EVOLUTION PETROLEUM CORP — Regulatory Filings 2004

Aug 9, 2004

8-K/A 1 v01046e8vkza.htm FORM 8-K/A Natural Gas Systems, Inc. - August 9, 2004 PAGEBREAK

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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Amendment No. 2

to

FORM 8-K

Current Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Date of Report: August 9, 2004 Date of Earliest Event Reported: May 26, 2004

NATURAL GAS SYSTEMS, INC.

(Exact Name of Registrant as Specified in its Charter)

Nevada

(State or Other Jurisdiction of Incorporation)

0-27862	80-0028196
(Commission File Number)	(I.R.S. Employer Identification No.)
820 Gessner, Suite 1340, Houston, Texas	77024
(Address of Principal Executive Offices)	(Zip Code)

(713) 935-0122

(Registrant’s Telephone Number, Including Area Code)

REALTY INTERACTIVE, INC.

378 North Main Street, No. 124, Layton, Utah 84043

(Former Name or Former Address, if Changed Since Last Report).

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SIGNATURES

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Explanatory Note:

Natural Gas Systems, Inc. is filing this Amendment No. 2 to this Current Report on Form 8-K, which was initially filed on June 3, 2004 and amended on June 21, 2004, solely to file the financial statements of Natural Gas Systems, Inc. in response to Item 7. These financial statements appear beginning on Page F-1 of this Current Report on Form 8-K.

This Amendment does not reflect events occurring after the filing of the June 3, 2004 Form 8-K, nor does it modify or update those disclosures in any way, except as required to reflect the effects of the above-described restatement. link2 "Item 7. Financial Statements, Pro Forma Financial Information and Exhibits"

Item 7. Financial Statements, Pro Forma Financial Information and Exhibits

(a) Financial Statements of Businesses Acquired.

The balance sheet of Natural Gas Systems, Inc. as of December 31, 2003, and the related statement of operations, stockholders’ equity and cash flows for the period from September 23, 2003 (the inception date) to December 31, 2003, appear beginning on page F-1 of this Current Report on Form 8-K and are hereby incorporated by reference herein.

The accompanying statements of revenues and direct operating expenses of the Delhi Field acquired on September 23, 2003, for the period from January 1, 2003 to September 23, 2003 and for the nine-month period ended December 31, 2002 appear beginning on page F- 20 of this Current Report on Form 8-K and are hereby incorporated by reference herein.

(b) Pro Forma Financial Information

The pro forma financial information required by Article 11 of Regulation S-X has not been presented because Reality Interactive, Inc. had no operations at the time of the merger.

(c) Exhibits.

| 2.1 | Agreement and Plan of Reorganization
dated as of April 12, 2004 among Reality Interactive,
Inc., Reality Acquisition Corp., Global Marketing
Associates, Inc., Dean H. Becker and Natural Gas
Systems, Inc. (filed as an exhibit to Reality
Interactive’s Report on Form 8-K/A dated April 22,
2004, which was filed with the Securities and
Exchange Commission on April 27, 2004, and
incorporated by reference into this Report on Form
8-K). |
| --- | --- |
| *16.1 | Letter dated June 2, 2004 from
Chisholm, Bierwolf & Nilson, LLC regarding its
concurrence with the statements made by Reality
Interactive concerning the change in accountants. |

*Previously filed

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link1 "SIGNATURES"

SIGNATURES

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

/s/ ROBERT HERLIN
Robert Herlin, Chief Executive Officer

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TABLE OF CONTENTS

Financial Statements of Natural Gas Systems, Inc. :
Report of Independent Registered Public Accounting Firm	F - 1
Consolidated Balance Sheets	F - 2
Consolidated Statements of Operations	F - 3
Statements of Changes in Stockholders’ Equity	F - 4
Consolidated Statements of Cash Flows	F - 5
Notes to Financial Statements	F - 6
Financial Statements of Properties Acquired :
Report of Independent Registered Public Accounting Firm	F - 21
Statement of Direct Operating Revenues and Expenses	F - 22
Notes to Financial Statements	F - 23
Pro Forma Unaudited Financial Information	F - 26

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors Natural Gas Systems, Inc.

We have audited the accompanying balance sheet of Natural Gas Systems, Inc. as of December 31, 2003, and the related statement of operations, stockholders’ equity and cash flows for the period from September 23, 2003 (the inception date) to December 31, 2003. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Natural Gas Systems, Inc. as of December 31, 2003, and the results of its operations and changes in its stockholders’ equity and cash flows for the period from September 23, 2003 (inception) to December 31, 2003 in conformity with accounting principles generally accepted in the United States of America.

Hein & Associates LLP Houston, Texas

July 30, 2004

F - 1

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NATURAL GAS SYSTEMS, INC.

