Summary of SOUTH TEXAS OIL CO

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. In some cases, forward-looking statements are identified by terms such as "may," "will," "should," "could," "would," "expects," "plans," "anticipates," "believes," "estimates," "projects," "predicts," "potential," and similar expressions intended to identify forward-looking statements. Such statements include, without limitation, statements regarding:

• fluctuations in oil or gas production or in oil or gas prices;
• estimates of required capital expenditures;
• fluctuations in the cost of drilling, completion and oil production or other costs of production and operations;
• our inability to meet growth projections;
• our plans and expectations with respect to future acquisitions of oil and gas rights leases;
• the expected benefits and results from our geophysical research and development efforts;
• our belief that we will have sufficient liquidity to finance operations into early 2009;
• the amount of cash necessary to operate our business;
• our ability to raise additional capital when needed;
• general economic conditions; and
• the anticipated future financial performance and business operations of our company.

These forward-looking statements are only predictions and involve known and unknown risks, uncertainties, and other factors that may cause our actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance, or achievements expressed or implied by such forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this Report. Except as otherwise required by law, we expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statement contained in this Report to reflect any change in our expectations or any change in events, conditions, or circumstances on which any of our forward-looking statements are based or to conform to actual results. Factors that could cause or contribute to differences in our future financial and operating results include those discussed in the risk factors set forth in our Annual Report on Form 10-KSB for the year ended December 31, 2007, as well as those discussed elsewhere in this Report. We qualify all of our forward-looking statements by these cautionary statements.

You should read this section in combination with the section entitled Management's Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2007 included in our Annual Report on Form 10-KSB for the year ended December 31, 2007.

Overview

We generate revenue primarily from our working interests in producing oil and gas properties, the majority of which are located in south and central Texas and a smaller acreage position located in Colorado. In the second and third quarters of 2007, we acquired additional working interests in south central Texas, which significantly increased our total leasehold acreage position and production capabilities. As of December 31, 2007, our average production base consisted of approximately 71% crude oil and 29% natural gas. We have obtained capital for investment in producing oil and gas properties primarily through the sale of our common stock to existing stockholders, and a $32.5 million credit facility and a $7 million senior secured note financing with affiliates of one of our significant stockholders.

Our strategy is to focus on the acquisition and development of onshore properties that have proved oil gas reserves and to attempt to acquire interests in proven fields and attempt to increase production by exploring other formations in the same fields where others have obtained production. Our primary operational strategy includes the operation of our own projects, which provides us substantial control over drilling and production costs. While much of the engineering and geology for our projects is performed by consulting firms, the actual drilling, rework and other field operations are performed on a project basis by contractors who bid for the work. We believe that operating our properties in this manner is cost-effective, as the range of expertise and services required varies by project and time duration. We have purchased two drilling rigs in an effort to further reduce costs and increase our operational efficiencies.

As of June 30, 2008, we had terminated a contract operating agreement with Sonterra Operating, Inc., ("Sonterra") under which Sonterra was the contract operator for our oil and gas operations, managing our daily operations and providing accounting services for our operated and non-operated properties. Michael J. Pawelek, our serving Chairman of the Board was appointed as our President and Chief Executive Officer on June 23, 2008 following the resignation of J. Scott Zimmerman from those positions. Mr. Pawelek had been the president and chief executive officer of Sonterra prior to joining us, and he remained a director of Sonterra until his resignation on November 6, 2008.
Contemporaneously with the termination of the contract operating agreement with Sonterra and Mr. Pawelek's appointment as our President and Chief Executive Officer, we entered into another contract operating agreement, under which we are providing contract operating services for Sonterra and overseeing certain of Sonterra's operations in a manner similar to the services that Sonterra previously provided to us.

Results of Operations

Three Months Ended September 30, 2008, Compared with Three Months Ended September 30, 2007

Revenues

Oil and gas sales increased 37% to $2,153,255 from $1,575,010 for the third quarters of 2008 and 2007, respectively, primarily as a result of higher average realized prices for crude oil and natural gas. Revenue generated by drilling services was $397,811 for the third quarter of 2007, compared to zero for the third quarter of 2008. Our drilling rigs were undergoing repair during the first three quarters of 2008, and were not engaged in income generating activities.

