Freedom Holding Corp. - Quarter Report: 2008 December (Form 10-Q)

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.

 

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

 

As of February 4, 2009, the registrant had 47,378,420 shares of common stock, par value $0.001, issued and outstanding.

 

BMB MUNAI, INC.

FORM 10-Q

TABLE OF CONTENTS

 

 

 

 

PART I - FINANCIAL INFORMATION

Item 1 - Unaudited Consolidated Financial Statements

BMB MUNAI, INC.

CONSOLIDATED BALANCE SHEETS (UNAUDITED)

 

 

 

See notes to the unaudited consolidated financial statements.

 

 

 

 

 

See notes to the unaudited consolidated financial statements.

 

 

 

 

See notes to the unaudited consolidated financial statements.

 

 

 

 

See notes to the unaudited consolidated financial statements.

 

 

NOTE 1 - DESCRIPTION OF BUSINESS

 

The corporation now known as BMB Munai, Inc., a Nevada corporation (“BMB Munai” or the “Company”) was originally incorporated in Utah in July 1981. On February 7, 1994, the corporation changed its name to InterUnion Financial Corporation (“InterUnion”) and its domicile to Delaware. BMB Holding, Inc. (“BMB Holding”) was incorporated on May 6, 2003 for the purpose of acquiring and developing oil and gas fields in the Republic of Kazakhstan. On November 26, 2003, InterUnion executed an Agreement and Plan of Merger (the “Agreement”) with BMB Holding. As a result of the merger, the shareholders of BMB Holding obtained control of the corporation. BMB Holding was treated as the acquiror for accounting purposes. A new board of directors was elected that was comprised primarily of the former directors of BMB Holding and the name of the corporation was changed to BMB Munai, Inc. BMB Munai changed its domicile from Delaware to Nevada on December 21, 2004.

 

The Company’s consolidated financial statements presented are a continuation of BMB Holding, and not those of InterUnion Financial Corporation, and the capital structure of the Company is now different from that appearing in the historical financial statements of InterUnion Financial Corporation due to the effects of the recapitalization.

 

The Company has a representative office in Almaty, Republic of Kazakhstan.

 

From inception (May 6, 2003) through January 1, 2006 the Company had minimal operations and was considered to be in the development stage. The Company began generating significant revenues in January 2006 and is no longer in the development stage.

 

Currently the Company has completed twenty-four wells. As discussed in more detail in Note 2, the Company engages in exploration of its licensed territory pursuant to an exploration license and has not yet applied for or been granted a commercial production license.

 

NOTE 2 - SIGNIFICANT ACCOUNTING POLICIES

 

The consolidated financial information included herein is unaudited, except for the balance sheet as of March 31, 2008, which is derived from the Company’s audited consolidated financial statements for the year ended March 31, 2008. However, such information includes all adjustments (consisting solely of normal recurring adjustments), which are, in the opinion of management, necessary for a fair statement of the results of operations for the interim periods. The consolidated results of operations for the interim period are not necessarily indicative of the consolidated results to be expected for an entire year.

 

 

 

Certain information and footnote disclosures normally included in financial statements, prepared in accordance with accounting principles generally accepted in the United States, have been condensed or omitted in this Quarterly Report on Form 10-Q, pursuant to certain rules and regulations of the Securities and Exchange Commission. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in our Annual Report for the year ended March 31, 2008 on Form 10-K, as amended.

 

The accounting principles applied are consistent with those as set out in the Company’s annual Consolidated Financial Statements for the year ended March 31, 2008.

 

Basis of consolidation

 

The Company’s consolidated financial statements present the consolidated results of BMB Munai, Inc., and its wholly owned subsidiary, Emir Oil LLP (hereinafter collectively referred to as the “Company”). All significant inter-company balances and transactions have been eliminated from the Consolidated Financial Statements.

 

Use of estimates

 

The preparation of Consolidated Financial Statements in conformity with US GAAP requires management to make estimates and assumptions that affect certain reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the Consolidated Financial Statements and revenues and expenses during the reporting period. Accordingly, actual results could differ from those estimates and affect the results reported in these Consolidated Financial Statements.

 

Restatement of Financial Statements

 

The consolidated statement of cash flows for the nine months ended December 31, 2007 has been restated to correct the classification of inventories of materials for oil and gas projects and prepayments for materials used in oil and gas projects from current assets to long term assets. The Company concluded inventories of materials for oil and gas projects and prepayments for materials used in oil and gas projects should be treated as long term assets due to their future classification to oil and gas properties once the materials are used in the projects. The correction of these balances had no effect on the previously reported net income. The effects of the restatements were as follows:

 

8

 

 

 

 

Concentration of Credit Risk and Accounts Receivable

 

Financial instruments that potentially subject the Company to a concentration of credit risk consist principally of cash and accounts receivable. The Company places its cash with high credit quality financial institutions. Substantially all of the Company’s accounts receivable are from purchasers of oil and gas. Oil and gas sales are generally unsecured. The Company has not had any significant credit losses in the past and believes its accounts receivable are fully collectable. Accordingly, no allowance for doubtful accounts has been provided.

 

Licences and contracts

 

Emir Oil LLP is the operator of the Company’s oil and gas fields in Western Kazakhstan. The Government of the Republic of Kazakhstan (the “Government”) initially issued the license to Zhanaozen Repair and Mechanical Plant on April 30, 1999 to explore the Aksaz, Dolinnoe and Emir oil and gas fields (the “ADE Block” or the “ADE Fields”). On June 9, 2000, the contract for exploration of the Aksaz, Dolinnoe and Emir oil and gas fields was entered into between the Agency of the Republic of Kazakhstan on Investments and the Zhanaozen Repair and Mechanical Plant. On September 23, 2002, the contract was assigned to Emir Oil LLP. On September 10, 2004 the Government extended the term of the Contract for exploration and License from five years to seven years through July 9, 2007. On February 27, 2007, the Ministry of Energy and Mineral Resources of the Republic of Kazakhstan (“MEMR”) granted a second extension of the Company’s exploration contract. Under the terms of the contract extension, the exploration period was extended to July 2009 over the entire exploration contract territory. On December 7, 2004 the Government assigned to Emir Oil LLP exclusive right to explore an additional 260 square kilometers of land adjacent to the ADE Block, which is referred to as the “Southeast Block.” The Southeast Block includes the Kariman field and the Yessen and Borly structures and is governed by the terms of the Company’s original contract. On June 24, 2008 the MEMR agreed to extend the exploration stage of the Company’s contract from July 2009 to January 2013 in order to permit the Company to conduct additional exploration drilling and testing activities within the ADE Block and the Southeast Block.

 

 

 

On October 15, 2008 the MEMR approved Addendum # 6 to Contract No. 482 with Emir Oil LLP, dated June 09, 2000 extending Emir Oil LLP’s exploration territory from 460 square kilometers to a total of 850 square kilometers (approximately 210,114 acres). The additional territory is located to the north and west of the Company’s current exploration territory, extending the exploration territory toward the Caspian Sea and is referred to herein as the “Northwest Block.”

 

To move from the exploration stage to the commercial production stage, the Company must apply for and be granted a commercial production contract. The Company is legally entitled to apply for a commercial production contract and has an exclusive right to negotiate this Contract. The Government is obligated to conduct these negotiations under the Law of Petroleum in Kazakhstan. If the Company does not move from the exploration stage to the commercial production stage, it has the right to produce and sell oil, including export oil, under the Law of Petroleum for the term of its existing contract.

 

Major Customers

 

During the nine months ended December 31, 2008 and 2007, sales to one customer represented 81% and 91%, respectively, of total sales volume. The loss of this customer could have a material adverse affect on the Company, although there is an available market for the Company’s crude oil and natural gas production from other purchasers.

 

Foreign currency translation

 

Transactions denominated in foreign currencies are reported at the rates of exchange prevailing at the date of the transaction. Monetary assets and liabilities denominated in foreign currencies are translated to United States Dollars at the rates of exchange prevailing at the balance sheet dates. Any gains or losses arising from a change in exchange rates subsequent to the date of the transaction are included as an exchange gain or loss in the Consolidated Statements of Operations.

 

Share-based compensation

 

The Company accounts for options granted to non-employees at their fair value in accordance with SFAS No. 123R, Share Based Payment and EITF Abstracts Issue 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. Under SFAS No. 123R, share-based compensation is determined as the fair value of the equity instruments issued. The measurement date for these issuances is the earlier of the date at which a commitment for performance by the recipient to earn the equity instruments is reached or the date at which the recipient's performance is complete. Stock options granted to the “selling agents” in private equity placement transactions have been offset to the proceeds as a cost of capital. Stock options and stocks granted to other non-employees are recognized in the Consolidated Statements of Operations.

 

 

 

The Company has a stock option plan as described in Note 11. Compensation expense for options and stocks granted to employees is determined based on their fair values at the time of grant, the cost of which is recognized in the Consolidated Statements of Operations over the vesting periods of the respective options.

