NXT Energy Solutions Inc. - Quarter Report: 2002 September (Form 10-Q)

Although we commenced receiving production revenues in the first quarter of fiscal 2002, the amount of those revenues going forward does not cover our operating costs. Until the first quarter of fiscal 2002, we were a development stage company. Our ability to continue as a going concern in the longer term will be dependent upon our ability, either through our joint venture arrangements or for our own account, to successfully identify hydrocarbon bearing prospects, and to finance, develop, extract and market oil and natural gas from these prospects for a profit. We anticipate that we will continue to incur further operating losses until such time as we receive sufficient revenues from our production with respect to prospects currently in the development stage, or through prospects we identify and exploit for our own account.

We have taken steps since the beginning of fiscal 2002 to significantly cut-back our administration, exploration and research and development costs from approximately $250,000 per month to approximately $70,000 to $75,000 per month through a number of cost-saving measures until such time as we attain sufficient operating revenues or other sources of capital to finance operation and exploration costs. These steps included the sale of our Piaggio P180 Avanti aircraft for net proceeds of $1,054,464 (see note 4), and the sale of certain oil and natural gas properties for proceeds of $199,326. We believe these actions and the sale of non-core oil and natural gas properties and undeveloped lands will enable us to maintain a minimal level of operations over the next 12 to 18 months.

We can give no assurance that any or all projects in our pending drilling, completion and tie-in programs will be commercial, or if commercial, will generate sufficient revenues to cover our operating or other exploration costs. Should this not be the case, we would be forced, unless we can raise sufficient additional working capital, to suspend our operations, and possibly even liquidate our assets and wind-up and dissolve our company.

We are authorized under our Articles of Incorporation to issue common stock and series 'A' preferred stock (sometimes referred to in our consolidated financial statements as "common shares" and "series 'A' preferred shares", respectively). See notes 8 and 9.

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We have prepared these consolidated financial statements for our three-month and nine-month interim periods as at and ended September 30, 2002 and 2001 in accordance with accounting principles generally accepted in the United States for interim financial reporting. While these financial statements for these interim periods reflect all normal recurring adjustments which, in the opinion of our management, are necessary for fair presentation of the results of the interim period, they do not include all of the information and notes required by accounting principles generally accepted in the United States for complete financial statements. Refer to our consolidated financial statements included in our annual report on Form 10-K for our fiscal year ended December 31, 2001.

We have consolidated the accounts of our wholly-owned subsidiaries with those of NXT in the course of preparing these consolidated financial statements. All significant intercompany balances and transactions amongst NXT and its subsidiaries have been eliminated as a consequence of the consolidation process, and are therefore not reflected in these consolidated financial statements.

Certain items in our prior year's consolidated financial statements have been reclassified to conform to our current period's consolidated financial statement presentation.

The preparation of these consolidated financial statements in accordance with generally accepted accounting principles in the United States requires our management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of these consolidated financial statements and the reported amount of revenues and expenses during the reporting periods. Actual results may differ from those estimates.

For purposes of preparing the consolidated balance sheets and statements of cash flows contained in these consolidated financial statements, we consider all investments with original maturities of ninety days or less to constitute "cash and cash equivalents".

We amortize debt issuance costs on a straight-line basis over the life of the related debt.

Our financial instruments consist of cash and cash equivalents, accounts receivable, notes receivable, trade payables, wages and employee benefits payable, accrued liabilities and long-term debt. The book values of these financial instruments, other than long-term debt, approximates their fair values due to their short-term to maturity and similarity to current market rates. It is the opinion of our management that we are not exposed to significant interest, currency or credit risks arising from these financial instruments.

We carry our aircraft and flight equipment held for sale at the lower of the carrying amount or the fair value less cost to sell. A loss shall be recognized for any initial or subsequent write-down to fair value less cost to sell. These assets are not depreciated as long as they are held for sale. Interest and other expenses related to these assets continue to be accrued.

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We follow the full cost method of accounting for oil and natural gas properties and equipment whereby we capitalize all costs relating to our acquisition of, exploration for and development of oil and natural gas reserves. These capitalized costs include:

We only capitalize overhead that is directly identified with acquisition, exploration or development activities. All costs related to production, general corporate overhead and similar activities are expensed as incurred.

