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| FEEC.OB > SEC Filings for FEEC.OB > Form 10-Q on 2-Nov-2009 | All Recent SEC Filings |
2-Nov-2009
Quarterly Report
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2008 ("2008 Annual Report"), the financial statements and related notes in this Quarterly Report, the risk factors contained herein and in our 2008 Annual Report, and all of the other information contained elsewhere in this report. The terms "we," "us," "our" and "our company" refer to Far East Energy Corporation and its subsidiaries, unless the context suggests otherwise. The term "FEEB" refers to Far East Energy (Bermuda), Ltd., a wholly-owned subsidiary, which conducts substantially all of our operations in China.
Overview. We continued to employ numerous safety precautions to try to ensure the safety of our employees and independent contractors. We believe that good environmental, social, health and safety performance is an integral part of our business success. We conduct our business with respect and care for our employees, contractors, communities, and the environments in which we operate as well as the applicable laws and regulations concerning the environment, occupational safety and health in the jurisdictions in which we operate. Our vision is to conduct our business without harm to people and the environment while creating value for our shareholders as well as for China, including the regions and communities within which we operate. Our commitment to these principles is demonstrated by the fact that we have had no lost-time accidents in the past 4 years-plus and no major environmental incidents. We have a commitment to being good corporate citizens of China, striving to emphasize and utilize very high levels of Chinese content in personnel, services, and equipment; and we have achieved very high percentages of Chinese content in each category.
During the first quarter of 2009, we successfully initiated a strategic alliance with Arrow Energy International Pte Ltd ("Arrow") (see "Strategic Alliance with Arrow" below). During the first nine months of 2009, we continued our efforts to explore and develop CBM in Shanxi Province in northern People's Republic of China ("PRC" or "China") and in Yunnan Province in southern PRC.
During the nine months ended September 30, 2009, we incurred exploration expenditures of $5.5 million, of which $2.1 million were capitalized. Assuming that we obtain approval of the extension of the Qinnan production sharing contract ("PSC") from our Chinese partner company and the Ministry of Commerce ("MOC") of the PRC, and satisfy the other conditions under the Farmout Agreement (as defined below) with Arrow prior to November 20, 2009, then the additional payment of $8 million and reimbursement of certain 2009 Qinnan expenditures incurred by us due upon the occurrence of these events from Arrow together with funds currently available should provide sufficient working capital to meet our current minimum exploration expenditures for all three of our PSCs through early 2010. Management will continue to seek to raise additional capital to continue operations beyond early 2010 and to meet future expenditure requirements necessary to retain our rights under the PSCs. In the event that the MOC does not approve the Farmout Agreement, we will need to either renegotiate the terms and conditions of our strategic alliance with Arrow or seek additional capital earlier than anticipated to continue operations beyond fourth quarter of 2009.
Management intends to seek to obtain additional funds by various methods, which might include the issuance of equity securities, issuance of debt instruments, continued exercise of warrants issued to investors, obtaining farmout partners and/or the potential sale of property interests, among other alternatives. The global financial crisis has created liquidity problems for many companies and financial institutions and international capital markets have stagnated, especially in the United States and Europe. A continuing downturn in these markets could impair our ability to obtain, or may increase our costs
associated with obtaining, additional funds through the sale of our securities. During the quarter ended September 30, 2009, we filed a registration statement with the SEC for the offer and sale from time to time up to $75 million of the Company's securities. The registration statement is not yet effective. There can be no assurance that we will be able to maintain the effectiveness of the registration statement after the registration statement becomes effective. While we will continue to seek to raise funds, there can be no assurance that we will be able to enter any transaction or that we will be successful in obtaining funds through debt or equity financing. Raising additional funds by issuing common stock or other types of equity securities would further dilute our existing stockholders. Under certain circumstances, the structure of certain transactions may require the approval of the Chinese authorities, which could delay closing or make the consummation of a transaction more difficult. There can be no assurance that the Chinese authorities will provide the approvals necessary for a transaction or transfer, including the Farmout Agreement with Arrow. In addition, the terms and conditions of any potential transaction or of any debt or equity financing are uncertain and we cannot predict the timing, structure or other terms and conditions of any such arrangements. There can be no guarantee of future fundraising or exploration success or that we will realize the value of our unevaluated exploratory well costs. Management believes that we will continue to be successful in obtaining the funds necessary to continue as a going concern.