CONSOLIDATED BALANCE SHEET

	December 31, — 2003	2004
		(Unaudited)
ASSETS
Current Assets
Cash and short-term investments	$ 830,312	$	113,843
Receivables	56,837		73,625
Inventories	109,216		119,908
Prepaid expenses	25,930		11,413
Retainers and deposits	210,000		342,473
Total current assets	1,232,295		661,262
Oil and gas properties being amortized (full cost method)	2,971,468		3,012,515
Oil and gas properties not being amortized	–		17,203
Less: accumulated amortization	(13,960	)	(27,537	)
Net oil and gas properties	2,957,508		3,002,181
Furniture, fixtures and equipment, at cost	3,091		3,091
Less: accumulated depreciation	(386	)	(772	)
Net furniture, fixtures and equipment	2,705		2,319
Other assets (cash balances earmarked for bonding requirements)	301,835		301,835
Total Assets	$ 4,494,343	$	3,967,597
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Accounts payable	$ 114,188	$	105,362
Accrued liabilities	41,118		4,035
Notes payable	1,437,073		1,088,499
Production taxes payable	665		–
Total current liabilities	1,593,044		1,197,896
Deferred plugging and abandonment liabilities	305,004		308,206
Stockholder’s equity:
Common stock, par value $0.001 per share; 100,000,000
shares authorized, 20,864,000 and 21,000,000 shares issued
and outstanding in 2003 and 2004, respectively	20,865		21,000
Additional paid-in capital	3,399,085		3,534,350
Deferred stock based compensation	(486,750	)	(432,443	)
Accumulated deficit	(336,905	)	(661,412	)
Total stockholders’ equity	2,596,295		2,461,495
Total liabilities and stockholders’ equity	$ 4,494,343	$	3,967,597

See accompanying notes to financial statements.

F - 2

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NATURAL GAS SYSTEMS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS

	For the Period
	from
	September 23,		Quarter
	2003 (Inception)		Ended
	to December 31,		March 31,
	2003		2004
			(Unaudited)
Revenues:
Oil sales	$ 24,229		$ 48,572
Total revenues	24,229		48,572
Expenses:
Operating costs	76,303		58,696
Production taxes	3,002		6,025
Depletion	13,960		13,576
General and administrative	239,093		270,620
Total expenses	332,358		348,917
Loss from operations	(308,129	)	(300,345	)
Other revenues and expense:
Interest income	1,148		2,264
Interest expense	(29,924	)	(26,426	)
Total other revenues and expense	(28,776	)	(24,162	)
Net loss	$ (336,905	)	$ (324,507	)

See accompanying notes to financial statements.

F - 3

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NATURAL GAS SYSTEMS, INC. STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY FOR THE PERIOD FROM SEPTEMBER 23, 2003 (INCEPTION) TO MARCH 31, 2004

								Total
			Additional			Accumulated		Stockholders’
Shares		Dollars	Paid-In Capital	Deferred		Deficit		Equity
Balances, September 23, 2003	–	$ –	$ –	$ –		$ –		$ –
Sales of common stock	20,864,800	20,865	2,861,935	–		–		2,882,800
Stock-based compensation	–	–	537,150	(486,750	)	–		50,400
Net loss	–	–	–	–		(336,905	)	(336,905	)
Balances, December 31, 2003	20,864,800	20,865	3,399,085	(486,750	)	(336,905	)	2,596,295
Sales of common stock
(unaudited)	135,200	135	135,265	–		–		135,400
Deferred compensation
(unaudited)	–	–	–	54,307		–		54,307
Net loss (unaudited)	–	–	–	–		(324,507	)	(324,507	)
	21,000,000	$ 21,000	$ 3,534,350	$ (432,443	)	$ (661,412	)	$ 2,461,495

See accompanying notes to financial statements.

F - 4

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NATURAL GAS SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS

	For the Period
	from
	September 23,		Quarter
	2003 (Inception)		Ended
	to December 31,		March 31,
	2003		2004
			(Unaudited)
Operating activities:
Net loss	$ (336,905	)	$ (324,507	)
Adjustments to reconcile net loss to net cash provided (used) by
operating activities:
Depletion	13,960		13,576
Depreciation	386		386
Stock-based compensation expense	50,400		54,308
Accretion of debt discount	29,924		–
Accretion of deferred plugging and abandonment liability	3,169		3,202
Increase in receivables	(28,762	)	(16,788	)
Increase in inventories	(109,216	)	(10,692	)
Increase (decrease) in accounts payable	114,188		(8,826	)
Increase (decrease) in other current liabilities	41,783		(37,748	)
Decrease (increase) in prepaid expenses	(25,930	)	14,517
Increase in retainers and deposits	(210,000	)	(132,473	)
Net cash used by operating activities	(457,003	)	(445,045	)
Investing activities:
Capital expenditures for oil and gas properties	(1,290,560	)	(58,250	)
Capital expenditures for furniture, fixtures, and equipment	(3,090	)	–
Cash restricted for Delhi bonding requirements	(301,835	)	–
Net cash used in investing activities	(1,595,485	)	(58,250	)
Financing activities:
Payments on notes payable	–		(348,574	)
Proceeds from issuance of common stock	2,882,800		135,400
Net cash provided (used) by financing activities	2,882,800		(213,174	)
Net increase (decrease) in cash	830,312		(716,469	)
Cash and cash equivalents, beginning of period	–		830,312
Cash and cash equivalents, end of period	$ 830,312		$ 113,843
Supplemental Cash Flow Information:
Interest paid	–		–
Interest taxes paid	–		–
Non-cash transactions:
Seller note issued to acquire properties, net of discount	$ 1,407,049		–
Assumption of plugging and abandonment liability	$ 301,835		–

See accompanying notes to financial statements.