Production Expenses

The 49% increase in production expenses from $693,003 to $1,035,250 for the third quarters of 2007 and 2008, respectively, resulted from an increase in the number of producing wells associated with our property acquisitions completed in the second and third quarters of 2007.

General and Administrative Expenses ("G&A")

General and administrative expenses were $2,526,009 for the third quarter of 2008 compared to $314,931 for the third quarter of 2007, an increase of 702%. This increase largely resulted from non-cash charges recognized during the third quarter of 2008 for stock compensation. These charges included approximately $1.5 million for employee stock compensation related to stock grants awarded in June of 2008 and stock options awarded in the fourth quarter of 2007. Also included was a $170,550 charge related to stock issued in exchange for third party consulting services received. Additional increases in general and administrative costs resulted from increased payroll and related costs associated with a growth in the number of employees compared to the third quarter of 2007. We continued to make payments pursuant to certain consulting contracts initiated in the first and second quarters of 2008 that will be terminating in the fourth quarter of 2008 and first quarter of 2009.

Depreciation, depletion and amortization ("DD&A")

The 62% increase in DD&A to $573,075 for the third quarter of 2008 from $354,187 for the third quarter of 2007 was attributable to increased costs subject to DD&A, resulting from additional capital spending for drilling and capital workover projects.

Interest Expense

Interest expense recognized for the third quarter of 2008 was $1,107,161, compared to $773,465 for the third quarter of 2007, an increase of 43%. This increase is a direct result of increase in debt outstanding under the Longview and Marquis credit facility and the new senior secured debt issued to Marquis during the third quarter of 2008, described in Note 2 to the financial statements. Borrowings under the facility were higher during the third quarter of 2008 compared to the third quarter of 2007. We have used proceeds from the facility to finance property acquisitions and our property development programs in the periods since the third quarter of 2007. Additionally the facility was used to provide financing during the first and second quarters of 2008 to finance the $5.3 million loss incurred from derivative transactions.

Gain/Loss from Derivatives

We recognized a $30,614 gain on remaining open long positions in the third quarter of 2008. Any losses generated by our derivative trading activities were completely offset by additional contracts purchased at the end of the quarter. Those uncovered contracts will expire and will be settled by year end.

Net Loss

During the third quarter of 2008, we realized a net loss of $3,948,843, compared to a net loss of $495,143 for the third quarter of 2007. The increase in net loss resulted mainly from the $1.7 million in non-cash stock compensation charges, an increase in other general and administrative expense components of approximately $500,000, current period amortization of debt issuance costs of $635,793, a $342,247 increase in production expenses, and a $333,686 increase in interest expense. Continued increases in interest expense and production expenses may be realized. We intend to continue growth and development of our assets and administrative and operational infrastructure.

Nine Months Ended September 30, 2008, Compared with Nine Months Ended September 30, 2007

Revenues

Oil and gas sales increased 219% from $2,466,906 to $7,877,500 for the nine months ended September 30, 2007 and 2008, respectively, as a result of increased production volumes contributed by oil and gas properties acquired during the second and third quarters of 2007 and higher average realized prices for crude oil and natural gas. Revenue generated by drilling services was $920,312 for nine months ended September 30, 2007, compared to zero for the same period of 2008. Our drilling rigs were undergoing repair during the first three quarters of 2008 and were not engaged in income generating activities.

Production Expenses

The 140% increase in production expenses from $1,129,776 to $2,716,093 for the nine months ended September 30, 2007 and 2008, respectively, resulted from the increase in the number of producing wells associated with our property acquisitions completed in the second and third quarters of 2007.

General and Administrative Expenses ("G&A")

General and administrative expenses were $5,613,767 for the nine months ended September 30, 2008 compared to $781,246 for the same period in 2007, an increase of 619%. This increase resulted from an increase in payroll and related expense, consulting fees and travel costs for the increased administrative responsibilities associated with the oil and gas properties acquired in the first and second quarters of 2007. Additionally, legal expenses increased by approximately $300,000 due to costs recognized in the first and second quarters of 2008 related to the settlement of litigation described in Note 3 to the financial statements. Also contributing to the increase in G&A was the $1.95 million of stock compensation expense associated with the restricted stock granted to the new employees who joined our management team as officers during the third quarter of 2008 and stock options issued during the first quarter of 2008. Finally, G&A for the third quarter of 2008 included contract operating fees paid to a third party entity that provided management services to us during April through June of 2008, including oversight over daily operational and administrative matters. Concurrent with our hiring of our new officers at the end of June, this contract operating arrangement with the third party was terminated.