If our operating requirements or drilling obligations materially change from those currently planned, we may require more capital than currently anticipated or may be required to raise capital earlier than anticipated. For example, it is possible that the Ministry of Land and Resources ("MLR"), China United Coalbed Methane Co. Ltd. ("CUCBM") or China National Petroleum Company ("CNPC") could seek to, among other things, modify our operating requirement or drilling obligations which may result in an increase our capital expenditures or accelerate our drilling program. If we are unable to commit to the expenditures or accelerate our drilling and dewatering efforts it may adversely affect our ability to extend the terms of our PSCs. Raising additional funds by issuing common stock or other types of equity securities would further dilute our existing stockholders. If we fail to obtain the necessary funds to complete our exploration activities under our PSCs, and we cannot obtain extensions to the requirements under our PSCs, we would not be able to successfully complete our exploration activities and we may lose rights under our PSCs.
Strategic Alliance with Arrow. On March 13, 2009, we formed a strategic alliance related to our Qinnan Block with Arrow. In conjunction with the strategic alliance, FEEB and Arrow entered into a Farmout Agreement (the "Farmout Agreement") under which, subject to certain conditions, FEEB will assign to Arrow 75.25% of its rights in the Qinnan PSC in the Shanxi Province (the "Assignment"). The Farmout Agreement conditions the Assignment on, among other things, the receipt of required approvals from the government of the PRC on or prior to November 20, 2009 or such later date as we may agree upon. The terms of the Farmout Agreement were subsequently amended in early October 2009 to provide, among other things, that requisite approvals from Chinese authorities must be received and other conditions must be satisfied by November 20, 2009 rather than by the original deadline of October 15, 2009 (the "Amendment"). In conjunction with the Amendment, FEEB and Arrow also agreed that interest on the Exchangeable Note would begin to accrue as originally scheduled on October 16, 2009. Upon satisfaction of the conditions, Arrow will make an initial payment of $8 million to us, and, subject to certain conditions, will fund all exploration costs associated with the Qinnan PSC, up to a maximum of $30 million. In addition, under the Farmout Agreement, if we obtain Chinese governmental approval of an overall development program ("ODP") for the Qinnan area, Arrow will pay FEEB an additional $8 million in cash as a bonus. If the conditions under the Farmout Agreement are not satisfied prior to November 20, 2009, then either party has the right to terminate the agreement by delivering notice of such termination to the other party. Additionally, on March 13, 2009, (i) we entered into a securities purchase agreement with Arrow ("Securities Purchase Agreement"); (ii) FEEB issued an exchangeable note ("Exchangeable Note"), $10 million principal amount, to Arrow for $10 million in cash, which we received shortly after the note was executed; (iii) we issued a warrant to Arrow for 7,420,000 shares of our common stock, at an exercise price of $1.00 per share ("Warrant"); and (iv) the Company and Arrow entered into a registration rights
agreement. The Company incurred approximately $0.5 million in costs in connection with the formation of the strategic alliance.
Under the Securities Purchase Agreement, the Company issued the Warrant to Arrow and FEEB issued the Exchangeable Note to Arrow for $10 million in cash, of which $2 million was to be set aside to be used exclusively to satisfy FEEB's existing exploration and development commitments in connection with the Qinnan PSC. This restricted portion of the proceeds was recorded as restricted cash on the balance sheet. During the period from the formation of the strategic alliance to the end of the third quarter, we used approximately $0.9 million of the $2 million for exploration expenditures related to the Qinnan PSC. See Note 1 - "Summary of Significant Accounting Policies - Restricted Cash."
The Exchangeable Note has an initial principal amount of $10 million and bears interest at a rate of 8% per annum, beginning on October 16, 2009 if the required approvals from the PRC government to effect the Assignment are not received. Principal and interest is due and payable on the maturity date of March 13, 2011. Arrow has the right at any time to exchange the Exchangeable Note in whole or in part for shares of common stock at an exchange rate of 21,052.63 shares per $10,000, or $0.475 per share ("the Exchange Rate"), of principal and interest. However, if certain conditions to the effectiveness of the Assignment are satisfied on or before November 20, 2009, the entire principal amount of the Exchangeable Note will automatically be exchanged for shares of common stock at the Exchange Rate.
The Exchangeable Note contains certain restrictive covenants applicable to the Company and FEEB, including, among others, restrictions on the incurrence of indebtedness that ranks senior to or pari passu with the Exchangeable Note and restrictions on FEEB's ability to sell all of its rights under the Shouyang PSC. The Company has guaranteed FEEB's payment obligations under the Exchangeable Note.