F - 5

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

1.	Company’s Business
	Natural Gas Systems, Inc. is a petroleum company engaged primarily in the
acquisition, exploitation and development of properties for the production
of crude oil and natural gas from underground reservoirs. Formed in
September 2003, the Company acquires established oil and gas properties
and exploits them through the application of conventional and specialized
technology to increase production, ultimate recoveries, or both. The
terms “Company” and “NGS” refer to Natural Gas Systems, Inc., and its
subsidiaries. NGS currently conducts operations through its 100% working
interest in the Delhi Field.
2.	Significant Risks and Uncertainties
	Preparation of the Company’s financial statements requires management to
make estimates and assumptions that affect the reported amounts of assets,
liabilities and contingencies as of the balance sheet date, and the
reported amount of revenues and expenses during the reporting period. On
an ongoing basis, management reviews its estimates, including those
related to litigation, environmental liabilities, income taxes,
abandonment costs and the determination of proved reserves. Changes in
circumstances may result in revised estimates and actual results may
differ from those estimates.
	The Company’s business makes it vulnerable to changes in crude oil
and natural gas prices. Such prices have been volatile in the past and
can be expected to be volatile in the future. This volatility can
dramatically affect cash flows and proved reserves, since price declines
reduce the estimated quantity of proved reserves and increase annual
amortization expense (which is based on proved reserves). Other risks related to proved
reserves, revenues and cash flows include the Company’s current reliance on the
concentration of a few wells. The reserve report dated as of
January 1, 2004, identifies eight wells that make up
approximately 60% of the Company’s PV10. At July 31, 2004,
approximately 85% of the Company’s production was derived from three wells.
3.	Summary of Significant Accounting Policies
	Principles of Consolidation – The consolidated financial statements
include the Company and its subsidiaries. All material intercompany
accounts and transactions have been eliminated.

F - 6

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

| 3. |
| --- |
| Oil and Gas Properties and Furniture, Fixtures and Equipment – The Company
follows the full cost method of accounting for its investments in oil and
natural gas properties. All costs incurred in the acquisition,
exploration and development of oil and natural gas properties, including
unproductive wells, are capitalized. Included in capitalized costs are
general and administrative costs that are directly related with
acquisition, exploration and development activities. Proceeds from the
sale of oil and natural gas properties are credited to the full cost pool,
unless the sale involves a significant quantity of reserves, in which case
a gain or loss is recognized. Under the rules of the Securities and
Exchange Commission (“SEC”) for the full cost method of accounting, the
net carrying value of oil and natural gas properties, reduced by the asset
retirement obligation, is limited to the sum of the present value (10%
discount rate) of the estimated future net cash flows from proved
reserves, based on the current prices, plus the lower of cost or estimated
fair market value of unproved properties adjusted for related income tax
effects. |
| Capitalized costs of proved oil and natural gas properties are depleted on
a unit of production method using proved oil and natural gas reserves.
Costs depleted include net capitalized costs subject to depletion and
estimated future dismantlement, restoration and abandonment costs. |
| Equipment, which includes computer equipment, hardware and software and
furniture and fixtures, is recorded at cost and is generally depreciated
on a straight-line basis over the estimated useful lives of the assets,
which range in period of three to seven years. |
| Repairs and maintenance are charged to expense as incurred. |
| Statement of Cash Flows – For purposes of the statements of cash flows,
cash equivalents include highly liquid financial instruments with
maturities of three months or less as of the date of purchase. |
| Concentrations of Credit Risk – All of the Company’s trade receivables are
due from one purchaser. Accounts receivable are generally not
collateralized. |
| Revenue Recognition – The Company recognizes oil and natural gas revenue
from its interests in producing wells as oil and natural gas is sold. |

