UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

WARREN RESOURCES, INC.

(Exact Name of Registrant as Specified in its Charter.)

 

 

Registrant’s telephone number, including area code:

(212) 697-9660

 

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

Yes ý No o

 

The aggregate number of Registrant’s outstanding shares on November 6th, 2003 was 17,349,070 shares of Common Stock, $0.0001 par value.

 

 

WARREN RESOURCES, INC.

 

INDEX

 

PART I—	FINANCIAL INFORMATION
	Item 1. Financial Statements
	Balance sheets as of September 30, 2003 and December 31, 2002
	Statements of operations for the three and nine months ended September 30, 2003 and 2002
	Statements of cash flows for the nine months ended September 30, 2003 and 2002
	Notes to financial statements
	Item 2. Management’s discussion and analysis of financial conditions and results of operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Evaluation of Disclosure Controls and Procedures
PART II—	OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 2. Changes in Securities
	Item 3. Defaults upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits and Report on Form 8-K
	Signatures

 

2

 

PART I—FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Warren Resources, Inc. and Subsidiaries
CONSOLIDATED BALANCE SHEETS

 

		September 30, 2003			December 31, 2002
		(Unaudited)
ASSETS
CURRENT ASSETS
Cash and cash equivalents		$	19,026,485		$	23,184,936
Accounts receivable – trade		8,092,101			6,895,483
Accounts receivable from affiliated partnerships		340,560			921,252
Trading securities		814,761			78,383
Restricted investments in U.S. Treasury Bonds–available-for-sale, at fair value (amortized cost of $1,011,376 in 2003 and $683,513 in 2002)		1,149,392			810,822
Other current assets		1,603,644			2,053,248
Total current assets		31,026,943			33,944,124
OTHER ASSETS
Oil and gas properties—at cost, based on successful efforts method of accounting, net of accumulated depletion and amortization		83,102,130			48,684,362
Property and equipment—at cost, net		601,949			751,479
Restricted investments in U.S. Treasury Bonds—available for sale, at fair value (amortized cost of $10,073,525 in 2003 and $7,571,860 in 2002)		11,548,646			9,058,851
Deferred bond offering costs (net of accumulated amortization of $3,568,411 in 2003 and $3,051,046 in 2002)		2,872,657			3,390,022
Goodwill		3,430,246			3,430,246
Other assets		6,070,918			5,365,435
Restricted Cash		—			3,637,775
Total other assets		107,626,546			74,318,170
		$	138,653,489		$	108,262,294
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES
Current maturities of debentures		$	4,909,470		$	5,466,970
Current maturities of other long-term liabilities		270,512			178,980
Accounts payable and accrued expenses		4,267,206			3,822,809
Deferred income—turnkey drilling contracts with affiliated partnerships		29,443,117			32,265,725
Total current liabilities		38,890,305			41,734,484
LONG-TERM LIABILITIES
Debentures, less current portion		44,185,230			49,202,730
Other long-term liabilities, less current portion		1,556,100			1,353,129
		45,741,330			50,555,859
MINORITY INTEREST		13,429,418			8,970,078
STOCKHOLDERS’ EQUITY
8% convertible preferred stock, par value $.00001; authorized 20,000,000 shares, issued and outstanding, 4,965,814 shares in 2003 and 1,784,197 shares in 2002 (aggregate liquidation preference $59,589,768 in 2003 and $21,410,364 in 2002)		57,932,875			20,955,838
Common Stock - $.0001 par value; authorized, 100,000,000 shares; issued 17,349,070 in 2003 and 17,581,996 shares in 2002)		1,735			1,758
Additional paid-in-capital		49,528,469			52,424,147
Accumulated deficit		(67,112,933		)	(66,529,795		)
Accumulated other comprehensive income, net of applicable income taxes of $646,000 in 2003 and $646,000 in 2002		970,345			971,508
		41,320,491			7,823,456
Less common stock in Treasury—at cost; 632,250 shares in 2003 and 707,691 shares in 2002		728,055			821,583
Total shareholders’ equity		40,592,436			7,001,873
		$	138,653,489		$	108,262,294

 

The accompanying notes are an integral part of these financial statements

 

3

 

Warren Resources, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS

 

		Three Months Ended September 30, (Unaudited)						Nine Months Ended September 30, (Unaudited)
		2003			2002			2003			2002
REVENUES
Turnkey contracts with affiliated partnerships		$	2,399,536		$	2,468,774		$	4,276,208		$	8,842,756
Oil and gas sales from marketing activities		1,360,088			2,334,584			4,149,612			9,121,277
Well services		321,744			373,663			823,164			1,506,466
Oil and gas sales		1,411,699			146,350			4,244,192			344,441
Net gain (loss) on investments		(69,804		)	208,784			56,526			471,963
Interest and other income		235,269			262,089			987,514			1,152,813
Gain on sale of assets		515,000			—			515,000			—
		6,173,532			5,794,244			15,052,216			21,439,716
EXPENSES
Turnkey contracts		2,042,655			1,830,119			3,277,295			6,474,053
Cost of marketed oil and gas purchased from affiliated partnerships		1,335,914			2,294,532			4,066,993			9,002,326
Well services		118,592			147,062			448,367			721,051
Production & exploration		612,817			(815,478		)	2,565,233			974,941
Depreciation, depletion and amortization		286,362			377,586			805,657			2,094,203
General and administrative		746,372			2,017,970			2,911,258			4,451,307
Interest		95,814			1,484,395			1,334,248			4,427,963
Contingent repurchase obligation		—			—			—			(3,064,661		)
		5,238,526			7,336,186			15,409,051			25,081,183
Income (Loss) before provision for income taxes		935,006			(1,541,942		)	(356,835		)	(3,641,467		)
Deferred income tax expense (benefit)		194,000			(453,000		)	—			(539,000		)
Net Income (Loss) before minority interest and change in accounting principle		741,006			(1,088,942		)	(356,835		)	(3,102,467		)
Minority Interest		(76,040		)	—			(138,085		)	—
Net Income (Loss) before change in accounting principle		664,966			(1,088,942		)	(494,920		)	(3,102,467		)
Cumulative Effect of Change in Accounting Principle		—			—			(88,218		)	—
Net Income (Loss)		664,966			(1,088,942		)	(583,138		)	(3,102,467		)
Less dividends on preferred shares		1,036,235			—			2,772,303
Net Loss Applicable to Common Stockholders		$	(371,269	)	$	(1,088,942	)	$	(3,355,441	)	$	(3,102,467	)
Basis and Diluted Loss per Common Share
Loss Before Accounting Change		$	(0.02	)	$	(0.06	)	$	(0.19	)	$	(0.18	)
Cumulative Effect of Change in Accounting Principle		—			—			(0.01		)	—
Net Loss		$	(0.02	)	$	(0.06	)	$	(0.20	)	$	(0.18	)
Weighted Average Common Shares Outstanding		16,853,777			17,535,227			16,865,276			17,534,745

 

The accompanying notes are an integral part of these financial statements

 

4

 

Warren Resources, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS

 

