Discovery Energy Corp. - Quarter Report: 2018 May (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(MARK ONE)

For the quarterly period ended May 31, 2018

For the transition period from                to                 

Commission file number 000-53520

DISCOVERY ENERGY CORP.

(Exact Name of Registrant as Specified in Its Charter)

One Riverway Drive, Suite 1700, Houston, Texas 77056

(Address of principal executive offices)

713-840-6495

(Registrant’s telephone number)

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. Yes [X] No [  ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [X] No [  ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [  ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X]

Indicate the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: 143,040,396 as of July 13, 2018.

PART I FINANCIAL INFORMATION

Item 1. Financial Statements.

Discovery Energy Corp.

Consolidated Balance Sheets

(Unaudited)

The accompanying notes are an integral part of these unaudited interim consolidated financial statements.

Discovery Energy Corp.

Consolidated Statements of Operations and Comprehensive Loss

For the Three Months Ended May 31, 2018 and 2017

(Unaudited)

The accompanying notes are an integral part of these unaudited interim consolidated financial statements.

Discovery Energy Corp.

Consolidated Statements of Cash Flows

For the Three Months Ended May 31, 2018 and 2017

(Unaudited)

The accompanying notes are an integral part of these unaudited interim consolidated financial statements.

Discovery Energy Corp.

Notes to the Unaudited Consolidated Financial Statements

The principal business of Discovery Energy Corp. (“Company”) is the exploration and development of the 584,651 gross acres (“Prospect”) in South Australia covered by Petroleum Exploration License PEL 512 (“License”). In May 2012, the Company incorporated a wholly-owned Australian subsidiary, Discovery Energy SA Ltd., for the purpose of acquiring a 100% working interest in the License. On May 25, 2016, its status changed from a public to a private legal entity and its name to Discovery Energy SA Pty Ltd. (“Subsidiary”). The Company has not presently determined whether or not the Prospect, which overlies portions of the Cooper and Eromanga basins, contains any crude oil and/or natural gas reserves that are economically recoverable. While the Company’s present focus is on the Prospect, it may consider pursuing other crude oil and/or natural gas exploration opportunities.

Basis of Presentation

The accompanying unaudited interim consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) and the rules of the U.S. Securities and Exchange Commission (“SEC”), and should be read in conjunction with the audited consolidated financial statements and notes thereto contained in the Company’s February 28, 2018 Annual Report on Form 10-K filed with the SEC. In the opinion of management, all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the Company’s financial position and results of operations for the interim periods presented are reflected herein. The results of operations for interim periods are not necessarily indicative of the results to be expected for the full year. Notes to these financial statements, which would substantially duplicate the disclosure contained in the audited financial statements for the most recent fiscal year ended February 28, 2018, as reported on the related Form 10-K, have been omitted.

Principles of Consolidation

These consolidated financial statements include the accounts of the Company and the Subsidiary. Intercompany transactions and balances have been eliminated upon consolidation.

Use of Estimates

The preparation of these financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of these financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

Cash and Cash Equivalents

The Company considers all highly liquid instruments with maturities of three months or less at the time of acquisition to be cash equivalents. The Company maintains its cash in bank accounts which, at times, may exceed federally insured limits as guaranteed by the Federal Deposit Insurance Corporation. At May 31, 2018, approximately $11,801 of the Company’s cash balances were uninsured. These accounts have not incurred losses as of the date of this report.

Oil and Gas Property and Exploration Costs

The Company is in the exploration stage of evaluating the Prospect and has not yet realized any revenues from its operations. It applies the successful efforts method of accounting for expenditures associated with crude oil and natural gas properties. Under this method, exploration costs such as exploratory geological and geophysical costs, delay rentals and exploratory overhead are expensed as incurred. Costs to acquire mineral interests in crude oil and/or natural gas properties, drill and equip exploratory wells that find proved reserves and drill and equip development wells are capitalized. Acquisition costs of unproved leaseholds are assessed for impairment during the holding period and transferred to proven crude oil and/or natural gas properties to the extent associated with successful exploration activities. Significant undeveloped leases are assessed individually for impairment, based on the Company’s current exploration plans, and a valuation allowance is provided if impairment is indicated. Capitalized costs from successful exploration and development activities associated with producing crude oil and/or natural gas leases, along with capitalized costs for support equipment and facilities, are amortized to expense using the unit-of-production method based on proved crude oil and/or natural gas reserves on a field-by-field basis, as estimated by qualified petroleum engineers.