 

Share-based compensation incurred for the nine months ended December 31, 2008 and 2007 was $12,731,285 and $1,479,804, respectively.

 

Risks and uncertainties

 

The ability of the Company to realize the carrying value of its assets is dependent on being able to develop, transport and market oil and gas. Currently exports from the Republic of Kazakhstan are primarily dependent on transport routes either via rail, barge or pipeline, through Russian territory. Management believes that over the life of the project, transportation options will improve as additional pipelines and rail-related infrastructure is built that will increase transportation capacity to the world markets; however, there is no assurance that this will happen in the near future.

 

Recognition of revenue and cost

 

Revenue and associated costs from the sale of oil are charged to the period when persuasive evidence of an arrangement exists, the price to the buyer is fixed or determinable, collectability is reasonably assured, delivery of oil has occurred or when ownership title transfers. Produced but unsold products are recorded as inventory until sold.

 

Export duty

 

The formula for determining the amount of the crude oil export duty is based on a sliding scale that is tied to the world market price for oil. The amount of the export duty can change with fluctuations in world oil prices. The export duty fees are expensed as incurred and are classified as costs and operating expenses.

 

In December 2008 the Government issued a resolution that cancelled the export duty effective January 26, 2009 for companies operating under the new tax code. With the enactment of a new tax codes and an amendment to our contract, the Company became subject to two new taxes effective January 1, 2009:

 

 

 

 

 

Income taxes

 

The Company accounts for income taxes using the liability method. Under the liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. 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. Under the liability method, the effect on previously recorded deferred tax assets and liabilities resulting from a change in tax rates is recognized in earnings in the period in which the change is enacted.

 

Cash and cash equivalents

 

The Company considers all demand deposits, money market accounts and marketable securities purchased with an original maturity of three months or less to be cash and cash equivalents. The fair value of cash and cash equivalents approximates their carrying amounts due to their short-term maturity.

 

Prepaid expenses and other assets

 

Prepaid expenses and other assets are stated at their net realizable values after deducting provisions for uncollectible amounts. Such provisions reflect either specific cases or estimates based on evidence of collectability. The fair value of prepaid expense and other asset accounts approximates their carrying amounts due to their short-term maturity.

 

Prepayments for materials used in oil and gas projects

 

The Company periodically makes prepayments for materials used in oil and gas projects. These prepayments are presented as long term assets due to their transfer to oil and gas properties after materials are supplied and the prepayments are closed.

 

Inventories

 

Inventories of equipment for development activities, tangible drilling materials required for drilling operations, spare parts, diesel fuel, and various materials for use in oil field operations are recorded at the lower of cost and net realizable value. Under the full cost method, inventory is transferred to oil and gas properties when used in exploration, drilling and development operations in oilfields.

 

 

 

Inventories of crude oil are recorded at the lower of cost or net realizable value. Cost comprises direct materials and, where applicable, direct labor costs and overhead, which has been incurred in bringing the inventories to their present location and condition. Cost is calculated using the weighted average method. Net realizable value represents the estimated selling price less all estimated costs to completion and costs to be incurred in marketing, selling and distribution.

 

The Company periodically assesses its inventories for obsolete or slow moving stock and records an appropriate provision, if there is any. The Company has assessed inventory at December 31, 2008 and no provision for obsolete inventory has been provided.

 

Oil and gas properties

 

The Company follows the full cost method of accounting for its costs of acquisition, exploration and development of oil and gas properties.

 

Under full cost accounting rules, the net capitalized costs of evaluated oil and gas properties shall not exceed an amount equal to the present value of future net cash flows from estimated production of proved oil and gas reserves, based on current economic and operating conditions, including the use of oil and gas prices as of the end of the period.

 

Given the volatility of oil and gas prices, it is reasonably possible that the estimate of discounted future net cash flows from proved oil and gas reserves could change. If oil and gas prices decline, even if only for a short period of time, it is possible that impairments of oil and gas properties could occur. In addition, it is reasonably possible that impairments could occur if costs are incurred in excess of any increases in the cost ceiling, revisions to proved oil and gas reserves occur, or if properties are sold for proceeds less than the discounted present value of the related proved oil and gas reserves.

 

All geological and geophysical studies, with respect to the licensed territory, have been capitalized as part of the oil and gas properties.

 

The Company’s oil and gas properties primarily include the value of the license and other capitalized costs.

 

Depletion of producing properties is computed using the unit-of-production method based on estimated proved reserves.

 

 

 

Liquidation fund

 

Liquidation fund (site restoration and abandonment liability) is related primarily to the conservation and liquidation of the Company’s wells and similar activities related to its oil and gas properties, including site restoration. Management assessed an obligation related to these costs with sufficient certainty based on internally generated engineering estimates, current statutory requirements and industry practices. The Company recognized the estimated fair value of this liability. These estimated costs were recorded as an increase in the cost of oil and gas assets with a corresponding increase in the liquidation fund which is presented as a long-term liability. The oil and gas assets related to liquidation fund are depreciated on a unit-of-production basis separately for each field. An accretion expense, resulting from the changes in the liability due to passage of time by applying an interest method of allocation to the amount of the liability, is recorded as accretion expenses in the Consolidated Statement of Operations.

 

The adequacy of the liquidation fund is periodically reviewed in the light of current laws and regulations, and adjustments are made as necessary.

 

Other fixed assets

 

Other fixed assets are valued at historical cost adjusted for impairment loss less accumulated depreciation. Historical cost includes all direct costs associated with the acquisition of the fixed assets.

 

Depreciation of other fixed assets is calculated using the straight-line method based upon the following estimated useful lives:

 

 

Maintenance and repairs are charged to expense as incurred. Renewals and betterments are capitalized as leasehold improvements, which are amortized on a straight-line basis over the shorter of their estimated useful lives or the term of the lease.

 

Other fixed assets of the Company are evaluated annually for impairment. If the sum of expected undiscounted cash flows is less than net book value, unamortized costs of other fixed assets will be reduced to a fair value.

 

 

 

Convertible notes payable issue costs

 

In accordance with the Accounting Principles Board Opinion 21 “Interest on Receivables and Payables”, the Company recognizes convertible notes payable issue costs on the balance sheet as deferred charges, and amortizes the balance over the term of the related debt. The Company follows the guidance in the EITF 95-13 “Classification of Debt Issue Costs in the Statement of Cash Flows” and classifies cash payments for bond issue costs as a financing activity, where not capitalized as part of oil and gas properties.

 

Restricted cash

 

Restricted cash includes funds deposited in a Kazakhstan bank and is restricted to meet possible environmental obligations according to the regulations of the Republic of Kazakhstan.

 

Functional currency

 

The Company makes its principal investing and financing transactions in U.S. Dollars and the U.S. Dollar is therefore its functional currency.

 

Income per common share

 

Basic income per common share is computed by dividing net income by the weighted-average number of common shares outstanding during the period. Diluted income per share reflects the potential dilution that could occur if all contracts to issue common stock were converted into common stock, except for those that are anti-dilutive.

 

Recent accounting pronouncements

In May 2008, the FASB issued Statement No. 163, “Accounting for Financial Guarantee Insurance Contracts—an interpretation of FASB Statement No. 60”. This Statement requires that an insurance enterprise recognize a claim liability when the insurance enterprise expects, based on the present value of expected net cash outflows to be paid under the insurance contract discounted using a risk-free rate, that a claim loss will exceed the unearned premium revenue. That approach is similar to the recognition approach for some liabilities for future policy benefits relating to a long-duration insurance contract in Statement 60. An insurance enterprise is required to measure the claim liability equal to the present value of expected net cash outflows. Expected net cash outflows are probability-weighted cash flows that reflect the likelihood of all possible outcomes for payments by the insurance enterprise under the insurance contract. Under this Statement,   the   expected  net  cash   outflows   are  developed   using   the   insurance   enterprise’s   own

 

 

 

assumptions about the likelihood of all possible outcomes based on all information available to the insurance enterprise (including relevant market information). An insurance enterprise is required to provide expanded disclosures about financial guarantee insurance contracts. Those disclosures would focus, in part, on the information included in the risk-management activities used by the insurance enterprise to evaluate credit deterioration in its insured financial obligations, including (1) the groupings or categories used to track insured financial obligations with credit deterioration, (2) the insurance enterprise’s policies for placing an insured financial obligation in and monitoring each grouping or category, and (3) financial information about the insured financial obligations included within those groupings and categories. This Statement is effective for financial statements issued for the fiscal years and interim periods beginning after December 15, 2008. Management does not anticipate this Statement will impact the Company’s consolidated financial position or consolidated results of operations and cash flows.

 

In May 2008, the FASB issued Statement No. Statement No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” This Statement identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy). The Board does not expect that this Statement will result in a change in current practice. However, transition provisions have been provided in the unusual circumstance that the application of the provisions of this Statement results in a change in practice. This Statement is effective after 60 days following the SEC’s approval of the PCAOB amendment to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. Management does not anticipate this Statement will impact the Company’s consolidated financial position or consolidated results of operations and cash flows.