		For the nine months ended September 30, (Unaudited)
		2003			2002
Cash flows from operating activities:
Net loss		$	(583,138	)	$	(3,102,467	)
Adjustments to reconcile net loss to net cash used in operating activities:
Accretion of discount on available-for-sale debt securities		(415,372		)	(390,227		)
Amortization and write-off of deferred bond offering costs		517,365			366,014
Gain on sale of US treasury bonds—available for sale		(121,495		)	(28,104		)
Depreciation, depletion and amortization		805,657			2,094,203
Deferred tax benefit		—			(539,000		)
Leases contributed to partnerships		—			254,332
Gain on sale of assets		(515,000		)	—
Change in assets and liabilities:
(Increase) Decrease in trading securities		(736,378		)	205,989
Decrease in accounts receivable—trade		3,827,222			2,147,677
(Increase) Decrease in accounts receivable from affiliated partnerships		580,692			(174,308		)
(Increase) Decrease in other assets		(255,879		)	857,417
Decrease in accounts payable and accrued expenses		(591,836		)	(3,848,383		)
Decrease in deferred income from affiliated partnerships		(2,822,608		)	(8,410,507		)
Decrease in contingent repurchase obligation to affiliated partnerships		—			(3,318,993		)
Increase (Decrease) in other long term liabilities		(571,159		)	435,000
Net cash used in operating activities		(881,929		)	(13,451,357		)
Cash flows from investing activities:
Purchases of U.S. Treasury Bonds—available-for-sale		—			(14,906		)
Purchases of oil and gas properties		(6,325,689		)	(3,819,925		)
Purchase of property and equipment		(7,459		)	(1,780		)
Proceeds from the sale of oil and gas properties, net of selling fees		—			4,175,552
Proceeds from the sale of property and equipment, net of selling fees		52,353			—
Proceeds from U.S. Treasury Bonds—available-for-sale		1,345,116			781,893
Net cash provided by (used in) investing activities		(4,935,679		)	1,120,834
Cash flows from financing activities:
Payments on other long-term debt		(1,542,939		)	(2,538,924		)
Issuance of preferred stock, net		4,968,034			815,430
Dividends paid on preferred stock		(1,735,998		)	—
Repurchase of common stock		(29,940		)	(2,624		)
Net cash provided by (used in) financing activities		1,659,157			(1,726,118		)
Net Decrease in cash and cash equivalents		(4,158,451		)	(14,056,641		)
Cash and cash equivalents at beginning of period		23,184,936			22,923,605
Cash and cash equivalents at end of period		$	19,026,485		$	8,866,964
Supplemental disclosure of cash flow information
Cash paid for interest, net of amount capitalized		$	816,883		$	4,027,364
Cash paid for income taxes		—			—

 

The accompanying notes are an integral part of these financial statements

 

5

 

WARREN RESOURCES, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

SEPTEMBER 30, 2003

 

NOTE 1—ORGANIZATION

 

Warren Resources, Inc. (the “Company”), was formed on June 12, 1990 under the laws of the state of New York for the purpose of acquiring and developing oil and gas properties. On September 5th, 2002, the Company changed its state of incorporation to Delaware. As a result, all shares of the Company’s stock were converted into shares of the Delaware corporation. The Company’s properties are primarily located in New Mexico, Texas, Wyoming and California. In addition, the Company serves as the managing general partner (the “MGP”) to affiliated partnerships and joint ventures.

 

The accompanying unaudited financial statements and related notes present the Company’s consolidated financial position as of September 30, 2003 and December 31, 2002, the results of operations for the three and nine months ended September 30, 2003 and 2002 and cash flows for the nine months ended September 30, 2003 and 2002. The unaudited financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions of Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2003 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2003. Certain reclassifications have been made to the 2002 amounts to conform to the 2003 presentation. The accounting policies followed by the Company are set forth in Note A to the Company’s financial statements in Form 10-K for the year ended December 31, 2002. These interim financial statements and notes thereto should be read in conjunction with our annual consolidated financial statements presented in our 2002 Annual Report on Form 10-K.

 

NOTE 2—STOCK OPTIONS

 

At September 30, 2003, the Company had stock-based compensation plans. The Company accounts for those plans under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The following table illustrates the effect on net loss and loss per share if the Company had applied the fair-value recognition provisions of Financial Accounting Standards Board (FASB) Statement No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation:

 

		Three months ended September 30,						Nine months ended September 30,
		2003			2002			2003			2002
Net Income (Loss), as reported		$	664,966		$	(1,088,942	)	$	(583,138	)	$	(3,102,467	)
Deduct: Total stock-based employee compensation expense determined under fair-value-based method for all awards, net of related tax effects		$	(1,520	)	$	(102,420	)	$	(547,278	)	$	(307,260	)
Pro forma Net Income (Loss)		$	663,446		$	(1,191,362	)	$	(1,130,416	)	$	(3,409,727	)
Basic and Diluted Income (Loss) Per Share:
As Reported -		$	0.04		$	(0.06	)	$	(0.03	)	$	(0.18	)
Pro Forma -		$	0.04		$	(0.07	)	$	(0.07	)	$	(0.19	)

 

6

 

NOTE 3—MANAGEMENT’S PLANS

 

The Company had a net profit of $665 thousand for the quarter ended September 30, 2003, as compared to a loss of $1.1 million for the corresponding quarter ending September 30, 2002. At September 30, 2003, current liabilities exceeded current assets by approximately $7.9 million. During 2002, the Company raised $5.4 million for its drilling programs compared to $18.1 million and $46.5 million in 2001 and 2000, respectively. As a result, the Company’s turnkey revenue and total gross profit in 2003 will be less than in 2002 and 2001 and the number of the Company’s oil and gas properties developed through partnership arrangements will be reduced.

 

In order to improve operations and liquidity and meet its cash flow needs, the company has or intends to do the following:

 

•                  Raise additional capital through the sale of preferred and common stock.

 

•                  Obtain a credit facility based in part on the value of our proven reserves.

 

•                  Continue to privately place drilling programs, which based on prior experience management anticipates raising approximately $6.0 million in 2003.

 

•                  Generate turnkey profit and operating cash flow from turnkey drilling contracts equal to approximately 25% of the total amount of total turnkey price.

 

•                  Reduce fixed overhead expenses and primarily conduct developmental drilling operations in our two main target areas, coalbed methane properties in Wyoming and oil formations in the Wilmington field in California.

 

•                  Increase oil and gas revenues by exchanging preferred stock for interests in producing properties.

 

•                  Use $2.0 million of deferred drilling credits from Anadarko Petroleum Corporation to develop our acreage in the Washakie Basin, Wyoming.

 

As a result of these plans, management believes that it will generate sufficient cash flows to meet its current obligations in 2003.

 

NOTE 4—REPURCHASE OBLIGATION

 

Certain Company sponsored oil and gas partnerships provide investor partners a right to tender their interest to the Company for repurchase at specified future dates. In the event the Company does repurchase the investor interest, the Company will be entitled to receive any future cash flows from the underlying oil and gas properties. The determination of whether a contingent repurchase obligation exists is based upon the estimated discounted present value of future net revenues of proved developed and undeveloped reserves of each partnership, net of future capital costs and the Company’s working interest, from reserve studies prepared by petroleum engineers compared to the formula purchase price. A contingent repurchase obligation expense and liability of $3,318,993 was recognized at December 31, 2001 based on oil and gas pricing at March 15, 2002. During the first quarter of 2002, the Company assigned additional proved undeveloped reserves located in the Wilmington Unit to various partnerships to satisfy the liability relating to its contingent repurchase obligation. Based upon this calculation using prices at March 31, 2002, the liability relating to the Company’s contingent repurchase obligation was extinguished. As a result, a gain of approximately $3,065,000 was recognized for the three-month period ending March 31, 2002. As a result of the recapitalization of thirteen of our drilling programs in 2003 and during the fourth quarter of 2002 (See Note 15), we believe that we will have no excess liability for an amount to be paid in excess of the fair value received resulting from a repurchase obligation in the future.

 

NOTE 5—PLUGGING AND ABANDONMENT LIABILITY

 

In June 2001, the Financial Accounting Standard Board issued SFAS No. 143, “Accounting for Asset Retirement Obligations” which 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. This statement is effective for fiscal years beginning after June 15, 2002. The Company adopted SFAS No. 143 on January 1, 2003 and recorded a net asset of $557,000, a related liability of $645,000 (using a 10% discount rate) and

 

7

 

a cumulative effect on change in accounting principle on prior years of $88,000. The new standard had no material impact on income before the cumulative effect of adoption in the first quarter of 2003, nor would it have had a material impact on the quarterly results for 2002 assuming an adoption of this accounting standard on a proforma basis. During the three and nine months ending September 30, 2003 the asset retirement liability was increased by approximately $18,000 and $60,000 respectively, as a result of accretion and recorded as interest expense. During the nine months ended September 30, 2003 there has been no significant changes in cash flow assumptions for the liability or liabilities incurred or settled during the period. The Company has treasury bills held in escrow with a fair market of $2,731,000 which are legally restricted for potential plugging and abandonment liability in the Wilmington field.

