PANHANDLE ROYALTY CO - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(X) Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the period ended December 31, 2002
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( ) Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from to
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Commission File Number 0-9116
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PANHANDLE ROYALTY COMPANY
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(Exact name of registrant as specified in its charter)

OKLAHOMA 73-1055775
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

Grand Centre Suite 210, 5400 N Grand Blvd., Oklahoma City, Oklahoma 73112
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(Address of principal executive offices)

Registrant's telephone number including area code (405) 948-1560
------------------------------

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

X Yes No
--- ---

Outstanding shares of Class A Common stock (voting) at February 3, 2003:
2,082,190
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INDEX

PART I. FINANCIAL INFORMATION

PANHANDLE ROYALTY COMPANY
CONDENSED CONSOLIDATED BALANCE SHEETS
(Information at December 31, 2002 is unaudited)

(1)

PANHANDLE ROYALTY COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

(2)

PANHANDLE ROYALTY COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(See accompanying notes)

(3)

PANHANDLE ROYALTY COMPANY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1: Accounting Principles and Basis of Presentation

The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with the instructions to Form 10-Q as
prescribed by the Securities and Exchange Commission, and effective
October 1, 2001, include the Company's wholly-owned subsidiary, Wood
Oil Company (Wood). Management of Panhandle Royalty Company believes
that all adjustments necessary for a fair presentation of the
consolidated financial position and results of operations for the
periods have been included. All such adjustments are of a normal
recurring nature. The consolidated results are not necessarily
indicative of those to be expected for the full year.

NOTE 2: Income Taxes

The Company utilizes tight gas sands production tax credits to reduce
its federal income tax liability, if any. These credits are scheduled
to be available through calendar year 2002. The Company's provision for
income taxes is also reflective of excess percentage depletion,
reducing the Company's effective tax rate from the federal statutory
rate.

NOTE 3: Earnings (Loss) Per Share

The following table sets forth the number of shares utilized in the
computation of basic and diluted earnings (loss) per share, giving
consideration to, certain shares that may be issued under the
Non-Employee Director's Deferred Compensation Plan, to the extent
dilutive:

NOTE 4: Long-term Debt

The Company has a $5,000,000 line-of-credit with BancFirst in Oklahoma
City, OK. This facility matures on January 31, 2005. At December 31,
2002, the Company had $2,250,000 outstanding under the BancFirst
facility ($2,875,000 at February 5, 2003). In addition, on October 1,
2001, the Company utilized a $20,000,000 five year term loan from
BancFirst to make the Wood Oil acquisition. Monthly payments on the
term loan, which began in December 2001, are $333,000 plus, accrued
interest. At December 31, 2002 the outstanding balance of the term loan
was $15,671,000. The line-of-credit and term loan bear interest equal
to the national prime rate minus 1/4% (4.0% at December 31, 2002).

NOTE 5: Dividends

On December 18, 2002, the Company's Board of Directors approved payment
of a $.07 per share dividend, to be paid on March 17, 2003, to
shareholders of record on February 14, 2003.

(4)

NOTE 6: Recently Issued Accounting Pronouncements

In August 2001, the FASB issued SFAS No. 143, Accounting for Asset
Retirement Obligations (SFAS No. 143). SFAS No. 143 requires entities
to record the fair value of a liability for an asset retirement
obligation in the period in which it is incurred and a corresponding
increase in the carrying amount of the related long-lived asset.
Subsequently, the asset retirement cost should be allocated to expense
using a systematic and rational method and the liability should be
accreted to its face amount. The Company adopted SFAS No. 143 on
October 1, 2002. The primary impact of this standard relates to oil and
gas wells on which the Company has a legal obligation to plug and
abandon the wells. Prior to SFAS No. 143, the Company had not recorded
an obligation for these plugging and abandonment costs due to its
assumption that the salvage value of the surface equipment would
offset the cost of dismantling the facilities and carrying out the
necessary clean-up and reclamation activities. The adoption of SFAS No.
143 on October 1, 2002, resulted in a net increase to Property and
Equipment and Retirement Obligations of approximately $325,000 and
$250,000, respectively, as a result of the Company separately
accounting for salvage values and recording the estimated fair value of
its plugging and abandonment obligations on the balance sheet. The
impact of adopting SFAS No. 143 has been accounted for through a
cumulative effect adjustment that amounted to $46,500, net of taxes
($.02 per share). The increase in expense resulting from the accretion
of the asset retirement obligation and the depreciation of the
additional capitalized well costs is expected to be substantially
offset by the decrease in depreciation from the Company's consideration
of the estimated salvage values in the calculation.