 

In March 2008, the FASB issued Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133”. This Statement requires that objectives for using derivative instruments be disclosed in terms of underlying risk and accounting designation. This disclosure better conveys the purpose of derivative use in terms of the risks that the entity is intending to manage. Disclosing the fair values of derivative instruments and their gains and losses in a tabular format should provide a more complete picture of the location in an entity’s financial statements of both the derivative positions existing at period end and the effect of using derivatives during the reporting period. Disclosing information about credit-risk-related contingent features should provide information on the potential effect on an entity’s liquidity from using derivatives. This Statement requires cross-referencing within the footnotes, which should help users of financial statements locate important information about derivative instruments. This Statement is effective for financial statements issued for the fiscal years and interim periods beginning after November 15, 2008. Management does not anticipate this Statement will impact the Company’s consolidated financial position or consolidated results of operations and cash flows.

 

 

 

In December 2007, the FASB issued Statement No. 160, “Non-controlling Interests in Consolidated Financial Statements”. This Statement requires the ownership interests in subsidiaries held by parties other than the parent be clearly identified, labeled, and presented in the consolidated statement of financial position within equity, but separate from the parent’s equity; the amount of consolidated net income attributable to the parent and to the non-controlling interest be clearly identified and presented on the face of the consolidated statement of income; changes in a parent’s ownership interest while the parent retains its controlling financial interest in its subsidiary be accounted for consistently; when a subsidiary is deconsolidated, any retained non-controlling equity investment in the former subsidiary be initially measured at fair value; entities provide sufficient disclosures that clearly identify and distinguish between the interests of the parent and the interests of the non-controlling owners. This Statement is effective for financial statements issued for the fiscal years beginning after December 15, 2008. Management does not anticipate this Statement will impact the Company’s consolidated financial position or consolidated results of operations and cash flows.

 

In December 2007, the FASB issued a revision of Statement No. 141 (R), “Business Combinations”. This Statement establishes principles and requirements for how the acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree; recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. This Statement applies prospectively to business combinations for which the acquisition date is after the beginning of the first annual reporting period beginning after December 15, 2008. Management does not anticipate this Statement will impact the Company’s consolidated financial position or consolidated results of operations and cash flows.

 

In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. In February 2008, the FASB issued FASB Staff Position (FSP FIN) No. 157-2 which extended the effective date for certain nonfinancial assets and nonfinancial liabilities to fiscal years beginning after November 15, 2008. The Company does not expect the adoption of SFAS No. 157 to have a material impact on the consolidated financial statements.

 

 

 

NOTE 3 - CASH AND CASH EQUIVALENTS

 

As of December 31, 2008 and March 31, 2008 cash and cash equivalents included:

 

 

As of December 31, 2008 and March 31, 2008 cash and cash equivalents included $3,169,573 and $14,203,574 placed in money market funds having 30 day simple yields of 0.61% and 2.58%, respectively.

 

NOTE 4 - PREPAID EXPENSES AND OTHER ASSETS

 

Prepaid expenses and other assets as of December 31, 2008 and March 31, 2008, were as follows:

 

 

 

 

 

NOTE 5 - OIL AND GAS PROPERTIES

 

Oil and gas properties using the full cost method as of December 31, 2008 and March 31, 2008, were as follows:

 

 

The purchase of Emir Oil LLP has been accounted for as a non-taxable business combination. Since goodwill was not recognized in this stock-based subsidiary acquisition involving oil and gas properties, a recognition of a deferred tax liability related to the acquisition increases the financial reporting basis of the oil and gas properties.

 

In November 2007 the Company entered into a consulting agreement with Caspian Energy Consulting Ltd. (“Consultant”). In addition to extending the existing exploration contract, which is described in Note 14, the consulting agreement provided that in the event the Consultant is successful in execution and delivery to the Company of a new exploration contract for a new contract territory, the Company will pay the amount of $4,000,000. As discussed in Note 19, the Consultant was successful in extending the Company’s contract territory. Due to the territory extension increasing the Company’s drilling area, as well as increasing possible reserves, these expenditures have been accrued and capitalized as part of oil and gas properties.

 

 

 

NOTE 6 – INVENTORIES FOR OIL AND GAS PROJECTS

 

As of December 31, 2008 and March 31, 2008 inventories included:

 

 

NOTE 7 - CONSTRUCTION IN PROGRESS

 

On April 13, 2006 the Company entered into an Agreement on Joint Business

(the “Agreement”) with Ecotechnic Chemicals AG incorporated in Switzerland, (“Ecotechnic”) for construction of a facility to utilize the associated gas from the Company’s fields (the “Facility”).

 

In accordance with terms of the Agreement, as of December 31, 2008 and March 31, 2008, the Company has made payments of $7,841,561 and $7,261,561, respectively, for development of project documentation, purchase of equipment, transportation and customs, and construction of a gas pipe-line.

 

NOTE 8 - LONG TERM VAT RECOVERABLE

 

As of December 31, 2008 and March 31, 2008 the Company had long term VAT recoverable in the amount of $8,784,501 and $8,106,397, respectively. The VAT recoverable is a Tenge denominated asset due from the Republic of Kazakhstan. The VAT recoverable consists of VAT paid on local expenditures and imported goods. VAT charged to the Company is recoverable in future periods as either cash refunds or offsets against the Company's fiscal obligations, including future income tax liabilities. Management cannot estimate which part of this asset will be realized in the current year because in order to return funds or offset this tax with other taxes a tax examination must be performed by local Kazakhstan tax authorities. During the nine months ended December 31, 2008 the Company received refunds of VAT in the amount of $2,818,787.

 

 

 

NOTE 9 - CONVERTIBLE NOTES PAYABLE

 

On July 16, 2007 the Company completed the private placement of $60 million in principal amount of 5.0% convertible senior notes due 2012 (“Notes”) to non-U.S. persons outside of the United States in accordance with Regulation S under the U.S. Securities Act of 1933, as amended (the “Securities Act”) and in compliance with the laws and regulations applicable in each country where the placement took place.

 

The Notes carry a 5% coupon and have a yield to maturity of 6.25%. Interest is paid at a rate of 5.0% per annum on the principal amount, payable semiannually in arrears on January 13 and July 13 of each year.

 

The Notes are convertible into the Company’s common shares. The initial conversion price was set at $7.2094 per share, subject to customary adjustments in certain circumstances, including but not limited to, changes of control and certain future equity financings. If the conversion price is adjusted pursuant to the conversion provisions, the conversion price shall not be adjusted below $6.95, provided that if the conversion price is adjusted due to (1) the payment of a dividend; (2) a bonus issue; (3) a consolidation or subdivision of the shares; (4) the issuance of shares, share-related securities, rights in respect of shares or rights in respect of share-related securities to all or substantially all of the shareholders as a class; (5) the issuance of other securities to substantially all shareholders as a class; or (6) other arrangements to acquire securities, then the minimum conversion price will be adjusted at the same time by the same proportion.

 

A change of control event occurs if an offer in respect of the Company’s common shares, for which the consideration is or can be received wholly or substantially in cash, has become or been declared unconditional in all respects and the Company becomes aware that the right to cast more than 50% of the votes which may ordinarily be cast on a poll at a general meeting of the shareholders has or will become unconditionally vested in the offeror and/or any associate(s) of the offeror, or an event occurs which has a like or similar effect. If a change of control event occurs, the conversion price in respect of a conversion date that occurs after the date on which notice of such change in control event is given by the Company, but on or prior to the 60th day following the date of such notice, shall become the product of (1) the conversion price that would otherwise apply on such conversion date in the absence of a change of control event and (2) the percentage determined in accordance with the following:

 

 

 

 

If a holder of notes shall convert its notes following the date on which notice of a change in control event is given by us but on or prior to the 60th day following the date of such notice, then we shall pay to such holder the following U.S. Dollar amounts per U.S. Dollar of notes held by the holder that are to be so converted.

 

 

The Notes are callable after three years at a price equal to 104% of the principal amount thereof plus any accrued and unpaid interest to the date fixed for redemption, subject to the share price trading at least 30% above the conversion price. Holders of the Notes will have the right to require the Company to redeem all or a portion of their Notes on July 13, 2010 at a price equal to 104% of the principal amount thereof plus any accrued and unpaid interest to the date fixed for redemption. Unless previously redeemed, converted or purchased and cancelled, the Notes will be redeemed by the Company at a price equal to 107.2% of the principal amount thereof on July 13, 2012. The Notes constitute direct, unsubordinated and unsecured, interest bearing obligations of the Company.

 

The net proceeds from the issuance of the Notes have been used for further exploration of the Company’s oil and gas drilling and production activities in western Kazakhstan.

 

The Company granted a registration right to the Noteholders. The Company agreed to file, pursue to effectiveness and maintain effective a registration statement in respect of the Notes and the underlying shares of common stock issuable upon the conversion of the Notes (collectively, the “Covered Securities”), until such time as all Covered Securities:

 

 

 

 

 

 

 

On October 19, 2007 the Company filed with the U.S. Securities and Exchange Commission (“SEC”) a registration statement on Form S-3, as amended on October 25, 2007 and January 23, 2008, (the “Shelf Registration Statement”) registering the Covered Securities for resale. The Shelf Registration Statement was declared effective by the SEC on January 25, 2008.