 

NOTE 6—CHANGES IN SHAREHOLDERS’ EQUITY

 

For the nine months ended September 30, 2003, dividends on preferred shares were approximately $2.8 million and were treated as a reduction in additional paid in capital. During the nine months ended September 30, 2003 the Company bought and retired 157,485 shares of its common stock for approximately $30,000. The company also retired 75,441 shares of treasury stock with a cost of approximately $93,528.

 

As of September 30, 2003, 4,965,814 shares of convertible preferred stock were issued and outstanding, with accrued dividends of $1,036,235. The Company has incurred cumulative issuance costs of approximately $1.7 million in relation to these shares. For the nine months ended September 30, 2003, the Company issued 3,181,617 preferred shares, 1,952,151 relating to the recapitalization of our drilling programs, 343,514 relating to bond conversions and 885,952 for cash consideration of approximately $10.6 million. The preferred stock pays an 8% cumulative dividend, payable quarterly. The holders of the preferred stock are not entitled to vote except as defined by the agreement or as provided by applicable law.  The preferred stock may be voluntary converted at the election of the holder, commencing one year after the date of issuance.  Each outstanding redeemable convertible preferred share is convertible into common stock of the Company based on the table below.  The conversion rate is subject to adjustment from time to time as defined by the agreement.

 

 

Additionally, commencing seven years after the date of issuance, holders of the preferred stock may elect to require the Company to redeem their preferred stock at a redemption price equal to the liquidation value of $12.00 per share, plus accrued but unpaid dividends, if any (“Redemption Price”).  Upon the receipt of a redemption election, the Company, at its option, shall either: (1) pay the holder cash in the amount equal to the Redemption Price or (2) issue to holder shares of common stock up to a maximum of 1.5 shares of common stock for each one share of preferred stock redeemed. The Company is accreting the carrying value of its preferred stock to its redemption price using the effective interest method with changes recorded to additional paid in capital.

 

NOTE 7—LOSS PER SHARE

 

Basic loss per share is computed by dividing net loss by the weighted average number of shares of common stock outstanding during the period. Diluted loss per share is based on the assumption that stock options are converted into common shares using the treasury stock method and convertible bonds, debentures and preferred stock are converted using the if-converted method. Conversion is not assumed if the results are anti-dilutive.  Potential common shares at September 30, 2003 and September 30, 2002, of 10,404,758 and 5,881,026, respectively, relating to convertible bonds, debentures and preferred stock and 2,289,012 and 1,770,000, respectively, relating to incentive stock options, were excluded from the computation of diluted loss per share because they are anti-dilutive. Incentive stock options have a weighted average exercise price of $5.04 and $4.51 at September 30, 2003 and September 30, 2002, respectively. The Convertible Bonds and Debentures may be converted from the date of issuance until maturity at 100% of principal amount into common stock of the Company at prices ranging from $5 to $50.  The preferred stock may be converted at the discretion of the holder (See note 6).

 

8

 

NOTE 8—LONG TERM DEBT

 

The Convertible Bonds and Debentures may be converted from the date of issuance until maturity at 100% of principal amount into common stock of the Company at prices ranging from $5 to $50. Each year the holders of the Convertible Debentures may tender to the Company up to 10% of the aggregate Debenture issued.

 

		September 30, 2003			December 31, 2002
12% Sinking Fund Debentures, due December 31, 2007		$	10,116,000		$	14,376,000
12% Secured Convertible Debentures, due December 31, 2009		790,000			790,000
12% Secured Convertible Bonds, due December 31, 2010		1,715,000			1,715,000
13.02% Sinking Fund Convertible Debentures, due December 31, 2010		14,770,200			14,780,200
13.02% Sinking Fund Convertible Debentures, due December 31, 2015		11,837,500			12,137,500
12% Secured Convertible Bonds, due December 31, 2016		1,395,000			1,460,000
12% Sinking Fund Convertible Debentures, due December 31, 2017		5,650,000			6,590,000
12% Secured Convertible Bonds, due December 31, 2020		1,635,000			1,635,000
12% Secured Convertible Bonds, due December 31, 2022		1,186,000			1,186,000
		49,094,700			54,669,700
Less: Current Portion		4,909,470			5,466,970
Long Term Portion		$	44,185,230		$	49,202,730

 

NOTE 9—CAPITALIZED INTEREST

 

Interest of approximately $1,603,000 and $454,000 was capitalized during the three months ended September 30, 2003 and 2002, respectively, relating to our California and Wyoming properties. Interest of approximately $4,134,000 and $1,362,000 was capitalized for the nine months ended September 30, 2003 and 2002, respectively, relating to the same properties.

 

NOTE 10—INCOME TAXES

 

For the periods ended September 30, 2003 and 2002, the Company’s effective income tax rate differed from the federal statutory rate due to changes in the valuation allowance for deferred tax assets.

 

NOTE 11—LITIGATION

 

On September 28, 1999, Magness Petroleum Company, our joint venture partner in the Wilmington Field, filed a complaint against Warren, Warren E&P, and certain Warren subsidiaries in the Superior Court of Los Angeles County, alleging that we had breached our joint venture agreement with Magness and an alleged oral agreement regarding advance payment of expenses for drilling and completion operations.  Magness sought dissolution of the joint venture, an accounting and a declaratory judgment as to the rights of the parties under the joint venture agreement.  We were successful in enforcing the arbitration provision in the joint venture agreement and entered into an agreement with Magness to submit the matter for arbitration by the Judicial Arbitration Mediation Services, or “JAMS,” before the Honorable Keith J. Wisot, a retired Los Angeles Superior Court Judge.  Judge Wisot, as the arbitrator, ruled that the joint venture agreement is a valid enforceable agreement, declined to dissolve the joint venture, denied Magness’ claims for breach of contract, and held that he and JAMS would retain jurisdiction to enforce the Final Award. On August 8, 2001, Magness filed a demand with the American Arbitration Association, or “AAA,” reasserting its claims for dissolution of the joint venture and breach of contract. Subsequently Warren sought to enforce the original Final Award render by Judge Wisot in the JAMS arbitration. After a procedural

 

9

 

determination of proper arbitration forum that was eventually determined by the California Court of Appeals in December 2002 and a Motion for Clarification filed in January 2003 before the California Superior Court, in September 2003 the California Superior Court ordered that JAMS will hear Warren’s motion to enforce the Final Award covering unauthorized direct labor charges and tangible costs and AAA will hear Magness’s new theory of dissolution of the Joint Venture and Warren’s drilling rights if the Joint Venture is not dissolved and Warren’s claims for damages for preventing resumption of drilling activities. The respective arbitrators have not set any conferences or hearings to hear the recently assigned matters before JAMS or AAA. Accordingly, pending final resolution, further development of the Wilmington Field will be curtailed.

 

In 1998, Warren E&P was sued in the 81^st Judicial District Court of Frio County, Texas by Stricker Drilling Company, Inc. and Manning Safety Systems to recover the value of lost equipment based on a well blow out.  Warren was later joined in the suit as a defendant.  As a result of the lawsuit, Gotham Insurance Company, Warren E&P’s well blow-out insurer, intervened.  The suit was settled in 1999 with all parties except Gotham.  Gotham paid over $1.7 million under the insurance policy and now seeks a refund of approximately $1.5 million of monies paid, denying coverage, and alleging fraud and misrepresentation and a failure of Warren E&P to act with due diligence and pursuant to safety regulations.  Warren E&P countersued for the remaining proceeds under the policy coverage.  In the summer and fall of 2000, summary judgments were entered for Warren E&P on essentially all claims except its bad faith claims against Gotham.  Gotham’s claims against Warren E&P and Warren were rejected.  Final judgment was rendered on May 14, 2001 in Warren E&P’s favor for the remaining policy proceeds, interest and attorney fees.  Gotham appealed the final judgment to the San Antonio Court of Appeals seeking a refund of approximately $1.5 million.  The case on appeal was orally argued on March 28, 2002. On July 23, 2003, a three judge panel of the San Antonio Court of Appeals rendered its decision in favor of Gotham on all points, except for the amount of restitution owed by Warren E&P and related parties, reversing the earlier summary judgment entered by the trial court for Warren E&P. Although the three judge panel of the San Antonio Court of Appeals acknowledged that Gotham asked for the Court to render its judgment in Gotham’s favor on its restitution claims, Gotham gave no particulars, and therefore the Court of Appeals remanded Gotham’s restitution claims to the trial court for further proceedings consistent with its opinion. Although the ultimate resolution is uncertain, counsel has advised Warren E&P that it believes the three judge panel of the San Antonio Court of Appeals committed numerous errors of fact and law, primarily relying on their erroneous conclusion that Warren E&P as operator of the oil well incurred no loss. Accordingly, Warren E&P is appealing the San Antonio Court of Appeals panel decision to the Texas Supreme Court, which may be accepted and heard by the Texas Supreme Court at their discretion.

