of management fee was stopped following the acquisition of Yu Qiao by the Company.
LongDe is a party to a 20-year contract with PetroChina Group entered into in May 2003, pursuant to which LongDe has the right to explore, develop and produce oil at the Hetingbao 301 oilfield in the PRC. Pursuant to such between PetroChina and LongDe, PetroChina is entitled to 20% of LongDe’s output in the first ten years and 40% of LongDe’s output thereafter until the end of the contract.
As the controlling shareholder of Yu Qiao, the Company has the rights to extract and develop Qian’an 112 and other oil fields under contracts that Yu Qiao has entered into with PetroChina. These oilfields include the Daan 34 oilfield and Gudian 31 oilfield in Jilin Province.
Song Yuan Technical Joint Venture
On July 26, 2006, the Company entered into a joint venture agreement with Wang Hong Jun (“Mr. Wang”), the president and a stockholder of the Company and Ju Guizhi (“Ms. Ju”), mother of Mr. Wang, to contribute to the increased registered capital of Song Yuan North East Petroleum Technical Service Co. Ltd. (“Song Yuan Technical”). The purpose of Song Yuan Technical is to acquire oil and gas properties and to engage in the exploration of crude oil in the PRC. On December 20, 2006, Mr. Wang transferred his interest (4.5%) in Song Yuan Technical to Ms. Ju and as a result, the Company owns a 90% equity interest in Song Yuan Technical, and Ms. Ju owns the remaining 10% equity interest in Song Yuan Technical.
Acquisition of LongDe
In order to comply with certain PRC laws relating to foreign entities’ ownership of oil and gas companies in the PRC, prior to March 17, 2008, Song Yuan Technical directly owned a 70% equity interest in LongDe, while Sun Peng and Ai Chang Shan, respectively, owned 10% and 20% of the equity interests in Long De in trust for Song Yuan Technical. On March 17, 2008, Song Yuan Technical acquired an additional 20% equity interest in LongDe, 10% from Sun Peng, and 10% from Ai Chang Shan. Accordingly, Song Yuan Technical now owns directly 90% of the equity interests in LongDe, with Ai Chang Shan holding the remaining 10% in trust for Song Yuan Technical. The acquisition of LongDe was made pursuant to the laws of the PRC. As a 90% owner of Song Yuan Technical, the Company effectively controls LongDe.
This beneficial ownership structure is governed by two trust agreements: (i) Trust Agreement dated October 8, 2006 by and between Song Yuan Technical and Ai Chang Shan, and (ii) Trust Agreement dated April 18, 2008 by and between Song Yuan Technical and Wang Hongjun. Pursuant to the first trust agreement, Ai Chang Shan holds 20% of the equity interest in Long De in trust for the benefit of Song Yuan Technical. On March 17, 2008, Ai Chang Shan entered into a transfer agreement whereby Ai Chang Shan transferred 10% of the equity interest of Long De held in trust pursuant to the trust agreement to Song Yuan Technical to be held directly by Song Yuan Technical. Currently under the trust agreement dated October 8, 2006, Ai Chang Shan holds 10% of the total equity interest of Long De in trust for the benefit of Song Yuan Technical. Pursuant to the second trust agreement, Wang Hongjun holds 10% of the total outstanding equity interest in LongDe in trust for the benefit of Song Yuan Technical.
Acquisition of Yu Qiao
The Company acquired a beneficial interest in 100% of the equity interest in Yu Qiao from Yu Qiao’s shareholders, Ms. Ju (70%), Meng Xiangyun (20%) and Wang Bingwu (10%) on January 26, 2007. In order to comply with PRC laws, which restrict ownership of oil and gas companies by foreign entities, following the acquisition, Meng Xiangyun and Wang Pingwu held 20% and 10% of the equity interest, respectively, in Yu Qiao in trust for the benefit of Song Yuan Technical.
On March 17, 2008, the trust agreement with Meng Xiangyun was cancelled and the 20% equity interest in Yu Qiao held in trust by Meng Xiangyun was transferred to Song Yuan Technical. As a result of the termination of the trust agreement and the transfer, Song Yuan Technical became the direct owner of the 20% equity interest in Yu Qiao held in trust by Meng Xiangyun.