In October 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets (SFAS No. 144). SFAS No.
144 addresses financial accounting and reporting for the impairment of
long-lived assets and for long-lived assets to be disposed of. It
supercedes, with exceptions, SFAS No. 121. SFAS No. 144 was adopted by
the Company on October 1, 2002. The adoption of SFAS No. 144 had no
material impact on the Company's financial position or results of
operations.

In June 2002, FASB issued SFAS 146, Accounting for Costs Associated
with Exit or Disposal Activities. SFAS 146 addresses financial
accounting and reporting for costs associated with exit or disposal
activities and nullifies Emerging Issues Task Force Issue No. 94-3,
Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity. The pronouncement is effective for
exit or disposal activities initiated after December 31, 2002.
Management does not believe that the adoption of SFAS 146 will have any
material impact on its financial position or results of operations in
the near term.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

FORWARD-LOOKING STATEMENTS AND RISK FACTORS

Forward-Looking Statements for 2003 and later periods are made in this
document. Such statements represent estimates of management based on the
Company's historical operating trends, its proved oil and gas reserves and other
information currently available to management. The Company cautions that the
forward-looking statements provided herein are subject to all the risks and
uncertainties incident to the acquisition, development and marketing of, and
exploration for oil and gas reserves. These risks include, but are not limited
to, oil and natural gas price risk, environmental risks, drilling risk, reserve
quantity risk and operations and production risk. For all the above reasons,
actual results may vary materially from the forward-looking statements and there
is no assurance that the assumptions used are necessarily the most likely to
occur.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 2002, the Company had negative working capital of
$2,395,822, as compared to negative working capital of $2,399,457 at September
30, 2002. Negative working capital is a result of $3,996,000 being recorded as
the current portion of the $20,000,000 term loan used to fund the acquisition of
Wood Oil Company ("Wood Acquisition") on October 1, 2001. Monthly payments on
the term loan of $333,000, plus, accrued interest began on December 1, 2001.
Cash flow from operating activities increased 15% to $2,359,017 for the first
three-months of fiscal 2003, as compared to the first three-months of fiscal
2002, primarily due to a significant increase in product sales prices.

Capital expenditures for oil and gas activities for the 2003
three-month amounted to $2,233,780, as compared to $2,367,539 for the 2002
period exclusive of $15,229,466 used to acquire Wood Oil Company. Capital
expenditures are anticipated to increase through fiscal 2003 as the increase in
product prices should cause an increase in drilling activity as the year
progresses. Management's capital expenditures budget is approximately $9,000,000
for fiscal 2003.

The Company has historically funded its capital expenditures, overhead
expenditures and dividend payments from operating cash flow. With the addition
of the monthly payments required on the term loan, the Company has utilized (as
of February 5, 2003), $2,875,000

(5)

of the $5,000,000 line-of-credit to help fund these expenditures. Management
expects to borrow additional funds under the line-of-credit during the remainder
of fiscal 2003. The Company may seek to expand the line-of-credit, if needed.
Also the Company has the potential availability of equity, which could be
offered in a public or private placement, if additional capital were needed for
capital expenditures, or for debt reduction, or a combination of uses.