 

As of December 31, 2008 and March 31, 2008 the Company has accrued interest of $1,391,667 and $641,667, respectively, relating to the convertible notes outstanding. The Company has also amortized the discount on the convertible notes (difference between the redemption amount and the carrying amount as of the date of issue) in the amount of $1,132,109 and $535,455 as of December 31, 2008 and March 31, 2008, respectively. The carrying value of convertible notes will be accreted to the redemption value of $64,323,785.

 

As of December 31, 2008 and March 31, 2008 the convertible notes payable amount is presented as follows:

 

 

In accordance with SFAS No. 34, Capitalization of Interest and FIN 33, Applying FASB Statement No. 34 to Oil and Gas Producing Operations Accounted for by the Full Cost Method and Interpretation of FASB Statement No. 34, accrued interest expense in the amount of $2,250,000 and accretion expense relating to the discount on convertible notes (difference between the redemption amount and the carrying amount as of the date of issue) in the amount of $596,654 was capitalized to oil and gas properties for the nine months ended December 31, 2008.

 

 

 

 

NOTE 10 - LIQUIDATION FUND

 

A reconciliation on the Liquidation Fund (Asset Retirement Obligation) at December 31, 2008 and March 31, 2008 is as follows:

 

Management believes that the liquidation fund should be accrued for future abandonment costs of 24 wells located in the Dolinnoe, Aksaz, Emir and Kariman oil fields. Management believes that these obligations are likely to be settled at the end of the production phase at these oil fields.

 

At December 31, 2008, undiscounted expected future cash flows that will be required to satisfy the Company’s obligation by 2013 for the Dolinnoe, Aksaz, Emir and Kariman fields, respectively, are $7,306,125. After application of a 10% discount rate, the present value of the Company’s liability at December 31, 2008 and March 31, 2008 was $4,897,510 and $3,728,531, respectively.

 

NOTE 11 - SHARE AND ADDITIONAL PAID IN CAPITAL

 

Share-Based Compensation

 

On July 17, 2008 the shareholders of the Company approved the BMB Munai, Inc. 2009 Equity Incentive Plan (“2009 Plan”) to provide a means whereby the Company could attract and retain employees, directors, officers and others upon whom the responsibility for the successful operations of the Company rests through the issuance of equity awards. 5,000,000 common shares are reserved for issuance under the 2009 Plan. Under the terms of the 2009 Plan the Board determines the terms of the awards made under the 2009 Plan, within the limits set forth in the 2009 Plan guidelines.

 

Common Stock Grants

 

On March 30, 2007, the Company granted common stock to officers, employees and outside consultants of the Company under the Plan. The total number of restricted common shares granted was 950,000. The restricted stock grants were valued at $5.38 per share. The restricted stock grants were awarded on the same terms and subject to the same vesting requirements. Previous vesting conditions stated that the restricted stock grants will vest to the grantees at such time as either of the following

 

 

 

events occurs (the "Vesting Events"): i) the Company enters commercial production and is granted a commercial production license from the Republic of Kazakhstan; or ii) the occurrence of an Extraordinary Event. An “Extraordinary Event” is defined in the restricted stock agreement as any consolidation or merger of the Company or any of its subsidiaries with another person, or any acquisition of the Company or any of its subsidiaries by any person or group of persons, acting in concert, equal to thirty percent (30%) or more of the outstanding stock of the Company or any of its subsidiaries, or the sale of all or substantially all of the assets of the Company or any of its subsidiaries. In the event of an Extraordinary Event, the grants shall be deemed full vested one day prior to the effective date of the Extraordinary Event. The Board of Directors shall determine conclusively whether or not an Extraordinary Event has occurred and the grantees have agreed to be bound by the determination of the Board of Directors. The grantees have the right to vote the shares, receive dividends and enjoy all other rights of ownership over the entire grant amount from the grant date, except for the right to transfer, assign, pledge, encumber, dispose of or otherwise directly or indirectly profit or share in any profit derived from a transaction in the shares prior to the occurrence of a Vesting Event. Shares will only vest to the grantee if the grantee is employed by the Company at the time a Vesting Event occurs. If a Vesting Event has not occurred at the time a grantee's employment with the Company ceases, for any reason, the entire grant amount shall be forfeited back to the Company. At the time the grants were made, it was anticipated that the grants would vest no later than July 9, 2009, the date the exploration stage of the Company’s exploration contract was scheduled to terminate. At the recommendation of the Compensation Committee, on September 11, 2008, the board of directors of the Company approved a change to the vesting conditions of the stock grants. The grants will now vest on the earlier of July 9, 2009 and the occurrence of an Extraordinary Event.

 

Compensation expense in the amount of $1,703,667 was recognized in the Consolidated Statement of Operations and Consolidated Balance Sheet for the nine months ended December 31, 2008.

 

As of December 31, 2008, there was $1,135,778 of total unrecognized non-cash compensation expense related to non-vested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of 0.5 years.

 

As further discussed in Note 14, on June 24, 2008, the Company was granted an extension of its existing exploration contract from July 2009 to January 2013. In connection therewith, the Company became obligated to issue 1,750,000 common shares to a consultant as the success fee for assisting the Company to obtain the extension. The shares are valued at $6.13 per share, which was the closing market price of Company’s shares on June 24, 2008.

 

 

 

On September 16, 2008 this consulting agreement between the Company and the consultant discussed in the preceding paragraph was revised and parties agreed to decrease number of shares issued for services provided by 500,000 shares. The non-cash compensation expenses for consulting services were reversed in the amount of $3,065,000 (500,000 shares valued at $6.13 per share which was the closing market price of Company’s shares on June 24, 2008) for the three months ended September 30, 2008.

 

On July 17, 2008 at the recommendation of the compensation committee of the board of directors, the Company’s board of directors approved, subject to certain vesting requirements, restricted stock awards to certain executive officers, directors, employees and outside consultants of the Company pursuant to the BMB Munai, Inc. 2004 Stock Incentive Plan (the “2004 Plan”). The total number of shares granted was 1,330,000. Grants were made to 14 people, 12 of whom are non-U.S. persons. The restricted stock grants were made without registration pursuant to Regulation S of the Securities Act Rules and/or Section 4(2) under the Securities Act of 1933. The restricted stock grants will vest to the grantees at such time as either of the following events occurs (the “Vesting Events”): i) the one-year anniversary of the grant date; or ii) the occurrence of an Extraordinary Event. An “Extraordinary Event” is defined in the restricted stock agreement as any consolidation or merger of the Company or any of its subsidiaries with another person, or any acquisition of the Company or any of its subsidiaries by any person or group of persons, acting in concert, equal to thirty percent (30%) or more of the outstanding stock of the Company or any of its subsidiaries, or the sale of all or substantially all of the assets of the Company or any of its subsidiaries. In the event of an Extraordinary Event, the grants shall be deemed full vested one day prior to the effective date of the Extraordinary Event. The Board of Directors shall determine conclusively whether or not an Extraordinary Event has occurred and the grantees have agreed to be bound by the determination of the Board of Directors. The shares representing the restricted stock grants shall be issued as soon as practicable, will be deemed outstanding from the date of grant, and will be held in escrow by the Company subject to the occurrence of a Vesting Event. The grantees will have the right to vote the shares, receive dividends and enjoy all other rights of ownership over the entire grant amount from the grant date, except for the right to transfer, assign, pledge, encumber, dispose of or otherwise directly or indirectly profit or share in any profit derived from a transaction in the shares prior to the occurrence of a Vesting Event. Shares will only vest to the grantee if the grantee is employed by the Company at the time a Vesting Event occurs. If a Vesting Event has not occurred at the time a grantee’s employment with the Company ceases, for any reason, the entire grant amount shall be forfeited back to the Company.

 

 

 

Non-cash compensation expense in the amount of $3,365,118 was recognized in the Consolidated Statement of Operations and Consolidated Balance Sheet for the nine months ended December 31, 2008.

 

As of December 31, 2008, there was $3,989,782 of total unrecognized non-cash compensation expense related to non-vested share-based compensation arrangements granted under the Plan. That cost is expected to be recognized over a weighted-average period of 0.5 years.

 

Stock Options

 

Stock options outstanding and exercisable as of December 31, 2008, were as follows:

 

 

Additional information regarding outstanding options as of December 31, 2008, was as follows:

 

 

Warrants

 

On November 26, 2003, the Company granted warrants to placement agents in connection with funds raised on the Company’s behalf. These warrants granted the placement agents the right to purchase up to 142,857 shares of the Company’s common stock at an exercise price of $3.50 per share. These warrants have been offset to the proceeds as a cost of capital. On July 28, 2008, 14,286 of these warrants were exercised. The remaining warrants for 38,094 shares expired at the end of November 2008.