F - 7

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

| 3. |
| --- |
| Stock Options – As permitted by SFAS No. 123, “Accounting for Stock Based
Compensation,” the Company follows the accounting requirements for stock
options and stock-based awards contained in Accounting Principles Board
Opinion No. 25, “Accounting for stock Issued to Employees,” and related
Interpretations and consensus of the Emerging Issues Task Force in terms
of measuring compensation expense. |
| SFAS 123, “Accounting for Stock-Based Compensation,” as amended by SFAS
148, “Accounting for Stock-Based Compensation – Transition and
Disclosure,” established accounting and disclosure requirements using a
fair value-based method of accounting for stock-based employee
compensation plans. The Company accounts for stock-based compensation
using the intrinsic value method prescribed in Accounting Principles Board
Opinion 25, “Accounting for Stock Issued to Employees” (“APB 25”). |
| Fair Value of Financial Instruments – Our financial instruments consist of
cash and cash equivalents, accounts receivable, accounts payable and
seller notes. The carrying amounts of cash and cash equivalents, accounts
receivable and accounts payable approximate fair value due to the highly
liquid nature of these short-term instruments. The fair values of the
seller notes approximates their carrying amounts as of December 31, 2003,
based upon interest rates currently available to us for borrowings with
similar terms. |
| New Accounting Pronouncements – In June 2001, the FASB issued SFAS No.
143, “Accounting for Asset Retirement Obligations.” SFAS No. 143 requires
the fair value of a liability for an asset retirement obligation to 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 assets. SFAS
No. 143 was effective for the Company at inception. |
| During December 2003, the FASB issued Interpretation No. 46R,
“Consolidation of Variable Interest Entities” (“FIN 46”), which requires
the consolidation of certain entities that are determined to be variable
interest entities (“VIE’s”). An entity is considered to be a VIE when
either (i) the entity lacks sufficient equity to carry on its principal
operations, (ii) the equity owners of the entity cannot make decisions
about the entity’s activities or (iii) the entity’s equity neither absorbs
losses or benefits from gains. NGS owns no interest in variable interest
entities, and therefore this new interpretation has not affected the
Company’s consolidated financial statements. |

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

3.	Summary of Significant Accounting Policies (continued)
	Unaudited Information – The balance sheet as of March 31, 2004 and the
statements of operations for the three-month period ended March 31, 2004
were taken from the Company’s books and records without audit. However,
in the opinion of management, such information includes all adjustments
which are necessary to make not misleading the Company’s financial
position as of March 31, 2004 and the results of operations for three
months ended March 31, 2004. The results of operations for the interim
periods presented are not necessarily indicative of those expected for the
year.
4.	Acquisitions
	During September 2003, NGS completed the acquisition of a 100% working
interest in the Delhi Field, currently the only operating asset of the
Company. The acquisition closed on September 25, 2003, whereby NGS paid
$995,000 in cash, issued a purchase money mortgage for $1,500,000 (See
Note 7, Notes Payable, for a description of the mortgage) and assumed a
plugging and abandonment reclamation liability in the amount of
approximately $302,000 (see Note 5, Asset Retirement Obligations), in
exchange for the conveyance of all the underlying leasehold interests. In
addition to the mortgage, the property is burdened by a 20% royalty
interest.
5.	Asset Retirement Obligations
	When an oil or gas property ceases economic production, the Company
dismantles and removes all surface equipment, plugs the wells and restores
the property’s surface in accordance with various regulations and
agreements before abandoning the property. The state of Louisiana
requires operators of oil and gas properties to secure plugging,
abandonment and reclamation liabilities with financial collateral in favor
of the state. In the case of the Delhi Field, the previous owner had
established a Site Specific Trust Fund (SSTA Account) that is considered a
fully funded liability by the state of Louisiana. Pursuant to the
Company’s agreement to purchase the Delhi Field in September of 2003, NGS
agreed to replace the seller’s collateral on the SSTA Account within 120
days of closing. At December 31, 2003, NGS had not yet posted its
collateral, but the Company earmarked $301,835 in cash balances by
transferring this amount to “Other Assets” on the Company’s balance sheet.

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

| 5. |
| --- |
| In accordance with FAS 143, the Company has recorded an estimated asset
retirement obligation (“ARO”) for its Delhi Field of approximately
$302,000, of which $274,000 relates to the Company’s wells and $28,000
relates to wells operated by the Company for a third party. Accordingly,
the Company has recorded an asset retirement obligation in the amount of
$302,000 with an offsetting $274,000 charge to the full cost pool, and a
$28,000 receivable due from the 3rd party, which was received in the
second quarter of 2004. |
| Also in accordance with FAS 143, the Company provides accretion expense on
all ARO liabilities. For the Delhi Field, NGS uses the 10-year constant
maturity Treasury yield of 4.27% available at September 30, 2003, which
equates to 1.05% per quarter. |
| During the quarter ended March 31, 2004, NGS replaced the seller’s
collateral by posting a letter of credit in the face amount of $301,835,
fully collateralized by a certificate of deposit issued on Wells Fargo
Bank. |
| The following table describes the change in the Company’s asset retirement
obligations for the period from September 23, 2003 (inception) to March
31, 2004: |