 

Warren is party to various other matters of litigation arising in the normal course of business. Management believes that the ultimate outcome of the matters will not have a material effect on the Company’s financial condition or results of operations.

 

NOTE 12—BUSINESS SEGMENT INFORMATION

 

The Company’s operating activities can be divided into four major segments: turnkey contracts, oil and gas marketing, oil and gas exploration and production operations and well services. The Company drills oil and natural gas wells for Company-sponsored drilling programs and retains an interest in each well. Also, the Company markets natural gas for affiliated drilling programs. The Company charges Company-sponsored drilling programs and other third parties competitive industry rates for well operations and gas gathering. Segment information is as follows:

 

		Three Months Ended						Nine Months Ended
		September 30, 2003			September 30, 2002			September 30, 2003			September 30, 2002
Revenue
Turnkey Contracts		$	2,399,536		$	2,468,774		$	4,276,208		$	8,842,756
Oil and Gas Marketing		1,360,088			2,334,584			4,149,612			9,121,277
Oil and Gas Operations		1,926,699			146,350			4,759,192			344,441
Well Services		321,744			373,663			823,164			1,506,466
Other		165,465			470,873			1,044,040			1,624,776
		$	6,173,532		$	5,794,244		$	15,052,216		$	21,439,716

 

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		September 30, 2003			September 30, 2002			September 30, 2003			September 30, 2002
Operating Income (Loss)
Turnkey Contracts		$	328,692		$	611,842		$	919,667		$	5,357,552
Oil and Gas Marketing		24,174			40,052			82,619			118,951
Oil and Gas Operations		1,062,792			621,008			1,495,779			(2,567,587		)
Well Services		203,152			227,202			374,797			710,756
Other		(683,804		)	(3,042,046		)	(3,229,697		)	(7,261,139		)
		$	935,006		$	(1,541,942	)	$	(356,835	)	$	(3,641,467	)

 

NOTE 13—NEW ACCOUNTING PRONOUNCEMENTS

 

In November 2002, FASB Interpretation 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN 45), was issued. FIN 45 requires a guarantor entity, at the inception of a guarantee covered by the measurement provisions of the interpretation, to record a liability for the fair value of the obligation undertaken in issuing the guarantee. The Company previously did not record a liability when guaranteeing obligations unless it became probable that the Company would have to perform under the guarantee. FIN 45 applies prospectively to guarantees the Company issues or modifies subsequent to December 31, 2002, but has certain disclosure requirements effective for interim and annual periods ending after December 15, 2002. The Company has historically issued guarantees only on a limited basis and FIN 45 has not had a material effect on its 2003 financial statements. Disclosures required by FIN 45 are not required because the Company does not have any existing guarantees at September 30, 2003.

 

In January 2003, the FASB issued FASB Interpretation 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 clarifies the application of Accounting Research Bulletin 51, Consolidated Financial Statements, for certain entities that do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties or in which equity investors do not have the characteristics of a controlling financial interest (“variable interest entities”). Variable interest entities within the scope of FIN 46 will be required to be consolidated by their primary beneficiary. The primary beneficiary of a variable interest entity is determined to be the party that absorbs a majority of the entity’s expected losses, receives a majority of its expected returns, or both. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The Company has determined that the adoption of the provisions of FIN 46 will not have an impact on it’s financial condition or results of operations relating to drilling programs formed in 1998 and after.

 

In May 2003, the FASB issued Statement 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. Statement 150 changes the classification in the statement of financial position of certain common financial instruments from either equity or mezzanine presentation to liabilities and requires an issuer of those financial statements to recognize changes in fair value or redemption amount, as applicable, in earnings. Statement 150 is effective for the first interim period beginning after June 15, 2003 (for the Company in the third quarter of 2003). The Company has determined that Statement 150 will not have an impact on it's financial condition or results of operations.

 

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NOTE 14—COMPREHENSIVE INCOME (LOSS)

 

Other comprehensive income (loss) consists primarily of net unrealized investment gains and losses, net of income tax effect. Total comprehensive income (losses) for the periods are as follow:

 

		2003			2002
Nine Months ending September 30,		$	(584,301	)	$	(2,292,786	)
Three Months ending September 30,		$	372,747		$	(409,221	)

 

NOTE 15—CONSENT SOLICITAION

 

In late 2002, each of the thirteen drilling programs formed from 1994 through 1997 commenced a Vote Solicitation of their partners to: (i) obtain the requisite 2/3rds affirmative approval of their respective partners to convert their drilling program from a Delaware limited partnership to an LLC wherein all LLC members would have limited liability, including Warren, and (ii) allow partners to select whether they wanted to be (a) a standard member in the LLC with substantially the same rights and obligations that they had as partners in their respective drilling fund, or (b) a preferred member in the LLC having certain preferential rights by consenting to Warren’s contribution of additional capital to the LLC upon conversion (the “Recapitalization”) in the form of its unregistered Preferred Shares in an amount equal to between 110% to 120% of the potential repurchase price of consenting partner’s interests calculated as of December 31, 2002. For its additional capital contribution, Warren received additional standard membership interests in the LLC and was specially allocated a prorata interest as a standard member in the wells and oil leases formerly allocable to the partners who elected to become Preferred Members. Election by a partner to become a preferred member terminated any repurchase rights they may have had under the original partnership’s buy/sell agreements. At December 31, 2002, six of the thirteen programs obtained the requisite approval to convert to LLCs and were consolidated in the financial statements for the year ended December 31, 2002. At March 31, 2003, all thirteen programs obtained the requisite votes to convert to LLCs and on average 72.9% of the program members elected to become preferred members in their LLC. As a result of the recapitalizations, the Company issued an aggregate of 3,229,716 Preferred Shares to the LLCs in 2002 and 2003. During the first quarter the Company issued 1,641,628 preferred shares to the remaining 7 LLCs as a capital contribution, with an estimated fair value of $19,699,536 and received its prorata share of additional standard membership interests in the LLCs. The fair value of the Preferred Shares was based on actual cash sales to independent parties in this time period. Due to the increase in control of these thirteen affiliated partnerships, the Company has consolidated these entities for financial reporting purposes at September 30, 2003. The Company accounted for the remaining 7 LLCs as a purchase transaction with the estimated fair value of the assets and liabilities assumed in the acquisition as follows:

 

 

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The following summarizes pro forma unaudited results of operations for the periods ended September 30, 2003 and 2002 as if these acquisitions had been consummated immediately prior to January 1, 2002. These pro forma results are not necessarily indicative of future results.

 

		Pro Forma (unaudited)						Pro Forma (unaudited)
		Three months ended September 30,						Nine months ended September 30,
		2003			2002			2003			2002
Revenues		$	6,173,532		$	6,881,848		$	17,375,299		$	24,702,526
Net Income (Loss)		$	664,966		$	(939,613	)	$	68,365		$	(2,654,480	)
Income (Loss) Per Share – Basic and diluted		$	0.04		$	(0.05	)	$	0.00		$	(0.15	)

 

NOTE 16—GOODWILL

 

The Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, effective January 1, 2002 and as such, has not subsequently recorded any amortization of goodwill. Under SFAS No. 142, companies only adjust the carrying amount of goodwill or indefinite life intangible assets upon an impairment.