On April 18, 2008, the 10% equity interest in Yu Qiao held by Wang Pingwu in trust was transferred to the Company’s President and Chairman, Wang Hongjun to hold in trust for the benefit of Song Yuan Technical.
Currently 90% of Yu Qiao is directly held by Song Yuan Technical and 10% of Yo Qiao is held in trust by Wang Hongjun for the benefit of Song Yuan Technical.
Oil and Gas Properties and Activities
As of March 31, 2009, the Company had a total of 247 producing wells, including 219 producing wells at the Qian’an 112 oilfield, 14 producing wells at the Hetingbao 301 oilfield, 7 producing wells at the Daan 34 oilfield and 7 producing wells at the Gudian 31 oilfield. Additionally, at that time the company had 7 wells under construction and not yet been placed into service.
All of the Company’s crude oil production is sold to the Jilin Refinery of PetroChina Group. The approximate distance of each of the Company’s oil fields from the Jilin Refinery is as follows: the Qian’an 112 oilfield is four kilometers away, the Hetingbao 301 oilfield is three kilometers away, the Daan 34 oilfield is fifteen kilometers away and the Gudian Oilfield 31 is thirty kilometers away.
PetroChina pays the Company a price per barrel equal to the monthly mean price calculated from the Mean of Platts Singapore (“MOPS”) daily price for sour, heavy Indonesian crude, as measured during the previous month. Platts is an international commodity and trading company that collects and publishes pricing data on a wide range of petroleum and non-petroleum commodity types. The price paid to the Company is FOB at the local Jilin Province PetroChina oil storage depot.
PetroChina pays the Company monthly in arrears, on approximately the 15th day after the end of each month. The amount paid to the Company in the first two months of each calendar quarter is decreased by the amount of oil surcharge tax the Company will owe to the PRC government at the end of that calendar quarter. PetroChina holds those amounts back from the Company until the end of each calendar quarter, and then pays those amounts to the Company with the balance due for oil deliveries in the final month of the quarter. For this reason, the Accounts Receivable balance at the end of each quarter is larger than the prior month’s oil sales revenue, because it includes the oil surcharge tax amounts the Company owes for the first two months of the quarter. As of March 31, 2009, the Company’s Accounts Receivable balance totaled $4,068,879, which is all due to the Company from PetroChina, and includes amounts related to the following items:
|
March Oil Sales, net of oil surcharge:
|
|
$ |
8,861,431 |
|
|
Quarterly total oil surcharge:
|
|
$ |
37,792 |
|
Operating Performance
Our operating performance is influenced by several factors, the most significant of which are the price we receive for our oil and the quantities of oil that we are able to produce. Global oil prices are the most important factor affecting the price that we receive for our oil production. The prices received for different grades of oil are based upon the world price of oil, which is then adjusted based upon the particular grade. Typically light oil is sold at a premium, while heavy grades of crude (such as the type we produce from the four fields we operate) are discounted.
Our oil development and acquisition activities require substantial and continuing capital expenditures. Historically, the sources of financing to fund our capital expenditures have included:
|
|
·
|
Cash flow from operations;
|
|
|
·
|
Sales of equity securities;
|
|
|
·
|
Loans from shareholders and third parties; and
|
|
|
·
|
Extension of credit from our suppliers, including particularly our suppliers of well drilling and completion services.
|
For the three months ended March 31, 2009 (the “Current Quarter”), the sale price we received for our crude oil production averaged $40.04 per barrel, compared with $94.27 per barrel for the three months ended March 31, 2008 (the “Comparable Quarter”).
Our oil producing activities are accounted for using the full cost method of accounting. Under this accounting method, we capitalize all costs incurred in connection with the acquisition of oil properties and the exploration for and development of oil reserves. These costs include lease acquisition costs, geological and geophysical expenditures, costs of drilling productive and non-productive wells (to date, all of the wells we have drilled have been productive wells), conversion of productive wells into production support infrastructure such as water-injection wells, and overhead expenses directly related to land and property acquisition and exploration and development activities. Proceeds from the disposition of oil properties are accounted for as a reduction in capitalized costs, with no gain or loss recognized unless a disposition involves a material change in the relationship between capitalized costs and reserves, in which case the gain or loss is recognized.