Asset retirement obligation at September 23, 2003	$
Accretion expense for 2003	3,169
Asset retirement obligation at December 31, 2003	305,004
Accretion expense for 2004	3,202
Asset retirement obligation at March 31, 2004	$ 308,206

| 6. |
| --- |
| Depletion expense for the period from September 23, 2003 (inception) to
December 31, 2003 and for the quarter ended March 31, 2004 totaled $13,960
and $13,576, respectively. |
| During 2003, no costs were excluded from amortization. For the quarter
ended March 31, 2004, $17,203 costs were not being amortized, pending the
closing or abandonment of property acquisitions under active
consideration. |

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

7.	Notes Payable
	In September, 2003, the Company issued $1,500,000 of notes payable in
connection with its acquisition of the Delhi Field. The notes are
collateralized by a first mortgage on the Company’s Delhi field and are
payable to the sellers in twelve equal monthly installments beginning on
January 30, 2004. Although the notes bear no interest, the Company has
imputed interest at 8% per annum, thus resulting in an initial recorded
principal amount of $1,407,049. At December 31, 2003, the balance of the
notes payable was $1,436,973, including $29,924 of imputed interest. At
March 31, 2004, the principal balance outstanding was $1,088,399.
8.	Common Stock and Stock Options
	At December 31, 2003, the Company had 20,864,800 issued and outstanding shares of common stock. During 2003, 18,000,000 common shares were issued
as founder’s capital at $0.001 per share, and 2,864,800 common shares were
sold and issued at $1.00 per share through a private equity offering to
accredited investors.
	At March 31, 2004, the Company had 21,000,200 issued and outstanding shares of common stock. During the quarter ended March 31, 2004, 135,400
common shares were sold and issued at $1.00 per share.
	The Company adopted a stock option plan in 2003 (the “Plan”). The purpose
of the Plan is to offer selected individuals an opportunity to acquire a
proprietary interest in the success of the Company, or to increase such
interest, by purchasing shares of the Company’s common stock. The Plan
provides both for the direct award or sale of shares and for the grant of
options to purchase shares in an aggregate amount not to exceed 4,000,000
shares. Options granted under the Plan may include nonstatutory options
as well as incentive stock options intended to qualify under Section 422
of the Code.
	At December 31, 2003, options totaling 600,000 shares of the Company’s
stock had been granted, subject to various vesting requirements. Options
to purchase 250,000, 250,000 and 100,000 shares were granted to Messrs.
Herlin, McDonald and Lee (counsel to the Company), respectively. Mr.
Herlin’s options are committed for subsequent transfer to Tatum Partners
in consideration of their services agreement with the Company. These
options were accounted for under APB 25, with respect to Messrs. Herlin
and McDonald, and under FASB 123 with respect to Mr. Lee, and gave
rise to expense of $537,150 which will be expensed over the respective
vesting periods of the options.
	No options were issued during the quarter ended March 31, 2004.

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

| 8. |
| --- |
| A reconciliation of reported loss as if the Company used the fair value
method of accounting for stock-based compensation has not been provided as
the results obtained from the fair value and intrinsic method were
essentially the same. |
| Fair value was estimated at the date of grant using the Black-Scholes
options pricing model with the following weighted average assumptions:
risk-free interest rate of approximately 2.5%; dividend yield of 0%;
volatility factor of .001 to .25; and a weighted-average expected life of
three years. These assumptions resulted in a weighted average grant date
fair value of $.87. For purposes of the pro forma disclosures, the
estimated fair value is amortized to expense over the awards’ vesting
period. |
| The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting
restrictions and are fully transferable. In addition, option valuation
models require the input of highly subjective assumptions including the
expected stock price volatility. Because the Company’s employee stock
options have characteristics significantly different from those of traded
options, and because changes in the subjective input assumptions can
materially affect the fair value estimate, in management’s opinion, the
existing models do not necessarily provide a single measure of the fair
value of its employee stock options. Pro forma compensation cost reflected
above may not be representative of the cost to be expected in future
years. |

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

| 8. |
| --- |
| At December 31, 2003, 3,400,000 shares were available for grant under the
plans. A summary of options transactions for the period from September
23, 2003 (inception) to December 31, 2003 follows: |

		Weighted
		Average
Number of		Exercise
Shares		Price
Outstanding at September 23, 2003	–	$ –
Granted	600,000	.10
Exercised	–	–
Canceled	–	–
Outstanding at December 2003	600,000	$ .10
Shares exercisable at December 31, 2003	–	–

	Options Outstanding	Weighted	Exercisable
Range of	Outstanding At	Average	December 31,
Exercisable Prices	December 31, 2003	Exercise Price	2003
.001	350,000	.001	–
.25	250,000	.25	–

The weighted average remaining contractual life of options outstanding at December 31, 2003, was approximately 46 months. The weighted average grant date fair value of the options granted in 2003 was $.89 per share. The options vest as follows: 2004 – 150,000; 2005 – 150,000; 2006 – 150,000; and 2007 – 150,000.