Long-lived Assets

The carrying values of long-lived assets are reviewed on a regular basis for the existence of facts or circumstances that may suggest impairment. The Company recognizes impairment when the sum of the expected undiscounted future cash flows are less than the carrying amount of the asset. Impairment losses, if any, are measured as the excess of the carrying amount of the asset over its estimated fair value.

Fair Value of Financial Instruments and Derivative Financial Instruments

The carrying amounts of cash, receivables, accounts payable, accrued liabilities and shareholder loans approximate their fair values due to the short maturity of these items. Certain fair value estimates may be subject to and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect these estimates. The Company does not hold or issue financial instruments for trading purposes, nor does it utilize derivative instruments in the management of its foreign exchange, commodity price, and/or interest rate market risks.

Income Taxes

Deferred income taxes are reported for timing differences between items of income or expense reported in these financial statements and those reported for income tax purposes. The Company uses the asset/liability method of accounting for income taxes. Deferred income taxes and tax benefits are recognized for the future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases, and for tax loss and credit carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The Company provides a valuation allowance for deferred taxes for the estimated future tax effects attributable to temporary differences and carry-forwards when realization is not more likely than not.

The Tax Cuts and Jobs Act of 2017 was signed into law on December 22, 2017. The law includes significant changes to the U.S. corporate income tax system, including a federal corporate rate reduction from 34% to 21%. In accordance with ASC 740, the impact of a tax law change is recorded in the period of enactment.

The Company accounts for uncertain income tax positions by recognizing the impact of a tax position, if that position is more likely than not of being sustained on examination by taxation authorities, based on the technical merits of the position.

Foreign Currency Translation

The Company’s functional and reporting currency is the United States dollar. Monetary assets and liabilities denominated in foreign currencies are translated using exchange rates prevailing at the balance sheet date. Non-monetary assets are translated at historical exchange rates, and revenue and expense items at average rates of exchange prevailing during the period. Differences resulting from translation are presented in equity as accumulated other comprehensive income (loss). Gains and losses arising on settlement of foreign currency denominated transactions or balances are included in the determination of income. Foreign currency transactions are primarily undertaken in Canadian and Australian dollars. The Company has not, to the date of these financial statements, entered into derivative instruments to offset the impact of foreign currency fluctuations.

Fair Value Considerations

The Company follows Accounting Standards Codification (“ASC”) 820, “Fair Value Measurements and Disclosures,” as amended by FASB Financial Staff Position (“FSP”) No. 157 and related guidance. These provisions relate to the Company’s financial assets and liabilities carried at fair value and the fair value disclosures related to financial assets and liabilities. ASC 820 defines fair value, expands related disclosure requirements, and specifies a hierarchy of valuation techniques based on the nature of the inputs used to develop the fair value measures. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, assuming the transaction occurs in the principal or most advantageous market for that asset or liability.

There are three levels of inputs to fair value measurements - Level 1, meaning the use of quoted prices for identical instruments in active markets; Level 2, meaning the use of quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active or are directly or indirectly observable; and Level 3, meaning the use of unobservable inputs. The Company uses Level 1 inputs for its fair value measurements whenever there is an active market, with actual quotes, market prices, and observable inputs on the measurement date. The Company uses Level 2 inputs for fair value measurements whenever there are quoted prices for similar securities in an active market or quoted prices for identical securities in an inactive market. The Company uses observable market data whenever available.

In accordance with ASC 815-40-25 and ASC 815-10-15, “Derivatives and Hedging” and ASC 480-10-25, “Liabilities-Distinguishing Liabilities from Equity”, the embedded derivatives associated with the convertible debenture payable and warrants are accounted for as liabilities during the term of the related debenture payable and warrants.

Loss Per Share

Basic Earnings Per Share (“EPS”) is computed by dividing net income (loss) available to common shareholders (numerator) by the weighted average number of shares outstanding (denominator) during the period. Diluted EPS give effect to all dilutive potential common shares outstanding during the period using the treasury stock method and to convertible preferred stock using the if-converted method. In computing diluted EPS, the average stock price for the period is used to determine the number of shares assumed to be purchased from the exercise of stock options and/or warrants. Diluted EPS excludes all dilutive potential shares if their effect is anti-dilutive.