Certain components of our G&A for the nine months ended September 30, 2008 are not expected to be recurring in nature. These include (i) significant legal expenses incurred in relation to the litigation settled during the period, (ii) fees paid for contract management services for the period preceding the addition of our new officers, and (iii) consulting fees paid to third parties for the provision of certain professional services that will be performed by our own management and staff in future periods. Salary and related costs and stock compensation expense are expected to increase as a result of the addition of our new officers and other employees at the end of June 2008 and in the third and fourth quarters of 2008, and as may be required in future periods. Certain of the consulting arrangements that are not expected to be renewed will expire over the succeeding six month period.

Depreciation, depletion and amortization ("DD&A")

The 316% increase in DD&A to $3,212,110 for the nine months ended September 30, 2008 from $771,347 for the same period in 2007 is attributable to the effect of the oil and gas property acquisitions that occurred in the second and third quarters of 2007. The acquisitions increased the costs subject to DD&A as the costs of the acquired properties were recognized, and increased the production volume used in the units of production calculation of the DD&A provision.

Interest Expense

Interest expense recognized for the nine months ended September 30, 2008 was $2,715,930, compared to $1,741,055 for the same period in 2007, an increase of 56%. This increase is a direct result of an increase in debt outstanding under the Longview and Marquis credit facility and the new senior secured note issued to Marquis during the third quarter of 2008 described in Note 2 to the financial statements. Borrowings were higher during the first three quarters of 2008 compared to the same period in 2007 because the facility was used to finance oil and gas property acquisitions made during the second, third and fourth quarters of 2007. Additionally the facility was used to provide financing during the second quarter of 2008 to finance the net $5.3 million loss incurred from derivative transactions.

Loss from Derivatives

A net loss from derivatives of $5.3 million was recognized during the nine months ended September 30, 2008, compared to $0 for the same period in 2007. Losses were not recognized from our derivative trading activities until the first quarter of 2008. The agreements that generated the losses during the second quarter of 2008 were completely offset by additional contracts purchased at the end of the quarter. Because of the contracts' covered status, we do not anticipate future additional losses to be realized from the contracts that were outstanding during the third quarter of 2008. We did not engage in derivative transactions during the nine months ended September 30, 2007.

Net Loss

During the nine months ended September 30, 2008, we realized a net loss of $14,106,359, compared to a net loss of $1,827,531 for the nine months ended September 30, 2007. The increase in net loss resulted predominately from the $5.3 million in net losses realized from derivative trading activities. Additionally the $4.8 million increase in G&A contributed to the increased net loss, as did the $1.6 million increase in production expenses and the $974,875 increase in interest expense from increased debt. We are not currently subject to derivative contracts that are expected to yield additional losses for the year; however, continued increases in interest expense, G&A and production expenses may be realized. We intend to continue growth and development of our assets and administrative and operational infrastructure.

Liquidity and Financial Condition

As of September 30, 2008, we had a working capital deficit of $4.7 million, the primary components of which were cash and cash equivalents, accounts receivable and prepaid expenses offset by accounts payable, current notes payable, long-term debt and other accrued expenses. The entire $7 million in principal due under the Marquis Senior Secured Debt agreement entered into in September of 2008, less the $250,000 discount recorded at issuance, is included in current liabilities as of September 30, 2008. As of December 31, 2007, our working capital balance was a negative $38,336, the primary components of which were cash and cash equivalents, trade accounts receivable and prepaid expenses. We expect to fund operations for the succeeding 12 months with existing cash and additional sources of financing as may be required. Given the need for, and costs associated with, additional exploration and development efforts, we will need to raise additional capital to satisfy our capital needs over the next 12 months.