RESULTS OF OPERATIONS

Revenues:

Total revenues increased $1,133,187 or 34% for the 2003 quarter as
compared to the 2002 quarter. Sales volumes for both oil and natural gas
decreased due to normal production decline in the 2003 quarter but the
substantial increase in average sales prices for both products produced the
revenue increase. The table below outlines the Company's production and average
sales prices for oil and natural gas for the three month periods of fiscal 2003
and 2002:

As the table outlines the 49% increase in oil price and the 59%
increase in gas price more than offset the 11% decline in equivalent production
to 1,117,189 mcfe. These price increases resulted in a 38% increase in oil and
gas revenue for the quarter.

Lease Operating Expenses and Production Taxes (LOE):

LOE increased 12% or $99,166 in the 2003 quarter. Production taxes
increased in the 2003 quarter as oil and gas sales revenues increased and
production taxes are paid as a percentage of oil and gas sales revenue. In
addition, well operating costs continue to increase as the Company adds
operating costs from the substantial number of new wells drilled each year.

Exploration Costs:

These costs increased $154,246 in the 2003 period as there were several
exploratory wells which completed drilling in 2003, thus increasing the chances
of drilling an exploratory dry hole, which costs are charged to exploration
costs in the period incurred. One well accounted for approximately $125,000 of
the increase.

Depreciation, Depletion, Amortization and Impairment (DD&A):

DD&A decreased $61,888 or 4% in the 2003 period. This decrease was
principally the result of decreased production volumes reducing the units of
production DD&A calculations for the quarter.

General and Administrative Costs(G&A):

G&A expenses increased $68,487 or 11% in the 2003 period. The increase
was due to increased professional service fees in the 2003 period for legal,
reservoir engineering and audit services. In addition, a charge of $35,000 was
incurred for the Non-Employee Directors Deferred Compensation Plan due to
Panhandle's common share price increasing from September 30 to December 31,
2002.

Interest Expense:

Interest expense decreased in the 2003 quarter due to a lower level of
debt and due to a decrease in the interest rate on the debt. The interest rate
is 1/4% below prime rate and the prime rate decreased throughout fiscal 2002.

Income Taxes:

The 2003 period provision for income taxes increased due to
substantially increased income before provision for income taxes. The Company
utilizes tight gas sands production tax credits (available through calendar year
2002) and excess percentage depletion to reduce its effective tax rate from the
federal statutory rate. The effective tax rate estimate was 27% and 25% for the
2002 and 2001 periods, respectively.

(6)

Overview:

The Company recorded a first quarter 2003 net income of $651,481, or
$.31 per share, as compared to a $76,856 net loss or $.04 per share, in the 2002
quarter. The improved 2003 quarter results were due to substantial increases in
the sales price of both oil and natural gas and partially offset by modestly
higher costs and expenses.

CRITICAL ACCOUNTING POLICIES

Preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates, judgements and assumptions that affect the reported amounts of
assets, liabilities, revenues and expenses, and the disclosure of contingent
assets and liabilities. However, the accounting principles used by the Company
generally do not change the Company's reported cash flows or liquidity.
Generally, accounting rules do not involve a selection among alternatives, but
involve a selection of the appropriate policies for applying the basic
principles. Interpretation of the existing rules must be done and judgements
made on how the specifics of a given rule apply to the Company.

The more significant reporting areas impacted by management's
judgements and estimates are crude oil and natural gas reserve estimation,
impairment of assets and tax accruals. Management's judgements and estimates in
these areas are based on information available from both internal and external
sources, including engineers, geologists and historical experience in similar
matters. Actual results could differ from the estimates as additional
information becomes known.

Oil and Gas Reserves

Of these judgements and estimates, management considers the estimation
of crude oil and natural gas reserves to be the most significant. Changes in
crude oil and natural gas reserve estimates affect the Company's calculation of
depreciation and depletion, provision for abandonment and assessment of the need
for asset impairments. The Company's consulting engineer with assistance from
Company geologists prepares estimates of crude oil and natural gas reserves
based on available geologic and seismic data, reservoir pressure data, core
analysis reports, well logs, analogous reservoir performance history, production
data and other available sources of engineering, geological and geophysical
information. These estimates are generally updated only annually unless the
Company experiences a significant production volume change on a significant
holding. As required by the guidelines and definitions established by the
Securities and Exchange Commission, these quarterly estimates are based on then
current crude oil and natural gas pricing. As previously discussed, crude oil
and natural gas prices are volatile and largely affected by worldwide
consumption and are outside the control of management. Projected future crude
oil and natural gas pricing assumptions are used by management to prepare
estimates of crude oil and natural gas reserves used in formulating managements
overall operating decisions in the exploration and production segment.