 

During 2002, the Company had set the beginning of the second quarter (April) as the annual period for goodwill impairment testing. During the second quarter of 2003, the Company retained an independent outside valuation expert to assist in developing the fair value analysis necessary to conduct the testing for impairment of its goodwill, all of which arose in its acquisition of Warren E&P. The results of this analysis indicated that no impairment of goodwill had occurred.

 

NOTE 17—SALE OF ASSETS

 

During the third quarter of 2003, we sold certain non-strategic oil and gas properties in New Mexico for approximately $0.5 million.

 

NOTE 18—SUBSEQUENT EVENTS

 

During the third quarter of 2003, certain joint venture general partnerships formed between accredited investors and Warren Resources, Inc. commenced a vote to (a) amend their joint venture agreement to allow for two classes of partners: preferred partners and common partners and (b) allow partners to select whether they wanted to be preferred partners having certain preferred rights in the joint venture by consenting to the additional capital contributed by the Company in the form of its unregistered Preferred Shares. For its additional capital contribution, Warren received additional common partner interests in the joint venture.  As of September 30, 2003, the joint ventures had not received the necessary 50% of affirmative votes required to effect the transaction.  As of November 4, 2003, the joint ventures had received 86% of affirmative votes.  As a result of this transaction, the Company expects to issue approximately one million Preferred Shares to the joint ventures during the fourth quarter of 2003.

 

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Item 2. Management’s discussion and analysis of financial conditions and results of operations

 

FORWARD-LOOKING INFORMATION

 

This Report on Form 10-Q and our other filings with the SEC contain 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. When used in this Report and our other filings with the SEC, the words “anticipated,” “believe,” “estimate,” “project,” “budget,” “will,” “should,” “hope,” “may”, “intend” and “expect” and similar expressions identify forward-looking statements. Although we believe that our plans, intentions and expectations reflected in these forward-looking statements are reasonable, these plans, intentions and expectations may not be achieved. Forward-looking statements in this Report and our filings with the SEC include, without limitation, statements regarding:

 

• financial position;

• business strategy;

• budgets;

• amount, nature and timing of capital expenditures;

• drilling of wells;

• natural gas and oil reserves;

• timing and amount of future production of natural gas and oil;

• operating costs and other expenditures;

• future net revenues from production and estimates of oil and gas reserves;

• cash flow and anticipated liquidity; and

• prospect development and property acquisitions.

 

These forward-looking statements are based on assumptions that the Company believes are reasonable, but they are open to a wide range of uncertainties and business risks, including the following:

 

• fluctuations of the prices received or demand for oil and natural gas over time;

• risks associated with oil and gas exploration;

• our ability to find, acquire, market, develop and produce new properties;

• availability and cost of material and equipment;

• uncertainty of reserve estimates and in the projection of future rates of production and timing of development expenditures;

• operating hazards;

• climactic conditions;

• availability of capital and unexpected substantial variances in capital requirements;

• the strength and financial resources of our competitors;

• regulatory developments;

• environmental risks; and

• general economic conditions.

 

Actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements contained in this Report and our other filings with the SEC. Important factors that could cause actual results to differ materially from our forward-looking statements are set forth in this Report and our other filings with the SEC, including under the heading “Risk Factors” in our annual report on Form 10-K. These factors are not intended to represent a complete list of the general or specific factors that may affect us. It should be recognized that other factors, including general economic factors and business strategies, may be significant, presently or in the future, and the factors set forth in this report and our other filings with the SEC may affect us to a greater extent than indicated. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the cautionary statements set forth in this Report and our other filings with the SEC. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.

 

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LIQUIDITY AND CAPITAL RESOURCES:

 

We have funded our activities primarily with the proceeds raised through privately placed drilling programs and our private sale of our equity and debt securities. These private placements primarily were made through a network of independent broker dealers. Since 1992, we have raised approximately $222 million through the private placements of interests in 30 drilling programs. Additionally, we have raised $71.6 million through the issuance of our debt securities and $44.9 million through the issuance of our equity securities. In our drilling programs, we fund the costs associated with acreage acquisition and the tangible portion of drilling activities, while investors in the drilling programs fund all intangible drilling costs.

 

In late 2002, each of the 13 drilling programs formed from 1994 through 1997 commenced a Vote Solicitation of their partners to: (i) obtain the requisite 2/3rds affirmative vote of their respective partners to convert their drilling program from a Delaware limited partnership to an LLC wherein all LLC members would have limited liability, including Warren, and (ii) allow partners to select whether they wanted to be (a) a standard member in the LLC with substantially the same rights and obligations that they had as partners in their respective drilling fund, or (b) a Preferred Member in the LLC having certain preferential rights by consenting to Warren’s contribution of additional capital to the LLC upon conversion (the “Recapitalization”) in the form of its unregistered Preferred Shares in an amount equal to between 110% to 120% of the potential repurchase price of consenting partner’s interests calculated as of December 31, 2002. For its additional capital contribution, Warren received additional standard membership interests in the LLC and was specially allocated a prorata interest as a standard member in the wells and oil leases formerly allocable to the partners who elected to become Preferred Members. Election by a partner to become a Preferred Member terminated their repurchase rights under the original buy/sell agreements. At September 30, 2003, all 13 programs obtained the requisite votes to convert to LLCs and on average 74.4% of the program members elected to become Preferred Members in their LLC. As a result of the Recapitalization, Warren issued 3,295,111 Preferred Shares in the aggregate, 1,952,151 during the first nine months of 2003, to the 13 LLCs as an additional capital contribution and received its prorata share of additional standard membership interests in the LLCs.

 

Our cash and cash equivalents decreased $4.2 million for the nine months ended September 30, 2003. This resulted from a $4.9 million decrease in cash used in investing activities and $0.9 million decrease in cash used in operating activities offset by a $1.6 million increase in cash provided from financing activities.

 

Cash provided from investing activities decreased due to expenditures on oil and gas properties during the first nine months of 2003.  This decrease was partially offset by the receipt of U.S. Treasury Bonds previously held in escrow on behalf of our drilling program and debentures. Primarily, the U.S. Treasury Bonds were released to us as a result of the Recapitalization discussed above.

 

Cash provided from operating activities decreased due to drilling wells on behalf of the drilling programs and the related recognition of deferred revenue during the first nine months of 2003.  Additionally, the funds raised through our drilling programs are primarily raised during the last quarter of our calendar year.  As a result, during the first nine months of the calendar year, we incur turnkey expenses related to drilling programs and do not raise a material amount of additional funds through drilling programs.  This decrease in cash provided from operating activities was offset by the receipt of life insurance funds relating to our Executive Vice President, James C. Johnson, Jr. who passed away in December 2002.

 

Cash provided from financing activities increased due the issuance of preferred stock for cash.  This increase was offset by the redemption of debentures and dividends paid on preferred stock.

 

Our most material commitment of funds relates to the drilling programs. Our deferred revenue balance relating to our drilling commitments totaled $29.4 million at September 30, 2003. This commitment varies pro rata with the amount of funds raised through our drilling programs.

 

The Company had a net loss of $0.6 million for the nine months ended September 30, 2003, as compared to a net loss of $3.1 million for the corresponding period ending September 30, 2002. At September 30, 2003, current liabilities exceeded current assets by approximately $7.9 million.  During the first nine months of 2003, shareholders’ equity increased $33.6 million from $7.0 million to $40.6 million, primarily from the Recapitalization discussed above and the sale of our preferred stock.

 

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During 2002, we raised $5.4 million for our drilling programs compared to $18.1 million and $46.5 million in 2001 and 2000, respectively. As a result, the Company’s turnkey revenue and total gross profit in 2003 will be less than in 2002 and 2001 and the number of the Company’s oil and gas properties developed through partnership arrangements will be reduced.

 

In order to improve operations and liquidity and meet its cash flow needs, we have or intend to do the following:

 

•  Raise additional capital through the sale of preferred and common stock.

 

•  Obtain a credit facility based in part on the value of our proven reserves.

 

•  Continue to privately place drilling programs, which based on prior experience, management anticipates raising approximately $6.0 million in 2003.

 

•  Generate turnkey profit and operating cash flow from turnkey drilling contracts equal to approximately 25% of the total amount of total turnkey price.