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

| 9. |
| --- |
| Laird Cagan, Chairman of the Board of the Company, is a Managing Director
of Cagan McAfee Capital Partners. Cagan McAfee Capital Partners performs
financial advisory services to the Company pursuant to a written
agreement. Terms of the agreement include a $15,000 per month fee, in
addition to other transaction fees that may be earned for completed
transactions. |
| As of December 31, 2003, the Company had disbursed $200,000 to Cagan
McAfee Capital Partners as an advance toward the anticipated expenses of
completing a reverse merger in a public shell on behalf of the Company.
In January 2004, another $100,000 had been advanced. These amounts are
included in retainers and deposits in the accompanying balance sheet. The
agreement specifies that the advances are refundable to the Company in the
event that a reverse merger is not completed by June 30, 2004. On May 26,
2004, a reverse merger was completed and the fees earned (see Note 14,
Subsequent Events). |
| Eric McAfee, also a Managing Director of Cagan McAfee Capital Partners,
has served as Vice Chairman of the Board of Verdisys, Inc., the provider
of certain horizontal drilling services to the Company. Subsequently in
2004, Mr. McAfee resigned from the Board of Directors of Verdisys, but
continues to hold shares in both companies. Mr. McAfee has represented to
the Company that he is also a 50% owner of Berg McAfee Companies, LLC,
which owns approximately 30% of Verdisys, Inc. |

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

10.
The following supplemental unaudited information regarding the Company’s
oil and gas activities is presented in accordance with FAS 69:

Capitalized Costs Relating to Oil and Gas Producing Activities

	December 31, — 2003	2004
Unproved oil and gas properties	$ –	$	17,203
Proved oil and gas properties	2,971,468		3,012,515
	2,971,468		3,029,718
Less accumulated amortization and impairment	(13,960	)	(27,537	)
Net Capitalized Costs	$ 2,957,508	$	3,002,181

Costs Incurred in Oil and Gas Producing Activities

	For the
	Period from
	September 23,
	2003	Quarter
	(Inception) to	Ended
	December 31,	March 31,
	2003	2004
Property acquisition costs:
Proved	$ 2,363,716	$ –
P&A liability assumed	273,760	–
Unproved	–	17,203
Exploration costs	–	–
Development costs	333,992	41,047
Total Property Acquisition Costs	$ 2,971,468	$ 58,250

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

1. Supplemental Oil and Gas Disclosures (continued)

Results of Operations for Oil and Gas Producing Activities

	For the
	Period from
	September 23,
	2003		Quarter
	(Inception) to		Ended
	December 31,		March 31,
	2003		2004
Oil and gas sales	$ 24,229		$ 48,572
Production costs	(76,303	)	(58,696	)
Production taxes	(3,002	)	(6,025	)
Depletion	(13,960	)	(13,576	)
Proved property impairment	–		–
Results of operations for oil and gas
producing activities (excluding corporate
overhead and financing costs)	$ (69,036	)	$ (29,725	)

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

1. Supplemental Oil and Gas Disclosures (continued)

Proved Developed and Undeveloped Reserves prepared by W.D. Von Gonten & Co. Petroleum Engineers

The following table sets forth the net proved reserves of the Company as of December 31, 2003, and the changes therein for the period from September 23, 2003 (inception) to December 31, 2003. The reserve information was reviewed by W.D. Von Gonten & Co., independent petroleum engineers. All of the company’s oil and gas producing activities are located in the United States.

(bbls)		(mcf)
September 23, 2003	–		–
Purchases of minerals in place	241,219		778,700
Extensions and discoveries	–		–
Production	(857	)	–
Sales of minerals in place	–		–
December 31, 2003	240,362		778,700

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

1. Supplemental Information on Oil & Gas Operations (continued)

Standardized Measure of Discounted Future Net Cash Flows at December 31, 2003

| The information that follows has been developed pursuant to SFAS No. 69
and utilizes reserve and production data prepared or reviewed by
independent petroleum consultants. Reserve estimates are inherently
imprecise and estimates of new discoveries are less precise than those of
producing oil and natural gas properties. Accordingly, these estimates are
expected to change as future information becomes available. |
| --- |
| The estimated discounted future net cash flows from estimated proved
reserves are based on prices and costs as of the date of the estimate
unless such prices or costs are contractually determined at such date.
Actual future prices and costs may be materially higher or lower. Actual
future net revenues also will be affected by factors such as actual
production, supply and demand for oil and natural gas, curtailments or
increases in consumption by natural gas purchasers, changes in
governmental regulations or taxation and the impact of inflation on costs.
Future income tax expense has been reduced for the effect of available net
operating loss carryforwards. |

Future cash inflows	$
Future production costs	(2,895,677	)
Future development costs	(357,000	)
Future income taxes	(2,412,000	)
Future Net Cash Flows	7,653,492
10% annual discount	(1,479,544	)
Standardized Measure	$ 6,173,948