For the quarter ended May 31, 2018 and the year ended February 28, 2018, the following share equivalents related to convertible debt and warrants to purchase shares of common stock were excluded from the computation of diluted net loss per share, as the inclusion of such shares would be anti-dilutive.

Comprehensive Income (Loss)

The Company recognizes currency translation adjustments as a component of comprehensive income (loss).

Recent Accounting Pronouncements

In April 2016, the FASB issued Accounting Standards Update (“ASU”) No. 2016-10, “Revenue from Contracts with Customers: Identifying Performance Obligations and Licensing” (Topic 606). In March 2016, the FASB issued ASU No. 2016-08, “Revenue from Contracts with Customers: Principal versus Agent Considerations (Reporting Revenue Gross versus Net)” (Topic 606). These amendments provide additional clarification and implementation guidance on the previously issued ASU 2014-09, “Revenue from Contracts with Customers”. The amendments in ASU 2016-10 provide clarifying guidance on materiality of performance obligations; evaluating distinct performance obligations; treatment of shipping and handling costs; and determining whether an entity’s promise to grant a License provides a customer with either a right to use an entity’s intellectual property or a right to access an entity’s intellectual property. The amendments in ASU 2016-08 clarify how an entity should identify the specified good or service for the principal versus agent evaluation and how it should apply the control principle to certain types of arrangements. The adoption of ASU 2016-10 and ASU 2016-08 is to coincide with an entity’s adoption of ASU 2014-09, which would be adopted for interim and annual reporting periods beginning after December 15, 2017. The Company has evaluated and adopted the standard and due to the nature of the Company’s oil and gas revenue agreements method there was no impact of the standard on its consolidated financial statements.

In August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments” (“ASU 2016-15”). ASU 2016-15 impacts how cash receipts and cash payments are presented and classified in the statement of cash flows. ASU 2016-15 is effective for fiscal years beginning after December 15, 2017. The new standard requires adoption on a retrospective basis unless it is impracticable to apply, in which case it requires application of the amendments prospectively as of the earliest date practicable. The Company has evaluated the impact of ASU 2016-15 on its consolidated financial statements and determined that none of the cash flow activity addressed under this ASU occurred during the current or prior period.

In February 2016, the FASB issued ASU 2016-02, a new lease standard requiring lessees to recognize lease assets and lease liabilities for most leases classified as operating leases under previous U.S. GAAP. The guidance is effective for fiscal years beginning after December 15, 2018, with early adoption permitted. The Company will be required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements. The Company has evaluated the adoption of the standard and, due to only one operating lease currently in place, believes that there will be minimal impact of the standard on its consolidated financial statements.

The Company does not anticipate that the adoption of other recently issued accounting pronouncements will have a significant impact on its financial statements.

These financial statements were prepared on a going concern basis, which implies that the Company will continue to realize its assets and discharge its liabilities in the normal course of business. The Company has not generated operating revenues since inception and is unlikely to generate earnings in the immediate or foreseeable future. The continuation of the Company as a going concern is dependent upon the ability of the Company to obtain necessary equity or debt financing to continue operations, successfully develop the Prospect and/or obtain producing properties with the goal of attaining profitable operations. The Company is currently attempting to complete a significant financing, and in this connection it might (a) place a significant amount of additional Debentures similar to those described below, (b) secure an alternative financing arrangement, possibly involving the Company’s equity securities, or (c) some combination of (a) and (b). The Company has no assurance that it will be able to raise significant additional funds to explore and develop the Prospect or additional funds needed for general corporate purposes.

As of May 31, 2018, the Company had not generated any revenues and had an accumulated loss of $31,829,014 since inception. These factors raise substantial doubts regarding the Company’s ability to continue as a going concern post the filing date of these financial statements. These financial statements do not include any adjustments related to the recoverability and classification of recorded asset amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.

Additional convertible debenture sales completed during the three months ended May 31, 2018 were as follows:

The License covers 584,651 gross acres in the Cooper and Eromanga basins situated in the State of South Australia.

On October 26, 2012, a 100% working interest in a 15-year License (three 5-year terms) was officially issued to the Subsidiary.