 

•  Reduce fixed overhead expenses and primarily conduct developmental drilling operations in our two main target areas, coalbed methane properties in Wyoming and oil formations in the Wilmington field in California.

 

•  Increase oil and gas revenues by exchanging preferred stock for interests in producing properties.

 

•  Use $2.0 million of deferred drilling credits from Anadarko Petroleum Corporation to develop our acreage in the Washakie Basin, Wyoming.

 

As a result of these plans, management believes that it will generate sufficient cash flows to meet its current obligations in 2003.

 

RESULTS OF OPERATIONS:

 

Three months Ended September 30, 2003 Compared to Three Months Ended September 30, 2002

 

Turnkey contract revenue and expenses. Turnkey contract revenue decreased $69,000 in the third quarter to $2.4 million, a 3% decrease compared to the corresponding quarter of the preceding year. Additionally, turnkey contract expense increased $0.2 million during the third quarter to $2.0 million, a 12% increase compared to the same period in 2002.  The drilling activity in the third quarter was flat when compared to the corresponding quarter of 2002.

 

Gross profit from turnkey activities was $0.4 million or 15% for the third quarter. This compares to gross profit of $0.6 million or 26% for the corresponding quarter in 2002. The decrease in gross profit percentage during the third quarter of 2003 results from drilling certain wells more economically in 2002 compared to the corresponding quarter of 2003.

 

Oil and gas sales and costs from marketing activities. Oil and gas sales from marketing activities decreased $1.0 million in the third quarter to $1.4 million, a 42% decrease compared to the same period last year. Cost of oil and gas marketing activities decreased $1.0 million in the quarter to $1.3 million, a 42% decrease compared to the same quarter in 2002. These decreases primarily resulted from the Recapitalizations as discussed above, whereby we now receive oil and gas production previously allocated to drilling programs.  Oil and gas production from the wells in the drilling programs in which we earn a marketing fee for the three months ended September 30, 2003 and 2002, was 0.4 Bcfe and 0.8 Bcfe, respectively.  This decrease was offset by higher average gas prices.  The average price per Mcfe during the third quarter of 2003 and 2002 was $4.38 and $2.60, respectively.

 

The gross profit from marketing activities for the third quarter of 2003 was $24 thousand as compared to $40 thousand in the same period last year.

 

Well services activities. Well services revenue decreased $52 thousand in the third quarter to $0.3 million, a 14% decrease compared to the corresponding quarter of the preceding year. Well services expense decreased $28

 

16

 

thousand in the third quarter to $0.1 million.  These nominal fluctuations in the third quarter of 2003 are consistent with the flat drilling activity compared to the same period in 2002.

 

Gross profit from well services activities was $0.2 million for the third quarter. This compared to gross profit of $0.2 million for the corresponding quarter of last year.

 

Oil and gas sales. Revenue from oil and gas sales increased $1.3 million in the third quarter to $1.4 million, a 865% increase compared to the same quarter in 2002, due to increased ownership in our drilling programs. We obtained oil and gas interests from our drilling programs as a result of the Recapitalizations referred to above.  Our share of pre-payout production from drilling programs formed subsequent to 1998 is generally 25% of the production allocated to these drilling programs.

 

Production & exploration. Production and exploration expense increased $1.4 million in the third quarter of 2003 to $0.6 million.  This compared to a credit balance of $0.8 for the comparable period of 2002.  The increase resulted from increased ownership in our drilling programs. We obtained oil and gas interests from our drilling programs as a result of the Recapitalizations referred to above.  Additionally, the credit balance in the comparable period in 2002 resulted from a $1.4 million reversal of plugging and abandonment liability relating to wells sold during this period.

 

Net gain (loss) on investments. Net loss on investments was $0.1 million for the third quarter of 2003.  Net gain on investments was $0.2 million during the third quarter of 2002.  Primarily, investments represent zero coupon U.S. treasury bonds held in our inventory. Fluctuations in net gain or loss on investments resulted from changes in long-term interest rates.

 

Interest and other income. Interest income decreased $27 thousand in the third quarter to $0.2 million, a 10% decrease compared to the same quarter in 2002.

 

Gain on sale of assets. The $0.5 million gain on the sale of assets resulted from the sale of certain non-strategic properties in New Mexico during the third quarter of 2003.

 

Depreciation, Depletion and Amortization. Depreciation, depletion and amortization expense decreased $0.1 million for the quarter to $0.3 million, a 24% decrease compared to the corresponding quarter last year. During the third quarter of 2002, we recorded impairment expense totaling $0.2 million relating to our Pewitt Ranch prospect in Texas.

 

General and administrative expenses. General and administrative expenses decreased $1.3 million in the third quarter of 2003 to $0.7 million, a 63% decrease compared to the corresponding quarter last year.  During the third quarter of 2002, we wrote off $0.9 million of previously capitalized offering expenses.  Additionally, the decrease resulted from a reduction in the number of employees employed during the third quarter of 2003 compared to the corresponding quarter of 2002.

 

Interest expense. Interest expense decreased $1.4 million in the third quarter to $0.1 million, a 94% decrease compared to the same quarter last year. Primarily, this decrease reflects an increase in the amount of interest capitalized to our Wyoming and California properties.

 

Nine months Ended September 30, 2003 Compared to Nine Months Ended September 30, 2002

 

Turnkey contract revenue and expenses. Turnkey contract revenue decreased $4.6 million in the first nine months of 2003 to $4.3 million, a 52% decrease compared to the corresponding period of the preceding year. Additionally, turnkey contract expense decreased $3.2 million during the first nine months of 2003 to $3.3 million, a 49% decrease compared to the same period in 2002. These decreases resulted from a lower level of drilling activity during the period compared to the corresponding period of the preceding year. The level of drilling activity is affected by the amount of funds raised from our drilling programs in the prior fiscal year. We raised $5.4 million from our drilling programs in 2002 compared to $18.1 million during 2001.

 

Gross profit (loss) from turnkey activities was $1.0 million or 23% for the first nine months of 2003. This compares to gross profit of $2.4 million or 27% for the corresponding period in 2002. The increase in gross profit percentage

 

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during the first nine months of 2002 results from drilling certain wells more economically than the corresponding period of 2003 and changes in working interests of various wells in our drilling programs.

 

Oil and gas sales and costs from marketing activities. Oil and gas sales from marketing activities decreased $5.0 million in the first nine months of 2003 to $4.1 million, a 55% decrease compared to the same period last year. Cost of oil and gas marketing activities decreased $4.9 million in the first nine months of 2003 to $4.1 million, a 55% decrease compared to the same quarter in 2002. These decreases primarily resulted from the Recapitalizations as discussed above, whereby we now receive oil and gas production previously allocated to drilling programs.  Oil and gas production from the wells in the drilling programs in which we earn a marketing fee for the nine months ended September 30, 2003 and 2002 was 1.0 Bcfe and 2.7 Bcfe, respectively.  This decrease was offset by higher average gas prices.  The average price per Mcfe during the first nine months of 2003 and 2002 was $4.26 and $2.59, respectively.

 

The gross profit from marketing activities for the first nine months of 2003 was $83 thousand as compared to $119 thousand in the same period last year.

 

Well services activities. Well services revenue decreased $0.7 million in the first nine months of 2003 to $0.8 million, a 45% decrease compared to the corresponding period of the preceding year. Well services expense decreased $0.3 million for the first nine months of 2003 to $0.4 million, a 38% decrease compared to the same period in 2002. The decreases in well services revenue resulted from the decrease in drilling activity during the first nine months of 2003 compared to the corresponding period of 2002 as discussed above.  Additionally, decreases in well revenue and expenses resulted from the sale of certain assets of our drilling subsidiary, CJS Pinnacle Petroleum LLC (Pinnacle) on February 14^th, 2002, for total consideration of $4.2 million. The operations of Pinnacle ceased since the sale.

 

Gross profit from well services activities was $0.4 million for the first nine months of 2003. This compared to gross profit of $0.8 million for the corresponding period last year. This decrease in gross profit resulted from the decrease in well services revenue and the sale of Pinnacle as discussed above.