Depreciation of the capitalized costs of oil properties, including estimated future development costs, is based upon estimates of proved oil reserves and production. Unproved oil properties are not amortized, but are individually assessed for impairment. The cost of any impaired property is transferred to the balance of oil properties being depleted. Reserve values are calculated annually, at our fiscal year-end, by a third-party geological consulting company, and are estimated in accordance with Statement of Financial Accounting Standards No. 19 (“FAS 19”) – Financial Accounting and Reporting by Oil and Gas Producing Companies (as amended), SEC Regulation S-K and Regulation S-X under the Securities Act of 1933 and the Securities Exchange Act of 1934, and the SEC’s Industry Guide 2.
Production, Average Sales Prices, and Production Costs
Our business operations are characterized by frequent, and sometimes significant, changes in the price we receive for the crude oil we produce and in the volumes of crude oil we produce. The following table shows selected operating data for the three months ended March 31, 2009 and March 31, 2008.
|
|
|
Three months ended
March 31,
|
|
|
|
|
2009
|
|
|
2008
|
|
|
Oil Output (Bbl)
|
|
|
222,091
|
|
|
|
114,862
|
|
|
Avg. Sale Price ($/bbl)
|
|
$
|
40.04
|
|
|
$
|
94.27
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating Revenue
|
|
$
|
8,899,223
|
|
|
$
|
10,823,974
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost of Sales
|
|
|
|
|
|
|
|
|
|
Production Costs
|
|
|
514,400
|
|
|
|
712,305
|
|
|
Depreciation
|
|
|
3,079,630
|
|
|
|
1,874,692
|
|
|
Amortization
|
|
|
2,979
|
|
|
|
2,842
|
|
|
Oil Surcharge
|
|
|
37,792
|
|
|
|
2,211,320
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross Profit
|
|
$
|
5,264,422
|
|
|
$
|
6,022,815
|
|
RESULTS OF OPERATIONS
Three Months Ended March 31, 2009 Compared To Three Months Ended March 31, 2008
Revenues. Revenues for the Current Quarter were $8,899,223 compared to $10,823,974 for the Comparable Quarter, a decrease of $1,924,751, or 17.8%. This decrease was due to a decrease in the average price we received for our crude oil. The average oil price for the Current Quarter was $40.04, a 57.5% decrease from $94.27 for the Comparable Quarter. Our output of crude oil for the Current Quarter was 222,091 barrels compared to 114,862 barrels for the Comparable Quarter, an increase of 93.4%, which substantially offset the impact of lower oil prices. This increase in production was mainly due to: (i) an increase in the number of producing wells from 165 in the Comparable Quarter to 247 in the Current Quarter; (ii) refracturing and other technical improvements made to the existing wells; and (iii) implementation of a water injection network, which helped to maintain production levels at certain of our existing wells.
Cost of sales. Cost of sales decreased by 24%, from $4,801,159 for the three months ended March 31, 2008 to $3,634,801 for the three months ended March 31, 2009. The decrease in cost of sales resulted primarily from a decrease in the oil surcharge paid to the PRC government, due to the decline in oil prices generally. For the Current Quarter, the Company paid an oil surcharge of $37,792 to the PRC government as compared to $2,211,320 paid for the Comparable Quarter. Under a regulation introduced in June 2006, a surcharge of 20% is imposed on the portion of the selling price of crude oil which exceeds $40 per barrel and a surcharge of 40% is imposed on the portion of the selling price of crude oil which exceeds $60 per barrel. This government oil surcharge tax is paid by the Company on a quarterly basis, following the end of each quarter. The significant decrease in the oil surcharge paid to the government was partially offset by an increase in depreciation of oil and gas properties. Depreciation increased from $1,874,692 in the Comparable Quarter to $3,079,630 in the Current Quarter, an increase of 64%. The increase in the depreciation of oil and gas properties was mainly attributable to the increase in proven oil reserves as of December 31, 2008, the higher volumes of oil produced and the increased depreciable production equipment base during the first quarter of 2009.