On September 30, 2008, we had assets of $71,708,017 compared to $63,428,393 on December 31, 2007, an increase of $8,279,624. We had total stockholders' equity of $19,029,825 on September 30, 2008 compared to $31,184,407 on December 31, 2007, a decrease in equity of $12,154,582 resulting from the net losses generated through the third quarter of 2008.

Net cash used in operating activities for the nine months ended September 30, 2008 was $911,321 as compared to net cash used by operating activities of $183,984 for same period in 2007.

Net cash used by investing activities for the nine months ended September 30, 2008 was $7,167,587 as compared to $20,649,783 cash used for investing activities for the same period in the prior year. The cash used in the first nine months of 2008 was primarily the result of capital expenditures made for the development of the Company's oil and gas properties and related production facilities.

Net cash provided by financing activities for the nine months ended September 30, 2008 was $15,611,417 compared to $19,974,328 cash provided by financing activities for the same period in the prior year. This increase is the result of additional debt issued, net of debt repayments and debt converted to equity during the period. Additionally, the increase in cash provided by issuance of new debt was partially offset by the use of $902,010 for the repurchase of shares of our common stock into treasury.

Commitments and Contingencies

Hedge Agreement

On February 19, 2008, we announced 2008 risk management activities with respect to the entry into hedge contracts with MF Global Ltd. Hedged production benchmark volumes were initially set at 16,000 barrels of oil per month, current net production. The underlying risk management agreement, which has an initial term ending December 31, 2008, was intended to deliver predictable cash flow for 2008, by using hedge transaction contacts with a "collar" floor price of $85 per barrel and a ceiling of $100 per barrel. On April 30, 2008, the parties agreed in principle to amend the risk management agreement to extend the term for an additional year and reduce the benchmark volumes by half to 8,000 barrels per month (approximately 263 barrels of oil per day) and to raise the collar ceiling to $109.75 per barrel for the calendar year 2009. As a result of the collar ceiling, we did not benefit from the price of oil exceeding $100.00 per barrel, since we are obligated to pay a call on the hedge contracts representing the differential between the average monthly price per barrel of oil in excess of the collar ceiling, based upon the stated benchmark production of 8,000 barrels per month.

On or about June 27, 2008, MF Global Ltd. orally agreed with us to terminate the financial effect of the hedge agreement by entering into offsetting hedge positions with respect to future trades pursuant to the hedge agreement, conditioned upon our settling all positions resulting from the differential between the average monthly price per barrel of oil in excess of the collar ceiling, based upon the stated benchmark production of 8,000 barrels per month.

Capital Commitment

On February 15, 2008, we entered into an amendment to a gas contract that we had previously entered into with DCP Midstream in October 2007, for the gathering, processing and marketing of our Bastrop Field natural gas volumes. The contract allows us to sell our natural gas in Bastrop County, Texas at a premium to NYMEX natural gas prices due to the high propane, ethane, butane and methane content of the natural gas. We began transporting this gas production on August 15, 2008, and will sell initial natural gas volumes of 150 to 200 thousand cubic feet per day (Mcf/d). As part of the contract terms, we were responsible for $186,000 of capital investment in the project, which we have fulfilled and for which we will receive a repayment of $0.25/Mcf over time if 220,000 MMcf of gas is produced within two years of first sales. There are no minimum volume commitments and, as gas volumes increase, the infrastructure will be improved to meet the field's throughput requirements.

Amended Credit Facility

We have a $32.5 million senior credit facility with Longview and Marquis. As of September 30, 2008, $34.3 million was outstanding, which included $1.9 million for interest accrued on the facility added to the principal of the underlying notes during the second and third quarters of 2008, in accordance with provisions of the borrowing agreement that permitted the capitalization of interest through December 31, 2008. Borrowings under the facility accrue interest at a rate equal to prime plus 4%, which was equal to 12.5% at June 30, 2008. The principal amount of the senior secured notes issued under the facility was increased during the three months ended September 30, 2008 by $1,000,000 for additional amounts borrowed during the period. On July 1, 2008, subsequent to entering into a June 2008 Amendment, we issued to Longview an additional senior secured note in the original principal amount of $1 million pursuant to the credit facility, bringing the aggregate amount of senior secured notes outstanding, before accrued interest added to the notes, to approximately $32.4 million of the $32.5 million available.