 

 

 

Warrants outstanding and exercisable as of December 31, 2008 were as follows:

 

 

 

NOTE 12 – REVENUES

 

The Company exports oil for sale to the world markets via the Aktau sea port. Sales prices at the port locations are based on the average quoted Brent crude oil price from Platt's Crude Oil Marketwire for the three days following the bill of lading date less discount for transportation expenses, freight charges and other expenses borne by the customer.

 

The Company sold its crude oil to the domestic market during November and December 2008, since netbacks on domestic market sales were more attractive than on export sales.

 

 

NOTE 13 – EXPORT DUTY

 

On April 18, 2008 the government of the Republic of Kazakhstan introduced an export duty on several products (including crude oil). The Company became subject to the duty beginning in June 2008. The export duty for nine month ended December 31, 2008 amounted to $7,912,459, which is being reported as a part of operating expenses. The formula for determining the amount of the crude oil export duty was based on a sliding scale that is tied to several factors, including the world market price for oil.

 

 

 

As discussed in Note 2, in December 2008 the government of the Republic of Kazakhstan issued a resolution that cancelled the export duty effective January 26, 2009 for companies operating under the new tax code.

 

NOTE 14 - CONSULTING EXPENSES

 

On November 19, 2007 the Company entered into a consulting agreement with Caspian Energy Consulting Ltd (“Consultant”). Upon the execution of the consulting agreement, the Company paid the Consultant $1,000,000. The consulting agreement also provided that in the event the Consultant was successful in negotiating an extension of the term of the Company’s existing exploration contract beyond July 2009, the Company would issue 500,000 common shares for each additional year of exploration status extension granted beyond July 2009.

 

On June 24, 2008, the Company was granted an extension of its existing exploration contract from July 2009 to January 2013. The compensation expenses for consulting services were recorded in the amount of $11,727,500, which represents $1,000,000 paid upon the execution of consulting agreement and non-cash share-based compensation in the amount of $10,727,500 as the successful fee for extension of time period for exploration. The share-based compensation represents 1,750,000 (500,000 shares for each additional year of exploration status extension) valued at $6.13 per share which was the closing market price of Company’s shares on June 24, 2008.

 

On September 16, 2008 this consulting agreement was revised and the parties agreed to decrease the number of shares issued for services provided by 500,000 shares to 1,250,000 shares. Non-cash compensation expenses for consulting services were reversed in the amount of $3,065,000 (500,000 shares valued at $6.13 per share which was the closing market price of Company’s shares on June 24, 2008) for the three months ended September 30, 2008.

 

The agreement also has a provision for the Consultant to pursue new exploration contracts for new territories, which is described in Note 19.

 

NOTE 15 – DISGORGEMENT FUNDS RECEIVED

 

In June 2008 the Company received a letter from a shareholder of the Company stating that the shareholder was returning realized profits from their trades of shares of the Company’s common stock during the nine month period preceding May 22, 2008 (the “Timeframe”). The shareholder also stated in the letter that during this Timeframe the shareholder was subject to Section 16 of the United States Security

 

 

 

Exchange Act of 1934 (the “Exchange Act”) because they owned more than 10% of the shares of Company common stock. As such, the shareholder decided to voluntarily comply with Section 16(b) of the Exchange Act by returning the realized profits to the Company in the amount of $1,650,293, (the “Disgorgement Amount”) which is net of amounts paid for brokerage commissions on each of the executed trades during the Timeframe. The Company had received the Disgorgement Amount in full before June 30, 2008.

 

NOTE 16 – INCOME TAXES

 

The Company’s consolidated pre-tax income is comprised primarily from operations in the Republic of Kazakhstan. Pre-tax losses from United States operations are also included in consolidated pre-tax income.

 

According to the Exploration Contract in the Republic of Kazakhstan, for income tax purposes the Company can capitalize the exploration and development costs and deduct all revenues received during the exploration stage to calculate taxable income. Therefore, the Exploration Contract allows the Company to be exempt from Kazakhstan corporate income tax for the period of the exploration phase.

 

Earnings of the Company’s foreign subsidiaries, since acquisition, have been undistributed. Those earnings are considered to be indefinitely reinvested and, accordingly, no U.S. federal and state income taxes have been provided thereon. Upon distribution of those earnings, in the form of dividends or otherwise, the Company would be subject to both U.S. income taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable to the Republic of Kazakhstan. Determination of the amount of unrecognized deferred U.S. income tax liability is not practical because of the complexities associated with its hypothetical calculation; however, unrecognized foreign tax credits may be available to reduce a portion of the U.S. tax liability.

 

No provision for income taxes has been recorded by the Company for the nine months ended December 31, 2008.

 

 

 

NOTE 17 - EARNINGS PER SHARE INFORMATION

 

The calculation of the basic and diluted earnings per share is based on the following data:

 

 

The dilutive weighted average common shares outstanding for the three and nine months ended December 31, 2008 does not include the effect of the potential conversion of the Notes because the average market share price for three and nine months ended December 31, 2008 was lower than potential conversion price of the convertible notes for this period.

 

The dilutive weighted average common shares outstanding for the three and nine months ended December 31, 2008 does not include the effect of potential conversion of certain warrants and stock options as their effects are anti-dilutive.

 

The dilutive weighted average common shares outstanding for the three and nine months ended December 31, 2007 does not include the effect of the potential conversion of the Notes because conversion of the Notes is not contingent upon any market event. Rather, the Notes are convertible to common stock upon the first to occur of (a) the tenth New York business day following the Shelf Registration Statement Effective Date and (b) 13 July 2008.

 

 

 

NOTE 18 - RELATED PARTY TRANSACTIONS

 

The Company leases ground fuel tanks and other oil fuel storage facilities and warehouses from Term Oil LLC. The lease expenses for the three months ended December 31, 2008 and 2007, totaled to $50,516 and $61,109, respectively. Also the Company had accounts payable to Term Oil LLC in the amount of $174,945 and $53,624 as of December 31, 2008 and March 31, 2008, respectively. One of our significant shareholders and the director of Emir Oil LLP is the owner of Term Oil LLC.

 

NOTE 19 - COMMITMENTS AND CONTINGENCIES

 

Consulting Agreement

 

On October 15, 2008 the MEMR increased Emir Oil LLP’s contract territory from 460 square kilometers to 850 square kilometers. In connection with this extension, and any other territory extensions or acquisitions, the Consultant will be paid a share payment in restricted common stock for resources and reserves associated with any acquisition. The value of any acquisition property will be determined by reference to a 3D seismic study and a resource/reserve report by a qualified independent petroleum engineer acceptable to the Company. The acquisition value (“Acquisition Value”) will be equal to the total barrels of resources and reserves, as defined and determined by the engineering report multiplied by the following values:

 

Resources at $.50 per barrel;

Probable reserves at $1.00 per barrel; and

Proved reserve at $2.00 per barrel.

 

The number of shares to be issued to the Consultant shall be the Acquisition Value divided by the higher of $6.50 or the average closing price of the Company’s trading shares for the five trading days prior to the issuance of the reserve/resource report, provided that in no event shall the total number of shares issuable to the Consultant exceed more than a total of 4,000,000 shares.

 

Historical Investments by the Government of the Republic of Kazakhstan

 

The Government of the Republic of Kazakhstan made historical investments in the ADE Block and the Southeast Block of $5,994,200 and $5,350,680, respectively. When and if, the Company applies for and, when and if, it is granted commercial production rights for the ADE Block and Southeast Block, the Company will be required to begin repaying these historical investments to the Government. The terms of repayment will be negotiated at the time the Company is granted commercial production rights.

 

 

 

Capital Commitments

 

Prior to the extension of the exploration period granted to Emir Oil LLP in June 2008, the terms of its subsurface exploration contract, required Emir Oil to spend a total of $48.8 million in exploration activities on the ADE Block and Southeast Block through July 2009. Through December 31, 2008 the Company had spent a total of $254.4 million in exploration activities.

 

In connection with the extensions granted in June and October 2008, the Company’s capital expenditure requirements have been revised. To retain its rights under the contract, the Company must spend $10.4 million by January 9, 2010. The Company must spend an additional $21.3 between January 10, 2010 and January 9, 2011, $27.2 million between January 10, 2011 and January 9, 2012 and $14.9 million between January 10, 2012 and January 9, 2013.

 

In addition to the minimum capital expenditure requirement, the Company must also comply with the other terms of the work program associated with the contract, which includes the drilling of at least ten new wells by January 9, 2013. The failure to meet the minimum capital expenditures or to comply with the terms of the work program could result in the loss of the subsurface exploration contract. The recent addendum to the Contract granting the territory extension also requires us to:

 

 

Litigation

 

In December 2003, a complaint was filed in the 15th Judicial Court in and for Palm Beach County, Florida, naming, among others, the Company and former directors, Georges Benarroch and Alexandre Agaian, as defendants. The plaintiffs, Brian Savage, Thomas Sinclair and Sokol Holdings, Inc. allege claims of breach of contract, unjust enrichment, breach of fiduciary duty, conversion and violation of a Florida trade secret statute in connection with a business plan for the development of the Aksaz, Dolinnoe and Emir oil and gas fields owned by Emir Oil, LLP. The parties mutually agreed to dismiss this lawsuit without prejudice.