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

1. Supplemental Information on Oil & Gas Operations (continued)

Changes in Standardized Measure

The following table sets forth the changes in standardized measure of discounted future net cash flows for the period from September 23, 2003 (inception) to December 31, 2003:

Standardized Measure, September 23, 2003	$
Net change in income taxes	(1,945,722	)
Oil and gas sales, net of costs	51,065
Purchase of minerals in place	8,068,605
Standardized Measure, December 31, 2003	$ 6,173,948

| 11. |
| --- |
| On May 17, 2004, the Company changed its fiscal year from December 31, to
June 30. |
| On May 26, 2004, the Company completed a reverse merger into Reality
Interactive, a public shell, wherein NGS took control of the surviving
company. Following completion of the merger, Reality Interactive
changed its name to Natural Gas Systems, Inc. The Company’s trading
symbol is NGSY and trades on the Over-the-Counter Bulletin Board (OTCBB).
The completion of the merger earned Cagan McAfee Capital Partners the
$300,000 fee described in Note 10, Related Party Transactions. |
| During the 2nd calendar quarter of 2004, NGS completed its 2nd round
private equity offering to accredited investors for the sale of 750,000
common shares at an effective price of $1 per share and began its 3rd
round private equity offering to accredited investors, of which, 250,000
common shares have been sold at an effective price of $1 per share (the
“effective price” includes warrants attached, all of which were
immediately exercised). Expenses for both offerings include placement
fees equal to 8% of proceeds, plus warrants exercisable at $1 per share on
8% of shares sold (additional to the warrants issued above). All offering
expenses were payable to Cagan McAfee Capital Partners in accordance with
the financial advisory services agreement described in Note 9, Related
Party Transactions. |

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NATURAL GAS SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(THE PERIOD SUBSEQUENT TO DECEMBER 31, 2003 IS UNAUDITED)

12.
The tax effect of significant temporary differences representing deferred
tax assets and liabilities at December 31, 2003, are as follows:

Oil and gas properties	$	)
Net operating loss carryforwards	228,043
Valuation Allowance	(114,485	)
Net deferred tax asset	$ –

| The increase in the valuation allowance during fiscal 2003 of $114,485 is
the result of additional net tax losses incurred during the year. |
| --- |
| As of December 31, 2003, the Company has net operating loss carryforwards
of approximately $670,714 that will expire in 2024. Future utilization of
the net operating loss carryforwards and other tax attributes may be
limited by changes in the ownership of the Company in May 2004 under
section 382 of the Internal Revenue Code. |
| The difference between the actual income expense or benefit of zero for
fiscal year 2003 and the expected amount using the statutory income tax
rate of 34% results from the 100% valuation allowance on the deferred tax
asset at year end. |

| 13. |
| --- |
| As of December 31, 2003 and March 31, 2004, the Company had
negative working capital of $360,749 and $536,634, respectively and
incurred losses for the periods ended December 31, 2003 and March 31,
2004 of $336,905 and $324,507, respectively. These matters raise
concerns about the Company’s ability to meet its future
obligations and fund future operations. |
| The Company has taken the following steps to provide funding
for operations, acquisitions of producing properties and to meet its
debt obligations: |

•	Substantially increased production from the Delhi Field.
•	Initiated a private offering of its common stock.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors Natural Gas Systems, Inc.

We have audited the accompanying statements of revenues and direct operating expenses of the Delhi Field acquired on September 23, 2003, for the period from January 1, 2003 to September 23, 2003 and for the nine-month period ended December 31, 2002. The statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the statements are free from material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the statements referred to above present fairly, in all material respects, the direct operating revenues and direct operating expenses of the Delhi Field acquired on September 23, 2003, in conformity with accounting principles generally accepted in the United States of America.

Hein & Associates LLP Houston, Texas

July 30, 2004

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NATURAL GAS SYSTEMS, INC.

STATEMENT OF REVENUES AND DIRECT OPERATING EXPENSES OF THE DELHI FIELD ACQUIRED ON SEPTEMBER 23, 2003

	For the — Period From	For the
	January 1,	Nine-Month
	2003 to	Period Ended
	September 23,	December 31,
	2003	2002
Oil and Gas Sales	$ 148,506	$ 64,491
Direct Operating Expenses	141,854	55,202
Net Revenue	$ 6,652	$ 9,289

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NATURAL GAS SYSTEMS, INC.