Operating Expenses. Operating expenses totaled $14,669,419 for the Current Quarter, compared to $553,665 for the Comparable Quarter, an increase of 2,550%. This increase is primarily a result of ceiling test impairment write down of $13,825,567, due to a significant decline of the oil price in the first quarter 2009 compared to the previous quarters. Also an increase of approximately $420,000 in selling, general and administrative costs, an increase of approximately $50,000 in amortization of deferred financing costs and approximately $330,000 in amortization of the discount on debenture from the Lotusbox secured debenture financing transaction consummated in late February 2008. Selling, general and administrative costs increased largely due to non-cash charges associated with stock and option grants made to Directors and certain key employees in the second and third quarters of 2008. Amortization of the discount on the debenture was recognized for only one month of the Comparable Quarter, versus the full three months of the Current Quarter, which accounts for the increase.
Other Income (Expense). Other expenses increased from $2,596,817 for the Comparable Quarter to $8,699,869 for the Current Quarter. This increase is primarily the result of the increase non-cash expenses of $8,260,630 associated with extinguishment of original Lotusbox debt and warrants restructure. Additionally the amortization of discount on debenture also increased from $371,246 for the Comparable Quarter to $670,492 for the Current Quarter. Also an increases in interest expense which increased from $119,697 in the Comparable Quarter to $280,000 in the Current Quarter.
Net Income. Net income decreased by 1,814%, from $1,005,344 for the three months ended March 31, 2008 to ($17,231,498) for the three months ended March 31, 2009, primarily as results of the decrease in average selling price and significant increased non-cash expenses as described above.
LIQUIDITY AND CAPITAL RESOURCES
Our capital resources consist primarily of cash flows from our oil producing properties. Our level of earnings and cash flows depend upon many factors, including the price we receive for crude oil we produce.
As of March 31, 2009, the Company had cash and cash equivalents of $19,609,128, other current assets of $4,816,323 and current liabilities of $22,177,596. For the three months ended March 31, 2009, our primary sources of liquidity were $5,785,631 provided by operating activities and $762,770 in cash provided by financing activities. This cash balance of $19,609,128 represents an increase of $6,369,915 over our cash balance as of December 31, 2008 and an increase of $6,874,783 over our cash balance as of March 31, 2008.
Net cash provided by operating activities was $5,785,631 for the Current Quarter compared to net cash provided by operating activities of $2,379,379 for the Comparable Quarter. The increase in net cash provided by operating activities was the result of a number of significant changes in our operating accounts. Cash from operating activities decreased due to a reduction in net income and higher cash payments of income and other taxes. However, this was more than offset by increased operating cash flows resulting from an increase in the non-cash benefit arising from Depreciation of oil and gas properties in the Current Quarter, and from a slight increase in the level of our accounts payable during the Current Quarter compared to a large reduction in accounts payable in the Comparable Quarter.
Net cash used in investing activities was $171,649 for the three months ended March 31, 2009 compared to $1,134,534 for the same period in 2008. This decrease is primarily due to the significant decrease in purchase of oil properties of $734,940 during the three months ended March 31, 2009.
Net cash provided by financing activities was $762,770 for the three months ended March 31, 2009 compared to $12,269,745 for the same period in 2008, which was primarily a result of the financing by Lotusbox Investments Limited, which was completed in the first quarter of 2008.
The Company has paid for the development of its producing oil wells and oil wells under construction with cash from operations as well as by funds raised as a result of the financing by Lotusbox Investments Limited. To fully implement the Company’s business plan and growth strategy the Company may require additional resources. The Company is continually evaluating opportunities to expand production and grow the Company’s operations, including via acquisition of additional leased oil fields or expansion into related businesses such as the provision of oil field services. The Company’s ability to obtain additional capital to achieve certain of these expansion goals will depend on market conditions, national and global economies and other factors beyond its control. We cannot assure you that the Company will be able to implement or capitalize on various financing alternatives or otherwise obtain required capital, the need for which could be substantial given the Company’s business and development goals. However, the Company anticipates that cash flows from operations will be sufficient to fund continued development at the four oil fields it currently operates.