The Warrant entitles Arrow to purchase 7,420,000 shares of common stock at an exercise price of $1.00 per share. The Warrant may be exercised in whole or in part only upon satisfaction of certain conditions to the effectiveness of the Assignment and is exercisable until the date that is eighteen months from March 13, 2009 (the "Exercise Period"). If, during the Exercise Period, the trading price of the common stock equals or exceeds $1.50 per share for fifteen or more consecutive trading days, the Company will have the right to require Arrow either to exercise the Warrant or relinquish its rights thereunder.
For additional information on the strategic alliance, see Item 1 - Business of our 2008 Annual Report.
Shouyang Block, Shanxi Province. We achieved critical desorption pressure in the Number 15 coal seam in a portion of the 1H Pilot area in the Shouyang block in early second quarter of 2009. During the third quarter of 2009, gas production in the Number 15 coal seam, although fluctuating daily, continued an overall upward rise.
During the third quarter of 2009, we fracture stimulated four existing wells which had declined in productivity over time. This work was successful in increasing water production from the stimulated wells by approximately 100% and improving wellbore connectivity with the Number 15 coal seam. We believe the improved communication between the wellbore and the formation may result in further increases in water production over time beyond the current 100% increase. If we are able to sustain the increase in water production, it should continue to help reduce reservoir pressure and continue to expand the developing gas saturation in the 1H Pilot Area.
As the Number 15 coal seam gas production appears to be moving in the anticipated direction, we have elected to pursue additional uphole completion opportunities in this 1H Pilot area. If successful, this should allow for cheaper prospecting of the reserve potential in this area without giving up the data gathering needed in the Number 15 coal seam.
Preliminary results indicate that a second coal seam, the Number 9 coal seam, may be capable of gas production in commercial quantities. We recompleted a well in the Number 9 coal seam in the 1H Pilot Area in late June and that well began producing gas from the Number 9 coal seam on July 15, 2009. Production in that well has generally ranged between 20 and 37 thousand cubic feet ("Mcf") per day since late July. Furthermore, we believe that the drainage of water caused by local mining activity may have liberated significant volumes of gas in the Number 3 coal seam in the 1H Pilot Area of the Shouyang Block. As a result of these developments, during the third quarter of 2009, we recompleted three wells from the Number 15 coal seam to the Number 9 coal seam to verify its production characteristics and potential long term production capacity. We are awaiting results of these stimulations. We are currently reentering a well to further test the Number 3 coal seam to assist us in determining whether it is a third productive seam in the 1H Pilot Area.
In early September, gas production in the 1H Pilot Area exceeded 300 Mcf per day. Although fluctuating daily due to the nature of early stage CBM exploration, which includes periodically taking wells offline for workovers intended to increase production, overall gas production has been increasing since January 1, 2009.
In April 2009, we drilled the P2 parameter well in an area approximately seven kilometers ("km") west of the 1H Pilot Area to test the production characteristics and potential of the area. The well started producing gas from the Number 15 coal seam within 60 days of being put on production which seemed to indicate high gas saturation in the Number 15 coal seam in this area. Recently, gas production from the well tripled within a period of 48 hours between October 24 and 26, 2009, rising from 16 to 17 Mcf a day to between 53 and 60 Mcf a day. Production has continued to increase; however, there can be no assurance that production will continue to increase or sustain current levels of production. We are encouraged to see gas production after a rather short period of dewatering as well as such an increase in gas production over a short period of time as both may indicate high gas saturation in the Number 15 Coal Seam in this area west of the 1H Pilot Area. However we intend to continue to collect data and conduct further analysis to determine the potential of this area.
Core analysis of the Number 9 coal seam in this P2 well indicates that the coal seam is almost completely saturated at the well location with a gas content of approximately 450 standard cubic feet per ton ("scf/ton"). The Number 15 coal seam has a gas content of approximately 490 scf/ton and is 75 to 80% gas saturated. A saturated coal seam, such as the #9 coal seam appears to be in this area, contains close to the maximum amount of gas that can exist in the coal based upon the reservoir temperature and pressure. In a saturated condition, the coal seam does not need to be dewatered to begin producing gas. This eliminates much of the delay in the start of gas production that is associated with dewatering. The recent significant increase in gas production seems to indicate that the Number 15 coal seam is also highly saturated in the area of the P2 well.