 

Oil and gas sales. Revenue from oil and gas sales increased $3.9 million in the first nine months of 2003 to $4.2 million, a 1132% increase compared to the same period last year, due to increased ownership in our drilling programs. We obtained oil and gas interests from our drilling programs as a result of the Recapitalizations referred to above.  Our share of pre-payout production from drilling programs formed subsequent to 1998 is generally 25% of the production allocated to these drilling programs.

 

Production & exploration. Production and exploration expense increased $1.6 million in the first nine months of 2003 to $2.6 million, a 163% increase compared to the same quarter last year.  This resulted from increased ownership in our drilling programs. We obtained oil and gas interests from our drilling programs as a result of the Recapitalizations referred to above.  Additionally, a plugging and abandonment liability of $1.4 million was reversed during the third quarter of 2002.

 

Net gain (loss) on investments. Net gain on investments was $0.1 million for the first nine months of 2003 and $0.5 million for the same period in 2002.  Primarily, investments represent zero coupon U.S. treasury bonds held in our inventory. Fluctuations in net gain or loss on investments resulted from changes in long-term interest rates.

 

Interest and other income. Interest income decreased $0.2 million in the first nine months of 2003 to $1.0 million, a 14% decrease compared to the same period in 2002. Primarily, this decrease is attributable to lower interest rates during 2003.

 

Gain on sale of assets. The $0.5 million gain of the sale of assets resulted from the sale of certain non-strategic properties in New Mexico during the third quarter of 2003.

 

Depreciation, Depletion and Amortization. Depreciation, depletion and amortization expense decreased $1.3 million for the first nine months of 2003 to $0.8 million, a 62% decrease compared to the corresponding period last year. During the third quarter of 2002, we recorded impairment expense totaling $1.1 million relating to our Kirby Decker prospect in Montana.

 

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General and administrative expenses. General and administrative expenses decreased $1.5 million in the first nine months of 2003 to $2.9 million.  During the third quarter of 2002, we wrote off $0.9 million of previously capitalized offering expenses.  Additionally, the decrease resulted from a reduction in the number of employees employed during 2003 compared to 2002.

 

Interest expense. Interest expense decreased $3.1 million in the first nine months to $1.3 million, a 70% decrease compared to the same period last year. Primarily, this decrease reflects an increase in the amount of interest capitalized to our Wyoming and California properties.

 

Contingent Repurchase Obligation. Repurchase obligation expense of $3.1 million was recorded in 2001 based on pricing at March 15, 2002. The repurchase obligation expense was reversed during the first quarter of 2002. As stated above, the determination of whether a repurchase liability exists is based upon estimates of future net cash flows from reserve studies prepared by petroleum engineers compared to the potential repurchase of drilling program units. Significant decreases in natural gas and oil prices at December 31, 2001 lowered the estimated future cash flows when compared to future potential repurchase obligations. As a result, a repurchase liability and a repurchase obligation expense of $3.3 million was recorded in 2001.

 

Open Disclosure Issues with the Securities and Exchange Commission

 

The Company has been advised by the Staff of the SEC that it, in consultation with the Staff of the Financial Standards Accounting Board, is considering certain implementation issues in the application of provisions of Statement of Financial Accounting Standards No. 141, “Business Combinations,” and Statement of Financial Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142), to companies in the extractive industries, including oil and gas companies. The Staff of the SEC is considering whether SFAS No. 142 requires registrants to reclassify costs associated with mineral rights, including both proved and unproved leasehold acquisition costs, as intangible assets in the balance sheet, apart from other capitalized oil and gas property costs. Historically, the Company and all other oil and gas companies have included the cost of these oil and gas leasehold interests as part of oil and gas properties. The Staff is also considering whether SFAS No. 142 requires registrants to provide the additional disclosures prescribed by SFAS No. 142 for intangible assets for costs associated with mineral rights.

 

The reclassification of these amounts would not affect the method in which such costs are amortized or the manner in which the Company assesses impairment of capitalized costs. As a result, net income would not be affected by the reclassification.

 

Item 3. Quantitative and qualitative disclosure about market risk

 

Commodity Risk. Our major market risk exposure is the commodity pricing applicable to our natural gas and oil production. Realized commodity prices received for our production are primarily driven by the prevailing worldwide price for crude oil and spot prices applicable to natural gas. The effects of price volatility is expected to continue.

 

Item 4. Evaluation of Disclosure Controls and Procedures

 

Quarterly evaluation of the Company’s Disclosure Controls and Internal Controls. Within the 90 days prior to the filing of this Quarterly Report on Form 10-Q, the Company evaluated the effectiveness of the design and operation of its “disclosure controls and procedures” (Disclosure Controls), and its “internal controls and procedures for financial reporting” (Internal Controls). This evaluation (the Controls Evaluation) was done under the supervision and with the participation of management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO). Rules adopted by the SEC require that in this section of the Quarterly Report we present the conclusions of the CEO and the CFO about the effectiveness of our Disclosure Controls and Internal Controls based on and as of the date of the Controls Evaluation.

 

CEO and CFO Certifications. Appearing immediately following the Signatures section of this Quarterly Report, there are two separate forms of “Certifications” of the CEO and the CFO. The first form of Certification is required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 (the Section 302 Certification). This section of the Quarterly Report which you are currently reading is the information concerning the Controls Evaluation referred

 

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to in the Section 302 Certifications and this information should be read in conjunction with the Section 302 Certifications for a more complete understanding of the topics presented.

 

Disclosure Controls and Internal Controls. Disclosure Controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 (Exchange Act), such as this Quarterly Report, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s (SEC) rules and forms. Disclosure Controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Internal Controls are procedures which are designed with the objective of providing reasonable assurance that (1)

our transactions are properly authorized; (2) our assets are safeguarded against unauthorized or improper use; and (3) our transactions are properly recorded and reported, all to permit the preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America.

 

Limitations on the Effectiveness of Controls. The Company’s management, including the CEO and CFO, does not expect that our Disclosure Controls or our Internal Controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

 

Scope of the Controls Evaluation. The CEO/CFO evaluation of our Disclosure Controls and our Internal Controls included a review of the controls’ objectives and design, the controls’ implementation by the Company and the effect of the controls on the information generated for use in this Quarterly Report. In the course of the Controls Evaluation, we sought to identify data errors, controls problems or acts of fraud and to confirm that appropriate corrective action, including process improvements, were being undertaken. This type of evaluation will be done on a quarterly basis so that the conclusions concerning controls effectiveness can be reported in our Quarterly Reports on Form 10-Q and Annual Report on Form 10-K. Our Internal Controls are also evaluated on an ongoing basis by other personnel in our organization and by our independent auditors in connection with their audit and review activities. The overall goals of these various evaluation activities are to monitor our Disclosure Controls and our Internal Controls and to make modifications as necessary; our intent in this regard is that the Disclosure Controls and the Internal Controls will be maintained as dynamic systems that change (including with improvements and corrections) as conditions warrant.

 

Among other matters, we sought in our evaluation to determine whether there were any “significant deficiencies” or “material weaknesses” in the Company’s Internal Controls, or whether the Company had identified any acts of fraud involving personnel who have a significant role in the Company’s Internal Controls. This information was important both for the Controls Evaluation generally and because items 5 and 6 in the Section 302 Certifications of the CEO and CFO require that the CEO and CFO disclose that information to our Board’s Audit Committee and to our independent auditors and to report on related matters in this section of the Quarterly Report. In the professional auditing literature, “significant deficiencies” are referred to as “reportable conditions”; these are control issues that could have a significant adverse effect on the ability to record, process, summarize and report financial data in the financial statements. A “material weakness” is defined in the auditing literature as a particularly serious reportable condition where the internal control does not reduce to a relatively low level the risk that misstatements caused by error or fraud may occur in amounts that would be material in relation to the financial statements and not be detected within a timely period by employees in the normal course of performing their assigned functions. We also sought to deal with other controls matters in the Controls Evaluation, and in each case if a problem was identified, we considered what revision, improvement and/or correction to make in accord with our on-going procedures.

 

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In accord with SEC requirements, the CEO and CFO note that, since the date of the Controls Evaluation to the date of this Quarterly Report, there have been no significant changes in Internal Controls or in other factors that could significantly affect Internal Controls, including any corrective actions with regard to significant deficiencies and material weaknesses.