Capital Commitments
As of March 31, 2009, the Company had commitments for capital expenditure of $784,000 with a contractor to complete the drilling of 7 oil wells under construction.
Crude Oil Price Trends
Changes in crude oil prices significantly affect our revenues, financial condition and cash flows. Markets for crude oil have historically been volatile and we expect this trend to continue. Prices for crude oil typically fluctuate in response to relatively minor changes in supply and demand, market uncertainty, seasonal, economic, political and other factors beyond our control. Although we are unable to accurately predict the prices we receive for our oil, any significant or sustained decline in oil prices may materially adversely affect our financial condition, liquidity, ability to obtain future debt or equity financing and operating results.
Production Trends
Like all other oil exploration and production companies, we experience natural production declines at existing wells. We recognize that oil production from a given well naturally decreases over time and that a downward trend in our overall production could occur unless the natural declines are offset by additional production from new wells, investment in measures to increase the production from existing wells (such as CO2 and water injection), or acquisitions of producing properties. If any production declines we experience are other than a temporary trend, and if we cannot economically replace our reserves, our results may be materially adversely affected and our stock price may decline. Our future growth will depend upon our ability to continue to add oil reserves in excess of our production at a reasonable cost.
We have achieved increased production and revenue from our four oilfields as a result of our significant investments in these areas. As of March 31, 2009, we have drilled 254 wells out of the 675 wells that we believe can be drilled in our four oilfields. Of these, 247 are produced oil in the Current Quarter. The remaining 7 have been drilled but not placed into production due to the relatively low oil price. We anticipate that we will continue to increase production in these areas. We are also actively seeking additional oil fields that we can lease and operate.
Operating Expense Trends
Costs associated with oil well drilling, improvement (e.g. fracturing and water injection), and maintenance in the northeastern Chinese oil fields where we operate have remained relatively constant over the past year. Similarly, service rates charged by oil field service companies have remained relatively constant over the past year. We are also generally somewhat buffered from changes in world oil prices due to the impact of the government oil surcharge tax. When prices rise, the amount of oil surcharge tax that we are required to pay increases; conversely price declines reduce the amount of oil surcharge tax. In the Current Quarter, the approximate amount of oil surcharge tax we paid was $0.17 per barrel, as compared to $19.25 per barrel in the Comparable Quarter.
CRITICAL ACCOUNTING POLICIES
Proved Reserves. Proved oil and gas reserves, as defined by SEC Regulation S-X Rule 4-10(a) (2i), (2ii), (2iii), (3) and (4), are the estimated quantities of crude oil that geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions, i.e., prices and costs as of the date the estimate is made. Prices include consideration of changes in existing prices provided only by contractual arrangements, but not on escalations based upon future conditions.
The Company’s estimates of proved reserves are made using available geological and reservoir data as well as production performance data. These estimates, made by the Company’s engineers, are reviewed annually and revised, either upward or downward, as warranted by additional data. Revisions are necessary due to changes in, among other things, reservoir performance, prices, economic conditions and governmental restrictions. Decreases in prices, for example, may cause a reduction in some proved reserves due to reaching economic limits sooner.
Properties and Equipment. The Company uses the full cost method of accounting for exploration and development activities as defined by the SEC. Under this method of accounting, the costs of unsuccessful, as well as successful, exploration and development activities are capitalized as properties and equipment. This includes any internal costs that are directly related to exploration and development activities but does not include any costs related to production, general corporate overhead or similar activities. Gain or loss on the sale or other disposition of oil and gas properties is not recognized, unless the gain or loss would significantly alter the relationship between capitalized costs and proved reserves of oil and natural gas attributable to a country. The application of the full cost method of accounting for oil and gas properties generally results in higher capitalized costs and higher DD&A rates compared to the successful efforts method of accounting for oil and gas properties.