We originally obtained the credit facility in January 2007, at which time the facility had an initial borrowing limit of $15 million that was increased to $30 million in September 2007. In connection with the increase in borrowing limit, we agreed to grant to Longview a perpetual overriding royalty interest in the oil and gas production of certain of our properties, and we granted security and pledge agreements that provided Longview with first priority security interests in substantially all of our assets.

In April 2008, we amended and restated the credit facility with Longview and Marquis in its entirety. By further amendment in April 2008, we agreed to grant to Longview and Marquis certain mortgages in our oil and gas producing properties and a perpetual overriding royalty interest in the oil and gas production of all of our current and future interests in the real property then owned by us.

On June 30, 2008, we, Longview and Marquis entered into another amendment to the credit facility, which (i) increased the aggregate maximum amount of senior secured notes from $32 million to $32.5 million and (ii) amended the senior secured notes to provide that the interest amounts due and payable under the senior secured notes will be capitalized and added to the principal amount of the senior secured notes for all interest amounts payable prior to the earlier of (a) December 31, 2008 and (b) the date on which we receive an aggregate of at least $15 million in gross proceeds in one or more transactions occurring after June 30, 2008 from any sales of our debt and/or equity securities, any other debt or equity financings, any farm-out financing transaction that does not include operating obligations of the financing party as a material term of the transaction, and any sales of our oil and gas assets.

Marquis Senior Secured Note

On September 19, 2008, we entered into a Securities Purchase Agreement with Marquis, pursuant to which on such date, among other things, we issued and sold to Marquis a Senior Secured Note in an original principal amount of $7,000,000, for gross proceeds of $6,750,000, prior to our payment of expenses incurred by the parties in connection with the transactions under the Securities Purchase Agreement. The Senior Secured Note carries an interest rate of 12.5% per annum payable quarterly in cash and matures in September of 2009. Upon our prepayment of all or any portion of the Senior Secured Note or at maturity, Marquis has the option to convert up to 50% of the principal (and interest relating thereto) to be paid by us on such date of prepayment or maturity, into shares of our common stock at a conversion rate of $4.00 per share (subject to adjustment for stock splits and other events).

The Senior Secured Note is secured by a general security interest in all tangible and intangible current and future assets owned or acquired by us and our subsidiaries (including mortgages on our and our subsidiaries' real property interests), which have guaranteed our obligations under the Senior Secured Note and other transaction documents. Marquis' secured position in this transaction is senior to the rights of all other secured parties, including the rights of Longview under that certain securities purchase agreement, as amended (the "April 2008 Purchase Agreement") dated as of April 1, 2008, among Marquis, Longview and us, pursuant to which we issued and sold secured notes in the aggregate principal amount of approximately $34,284,098 (the "Existing Notes"), except for the previously secured rights of Marquis, which will continue to rank pari passu with the rights granted to Marquis under the Senior Secured Note. In conjunction with the transactions described in the Securities Purchase Agreement, we entered into a September 2008 Waiver and Amendment with Marquis and Longview, pursuant to which the parties amended and waived certain provisions and covenants, including a financial covenant, contained in the Existing Notes issued to Longview and the April 2008 Purchase Agreement that conflicted with the terms and conditions of the Securities Purchase Agreement and the transactions contemplated thereby.

Under the Securities Purchase Agreement and Senior Secured Notes we will be subject to certain covenants, including restrictions on incurring additional indebtedness, issuing equity securities, granting or incurring liens, transacting with affiliates, and entering into mergers, consolidations and sales of assets. The Securities Purchase Agreement also requires that we comply with a financial covenant to maintain an average minimum daily production level. A breach of these covenants would give the holder of the Senior Secured Note the right to require immediate repayment of the entire principal amount of, and interest on, the Senior Secured Note prior to the scheduled maturity date of the Senior Secured Note.

Additionally, under the terms of the Securities Purchase Agreement, we retired certain existing demand notes held by Marquis, which demand notes had an aggregate principal balance due of $637,614.51 plus accrued interest, in exchange for 403,499 shares of our common stock. In addition, we conveyed to . . .