 

In April 2005, Sokol Holdings, Inc., also filed a complaint in United States District Court, Southern District of New York alleging that BMB Munai, Inc., Boris Cherdabayev, and former BMB directors Alexandre Agaian, Bakhytbek Baiseitov, Mirgali Kunayev and Georges Benarroch wrongfully induced Toleush Tolmakov to breach a contract under which Mr. Tolmakov had agreed to sell to Sokol 70% of his 90% interest in Emir Oil LLP.

 

 

 

In October and November 2005, Sokol Holdings filed amendments to its complaint in the U.S. District Court in New York to add Brian Savage and Thomas Sinclair as plaintiffs and to add Credifinance Capital, Inc., and Credifinance Securities, Ltd., (collectively “Credifinance”) as defendants in the matter. The amended complaints alleged: i) tortious interference with contract, specific performance, breach of contract, unjust enrichment, unfair competition-misappropriation of labors and expenditures against all defendants; ii) breach of fiduciary duty, tortious interference with fiduciary duty and aiding and abetting breach of fiduciary duty by Mr. Agaian, Mr. Benarroch and Credifinance; and iii) breach of fiduciary duty by Mr. Cherdabayev, Mr. Kunayev and Mr. Baiseitov, in connection with a business plan for the development of the Aksaz, Dolinnoe and Emir oil and gas fields owned by Emir Oil, LLP. The plaintiffs have not named Toleush Tolmakov as a defendant in the action nor have the plaintiffs ever brought claims against Mr. Tolmakov to establish the existence or breach of any legally binding agreement between the plaintiffs and Mr. Tolmakov. The plaintiffs seek damages in an amount to be determined at trial, punitive damages, specific performance and such other relief as the Court finds just and reasonable.

 

The Company moved for dismissal of the amended complaint or for a stay pending arbitration in Kazakhstan. That motion was denied, without prejudice to renewing it, to enable defendants to produce documents to plaintiffs relating to the issues raised in the motion. Following completion of document production, the motion was renewed. Briefing on the motion was completed on August 24, 2006. On June 14, 2007, the court ruled on our motion. The court (a) denied the motion to dismiss on the ground that Kazakhstan is a more convenient forum; (b) denied the motion to dismiss in favor of litigation in New York state court; (c) denied the motion to stay pending arbitration in Kazakhstan; and (d) denied the motion to dismiss on the ground that Mr. Tolmakov is an indispensable party. The court also (a) denied the motion (by defendants other than the Company) to dismiss for lack of personal jurisdiction and (b) granted the motion (by defendants other than the Company) to dismiss several claims for relief alleging breach of fiduciary duty, tortious interference with fiduciary duty and aiding and abetting breach of fiduciary duty. The court dismissed as moot the Company’s cross-motion to stay discovery and instructed the parties to comply with the Magistrate Judge’s discovery schedule.

 

The Company appealed the court’s refusal to stay the litigation pending arbitration in Kazakhstan. On September 28, 2008, the Court of Appeals issued a decision in which it (a) reversed the district court's refusal to stay the claim for specific performance pending arbitration and (b) affirmed the balance of the district court's order.

 

During the quarter, the Company changed its legal counsel to represent all defendants in the lawsuit from Bracewell & Giuliani LLP in New York, New York to Manning, Curtis, Bradshaw & Bednar LLC in Salt Lake City, Utah.

 

 

 

On December 12, 2008, plaintiffs sought leave to file a Third Amended Complaint to add claims for (a) breach of fiduciary duty against defendants Cherdabayev, Kunayev, Baiseitov, Agaian, Benarroch and Credifinance based on these defendants’ alleged role as promoters of Sokol, (b) fraud against all defendants; and (c) promissory estoppel against defendants Cherdabayev, Kunayev and Baiseitov. Defendants opposed the Motion for Leave to Amend. That motion has been fully briefed but it has not yet been decided by the court. Fact discovery on the existing claims has been completed and the parties are now conducting expert discovery and reports. No trial date has been established.

 

Economic Environment

 

In recent years, Kazakhstan has undergone substantial political and economic change. As an emerging market, Kazakhstan does not possess a well-developed business infrastructure, which generally exists in a more mature free market economy. As a result, operations carried out in Kazakhstan can involve significant risks, which are not typically associated with those in developed markets. Instability in the market reform process could subject the Company to unpredictable changes in the basic business infrastructure in which it currently operates. Uncertainties regarding the political, legal, tax or regulatory environment, including the potential for adverse changes in any of these factors could affect the Company’s ability to operate commercially. Management is unable to estimate what changes may occur or the resulting effect of such changes on the Company’s financial condition or future results of operations.

 

Legislation and regulations regarding taxation, foreign currency translation, and licensing of foreign currency loans in the Republic of Kazakhstan continue to evolve as the central government manages the transformation from a command to a market-oriented economy. The various legislation and regulations are not always clearly written and their interpretation is subject to the opinions of the local tax inspectors. Instances of inconsistent opinions between local, regional and national tax authorities are not unusual.

 

NOTE 20 - FINANCIAL INSTRUMENTS

 

As of December 31, 2008 and March 31, 2008 cash and cash equivalents included deposits in Kazakhstan banks in the amount $688,920 and $2,211,352, respectively, and deposits in U.S. banks in the amount of $6,784,740 and $15,027,485, respectively. Kazakhstan banks are not covered by FDIC insurance, nor does the Republic of Kazakhstan have an insurance program similar to FDIC. Therefore, the full amount of our deposits in Kazakhstan banks was uninsured as of December 31, 2008 and March 31, 2008. The Company’s deposits in U.S. banks are also in non-FDIC insured accounts which means they too are not insured to the $250,000 FDIC insurance limit. To mitigate this risk, the Company has placed all of its U.S. deposits in a money market account that invests in U.S. government backed securities. As of December 31, 2008 and March 31, 2008 the Company made advance payments to Kazakhstan companies and government bodies in the amount $12,101,945 and $21,266,329, respectively. As of December 31, 2008 and March 31, 2008 restricted cash reflected in the long-term assets consisted of $737,402 and $622,697, respectively, deposited in a Kazakhstan bank and restricted to meet possible environmental obligations according to the regulations of Kazakhstan. Furthermore, the primary asset of the Company is Emir Oil LLP; an entity formed under the laws of the Republic of Kazakhstan.

 

 

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

 

The following discussion is intended to assist you in understanding our results of operations and our present financial condition. Our Consolidated Financial Statements and the accompanying notes included in this Form 10-Q contain additional information that should be referred to when reviewing this material and this document should be read in conjunction with the Form 10-K of the Company for the year ended March 31, 2008.

 

Statements in this discussion may be forward-looking. These forward-looking statements involve risks and uncertainties, including those discussed below, which could cause actual results to differ from those expressed.

 

Cautionary Note Regarding Forward-Looking Statements

 

This report includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Rule 175 promulgated thereunder, that involve inherent risks and uncertainties. Words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “estimate,” “seek,” “could,” “should,” “predict,” “continue,” “future,” “may” and variations of such words and similar expressions are intended to identify such forward-looking statements. Forward-looking statements involve known and unknown risks, uncertainties, assumptions, estimates and other factors that could cause actual results, performance or events to differ materially from any results, performance or events expressed or implied by such forward-looking statements. All forward-looking statements are qualified in their entirety by reference to the factors discussed in this report and identified from time to time in our filings with the SEC including, among others, the following risk factors:

 

 

 

 

The above factors may affect future results, performance, events and the accuracy of any forward-looking statement. This list is illustrative but not exhaustive. In addition, new risks and uncertainties may arise from time to time. Accordingly, readers should not place undue reliance on any forward-looking statement.

 

Any forward-looking statement speaks only as of the date on which it is made and is expressly qualified by these cautionary statements. Except as may be required by law, we undertake no obligation to publicly update or revise any forward-looking statement for any reason or to update the reasons actual results could differ materially from those anticipated in such forward-looking statements, even if new information becomes available in the future.

 

Overview

 

BMB Munai is an independent oil and natural gas company engaged in the exploration, development, acquisition and production of crude oil and natural gas properties in the Republic of Kazakhstan (sometimes also referred to herein as the “ROK” or “Kazakhstan”). We hold a contract that allows us to explore and develop approximately 850 square kilometers in western Kazakhstan. Our contract grants us the right to explore and develop the ADE Block, which includes the Aksaz, Dolinnoe and Emir oil and gas fields, the Southeast Block, which includes the Kariman oil and gas field and the Borly and Yessen structures, and the recently granted territory referred to herein as the Northwest Block. The ADE Block, the Southeast Block and the Northwest Block are collectively referred to herein as “our properties.”