RECENT ACCOUNTING PRONOUNCEMENTS
In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157 “Fair Value Measurements”. Effective January 1, 2008, the Company adopted the measurement and disclosure other than those requirements related to nonfinancial assets and liabilities in accordance with guidance from FASB Staff Position 157-2 “Effective Date of FASB Statement No. 157”, which delayed the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of fiscal year 2009. In April 2009, the FASB issued Staff Position No. FAS 157-4 “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly” (“FSP FAS No. 157-4”). FSP FAS No. 157-4 clarifies the methodology used to determine fair value when there is no active market or where the price inputs being used represent distressed sales. FSP FAS No. 157-4 also reaffirms the objective of fair value measurement, as stated in SFAS No. 157 “Fair Value Measurements”, which is to reflect how much an asset would be sold for in an orderly transaction. It also reaffirms the need to use judgment to determine if a formerly active market has become inactive, as well as to determine fair values when markets have become inactive. FSP FAS No. 157-4 is effective for interim and annual reporting periods ending after June 15, 2009 and will be applied prospectively. The adoption of SFAS No. 157 did not have a material impact on the financial statements.
On December 31, 2008, the SEC published the revised rules and interpretations updating its oil and gas reporting requirements. Many of the revisions are updates to definitions in existing oil and gas rules to make them consistent with the petroleum resources management system, which is a widely accepted standard for the management of petroleum resources that was developed by several industry organizations. Key revisions include the ability to include nontraditional resources in reserves, the use of new technology for determining reserves, permitting disclosure of probable and possible reserves, and changes to the pricing used in determining reserves. To determine reserves companies must use a 12-month average price. The Company is required to comply with the amended disclosure requirement for registration statements filed after January 1, 2010, and for annual reports for fiscal years ending on or after December 15, 2009. Early adoption is not permitted. The Company is currently assessing the impact that the adoption will have on the Company’s disclosures, operating results, financial position and cash flows.
In December 2007, the Financial Accounting Standards Board (FASB) issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. SFAS 141R also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. This statement is effective beginning January 1, 2009. The adoption of this statement did not have a material impact on the Company’s financial position and results of operations.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements – an amendment of Accounting Research Bulletin No. 51.” SFAS No. 160 establishes accounting and reporting standards for noncontrolling interests (previously referred to as minority interests) in subsidiaries. SFAS No. 160 requires that a noncontrolling interest in a subsidiary should be accounted for as a component of equity separate from the parent’s equity, rather than as a liability. SFAS No. 160 was effective for the Company on January 1, 2009, and is being applied prospectively, except for the presentation and disclosure requirements, which have been applied retrospectively. The adoption of this statement did not have a material impact on the Company’s financial position and results of operations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Not required.
ITEM 4T. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this Quarterly Report on Form 10-Q (the “Evaluation Date”). The purpose of this evaluation is to determine if, as of the Evaluation Date, our disclosure controls and procedures were operating effectively such that the information, required to be disclosed in our Securities and Exchange Commission (“SEC”) reports (i) was recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) was accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, our disclosure controls and procedures were not operating effectively.
Limitations on the Effectiveness of Disclosure Controls and Procedures.
Disclosure controls and procedures and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act are recorded, processed, summarized and reported, within the time period specified in the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer as appropriate, to allow timely decisions regarding required disclosure.
Deficiencies Relating to Internal Controls over Financial Reporting
We recently completed an internal review of our financial reporting. As a result of this review, management and the audit committee concluded that the impact of certain non-cash accounting and disclosure errors on previously issued financial statements was material and required a restatement. The audit committee of our board of directors engaged an outside consulting firm to assist in its investigation of financial reporting revisions. Our investigation found that a number of factors at the Company contributed to the need to restate certain financial reports in order to correct non-cash accounting errors, including the following:
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the Company lacked adequate internal guidance or training on the reporting of certain non-cash accounting topics, such as warrant accounting, calculation of the ceiling test value of its oil properties, calculation of depreciation, depletion and amortization of oil properties, evaluation of the conditions which trigger the accounting treatment of a restructuring of terms of a liability as an extinguishment of debt, and accounting for stock issued to employees as compensation;
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the Company lacked adequate internal controls over the calculation methodologies used in calculation of depreciation, depletion and amortization, and of the ceiling test value, on its oil properties.