On May 19, 2014, the Company received notice from the Government of South Australia that it had issued certain modifications to the License and had suspended the License for a period of six months. Such a suspension functions like an extension. Under the amended License, the Company is required to drill 7 exploratory wells rather than 12, as originally required. The 7 required wells must be drilled in years 3, 4, and 5 (2, 2, and 3 wells, respectively). The amount of required 2D seismic was also reduced to 100 kilometers (in year 3) from 250 kilometers (in year 2) but the total 3D seismic work guarantee increased to 500 square kilometers from 400 square kilometers. However, the 3D seismic survey requirement is spread over years 2, 3 and 4 (100, 200 and 200 sq. km. respectively). Subsequent to this modification and suspension, the Company received two additional six-month suspensions, one in February 2015 and one in July 2015 (this additional suspension commenced upon the conclusion of the suspension received in February 2015). In February 2016, the Company received a third additional suspension, which was for one year and which commenced upon the conclusion of the suspension received in July 2015. Combined, these three additional suspensions amount to an accumulated total suspension of two years.

On June 22, 2016, the Company terminated the February 2016 License suspension in preparation for a 3D seismic survey (the “Survey”) that was comprised of approximately 179 square kilometers on the southwest portion of the Prospect. After archaeological and environmental reviews of the survey area, fieldwork by the seismic contractor began on July 26, 2016, but was halted at the beginning of September due to weather conditions. Even though only security personnel remained in the area, the Survey was considered an active project. As a result, License Year 2 ran to the 365th day on October 5, 2016. The work crew returned thirteen days later and completed the Survey on October 30, 2016. The License was suspended again on November 1, 2016.

On June 20, 2017, the Company completed its archeological, environmental and operational surveys of the prospective drilling locations identified as a result of the interpretation work associated with the Survey. Initial reports from this Work Area Clearance (“WAC”) survey identified minor issues that will not materially affect operational planning, well design or estimated costs.

Subsequent to completing the WAC, management requested that the government suspend the License for a period of nine months to allow sufficient time to finalize drilling plans, complete financing arrangements and contract the services required to drill multiple exploratory wells in the southern portion of the License area. This request was granted on July 17, 2017, resulting in a six-month extension from South Australian Energy Resources Division (“SAERD”) effective from July 5, 2017 to January 4, 2018, resulting in a new expiration date of October 28, 2020. The preceding suspension ended after January 4, 2018, and thus the time during which the work commitment must be completed began running after such date. To ensure the Company has sufficient time to completely formulate its drilling plans and procure financing to pursue the same, the Company requested a further suspension. This request was granted on June 19, 2018, resulting in a six-month extension from SAERD effective from May 31, 2018 to November 30, 2018 resulting in a new expiration date of April 30, 2021.

As a result of the activities, modifications and suspensions described above, the remaining work commitments are now as follows:

In three transactions during fiscal 2018, the Company acquired portions of the royalty interest associated with the PEL 512 License so that the Company now owns an aggregate 5.0% royalty interest, while the previous holders of the original 7.0% royalty interest continue to hold a 2.0% royalty interest.

As of May 31, 2018 and February 28, 2018, the Company owed $60,743 and $30,476, respectively, to certain Company directors for reimbursement of expenses paid on behalf of the Company.

From May 27, 2016 through May 31, 2018, the Company issued eleven rounds (I through XI) of senior secured convertible debentures, the proceeds of which have funded the initial 3D seismic survey with respect to the Prospect, the interpretation of seismic data acquired, expenses associated with the seismic survey, costs associated with the debenture issuances and general and administrative expenses. The debentures are secured by virtually all of the Company’s assets owned, directly or indirectly, but for the License. As discussed in this report, the Company may in the future sell additional senior secured convertible debentures having the same terms as those currently outstanding. The table below provides a summary of the senior secured convertible debentures issued through May 31, 2018 and related debt discount and amortization details.

The Company recognized $336,676 and $240,836 in debt discount amortization related to all of the debentures during the three months ended May 31, 2018 and 2017, respectively.

The debentures and related warrants issued by the Company contain a price-reset provision (“Reset Provision”) that gives rise to a derivative liability. The Company has measured its derivative liability at fair value and recognized the derivative value as a current liability and recorded the derivative value on its consolidated balance sheet. The derivative is valued primarily using a binomial latticed-based model based on unobservable inputs that are supported by little to no market activity. The Level 1 input is the stock price on the valuation date. The Level 2 inputs are the interest rate and expected volatility. There are no Level 3 inputs. These inputs represent management’s best estimate of what market participants would use in pricing the liability at the measurement date. Changes in the fair values of the derivative are recognized as earnings or losses in the current period in other income (expenses) on the consolidated statement of operations and comprehensive income (loss).