 

Exploration Stage Activities

 

Under the statutory scheme in Kazakhstan prospective, oil fields are developed in two stages. The first stage is exploration stage. During this stage the primary focus is on the search for commercial discoveries, i.e., discoveries of sufficient quantities of oil and gas to make it commercially feasible to pursue execution of, or transition to, a commercial production contract with the government.

 

As discussed above, we are currently engaged in exploration of our properties and are working to satisfy the requirements to move to commercial production. Based on discussions with the MEMR, the MEMR expects a contract holder to engage in three primary activities during exploration stage before it will be granted commercial production rights. These activities fall within three primary areas:

 

 

 

Minimum Work Program Requirements

 

In order to be assured that adequate exploration activities are undertaken during exploration stage, the MEMR establishes an annual mandatory minimum work program to be accomplished in each year of the exploration contract. Under the minimum work program the contractor is required to invest a minimum dollar amount in exploration activities within the contract territory, which may include geophysical studies, construction of field infrastructure or drilling activities. During the exploration stage, the contractor is also required to drill sufficient wells in each field to establish the existence of commercially producible reserves in any field for which it seeks a commercial production license. Failure to complete the minimum work program requirements for any particular field during the term of the exploration contract could preclude the contractor from receiving a longer-term production contract for such field, regardless the success of the contractor in proving commercial reserves during the partial fulfillment of the minimum work program.

 

The contract we hold follows the above format. The contract sets the minimum dollar amount we must expend during each year of our work program. Under our exploration license our work program year ends on July 9 each year until July 9, 2009. Thereafter our work program year end changes to January 9 of each year. Therefore our work program year does not coincide with our fiscal year. As a result of these timing differences, the amounts reflected in the table below as “Actually Made” may differ from amounts disclosed elsewhere in our Management’s Discussion and Analysis or Consolidated Financial Statements, which present figures based on our fiscal year rather than our work program year.

 

 

* Investment as of December 31, 2008.

 

As reflected in the above table, in connection with the extension of the term and territory of our exploration contract, we agreed to expend not less than $74.1 million dollars in additional work program activities through January 9, 2013.

 

 

Under the rules of the MEMR there is an option for expenditures above the minimum requirements in one period to be carried over to meet minimum obligations in future periods. As the above chart shows we have significantly exceeded the minimum expenditure requirement in each period of the contract and have more than doubled the total minimum capital expenditure requirement during the exploration stage.

 

In addition to mandatory minimum capital expenditures in each year, exploration contracts typically require the contract holder to drill a certain number of wells in each structure for which it plans to seek commercial production rights.

 

In Kazakhstan, typically, one exploratory well and two appraisal wells are sufficient to support a claim of commercially producible reserves in a particular field, although in some cases, commercial reserves have been demonstrated with fewer wells. The total number of wells the MEMR requires during exploration stage is generally determined by the number of fields or structures identified by the seismic studies done on a territory. 3D seismic studies completed on the ADE Block and the Southeast Block, have identified six potential fields or structures. We plan to perform 3D seismic studies on the Northwest Block to identify potential structures in that Block.

 

To date, we have drilled a total of 24 wells; - five wells in the Aksaz field, six wells in the Dolinnoe field, three wells in the Emir field and ten wells in the Kariman field.

 

Pursuant to the terms of the extensions of our exploration contract, we will be required to drill not less than ten new wells, in addition to those that are currently in progress, by January 9, 2013, to determine the existence of commercially producible reserves within the various structures in our license territory. In addition to these wells, we anticipate we will be required to drill at least three wells in each structure that we intend to move to commercial production.

 

Establishing the Existence of Commercially Producible Reserves

 

Establishing the existence of commercially producible reserves is accomplished through drilling wells and engaging in test production of those wells during the exploration stage. We have established the presence of oil and/or natural gas in each of the Aksaz, Dolinnoe, Emir and Kariman fields and are engaged in testing to gather the necessary data and to determine whether commercially producible reserves exist in any of those fields. We have not drilled wells in the other structures in the Southeast Block or in the Northwest Block. The failure to establish commercially producible reserves within any particular field would not preclude us from applying for commercial production rights to other fields within our contract territory where we establish commercially producible reserves.

 

 

Preparation, Submission and Approval of a Development Plan

 

Our goal during exploration stage is to study the geology and geophysical characteristics of each field and individual well, with a view to qualifying for a longer-term commercial production contract. Once we complete drilling of a well, our emphasis focuses on an extended period of testing the well’s production characteristics and capacities to evaluate its commercial viability and determine the best method for producing oil from the well and to gain insight into the further development of the entire field. During this stage of exploration, oil production is subject to wide fluctuations caused by varying pressures commonly experienced by new wells and by significant periods of well closure to accommodate various mandatory testing. In the event a well proves to be commercially viable, the data gathered during these testing procedures will be submitted by us to a third-party independent petroleum institute in Kazakhstan and will be the basis for preparing a development plan. The development plan, which is submitted to the MEMR for review and approval, sets forth the parameters and guidelines for future commercial production and ongoing development of each field.

 

Taxes, Royalties and Duties

 

During exploration stage, we have the right to sell the oil and natural gas we recover during test production. As noted above, under our original contract, we had been granted tax stability and were not required to pay export taxes. We were, however, required to pay a royalty at rates tied to annual crude oil production. In connection with the extension of the term of our exploration contract and the adoption of a new tax code in the Republic of Kazakhstan, we were required to renegotiate the taxes and royalties we pay. Consistent with the terms of our agreement with the government at the time the extension of our contract was granted, on January 16, 2009 we entered into Addendum No. 7 to our contract which provides that we agree to be subject to the provisions of the new tax effective from January 1, 2009.

 

The description of Addendum No. 7 in this report is only a summary of that document and is qualified in its entirety by reference to the terms of Addendum No. 7, a copy of which is attached as an exhibit to this report.

 

As noted above, in June 2008 we became subject to a crude oil export duty on all oil sold outside the Kazakhstan domestic market. In December 2008 the government of the Republic of Kazakhstan issued a resolution that cancelled the export duty effective January 26, 2009.

 

With the amendment to our contract, we became subject to two new taxes enacted under the of the new tax code, effective January 1, 2009:

 

 

 

We are currently evaluating the implications of the new tax code and how the changes may impact our results of operations. Under the new code, the amount we pay will be directly impacted by the price per barrel of oil. Based on our initial assessment, we believe at current world oil prices our tax obligations will be lower under the new tax code than under the export duty.

 

Drilling Operations

 

During the quarter ended December 31, 2008 we engaged in drilling operations on 4 wells: Aksaz-2 and 6, Kariman-11 and Dolinnoe-7.

 

We completed drilling of Dolinnoe-7 on September 11, 2008 to a depth of 3,756 meters; drilling of Aksaz-2 on September 25, 2008 to a depth of 4,292 meters; completed drilling of Kariman-11 on November 2, 2008 to a depth of 3,580 meters and Aksaz-6 on December 28, 2008, to a total depth of 4,330 meters. Upon completion of drilling, we have commenced extensive testing activities on each well, including necessary geological studies and tests. These activities are ongoing.

 

Well Performance and Production

 

The following table sets forth the number of oil and natural gas wells in which we owned an interest as of December 31, 2008.

 

 

As of the fiscal quarter ended December 31, 2008, each of the 24 wells identified above was in test production, testing or under/awaiting workover.

 

According to the laws of the Republic of Kazakhstan, we are required to test every prospective target on our properties separately, this includes the completion of well surveys on different modes with various choke sizes on each horizon.

 

In the course of well testing, when the transfer from target to target occurs, the well must be shut in; oil production ceases for the period of mobilization/demobilization of the workover rig, pull out of the hole, run in the hole, perforation, packer installation time, etc. This has the effect of artificially diminishing production rates averaged over a set period of time.

 

 

Following is a brief description of the current production status of each of our 24 wells.

 

 

 

 

 

During the quarter ending December 31, 2008, we revised our planned capital expenditure program for the remainder of the current and the upcoming fiscal year to significantly reduce our planned capital expenditures. This decision is based on several factors.

 

During the past several years we have pursued an aggressive capital expenditure and drilling program. We pursued this aggressive strategy, in part, because if we did not complete our exploration activities and move our contract territory to commercial production by July 2009, our rights to the contract territory could have been terminated and reverted back to the government of the Republic of Kazakhstan. With the grant of the extension of time to complete exploration activities, to January 2013, we now have more flexibility in the pace of our exploration drilling efforts and application for transition to commercial production.

 

As a result of reduced world oil prices and, correspondingly, revenues, we do not have sufficient capital available to continue to support the aggressive drilling strategy we pursued during the past several years. The reduction in anticipated revenues is due to several factors. The material drop in world oil prices has resulted in lower than expected revenue from production. The wells we have recently completed have not generated the production we anticipated. The decline curve on existing production has, in many cases, been more steep than expected, which has also contributed to lower production and revenue compared to expectations. Finally, the imposition by the Republic of Kazakhstan of the export duty on all oil sold outside the domestic market in Kazakhstan, has had the effect of reducing our income by about 20%.