Under the full cost method of accounting, capitalized costs are accumulated into cost centers on a country-by-country basis. These costs, plus a provision for future development costs (including estimated dismantlement, restoration and abandonment costs) of proved undeveloped reserves, are then depleted and depreciated using the unit-of-production method, based on estimated proved oil and gas reserves as determined by independent engineers where significant. For purposes of the depletion and depreciation calculation, proved oil and gas reserves are converted to a common unit of measure on the basis of their approximate relative energy content.

In applying the full cost method of accounting, capital costs in each cost center less accumulated depletion and depreciation and related deferred income taxes are restricted from exceeding an amount equal to the sum of the present value of their related estimated future net revenues discounted at 10% less estimated future expenditures, and the lower of cost or estimated fair value of unproved properties included in the costs being amortized, net of related tax effects. Should this comparison indicate an excess carrying value, a write-down would be recorded.

The carrying values of unproved oil and natural gas properties, which are excluded from the depletion calculation, are assessed on a quarterly basis to ascertain whether any impairment in value has occurred. This assessment typically includes a determination of potential sales proceeds for similar leases in similar areas, and independent appraisal where warranted. Impairment is recorded if this assessment indicates the future potential net cash flows are less than the capitalized costs.

All recoveries of costs through the sale or other disposition of oil and gas properties and equipment are accounted for as adjustments to capitalized costs, with no gain or loss recorded, unless the sale or disposition involves a significant change in the relationship between costs and the value of proved reserves or the underlying value of unproved property, in which case the gain or loss is computed and recognized.

We conduct oil and natural gas exploration, drilling, development and production activities through our joint venture partners. These consolidated financial statements reflect only our proportionate interest in these activities.

We carry our other capitalized property and equipment at cost, and depreciate or amortize them over their estimated service lives using the declining balance method as follows:

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When we retire or otherwise dispose of our other capitalized property and equipment, we remove their cost and related accumulated depreciation or amortization from our accounts, and record any resulting gain or loss in the results of operations for the period. Our management periodically reviews the carrying value of our property and equipment to ensure that any permanent impairment in value is recognized and reflected in our results of operations.

We recognize revenue from the sale of oil and natural gas when title passes to the customer.

We expense all research and development expenditures we incur to develop, improve and test our SFD survey system and related components, including allocable salaries.

We expense all survey support expenditures we incur, after netting costs which are reimbursable by our joint venture partners. Survey support expenditures consist primarily of the cost, including allocable salaries, to:

- conduct field evaluations to evaluate the SFD survey system; and

- develop, organize, staff and train our survey and interpretation operational functions.

We expense all survey operations and data analysis expenditures we incur, after netting costs which are reimbursable by our joint venture partners. Survey operations and data analysis expenditures consist primarily of:

Our only operations outside of the United States are in Canada. Foreign currency translation adjustments resulting from the translation of the financial statements of our Canadian subsidiaries, whose functional currency is Canadian dollars, into U.S. dollar equivalents for purposes of consolidating our financial statements, are included in other comprehensive loss. For purposes of consolidation, we use the following methodology to convert Canadian dollar denominated accounts and transactions into U.S. dollars:

We record the cumulative gain or loss arising from the conversion of the noted Canadian dollar denominated accounts and transactions into U.S. dollars as a foreign currency translation adjustment as a component of accumulated other comprehensive loss for that period.

Our basic loss per share is computed in accordance with SFAS No. 128, "Earnings Per Share", by dividing the net loss for the period by the weighted average number of common shares outstanding for the period. Our diluted loss per share is computed, also in accordance with SFAS No. 128, by including the potential dilution that could occur if holders of our dilutive securities were to exercise or convert these securities into common shares.

In accounting for the grant of our employee and director stock options, we have elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"), and related interpretations. Under APB 25, companies are not required to record any compensation expense relating to the grant of options to employees or directors where the awards are granted upon fixed terms with an exercise price equal to fair value and the only condition of exercise is continued employment. See note 11.

In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations". SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. NXT is required to adopt the provisions of SFAS No. 143 on January 1, 2003. NXT is currently evaluating the impact that the adoption of SFAS No. 143 will have on our consolidated financial condition and results of operations. We expect that there will be a small increase in our liabilities to recognize the fair value of restoration costs with respect to our oil and natural gas properties, with a commensurate increase in the capitalized cost of those assets and a resultant increase in amortization and depreciation expense associated with those increased capitalized costs.