The changes in fair values of the derivative liabilities related to the debentures and warrants for the three months ended May 31, 2017 are summarized as follows:

The fair values of derivative liability related to the Reset Provision contained within the debentures and warrants as of May 31, 2018 and February 28, 2018 were estimated on the transaction dates and balance sheet dates under the following assumptions:

The Company recognized a loss on the change in fair value of derivative liabilities of $11,111,284 and $6,299,288 during the three months ended May 31, 2018 and 2017, respectively.

As of May 31, 2018 and February 28, 2018, the Company had 143,040,396 shares of its common stock issued and outstanding.

Warrants

A summary of the activity in the Company’s warrants during the three months ended May 31, 2018 is presented below:

The intrinsic value of warrants outstanding at May 31, 2018 was $6,693,750.

On July 5, 2018, the Company amended the consulting agreement with Keith Spickelmier. Per this amendment, the directors agreed to increase the consulting fees for Mr. Spickelmier for our fiscal period commencing on March 1, 2018 and ending on February 28, 2019 from an aggregate of $125,000 to an aggregate of $160,000, a $35,000 increase. Other than for the preceding, the Agreement was not amended in any other respect.

Item 2. Management’s Discussion and Analysis.

CAUTIONARY STATEMENT FOR FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are based on current expectations and projections about future events. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about the Company that may cause actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, forward-looking statements can be identified by the use of terminology such as “may,” “might,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in the Company’s other Securities and Exchange Commission filings. The following discussion should be read in conjunction with the Company’s financial statements and related notes thereto included elsewhere in this report.

General

Discovery Energy Corp. (the “Company” or “Discovery”) was incorporated under the laws of the state of Nevada on May 24, 2006 under the name “Santos Resource Corp”. The Company’s current business plan is to explore for and develop crude oil and natural gas on the 584,651 gross acres prospect (the “Prospect”) in the State of South Australia covered by Petroleum Exploration License PEL 512 (the “License”). The License grants a 100% working interest in the preceding acreage, which overlies portions of the Cooper and Eromanga basins. The Company adopted this business plan near its fiscal 2012 year-end, after having previously abandoned its initial business plan involving mining claims in Quebec, Canada and after it had been dormant, from a business perspective, for a period of time. In connection with the adoption of the current business plan, it had a change of control, a change of management, a change of corporate name, and a change of status from a “shell” company, as that term is defined in Rule 405 of the Securities Act of 1933 and Rule 12b-2 under the Securities Exchange Act of 1934.

To date, the Company has achieved the following milestones:

Although the Company’s primary focus is on the exploration and development of the Prospect, the Company has received information about, and has had discussion regarding, possible acquisition of or participation in, other crude oil and/or natural gas opportunities. None of these discussions has led to any agreement in principle. Nevertheless, given an attractive opportunity and its ability to consummate the transaction, the Company could acquire one or more other crude oil and natural gas properties, or participant in one or more other crude oil and/or natural gas opportunities.

Current Primary Activities

The Company’s current primary activity is to complete either a major financing or a major joint venture relationship or both so that the Company can commence its initial drilling program and fulfill the obligations imposed on the Company by the work commitment relating to the License.

The License is subject to an initial five-year work program commitment, which imposes certain financial obligations on the Company. The Company is currently in Year 3 of the work commitment. In management’s view, the geotechnical work completed in the first and second years was sufficient to satisfy the License work requirements, and the Company’s reports in connection with these activities were filed in a timely manner with the South Australian government. The Company has received no comments from the government relating to work described in those reports. The Company has received a number of extensions and some modifications of the work commitment. In view of these extensions and modifications, the remaining work commitment involves the following:

The Company needs a significant amount of capital to fulfill its obligations under the work commitment. Moreover, the Debentures mature in May 2021, and the Company will need to raise funds or generate revenues through oil and gas production to repay the Debentures. Alternatively, all or a significant part of Company’s obligations under the work commitment could be satisfied by a properly structured major joint venture relationship. In view of all of the preceding, the Company has been and is currently undertaking certain financing activities and efforts to establish a major joint venture relationship. The Company’s capital requirements, and the Company’s financing and joint venture activities are described in the section captioned “Liquidity and Capital Requirements” below. The success of the initial phase of the Company’s plan of operation depends upon its ability to obtain additional capital or enter into a suitable joint venture arrangement in order to acquire additional seismic data with respect to the Prospect, and to drill successful exploratory and developmental wells. The Company’s failure to obtain required additional capital or enter into a suitable joint venture arrangement will materially and adversely affect the Company and its stockholders in ways that are discussed below. The Company cannot provide assurance that it will obtain the necessary capital or enter into a suitable joint venture arrangement.

Results of Operations

Results of operations for the three-month periods ended May 31, 2018 and 2017 are summarized in the table below:

Operating expenses for the three-month periods ended May 31, 2018 and 2017 are listed in the table below:

Results of Operations for the Three-Month Periods Ended May 31, 2018 and 2017

Revenues. The Company did not earn any revenues for either the quarter ended May 31, 2018 or the similar period in 2017. Sales revenues are not anticipated until such time as the Prospect has commenced commercial production of crude oil and/or natural gas. As the Company is presently in the exploration stage of its plan, no assurance can be provided that commercially exploitable hydrocarbon reserves on the Prospect will be discovered, or if such amounts are discovered, that the Prospect will commence commercial production.

Operating expenses. Total operating expenses incurred during the quarter ended May 31, 2018 were 16% lower than those incurred during the quarter ended May 31, 2017. The decrease of approximately $80,000 reflects reduced expenses incurred in all expense categories (especially for exploration costs), excluding professional fees. These results primarily reflect a reduced level of exploration activities.

Exploration costs decreased during the quarter ended May 31, 2018 by approximately $84,000, compared to the similar period in 2017. This decrease is a result of the completion of the geophysical and geological interpretation and analysis of the Survey data mostly in prior periods, offset to some extent by continuing efforts to identify specific drilling prospects based on that analysis.

Professional fees for the quarter ended May 31, 2018 increased approximately $27,000, or 21%, compared to the quarter ended May 31, 2017 due primarily to an increase in consulting services related to capital raising activities.

General and administrative expenses decreased approximately $12,000 during the quarter ended May 31, 2018, compared to the same period in the prior fiscal year.

Other income (expenses). The Company had net other expense in the amount of $11,891,713 for the quarter ended May 31, 2018, compared to net other expense in the amount of $6,841,060 for the quarter ended May 31, 2017, representing a change of approximately $5,051,000, which is mostly attributable to the $4,811,996 increase in the change in the valuation of the derivative liabilities associated with the Company’s debentures, in addition to increased interest expense of $236,985 also associated with the Company’s debentures during the three-month period ended May 31, 2018. These expenses are non-cash, as the Debenture interest was added to the outstanding balance of the Debentures in lieu of the payment thereof.

Net loss. The Company had a net loss of $12,312,242 for the quarter ended May 31, 2018, compared to a net loss of $7,341,194 for the quarter ended May 31, 2017, representing a change of approximately $4,971,000. Nearly all of the increase is attributable to the change in the calculated value of the derivative liabilities associated with the Company’s debentures. On a per share basis, net loss for the three-month period ended May 31, 2018 was $0.09 and net loss for the three-month period ended May 31, 2017 was $0.05.

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements.

Liquidity and Capital Resources

Financing History

From January 2012 through May 27, 2016, the Company financed its business activities primarily through private placements of shares of common stock. During that period, it conducted several rounds of equity financing in which it raised total “seed” capital in the amount of $2,723,750 resulting in the issuance of 19,657,501 shares of the Company’s common stock. Moreover, from time to time, officers and directors of the Company provided short-term bridge funding. These advances were repaid out of the proceeds from the Debenture Financings.