 

Upon careful evaluation of available options, we have decided to suspend our drilling programs until the global financial situation and crude oil prices stabilize at levels that we deem will make further drilling efforts economically efficient. We have managed to negotiate the suspension of drilling contracts with drilling contractors, Great Wall and Oil and Gas Exploration Crakow, without incurring penalties and fines. By the end of our third fiscal quarter, we had terminated all drilling activities.

 

During the quarter ending December 31, 2008, we experienced a significant drop in our average production due to several factors. We have experienced pressure drops that are significantly higher than previously expected which adversely affected production rates from several wells. We believe this dramatic decline is partially attributable to the length of time certain Kariman wells have been producing without significant workover activities, Kariman-2 for instance has been producing for over 2 years now, and to paraffin build-up on most wells due to the surprisingly harsh weather in Aktau this winter.

 

 

 

Another reason for the decrease in production is a lack of oil storage capacity. Given world market prices during the quarter, many oil producers in Kazakhstan were unwilling to export crude oil to international markets due to the negative netbacks to be realized after application of the excessively high export duty imposed by the government of Kazakhstan while world market prices plummeted starting in August 2008. Such circumstances forced us, similar to most other independent producers in Kazakhstan to supply 100% of our crude oil to domestic markets starting in late October 2008. This significant increase in the supply of crude oil to the domestic market in Kazakhstan led to severe logistical hiccups as there is only one refinery, the Atyrau refinery, that services western Kazakhstan. The refining capabilities of the Atyrau refinery are limited, this was exacerbated by the railroad spurs/network that is not suited for such increase in crude oil supply. As a result several times during the quarter ending December 31, 2008, we were unable to ship crude oil to the domestic markets for several days in a row. This led to the crude oil inventories at the oil storage facility we lease to exceed storage capacity. As a result, we had to partially or completely (through choke scale down) shutdown several wells. Due to the pressure drop and paraffin build-up during such suspension of production, we were unable to return to the previous production rates at several wells. In certain cases, such as Kariman-4 and Kariman-7, production has ceased altogether and has not been restored to date.

 

We have developed and plan to carry out a production restoration program based on installation and running of submersible centrifugal and bottom-hole pumps at non-producing or low-producing wells. We expect to complete such activities at the Kariman-4 and -7 wells during the quarter ending March 31, 2009.

 

We have halted drilling activities and plan to significantly scale down other capital expenditures, including workover activities and infrastructure development, until crude oil prices rebound and/or the global markets revive, which will allow us to generate sufficient cash flows and/or raise additional capital. However, we plan to engage in careful evaluation and carrying out activities with the purpose of oil production stimulation from existing wells. In essence, we plan to work with each and every well in our wellstock with the purpose of restoring and increasing production from such wells.

 

If we continue to experience greater than expected declines in production, or as prices fall to levels that could reduce the amount of crude oil we can produce economically, we may have to make downward adjustments to our estimated proved reserves. If this occurs, we could incur a “ceiling limitation write-down” under applicable accounting rules.  Under these rules, if the net capitalized cost of natural gas and crude oil properties exceed a ceiling limit, we must charge the amount of the excess to earnings.  This charge does not impact cash flow from operating activities, but it would reduce our stockholder’s equity and earnings.  The risk that we will be required to write-down the carrying value of natural gas and crude oil properties increases when natural gas and crude oil prices are low or when our production rates are lower than anticipated.  In addition, write-downs would occur if we were to experience substantial downward adjustments to our estimated proved reserves.  A write-down recorded in one period may not be reversed in a subsequent period even though crude oil prices or production may have increased the ceiling applicable to a subsequent period.

 

 

Results of Operations

 

Three months ended December 31, 2008, compared to the three months ended December 31, 2007.

 

Revenue and Production

 

The following table summarizes production volumes, average sales prices and operating revenue for our oil and natural gas operations for the three months ended December 31, 2008 and the three months ended December 31, 2007.

 

 

 

 

Revenues. We generate revenue under our exploration contract from the sale of oil recovered during test production. During the three months ended December 31, 2008 our oil production decreased 12% compared to the three months ended December 31, 2007.

 

During the three months ended December 31, 2008 we realized revenue from oil sales of $4,833,790 compared to $16,832,612 during the three months ended December 31, 2007. The significant contributing factor to the 71% decrease in revenue was a 65% decrease in the price per barrel we received for oil sales. We sold crude oil to the domestic market during November and December 2008, since netbacks on domestic market sales were more attractive than on export sales. During the three months ended December 31, 2008 and 2007 we exported 39% and 82% of our oil, respectively to the world markets and realized the world market price for those sales. Revenue from oil sold to the world markets made up 51% and 94% of total revenue, respectively, during the three months ended December 31, 2008 and 2007. Another factor contributing to the decrease in revenues was a 17% decrease in sales volume during the three months ended December 31, 2008 compared to the three months ended December 31, 2007. We currently anticipate revenues will be flat in upcoming quarters for several reasons.

 

As discussed above, our revenue is sensitive to changes in the price we receive for our oil. Oil prices fluctuate in response to many factors that are outside our control. Imbalances in the supply and demand for oil can have a dramatic effect on the price we receive for our production. In the past quarter world oil prices have dropped materially. This reduction in price has significantly reduced revenue from oil sales. Should world oil prices remain lower, we will continue to realize lower revenue.

 

Historically, sales to the domestic market in Kazakhstan would have resulted in a significant reduction in revenue and income from operations because the domestic market price has been markedly lower than world oil prices. As the gap between world oil prices and domestic prices shrank, we actually found it more financially attractive to sell our oil to the domestic market.

 

In December 2008 the government of the Republic of Kazakhstan issued a resolution cancelling the export duty effective January 26, 2009 for companies operating under the new tax code. Beginning January 1, 2009 a new tax code went into effect. We are currently trying to determining how these changes will impact our results of operations. While we believe the repeal of the export duty will allow us to sell oil to international markets and realize higher revenues, we also believe that this increase in price will be offset by the production decreases given the decline rates we are currently experiencing in our wells coupled with the suspension of any new drilling activity until financial conditions improve.

 

 

Costs and Operating Expenses

 

The following table presents details of our costs and expenses for the three months ended December 31, 2008 and 2007:

 

 

Export Duty. On April 18, 2008 the government of the Republic of Kazakhstan introduced an export duty on several products (including crude oil). We became subject to the duty in June 2008. The export duty for three month ended December 31, 2008 amounted to $2,172,559. The formula for determining the amount of the crude oil export duty is based on a sliding scale that is tied to the world market price for oil. The amount of the export duty can change with fluctuations in world oil prices. Fluctuations in the export duty, however, lag behind fluctuations in world oil prices by about 90 days. In December 2008 the government of the Republic of Kazakhstan repealed the export duty effective January 26, 2009. However, we are now subject to the new tax code that went into effect on January 1, 2009. We are currently investigating how the cancellation of the export duty and the new tax code may effect our results of operations.

 

Oil and Gas Operating Expenses. During the three months ended December 31, 2008 we incurred $1,449,981 in oil and gas operating expenses compared to $1,538,143 during the three months ended December 31, 2007. This decrease is due to decreased production volumes.

 

 

We calculate oil and gas operating expense per BOE based on the volume of oil actually sold rather than production volume because not all volume produced during the period is sold during the period. The related production costs are expensed only for the units sold, not produced.

 

Oil and gas operating expenses decreased 6% during the three months ended December 31, 2008 compared to the three months ended December 31, 2007. Expense per BOE, however, increased 14% during the three months ended December 31, 2008. Expense per BOE increased as a result of decreased crude oil sales. During the three months ended December 31, 2007 we sold 252,857 barrels of oil, during the three months ended December 31, 2008 we sold 209,758 barrels of oil. As expense per BOE is a function of total expense divided by the number of barrels of oil sold, the 17% decrease in sales volume more than offset the 6% decrease in expenses resulting in a 14%, or $0.83, increase in oil and gas operating expense per BOE.

 

General and Administrative Expenses. General and administrative expenses during the three months ended December 31, 2008 were $6,764,698 compared to $3,988,250 during the three months ended December 31, 2007. This represents a 70% increase in general and administrative expenses. This increase in general and administrative expenses was the result of several factors such as increased payroll and related costs, rent expense, taxes and professional services.

 

During the three months ended December 31, 2008 we recognized non-cash compensation expense of $2,421,726 resulting from restricted stock grants made previously to employees. By comparison, during the three months ended December 31, 2007 we recognized non-cash compensation expense in the amount of $576,957 for restricted stock grants issued to employees and outside consultants.

 

The increase in general and administrative expense during the three months ended December 31, 2008 compared to the three months ended December 31, 2007 was primarily the result of:

 

	•	the change in non-cash compensation expense described in the previous paragraph;
	•	a 91% increase in professional services resulting from legal fees incurred in our ongoing litigation; and
	•	a 50% increase in rent expense from renting special equipment, apartments and additional vehicles.