NOTES TO STATEMENT OF REVENUES AND DIRECT OPERATING EXPENSES

1.	Basis of Preparation
	The accompanying historical summaries of revenues and direct operating
expenses relate to the operations of the Delhi Field oil and gas
properties acquired by Natural Gas Systems, Inc. (the “Company”) on
September 23, 2003 from Delta Exploration
and Development Co. and Camark Production Co. The properties were acquired
for $1,000,000 in cash and an interest-free note payable in the amount of
$1,495,000.
	Revenues are recorded when the Company’s share of oil or natural gas and
related liquids are sold. Direct operating expenses are recorded when the
related liability is incurred. Direct operating expenses include lease
operating expenses, ad valorem taxes and production taxes. Depreciation
and amortization of oil and gas properties, general and administrative
expenses and income taxes have been excluded from operating expenses in
the accompanying historical summaries because the amounts would not be
comparable to those resulting from proposed future operations.
	The historical summaries presented herein were prepared for the purpose of
complying with the financial statement requirements of a business
acquisition to be filed on Form 8-K as promulgated by Regulation S-B Item
3-10 of the Securities Exchange Act of 1934.
2.	Supplemental Information on Oil and Gas Reserves (Unaudited)
	Proved oil and gas reserves consist of those estimated quantities of crude
oil, natural gas, and natural gas liquids that geological and engineering
data demonstrate with reasonable certainty to be recoverable in future
years from known reservoirs under existing economic and operating
conditions.
	The following estimates of proved reserves have been made by independent
engineers, based on the 80% net revenue interest purchased by the Company.
The estimated net interest in proved reserves are based upon subjective
engineering judgments and may be affected by the limitations inherent in
such estimation. The process of estimating reserves is subject to
continual revision as additional information becomes available as a result
of drilling, testing, reservoir studies and production history. There can
be no assurance that such estimates will not be materially revised in
subsequent periods.

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NATURAL GAS SYSTEMS, INC.

NOTES TO STATEMENT OF REVENUES AND DIRECT OPERATING EXPENSES

| 2. |
| --- |
| The changes in proved reserves of the Delhi Field properties acquired on
September 23, 2003 for the period from January 1, 2003 to September 23,
2003 and for the nine months ended December 31, 2002 are set forth below. |

Oil		(Thousand
(Barrels)		Cubic Feet)
Reserves at April 1, 2002	248,074		778,700
Production	(2,461	)	–
Revisions, extensions and discoveries	–		–
Reserves at January 1, 2003	245,613		778,700
Production	(4,394	)	–
Revisions, extensions and discoveries	–		–
Reserves at September 23, 2003	241,219		778,700

The standardized measure of discounted estimated future net cash flows related to proved oil and gas reserves as of September 23, 2003 and December 31, 2002 is as follows:

	September 23, — 2003	2002
Future cash inflows	$ 11,097,902	$	11,437,004
Future production costs	(2,892,314	)	(3,054,627	)
Future development costs	(357,000	)	(357,000	)
Future income taxes	(1,658,000	)	(1,718,000	)
Future net cash flows	6,190,588		6,307,377
10% annual discount	(1,290,548	)	(1,669,865	)
Standardized measure of discounted future net cash flows	$ 4,900,040	$	4,637,512

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NATURAL GAS SYSTEMS, INC.

NOTES TO STATEMENT OF REVENUES AND DIRECT OPERATING EXPENSES

| 2. |
| --- |
| The primary changes in the standardized measure of discounted estimated
future net cash flows for the period from January 1, 2003 to September 23,
2003 and for the nine-month period ended December 31, 2002, were as
follows: |

Beginning of period	2003 — $ 4,637,512	$	3,254,254
Sales of oil and gas produced, net of production costs	(6,652	)	(9,289	)
Effect of change in prices	(267,891	)	1,846,310
Accretion of discount	463,751		325,425
Net change in income taxes	47,492		(609,524	)
Revision of estimates and other	25,828		(169,664	)
End of period	$ 4,900,040	$	4,637,512

| Estimated future cash inflows are computed by applying year-end prices of
oil and gas to year-end quantities of proved reserves. Estimated future
development and production costs are determined by estimating the
expenditures to be incurred in developing and producing the proved oil and
gas reserves at the end of the year, based on period-end costs and
assuming continuation of existing economic conditions. Estimated future
income tax expense is calculated by applying year-end statutory tax rates
to estimated future pre-tax net cash flows related to proved oil and gas
reserves, less Natural Gas Systems’ tax basis of the properties involved
as if the purchase had occurred at April 1, 2002. |
| --- |
| The assumptions used to compute the standardized measure are those
prescribed by the Financial Accounting Standards Board and as such, do not
necessarily reflect the Company’s expectations of actual revenues to be
derived from those reserves nor their present worth. The limitations
inherent in the reserve quantity estimation process are equally applicable
to the standardized measure computations since these estimates are the
basis for the valuation process. |

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NATURAL GAS SYSTEMS, INC.

UNAUDITED PRO FORMA FINANCIAL INFORMATION

On September 23, 2003, Natural Gas Systems, Inc. (the “Company”) acquired interests in the Delhi Field for considering of $2,495,000. Unaudited pro forma financial statements have not been prepared to demonstrate the effect on the Company’s financial position and results of operations as if the properties had been acquired on December 31, 2002 (with respect to the pro forma balance sheet) and at January 1, 2003 and April 1, 2002 (with respect to the pro forma statements of income) because the Company did not exist prior to September 23, 2003.

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