In December 2001, management decided to place on the market our two aircraft and related flight equipment in order to decrease our operating costs. On May 1, 2002, we completed the sale of our Piaggio Avanti P180 aircraft to a third party for gross proceeds of $2,580,000, and net proceeds of $1,054,464 after settlement of principal and interest due on the related asset based collateralized loan. We recorded a write-down of $184,316 recognizing the decrease in the fair value of this asset less its selling costs as part of our operating loss for the first quarter of 2002. The sale of our remaining aircraft is expected to occur during fiscal 2002 through the assistance of independent sales agents or through our own efforts.

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Summarized below are our capitalized costs for the aircraft and flight equipment held for sale as of September 30, 2002 and December 31, 2001:

These assets are reported as part of assets of our United States operations as of September 30, 2002 and December 31, 2001. See note 14.

Summarized below are the oil and natural gas property costs we capitalized for our nine months ended and as of September 30, 2002 and December 31, 2001:

Net oil and natural gas property costs at September 30, 2002 are comprised of $2,312,682 ($2,144,706 at December 31, 2001) of proved property costs and $3,551,097 ($2,772,852 at December 31, 2001) of unproved property costs. We performed cost center ceiling tests on our oil and natural gas properties using the full cost method of accounting. At September 30, 2002, the ceiling test did not result in any write-downs.

On July 12, 2002, we closed the sale of our producing Beiseker, Alberta property for proceeds of $199,326 which resulted in a gain of $42,046 which has been recorded in other income.

The impairment of oil and natural gas properties also includes the write-down of the cost of drilling and completing wells which are either non-commercial or which we are unable to complete for technical reasons. While, as noted below, our management believes in the prospective commercial viability and non-impairment of the overall prospects of which each of these wells are a part and is continuing active exploration and development activities with respect to each of these prospects, we have nevertheless written-off these individual well costs as an impairment cost since this determination was made prior to the establishment of proved reserves.

At the end of each quarter, our management performs an overall assessment of each of our unproved oil and natural gas properties to determine if any of these properties has been subject to any impairment in value (see note 2). Based upon these evaluations, our management has determined that each of our oil and natural gas properties continued to have prospective commercial viability as of these dates, including each of those properties noted above that contain wells which we have written-off. Based upon these considerations, we have not recorded any impairments against our properties to date other than the above noted write-offs. While we are currently conducting active exploration and development programs with respect to each of these unproved oil and natural gas properties, we anticipate that all of these properties will be evaluated and the associated costs transferred into the amortization base or be impaired over the next five years.

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Summarized below are our capitalized costs for other property and equipment as of September 30, 2002 and December 31, 2001:

On May 1, 2002, we completed the sale of our Piaggio Avanti P180 aircraft to a third party and used the proceeds to settle the principal and interest due on this loan in full. See note 4. We also expensed the remaining unamortized debt issuance costs of $22,805. For the nine months ended September 30, 2002, we paid $61,264 ($63,914 for the nine months ended September 30, 2001) of interest on this long-term debt.

On September 18, 2001, we raised $4,374,237 in gross proceeds through a private placement of 3,803,684 common shares at $1.15 per share. Net proceeds to our company from this offering were $4,359,252 after deducting $14,985 in offering expenses. An additional 54,553 shares of common stock were issued as finders' fees in connection with the private placement.

The series 'A' preferred shares are not entitled to payment of any dividends, although they are entitled under certain circumstances to participate in dividends on the same basis as if converted into common shares. Each series 'A' preferred share carries a $7.50 liquidation preference should our company wind-up and dissolve. Each series 'A' preferred share is convertible by the holder into common shares based upon a $7.50 per share conversion price, subject to adjustment should NXT sell common shares or common share purchase options or warrants at prices less than $7.50 per share in specified circumstances. As a consequence of the private placement of common shares at $1.15 per share which closed in September 2001 (see note 8 above) and additional option issuances on August 13, 2002 and September 20, 2002, the current conversion price for the series 'A' preferred shares as of the date of this report has been adjusted to $2.58, which would result in each series 'A' preferred shareholder receiving approximately 2.91 common shares for each series 'A' preferred share he may convert should he exercise this right, or an aggregate of 2,326,280 common shares.