In the third quarter, we completed coring of parameter wells P3 and P4. The P3 and P4 wells are located approximately 7 km and 4 km southwest of the 1H Pilot Area, respectively. Both wells were cored in the Number 3 and Number 15 coal seams. The results of the core analysis for the P3 well indicate that the Number 3 coal seam is approximately 1 meter thick, contains a gas content of approximately 520 scf/ton and is approximately 60% saturated. The Number 15 coal seam is approximately 4 meters thick, has a gas content of approximately 540 scf/ton and is also approximately 60% saturated. The results of the core analysis for the P4 well indicate that the Number 3 coal seam is approximately 2.4 meter thick, contains a gas content of approximately 520 scf/ton and is approximately 70% saturated. The Number 15 coal seam is approximately 4 meters thick, has a gas content of approximately 730 scf/ton and is approximately 75% saturated. We anticipate fracture stimulating the P3 and P4 wells in the Number 15 coal seam during the fourth quarter of 2009 and testing these wells for production to determine reservoir parameters and attempt to establish gas production from the Number 15 coal seam.
If we raise sufficient capital, whether through the Arrow transaction or otherwise, we plan to drill an additional 15 to 20 wells on the west side of the field to increase our water withdrawal and to expand the gas saturation area across more of the field. This effort should have a very positive effect on overall gas production.
Due to the quantity of gas being produced in the field, we have begun discussions with our Chinese partner, CUCBM, regarding a gas marketing agreement that would allow us to jointly market our gas with CUCBM through a gas sales facility. We believe that any initial gas sales facility would be a compressed natural gas ("CNG") facility and would likely have a potential capacity to process between 1 and 3 million cubic feet of gas per day. We plan to begin negotiations for this facility after completing discussions with CUCBM for the marketing agreement and believe we could potentially begin gas sales in the second half of 2010. On October 16, 2009, a letter of intent was signed for the sale of gas produced from the Shouyang block between CUCBM and Shanxi International Energy Co. Ltd. Under the terms of the Shouyang PSC, gas produced by us and CUCBM, is sold by CUCBM on behalf of us. Shanxi International Energy Co. Ltd. intends to transport gas produced from the Shouyang block through a pipeline that it will build directly to the area of Far East's current Shouyang gas production. At this time, we are unable to accurately predict when construction of the pipeline will commerce and the anticipated completion date, although it is currently scheduled to be finished by July 2010.
Our planned gas sales strategy has three phrases. In the first phrase, we plan to sell our initial gas production as CNG. Then, if gas volumes grows to between 5 and 50 million cubic feet per day, together with CUCBM we plan to also begin to sell gas into pipelines within Shanxi Province, and then ultimately, when volumes were too big to be absorbed by the CNG and provincial markets, we would move gas into the large trunklines to Beijing and Shanghai.
Although we believe the results of our exploration activities in the Shanxi Province to date have been favorable, we will need to complete more wells to achieve commercial viability, which will require additional expenditures.
During the third quarter of 2009, the MOC approved modification agreements to extend the exploration period for the Shouyang PSC to June 30, 2011.
Qinnan Block, Shanxi Province. CNPC has recently replaced CUCBM as our Chinese partner company. We are in discussions with CNPC regarding the extension of the exploration period, which expired on June 30, 2009. However, the Chinese government has not yet given CNPC the authority to deal with foreign partners on the Qinnan PSC and other PSCs recently transferred from CUCBM to CNPC. At this time, CNPC continues to await authority to deal directly with foreign partners for the Qinnan Block. There can be no assurance that even if CNPC receives such authority to deal directly with foreign partners that CNPC will approve an extension of the exploration period or approve the Farmout Agreement with Arrow. As a result of the extended process for approval of the extension, until receipt of the extension, the Company plans to limit its expenditures in Qinnan to required expenditures under the Company's contractual obligations in order to conserve resources. At CNPC's request, we have provided certain operational and financial information about our Company to assist them in the decision making process. There can be no assurance that we will be successful in extending the Qinnan PSC. As discussed above, the terms of the Farmout Agreement with Arrow were subsequently amended in early October 2009 to provide, among other things, that requisite approvals from Chinese authorities must be received and other conditions must be satisfied by November 20, 2009 rather than by October 15, 2009.
Future plans with our proposed partner, Arrow, may include an extensive program of test wells for delineation of the coal seam on the east side of the block. These wells may involve a full array of evaluation techniques including extensive coring operations. In the future these vertical wells may be put in service as production monitoring wells or targets of intersection from the horizontal well development pattern. These plans are contingent on receiving all approvals and assignments from the Chinese government concerning PSC extensions and change of operatorship.