Successful Efforts Method of Accounting

The Company has elected to utilize the successful efforts method of
accounting for its oil and gas exploration and development activities.
Exploration expenses, including geological and geophysical costs, rentals and
exploratory dry holes, are charged against income as incurred. Costs of
successful wells and related production equipment and developmental dry holes
are capitalized and amortized by field using the unit-of-production method as
oil and gas is produced. The accounting method may yield significantly different
operating results than the full cost method.

Impairment of Assets

All long-lived assets are monitored for potential impairment when
circumstances indicate that the carrying value of the asset may be greater than
its future net cash flows. The evaluations involve a significant amount of
judgement since the results are based on estimated future events, such as
inflation rates, future sales prices for oil and gas, future costs to produce
these products, estimates of future oil and gas reserves to be recovered and the
timing thereof, the economic and regulatory climates and other factors. The need
to test a property for impairment may result from significant declines in sales
prices or unfavorable adjustments to oil and gas reserves. Any assets held for
sale are reviewed for impairment when the Company approves the plan to sell.
Estimates of anticipated sales prices are highly judgmental and subject to
material revision in future periods. Because of the uncertainty inherent in
these factors, the Company cannot predict when or if future impairment charges
will be recorded.

Tax Accruals

The estimation of the amounts of income tax to be recorded by the
Company involves interpretation of complex tax laws and regulations. Although
the Company's management believes its tax accruals are adequate, differences may
occur in the future depending on the resolution of pending and new tax matters.

(7)

The above description of the Company's critical accounting policies is
not intended to be an all-inclusive discussion of the uncertainties considered
and estimates made by management in applying accounting principles and policies.
Results may vary significantly if different policies were used or required and
if new or different information becomes known to management.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

The Company's results of operations and operating cash flows are
impacted by changes in market prices for oil and gas. Operations and cash flows
are also impacted by changes in the market interest rates related to the
revolving credit facility and the $20 million five-year term loan, both bearing
interest at an annual variable interest rate equal to the national prime rate
minus 1/4%. A one percent change in the prime interest rate would result in
approximately a $180,000 change in annual interest expense.

ITEM 4. CONTROLS and PROCEDURES

Panhandle Royalty Company management, including, the Chief Executive
Officer and Chief Financial Officer have conducted an evaluation of the
effectiveness of disclosure controls and procedures pursuant to Exchange Act
Rule 13a-15. Based upon that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that the Company's disclosure controls and
procedures are effective in ensuring that all material information required to
be filed in this quarterly report has been made known to them in a timely
fashion. There have been no significant changes in our internal controls or in
factors that could significantly affect internal controls, subsequent to the
date of the Chief Executive Officer and Chief Financial Officer completed their
evaluation.

PART II. OTHER INFORMATION

ITEM 6. EXHIBITS AND REPORT ON FORM 8-K

(a) EXHIBITS - Exhibit 99.1 and 99.2 - Certification under Section 906 of
the Sarbanes-Oxley Act of 2002

(b) Form 8-K - There were no reports on Form 8-K filed for the three months
ended December 31, 2002.

SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

PANHANDLE ROYALTY COMPANY

February 11, 2003 /s/ H W Peace II
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Date H W Peace II, President
and Chief Executive Officer

February 11, 2003 /s/ Michael C. Coffman
- ------------------------ -----------------------------
Date Michael C. Coffman,
Vice President,
Chief Financial Officer and
Secretary and Treasurer

(8)

CERTIFICATION

I, H W Peace II, certify that:

1. I have reviewed this quarterly report on Form 10-Q;

2. Based on my knowledge, this quarterly report does not
contain any untrue statement of a material fact or omit
to state a material fact necessary to make the
statements made, in light of the circumstances under
which such statements were made, not misleading with
respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and
other financial information included in this quarterly
report, fairly present in all material respects the
financial condition, results of operations and cash
flows of the registrant as of, and for, the periods
presented in this quarterly report;

4. The registrant's other certifying officer and I are
responsible for establishing and maintaining disclosure
controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for the registrant and we
have:

a). designed such disclosure controls and
procedures to ensure that material
information relating to the registrant,
including its consolidated subsidiaries, is
made known to us by others within those
entities, particularly during the period in
which this quarterly report is being
prepared;

b). evaluated the effectiveness of the
registrant's disclosure controls and
procedures as of a date within 90 days prior
to the filing date of this quarterly report
(the "Evaluation Date"); and

c). presented in this quarterly report our
conclusions about the effectiveness of the
disclosure controls and procedures based on
our evaluation as of the Evaluation Date;

5. The registrant's other certifying officer and I have
disclosed, based on our most recent evaluation, to the
registrant's auditors and the audit committee of the
registrant's board of directors (or persons performing
the equivalent function):

a). all significant deficiencies in the design or
operation of internal controls which could
adversely affect the registrant's ability to
record, process, summarize and report
financial data and have identified for the
registrant's auditors any material weaknesses
in internal controls; and

b). any fraud, whether or not material, that
involves management or other employees who
have a significant role in the registrant's
internal controls; and

6. The registrant's other certifying officer and I have
indicated in this quarterly report whether there were
significant changes in internal controls or in other
factors that could significantly affect internal
controls subsequent to the date of our most recent
evaluation, including any corrective actions with
regards to significant deficiencies and material
weaknesses.

Date: February 11, 2003

/s/ H W Peace II
-----------------------
H W Peace II
Chief Executive Officer

(9)

CERTIFICATION

I, Michael C. Coffman, certify that:

1. I have reviewed this quarterly report on Form 10-Q;

2. Based on my knowledge, this quarterly report does not
contain any untrue statement of a material fact or omit
to state a material fact necessary to make the
statements made, in light of the circumstances under
which such statements were made, not misleading with
respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and
other financial information included in this quarterly
report, fairly present in all material respects the
financial condition, results of operations and cash
flows of the registrant as of, and for, the periods
presented in this quarterly report;

4. The registrant's other certifying officer and I are
responsible for establishing and maintaining disclosure
controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for the registrant and we
have:

a). designed such disclosure controls and
procedures to ensure that material
information relating to the registrant,
including its consolidated subsidiaries, is
made known to us by others within those
entities, particularly during the period in
which this quarterly report is being
prepared;

b). evaluated the effectiveness of the
registrant's disclosure controls and
procedures as of a date within 90 days prior
to the filing date of this quarterly report
(the "Evaluation Date"); and

c). presented in this quarterly report our
conclusions about the effectiveness of the
disclosure controls and procedures based on
our evaluation as of the Evaluation Date;

5. The registrant's other certifying officer and I have
disclosed, based on our most recent evaluation, to the
registrant's auditors and the audit committee of the
registrant's board of directors (or persons performing
the equivalent function):

a). all significant deficiencies in the design or
operation of internal controls which could
adversely affect the registrant's ability to
record, process, summarize and report
financial data and have identified for the
registrant's auditors any material weaknesses
in internal controls; and

b). any fraud, whether or not material, that
involves management or other employees who
have a significant role in the registrant's
internal controls; and

6. The registrant's other certifying officer and I have
indicated in this quarterly report whether there were
significant changes in internal controls or in other
factors that could significantly affect internal
controls subsequent to the date of our most recent
evaluation, including any corrective actions with
regards to significant deficiencies and material
weaknesses.

Date: February 11, 2003

/s/ Michael C. Coffman
-----------------------
Michael C. Coffman
Chief Financial Officer

(10)

EXHIBIT INDEX