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On August 1, 1996, we granted a performance-based contractual right to acquire NXT warrants to the licensor of our SFD technology, Momentum Resources Corporation ("Momentum Resources"), in connection with the amendment of our exclusive SFD technology license with Momentum Resources to use the SFD technology for hydrocarbon exploration. The primary purpose of the amendment was to indefinitely extend the termination date of the license. Pursuant to this contractual right, Momentum Resources is entitled to a separate grant of warrants entitling it to purchase 16,000 common shares at the then current trading price for each month after December 31, 2000 in which production from SFD-identified prospects during that month exceeds 20,000 barrels of hydrocarbons. Momentum Resources has not earned any warrants under the SFD technology license as of September 30, 2002.

We have summarized below all outstanding options under our various stock option plans and arrangements as of September 30, 2002:

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The employee options outstanding as of September 30, 2002 vest over three to five years from the grant date, depending upon the recipient, based upon the continued provision of services as an employee or consultant. The director options granted before January 1, 2000 that are outstanding as of September 30, 2002 vest one-third on date of grant, and an additional one-third each on the first anniversary and second anniversary of the grant date, respectively, based upon the continued provision of services as a director. The director options granted after January 1, 2000 that are outstanding as of September 30, 2002 vest one-third each on the first through third anniversaries of the grant date, respectively, based upon the continued provision of services as a director. Both the employee and director options generally lapse, if unexercised, either five years from the date of vesting or five years from the date of grant.

We have a joint venture agreement with an oil and natural gas exploration company under which we are required to conduct SFD surveys to identify oil and natural gas prospects on selected exploration areas of up to 2,400 square miles, and our joint venture partner is required to drill each SFD-identified prospect they accept under the agreement.

Our recent practice with our joint venture partner has been to participate in selected prospects on a combination of working interest and overriding royalty basis, typically up to a 22.5% working interest and a 4% overriding royalty. In any situation where we elect to participate on a working interest basis, we must bear our share of mineral and drilling right acquisition (if necessary), drilling, completion and production costs incurred with respect to the prospect based upon our elected working interest percentage. Although we will bear our share of these costs, our joint venture partners will nevertheless remain responsible for conducting and managing all drilling, production and marketing activities to exploit the prospect.

On November 25, 1997, we entered into a five-year non-cancelable operating lease for our principal executive offices. This lease, which consists of 13,325 rentable square feet as of December 31, 2001, expires on January 31, 2003. Our combined obligations for base lease payments, building operating costs and other pass-through items as of September 30, 2002 was approximately $15,284 per month. As of May, 2002 we have sublet approximately 40 % of our rentable space at cost for the balance of our lease.

On June 1, 2000, we entered into a five-year operating lease for our hangar facility. This lease, which consists of 14,513 rentable square feet, expires May 31, 2005. Our combined monthly obligation as of September 30, 2002 was approximately $9,100 per month. Effective November 30, 2002, we have negotiated a termination of the lease as at December 31, 2002 at a cost of three months rent.

On May 15, 2001, as additional compensation to our investor relations consultant pursuant to an investor and public relations services agreement, we granted that consultant options to purchase 155,000 common shares at $2.50 per share. The underlying agreement provided that 50,000 options would vest immediately, and an additional 35,000 options would vest upon each of the first, second and third anniversary dates of the agreement, respectively, even if the agreement was not subsequently renewed by those dates so long as NXT has not terminated this agreement for "good cause" as defined in the agreement. These options lapse, to the extent vested and unexercised, five years after the date of vesting. Pursuant to SFAS No. 123, for our nine-month period ended September 30, 2002, we recorded compensation expense, as part of administrative expenses, determined in accordance with the Black-Scholes option pricing model in the amount of $25,688 ($68,258 for our nine-month interim period ended September 30, 2001) in connection with the grant and vesting of these options.

We currently operate in only one business segment, oil and natural gas exploration. We intend to develop all oil and natural gas exploration prospects identified using our proprietary SFD airborne survey technology either directly or with joint venture partners. We do not currently sell or market our SFD data as a separate product to third parties.

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Prior to the first quarter of 2002, the majority of our revenues were derived from interest earned on cash and cash equivalents.

Summarized below with respect to our three-month and nine month periods ended September 30, 2002 and 2001 is geographic information relating to:

Summarized below is geographic information relating to our assets as of September 30, 2002 and December 31, 2001, allocated amongst the geographic areas in which the assets were physically located or principally connected:

In preparing the above tables, we have eliminated all inter-segment revenues, expenses and assets.