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As part of its investigation, the audit committee proposed a number of recommendations, including the following:
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provide periodic training for employees on accounting and financial reporting practices, particularly with respect to oil industry measurements and disclosures;
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retain an outside consulting firm with expertise in financial accounting and oil industry accounting and disclosure matters, to assist the management team with its preparation of quarterly and annual financial reports;
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institute and cultivate a culture of excellence with respect to accounting and financial reporting practices to ensure that the foregoing contributing factors do not recur.
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The board of directors has accepted the recommendations proposed by the audit committee, and the board of directors implemented and resolved to continue to implement all of the recommendations.
Consequently, we have revised our financial reports for the periods from March 31, 2008 to September 30, 2009, including this amended quarterly financial report. This restatement, as well as specific information regarding its impact, is discussed in Note 1, “Restatement” to the Consolidated Financial Statements. Restatement of previously issued financial statements to reflect the correction of a misstatement is an indicator of the existence of a material weakness in internal control over financial reporting as defined in the Public Company Accounting Oversight Board’s Auditing Standard No. 2, “An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements.” We have identified deficiencies in our internal controls that did not prevent the misstatement of certain non-cash accounting items. These deficiencies, which we believe constituted a material weakness in our internal control over financial reporting, included inadequate training and understanding of the SEC and accounting rules for booking certain non-cash accounting items, including items specific to oil industry reporting. In light of the determination that previously issued financial statements should be restated, our management concluded that a material weakness in internal control over financial reporting existed as of March 31, 2009 and disclosed this matter to the audit committee, and our independent registered public accounting firm.
Remedial Actions
Our management, at the direction of our board of directors, is actively working to improve the control environment and to implement controls and procedures that will ensure the integrity of our financial statement preparation process.
We have implemented the following actions to mitigate weaknesses identified:
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we have retained an outside consulting firm with expertise in financial accounting and oil industry accounting and disclosure matters, to assist the management team with its review and restatement of the financial reports for the periods in question.
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We intend to implement the following actions in 2010:
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implement formal and informal training programs, particularly with respect to the accounting for non-cash items;
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during 2010 and thereafter, consult with our outside consulting firm on a interim basis on the preparation of financial reports.
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Evaluation of Disclosure Control and Procedures
Our Chief Executive Officer and our Chief Financial Officer, with the participation of other members of our senior management, reviewed and evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. In making this evaluation, the Chief Executive Officer and the Chief Financial Officer considered the issues discussed above, together with the remedial steps we have taken. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, because of the material weakness discussed above, as of March 31, 2009, our disclosure controls and procedures were not effective in recording, processing, summarizing and reporting information required to be disclosed by us in the reports we file or submit under the Securities Exchange Act of 1934 (the “Exchange Act”).
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-(f) of the Exchange Act. Under the supervision and with the participation of management, including our Chief Executive Officer, and our Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting as of June 30, 2008 based on the framework in Internal Control-Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on our evaluation under the framework in Internal Control-Integrated Framework, our management concluded we did not maintain effective controls over our financial reporting for the periods from March 31, 2008 to September 30, 2009, and these ineffective controls constituted a material weakness. As a result of this material weakness, our financial statements for the quarters ended March 31, 2008, June 30, 2008, September 30, 2008, March 31, 2009, June 30, 2009, and September 30, 2009, and the year ended December 31, 2008 were restated. These restatements affected certain non-cash items, including accounting for warrants, the Company’s proved oil properties, depreciation, depletion and amortization of oil properties, the ceiling test write-down of oil properties accounts, and accounting for the effect of a restructuring of a liability.
Because of this material weakness, management has concluded that, as of March 31, 2009, we did not maintain effective internal control over financial reporting, based on the criteria established in Internal Control-Integrated Framework issued by the COSO.