Since May 2016, the Company has successfully completed a series of placements of Debentures (debt instruments convertible into shares of the Company’s common stock). The Debentures were issued pursuant to a Securities Purchase Agreement executed on May 27, 2016. Through the date of this report, Debentures having an aggregate original principal amount of $6.85 million have been placed. In conjunction with certain Debentures, warrants were issued that give the Debenture Holders the right to purchase up to a maximum of 19,125,000 shares of the Company’s common stock at an initial per-share exercise price of $0.20. Each of the Debentures involves the following features:

The proceeds from the Debenture placements have generally been used for processing and interpretation of the Survey data and payment of the Company’s and the Holders’ expenses associated with the placements. A portion of the proceeds was used for the acquisition of a 5.0% royalty interest relating to the Prospect. Funds were also used for payment of general and administrative expenses. During the Company’s first quarter of 2019, Texican purchased its remaining additional Debentures with an aggregate original principal amount of $350,000.

Immediate, Short-Term Capital Needs

As of May 31, 2018, the Company had approximately $262,000 of cash on hand. As of July 18, 2018, the Company had approximately $22,800 of cash on hand and had negative working capital of approximately $619,000.

Management believes that the cash on hand, as of the date of this report, will be sufficient to finance general and administrative expenses through July 2018, although no assurance of this can be provided. However, this amount of cash will be insufficient to allow the Company to fulfill work commitment obligations in a timely manner. A plan for financing these obligations is discussed below. Management intends to finance all of the general and administrative expenses beyond available cash on hand by undertaking to raise up to $1.66 million through a private placement of shares of common stock. If successful in raising $1.66 million in a private placement, it is estimated that the related net proceeds will be sufficient to finance general and administrative activities through September 2019. However, no assurance can be given that the amount raised will be adequate. Moreover, no assurance can be provided of successfully raising any additional funds for this purpose. Furthermore, as previously stated, the funds from the private placement will not be sufficient to satisfy the license work commitments for future years.

Long-Term Capital Needs

The five-year work commitments relating to the License impose certain obligations on the Company. The work requirements of the first two years, which included geotechnical studies and the Survey, have been completed and reports and certain work materials have been submitted as required by the South Australian government. Going forward, additional funds will be required to meet the seismic and drilling obligations of License Years 3, 4 and 5. Working capital will also be needed to satisfy general and administrative expenses. Between June 2018 and April 2021, it is estimated that the Company will need to raise approximately $23 million to have sufficient capital to meet the remaining work commitments specified in the License and to fund operations. Net revenues produced from successful crude oil and/or natural gas wells could provide some of the funds required to meet these capital needs. However, no assurance can be given that this or any other amount of financing will be obtained or that any crude oil and or natural gas revenue will be earned.

If successful with the initial wells, work will continue with a full development plan, the scope of which is now uncertain but will be based on technical analysis of seismic data, field drilling and log reports, production history and cost estimates. However, all of the preceding plans are subject to the availability of sufficient funding and the receipt of all governmental approvals. Without sufficient available funds to undertake these tasks, additional financings or a joint venture partner will be required.

Failure to procure a joint venture partner or raise additional funds will preclude the Company from pursuing its business plan, as well as exposing it to the loss of the License, as discussed below. Moreover, if the business plan proceeds as just described, but the initial wells do not prove to hold producible reserves, the Company could be forced to cease its exploration efforts on the Prospect.

Major Financing Efforts and Other Sources of Capital

The Company’s capital strategy for most of its 2016, 2017 and 2018 fiscal years has been to secure a single or series of major capital raising transactions to provide sufficient funds to satisfy its capital needs for a number of years. The Company also continues its efforts to engage in smaller financing transactions to provide sufficient funds to satisfy ongoing and future general capital needs. Beginning in May 2016 and since then, the Company has completed a series of placements of its Debentures having an aggregate original principal amount of $6,850,000. The Company’s plan for financing its general and administrative expenses is described in the section captioned “Financing History and Immediate, Short-Term Capital Needs” above. The Company’s plan for financing its work commitment is described in the following paragraph.

The interpretation and analysis of the Survey resulted in an inventory of more than 30 leads judged to be potential areas of crude oil accumulations. These initial prospective locations were prioritized, and the results have been and are being presented to prospective investors with a view to securing the capital to commence the Company’s initial drilling program. Management is engaged in discussions with several prospective investors and financial intermediaries at this time, but has not reached an agreement in principle, much less a definitive agreement, in this regard. In the interim, the Company is also continuing efforts to raise comparably smaller amounts to cover general and administrative expenses. The Company can provide no assurance that it will be able to raise required funds.