Enhong-Laochang Area, Yunnan Province. In our Yunnan block, we are conducting a
strategic review of our Yunnan holdings to determine whether they fit within our
risk profile given the tight capital markets and general economic downturn. We
are taking into consideration, among other factors, our overall corporate
strategy, the prospective costs and benefits of the acreage, our relationship
with our Chinese partner companies and our current cash position in order to
formulate an optimal strategy for the Company. The strategy may include, but not
be limited to: (i) minimal capital spending to continue holding the acreage,
(ii) sale, farm-out or partial farm-out of the acreage, (iii) full or partial
relinquishment of the acreage, or (iv) continued staged exploration of the
acreage. We have not yet concluded this review and cannot make any projection as
to the likely outcome of this review. Moreover, our Chinese partner company in
the PSC, CUCBM, will have its own view and certain outcomes will be subject to
CUCBM and MOC approval.
During the third quarter of 2009, the MOC approved a modification agreement to extend the exploration period for the Yunnan PSC to June 30, 2011.
Production Sharing Contracts. Our operations in the Shouyang and Qinnan Blocks in Shanxi Province and the Enhong-Laochang area of Yunnan Province are conducted under three separate PSCs. The two Shanxi PSCs and the Yunnan PSC will expire on July 1, 2032 and January 1, 2033, respectively, subject to the existence of commercially productive reserves and unless extended or otherwise amended. The three PSCs are divided into three periods: exploration, development and production. All three PSCs are in the exploration period, although the exploration period of the Qinnan PSC expired on June 30, 2009, and is the subject of the extension request discussed elsewhere herein. Currently, we bear all exploration costs for discovering and evaluating CBM-bearing areas during the exploration period. During the third quarter of 2009, the MOC approved modification agreements to extend the exploration periods for the Shouyang PSC and the Yunnan PSC to June 30, 2011. CUCBM is our Chinese partner company in these PSCs and has the right to participate in up to 30% of the interest in the Shouyang PSC and up to 40% of the interest in the Yunnan PSC. The exploration period of the Qinnan PSC expired on June 30, 2009. CNPC has recently replaced CUCBM as our Chinese partner company for the Qinnan PSC. We are continuing to pursue an extension of the exploration period of the Qinnan PSC. It is possible that CNPC might elect to issue a new PSC, which could be on less favorable terms than those in the current PSC. At CNPC's request, we have provided certain operational and financial information about our Company to assist them in the decision making process. There can be no assurance that we will be successful in extending the exploration period of the Qinnan PSC or that a new PSC will be granted. Additionally, in connection with obtaining this extension or a new PSC, we may be required to commit to certain expenditures or to modify the terms or respective ownership interests and/or acreage in the PSC. If we are unable to raise sufficient funds to commit to these expenditures, it may adversely affect our ability to extend the PSC.
During the exploration period, all expenditures are funded by us. Expenditures in the development and production periods are funded in proportion to the respective participating share of the participants in the PSC. If we satisfy the conditions to the Farmout Agreement, including obtaining approval from our Chinese partners and the MOC, and successfully assign 75.25% of our participating interest in the Qinnan PSC to Arrow, Arrow will make an initial payment of $8 million to us, become the operator under the Qinnan PSC, and, subject to certain conditions, will fund all exploration costs associated with the Qinnan PSC up to a maximum of $30 million. If the conditions to the Farmout Agreement are not satisfied prior to November 20, 2009, then either party has the right to terminate the Farmout Agreement by delivering notice of such termination to the other party. Assuming that the Farmout Agreement conditions are met, after
Arrow reaches such $30 million cap, FEEB and Arrow will share further Qinnan development costs and any future revenues in proportion to the participating interests in the Qinnan PSC, provided that FEEB may, in its discretion, instead elect to assign all of its interest in the Qinnan PSC to Arrow subject to retaining a 2% overriding royalty interest. In addition, under the Farmout Agreement, if we obtain Chinese governmental approval of an ODP for the Qinnan area, Arrow will pay FEEB an additional $8 million in cash as a bonus, and FEEB will have the option to assign all of its interest in the Qinnan PSC to Arrow, while retaining a 5% overriding royalty interest. Qualified project costs incurred under the PSCs by us can be recovered from the value of the first 75% of gross production of CBM for the two Shanxi Province PSCs and 70% of gross production of CBM for the Yunnan PSC. Participants will pay their proportionate share of the value added tax and State royalty according to the relevant government regulations. In addition, with respect to the Shouyang and Qinnan . . .
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