Management’s assessment of the effectiveness of our internal control over financial reporting as of March 31, 2009 has not been audited by Baker Tilly Hong Kong Limited (successor to Jimmy Cheung & Co.), an independent registered public accounting firm, as stated in their report which is included herein.
Changes in Internal Control Over Financial Reporting
During 2010, we implemented the following actions to improve our control environment and to implement controls and procedures that will ensure the integrity of our financial reporting process:
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we have retained an outside consulting firm with specialized knowledge in financial accounting and specific knowledge of oil industry accounting to assist us with the review and restatement of the financial statements in question.
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We intend to implement the following additional actions in 2010:
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implement formal and informal training programs, particularly with respect to the accounting for non-cash items;
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continue our retention of an outside consulting firm to assist us with a review of financial report preparation.
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Except as discussed above, there has not been any change in our internal control over financial reporting that occurred during our quarter ended March 31, 2009 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On August 17, 2007, the Company filed a complaint in the Third Judicial District Court in and for Salt Lake County, State of Utah, naming Topworth Assets Limited ("Topworth") as the principal defendant. The Company asserted conversion, unjust enrichment, breach of warranty, fraud, and for declaratory relief causes of action. The actions arise out of the issuance of 3,715,000 shares of the Company's stock to Topworth in or about early 2004. The Company was able to recover from Topworth 2,715,000 of these shares shortly after their issuance, and now contends it is entitled to recover the remaining 1,000,000 shares because Topworth received all the stock by fraud. The Company sought and obtained an injunction preventing Topworth's transfer of this disputed stock.
In response to the Company's complaint and the issuance of the injunction against it, Topworth filed an answer to the complaint and a counterclaim against the Company, Wei Guo Ping, and Wang Hong Jun on December 11, 2007. Topworth asserts various legal theories that contend it performed consulting services to the Company; was entitled to all of the disputed stock as compensation for services; and was improperly required to return some of the disputed stock to the Company.
On March 5, 2009, the Company and Topworth entered into a Settlement and Release Agreement (the “Settlement”) whereby the Company and Topworth agreed to mutually release each other from any and all claims they have against each other, including any and all claims and counterclaims pending in the action brought by the Company in the Third District Court, State of Utah, Civil Case Number 070911868 (the “Action”). Under the Settlement, the parties’ shall dismiss the Company’s complaint and Topworth’s counterclaim. The 627,360 shares of common stock in the Company held in the name of Topworth (the “Shares”) that were a subject of dispute in the Action shall be disposed of on the following material terms: Topworth shall deliver all certificates representing the Shares to a designated custodian; the custodian shall hold the certificates until at least June 26, 2009; and, thereafter, the custodian shall release 100,000 of the Shares to Topworth each month until November 30, 2009, when Topworth will be entitled to receive all of the remaining Shares. The custodian shall release the Shares without any restriction on Topworth’s ability transfer or sell the Shares imposed by the Company subject to restrictions under the Securities Act of 1933, as amended. The Shares have been held in Topworth’s name and have been included in the Company’s outstanding shares; as such the Shares will not have an additional dilutive effect on the Company’s shareholders. Subsequently, Topworth, through its counsel, filed a stipulation and motion for order to dismiss with prejudice the Action in March 2009.
We know of no other material, active or pending legal proceedings against our Company, and, other than as disclosed above, we are not involved as a plaintiff in any other material proceeding or pending litigation. There are no proceedings in which any of our directors, officers or affiliates, or any registered or beneficial shareholder, is an adverse party or has a material interest adverse to our interest.
ITEM 1A. RISK FACTORS
There has been no material change in the Company's risk factors as previously disclosed in the Company’s amended and restated Annual Report on Form 10-K/A filed with the SEC on April ___, 2010.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
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Exhibit No.
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Description of Exhibit
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31.1
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Certifications pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
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32.1
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Certifications pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused this amended and restated report to be signed on its behalf by the undersigned, thereunto duly authorized.
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China North East Petroleum Holdings Limited
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August 31, 2010
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By:
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/s/ Jingfu Li
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Jingfu Li
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Acting CEO
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(Principal Executive Officer and Principal Financial and Accounting Officer)
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