In addition to smaller equity placements for short-term needs and a major capital raising transaction for long-term needs, the Company continues its efforts to secure one or more joint venture partners. An arrangement with such a partner could involve the sale of a portion of the Company’s interest in the Prospect to a joint venture partner for a cash payment or an agreement to perform some of the Company’s obligations under the License work commitment. The Company is engaged in discussions with several parties to become joint venture partners and is currently evaluating various proposals. Nevertheless, no assurance can be provided that the Company will secure a joint venture partner. The Company needs to complete a major capital raising transaction or a major joint venture arrangement to continue moving its business plan forward and to avoid materially adverse consequence that could result if it fails to do so.

Sales from production as a result of successful exploration and drilling efforts would provide the Company with incoming cash flow. The proved reserves associated with production would most likely increase the value of the Company’s rights in the Prospect. This, in turn, should enable the Company to obtain bank financing (after the wells have produced for a period of time to satisfy the potential lenders requirements). Both of these results would enable the Company to continue with its development activities. Positive cash flow is a critical success factor for the Company’s plan of operation in the long run. Management believes that, if the Company’s plan of operation successfully progresses (and production is realized) as planned, sufficient cash flow and debt financing will be available for purposes of properly pursuing its plan of operation, although the Company can make no assurances in this regard.

Finally, to reduce its cash requirements, the Company might attempt to satisfy some of its obligations by issuing shares of its common stock, which would result in dilution in the percentage ownership interests of the Company’s existing shareholders and could result in dilution of the net asset value per share of the Company’s existing shareholders.

Consequences of a Financing Failure

If required financing is not available on acceptable terms, the Company could be prevented from satisfying its work commitment obligations or developing the Prospect to the point that it is able to repay the Debentures, which become due in May 2021. Failure to satisfy work commitment obligations could result in the eventual loss of the License and the total loss of the Company’s assets and properties. Failure to timely pay the Debentures could result in the eventual exercise of the rights of a secured creditor and the possible partial or total loss of the Company’s assets and properties. Failure to procure required financing on acceptable terms could prevent the Company from developing the Prospect. If any of the preceding events were to occur, the Company could be forced to cease operations, which could result in a complete loss of stockholders’ equity. If additional financing is not obtained through an equity or debt offering, the Company could find it necessary to sell all or some portion of the Prospect under unfavorable circumstances and at an undesirable price. However, no assurance can be provided that the Company will be able to find interested buyers or that the funds received from any such partial sale would be adequate to fund additional activities. Future liquidity will depend upon numerous factors, including the success of the Company’s exploration and development program, satisfactory achievement of License commitments and capital raising activities.

Item 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

Discovery maintains disclosure controls and procedures designed to ensure that material information required to be disclosed in its filings under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that material information is accumulated and communicated to management, including its Chief Executive Officer (“CEO’) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required disclosures. The CEO and CFO have evaluated these disclosure controls and procedures as of the end of the period covered by this quarterly report on Form 10-Q and have determined that such disclosure controls and procedures were not effective as disclosed below.

Limitations on Effectiveness of Controls and Procedures

In light of the material weakness described below, management performed additional procedures during the quarter and additional analysis and procedures post-closing to ensure that these financial statements were prepared in accordance with generally accepted accounting principles. Accordingly, it is believed that the financial statements included in this report fairly present, in all material respects, the financial condition, results of operations and cash flows for the periods presented.

A material weakness is a control deficiency (within the meaning of the Public Company Accounting Oversight Board Auditing Standard 1305) or combination of control deficiencies that result in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

Management has determined that the Company does not have sufficient segregation of duties within its accounting functions, which is a basic internal control. Due to the size, nature and staffing of the Company, segregation of all conflicting duties may not always be possible and may not be economically feasible. However, to the extent possible, the limitations of transactions, the custody of assets and the recording of transactions should be performed by separate individuals. Management evaluated the impact of the failure to maintain effective segregation of duties on its assessment of internal controls over financial reporting and has concluded that the control deficiency represents a material weakness. The Company added a controller in August 2017 and intends to further increase its accounting staff, as soon as economically feasible and sustainable, to remediate this material weakness.

Changes in Internal Controls over Financial Reporting

There have been no changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II OTHER INFORMATION

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

Item 6. Exhibits.

The following exhibits are filed with this Quarterly Report or are incorporated herein by reference:

SIGNATURES

In accordance with the requirements of the Exchange Act, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.