 

Conclusions. Based upon the Controls Evaluation, our CEO and CFO have concluded that, subject to the limitations noted above, our Disclosure Controls are effective to ensure that material information relating to Warren and its consolidated subsidiaries is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared, and that our Internal Controls are effective to provide reasonable assurance that our financial statements are fairly presented in conformity with accounting principles generally accepted in the United States of America.

 

PART II—OTHER INFORMATION

 

Item 1. Legal Proceedings

 

On September 28, 1999, Magness Petroleum Company, our joint venture partner in the Wilmington Field, filed a complaint against Warren, Warren E&P, and certain Warren subsidiaries in the Superior Court of Los Angeles County, alleging that we had breached our joint venture agreement with Magness and an alleged oral agreement regarding advance payment of expenses for drilling and completion operations.  Magness sought dissolution of the joint venture, an accounting and a declaratory judgment as to the rights of the parties under the joint venture agreement.  We were successful in enforcing the arbitration provision in the joint venture agreement and entered into an agreement with Magness to submit the matter for arbitration by the Judicial Arbitration Mediation Services, or “JAMS,” before the Honorable Keith J. Wisot, a retired Los Angeles Superior Court Judge.  Judge Wisot, as the arbitrator, ruled that the joint venture agreement is a valid enforceable agreement, declined to dissolve the joint venture, denied Magness’ claims for breach of contract, and held that he and JAMS would retain jurisdiction to enforce the Final Award. On August 8, 2001, Magness filed a demand with the American Arbitration Association, or “AAA,” reasserting its claims for dissolution of the joint venture and breach of contract. Subsequently Warren sought to enforce the original Final Award render by Judge Wisot in the JAMS arbitration. After a procedural determination of proper arbitration forum that was eventually determined by the California Court of Appeals in December 2002 and a Motion for Clarification filed in January 2003 before the California Superior Court, in September 2003 the California Superior Court ordered that JAMS will hear Warren’s motion to enforce the Final Award covering unauthorized direct labor charges and tangible costs and AAA will hear Magness’s new theory of dissolution of the Joint Venture and Warren’s drilling rights if the Joint Venture is not dissolved and Warren’s claims for damages for preventing resumption of drilling activities. The respective arbitrators have not set any conferences or hearings to hear the recently assigned matters before JAMS or AAA. Accordingly, pending final resolution, further development of the Wilmington Field will be curtailed.

 

In 1998, Warren E&P was sued in the 81^st Judicial District Court of Frio County, Texas by Stricker Drilling Company, Inc. and Manning Safety Systems to recover the value of lost equipment based on a well blow out.  Warren was later joined in the suit as a defendant.  As a result of the lawsuit, Gotham Insurance Company, Warren E&P’s well blow-out insurer, intervened.  The suit was settled in 1999 with all parties except Gotham.  Gotham paid over $1.7 million under the insurance policy and now seeks a refund of approximately $1.5 million of monies paid, denying coverage, and alleging fraud and misrepresentation and a failure of Warren E&P to act with due diligence and pursuant to safety regulations.  Warren E&P countersued for the remaining proceeds under the policy coverage.  In the summer and fall of 2000, summary judgments were entered for Warren E&P on essentially all claims except its bad faith claims against Gotham.  Gotham’s claims against Warren E&P and Warren were rejected.  Final judgment was rendered on May 14, 2001 in Warren E&P’s favor for the remaining policy proceeds, interest and attorney fees.  Gotham appealed the final judgment to the San Antonio Court of Appeals seeking a refund of approximately $1.5 million.  The case on appeal was orally argued on March 28, 2002. On July 23, 2003, a three judge panel of the San Antonio Court of Appeals rendered its decision in favor of Gotham on all points, except for the amount of restitution owed by Warren E&P and related parties, reversing the earlier summary judgment entered by the trial court for Warren E&P. Although the three judge panel of the San Antonio Court of Appeals acknowledged that Gotham asked for the Court to render its judgment in Gotham’s favor on its restitution claims, Gotham gave no particulars, and therefore the Court of Appeals remanded Gotham’s restitution claims to the trial court for further proceedings consistent with its opinion. Although the ultimate resolution is uncertain, counsel has

 

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advised Warren E&P that it believes the three judge panel of the San Antonio Court of Appeals committed numerous errors of fact and law, primarily relying on their erroneous conclusion that Warren E&P as operator of the oil well incurred no loss. Accordingly, Warren E&P is appealing the San Antonio Court of Appeals panel decision to the Texas Supreme Court, which may be accepted and heard by the Texas Supreme Court at their discretion.

 

We are also a party to legal actions arising in the ordinary course of our business.  In the opinion of our management, based in part on consultation with legal counsel, the liability, if any, under these claims is either adequately covered by insurance or would not have a material adverse effect on us.

 

Item 2. Changes in Securities

 

a. Not applicable

 

b. Not applicable

 

c. At September 30, 2003, the Company had issued 4,965,814 shares of its Preferred Stock, with a value of $12.00 per share of which, 1,244,546 shares were issued to accredited investors for cash consideration of $14,934,552,  426,157 shares were issued to bond converters and 3,295,111 were issued as additional LLC capital contributions as a result of the Recapitalizations. The shares of Convertible Preferred Stock are restricted securities. The issuance was exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”) pursuant to Section 4(2) and/or Section 3(a)(9). The Company’s Board of Directors has authorized the issuance of up to 6,100,000 shares of Convertible Preferred Stock. Information on the Convertible Preferred Stock transaction is contained in the Company’s Form 8-K filed on December 17, 2002 and in this Form 10-Q for the quarterly periods ended September 30, 2003 in “Part 1 Financial Information” under the caption “ Notes to Consolidated Financial Statements” under “Note 6: Changes in Shareholders’ Equity” and is incorporated herein by reference.

 

Item 3. Defaults upon Senior Securities

 

Not applicable.

 

Item 4. Submission of Matters to a Vote of Security Holders

 

Not applicable.

 

Item 5. Other Information

 

                Not applicable.

 

 

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Item 6.  Exhibits and Reports on Form 8-K

 

a)                                    Exhibits

 

Exhibits not incorporated by reference to a prior filing are designated by an (*) and are filed herewith; all exhibits not so designated are incorporated herein by reference to a prior filing as indicated.

 

Exhibit Number		Description		Original Filed Exhibit		File Number
31*		Rule 13a-14(a)/15d-14(a) Certifications				1-8968
32*		Section 1350 Certifications				1-8968

 

(b)                                  Reports on Form 8-K

 

The registrant did not file any reports on Form 8-K during the quarter ended September 30, 2003.

 

Signatures, and Certifications of the Chief Executive Officer and the Chief Financial Officer of the Company.

 

The following pages include the Signatures page for this Form 10-Q, and two separate Certifications of the Chief Executive Officer (CEO) and the Chief Financial Officer (CFO) of the Company.

 

The first form of Certification is required by Rule 13a-14 under the Securities Exchange Act of 1934 (the Exchange Act) in accord with Section 302 of the Sarbanes-Oxley Act of 2002 (the Section 302 Certification). The Section 302 Certification includes references to an evaluation of the effectiveness of the design and operation of the Company’s “disclosure controls and procedures” and its “internal controls and procedures for financial reporting”. Item 4 of Part I of this Quarterly Report presents the conclusions of the CEO and the CFO about the effectiveness of such controls based on and as of the date of such evaluation (relating to Item 4 of the Section 302 Certification), and contains additional information concerning disclosures to the Company’s Audit Committee and independent auditors with regard to deficiencies in internal controls and fraud (Item 5 of the Section 302 Certification) and related matters (Item 6 of the Section 302 Certification).

 

The second form of Certification is required by section 1350 of chapter 63 of title 18 of the United States Code.

 

SIGNATURES

 

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

 

	WARREN RESOURCES, INC.
	(Registrant)
Date: November 6, 2003	By:	/s/ Timothy A. Larkin
		Timothy A. Larkin
		Senior Vice President, Chief Financial Officer and Principal Accounting Officer

 

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