10KSB/A 1 v048472_10ksba.txt ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ------------- FORM 10-KSB/A ------------- ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the Fiscal Year Ended December 31, 2004 Commission File No. 0-10157 CAPCO ENERGY, INC. ----------------------------------------------------------------- (Exact Name of Small Business Issuer as Specified in its Charter) COLORADO 84-0846529 -------------------------------- ------------------------------------ (State or other jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 5555 San Felipe, Suite 725, Houston, TX 77056 --------------------------------------------------------------- (Address of Principal Executive Office, Including Zip Code) Registrant's telephone number including area code: (713) 622-5550 Securities registered pursuant to Section 12(b) of the Act: None. Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $.001 PAR VALUE ---------------------------- Title of Class Indicate by check mark whether the Registrant (1) has filed all reports required to have been filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months or for such shorter period that the Registrant was required to file such reports and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| As of May 5, 2005, 113,280,769 shares of Common Stock were outstanding. The aggregate market value of the Common Stock of the Registrant held by non-affiliates on that date was approximately $23.9 million. State Issuer's revenues for its most recent fiscal year: $5,254,824 Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation SB is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. DOCUMENTS INCORPORATED BY REFERENCE: Portions of Registrant's proxy statement relating to Registrant's 2005 Annual Meeting of Shareholders have been incorporated by reference into Part III hereof. This Form 10-KSB/A is being filed to report two amendments to our annual report for the year ended December 31, 2004 ("Report"), which was originally filed on May 11, 2005. The first amendment is in Item 2-Description of Properties in the section titled "Proved Developed and Proved Undeveloped Reserves." Additional disclosure has been included in the Report to explain the reasons for the decline in proved reserves from the end of year 2003 to the end of year 2004. The second amendment is described in a paragraph titled "Reclassification resulting in amending the December 31, 2004, Form 10-KSB filing" located at the end of Note 1 to the consolidated financial statements. As explained in the footnote, we have revised the presentation of revenues, costs and expenses on the consolidated statement of operations. The accounts that previously comprised sales and cost of sales are now reported separately on the consolidated statement of operations. The revision had no effect on income from continuing operations as previously reported in the Report. ================================================================================ PART I ITEM 1. DESCRIPTION OF BUSINESS. GENERAL DEVELOPMENT OF BUSINESS Capco Energy, Inc. ("Capco" or the "Company"), with its mailing address at 5555 San Felipe, Suite 725, Houston, TX 77056, was incorporated as Alfa Resources, Inc. a Colorado corporation on January 6, 1981. In November 1999, the Company changed its name to Capco. Capco was organized for the purpose of engaging in oil and gas exploration, development and production activities. Effective December 31, 1999, Capco closed on the acquisition of 100% of Capco Resource Corporation ("Resource"), a corporation involved in oil and gas production. Based on the ownership of the respective companies at the time of this acquisition, it was determined that a change in control had occurred and accordingly, the transaction was considered a reverse acquisition for accounting purposes. The historical accounts of Resource are reflected in the financial statements for the period beginning with January 19, 1999, the inception date of Resource, at cost. In March 2000, the Company acquired an additional 70.2% equity ownership in Capco Resources Ltd. ("Limited"), increasing its equity ownership to approximately 80.4%, by the issuance of 47,470,232 shares of its Common Stock. From April 2000 through December 2002, the Company increased its equity ownership in Limited to 88.9% in exchange for issuing 5,095,720 Common Shares of the Company. In October 2000, the Company consummated a private placement with Chaparral Resources, Inc. by tendering $3.0 million in cash for 1.6 million restricted shares of Chaparral. These restricted shares were then exchanged with Limited for all of the outstanding shares of Capco Asset Management, Inc., a wholly-owned subsidiary of Limited. In April 2001, the Company purchased Meteor Enterprises, Inc. ("Enterprises") from Meteor Industries, Inc. ("Industries") for $5.6 million and assumption of certain environmental liabilities and other indemnities. Effective December 31, 2000, Industries had contributed substantially all of its assets and all of its businesses to its wholly owned subsidiary, Enterprises. The significant wholly owned subsidiaries of Enterprises at the date of acquisition were: Meteor Marketing, Inc. ("Marketing"), Graves Oil & Butane Co., Inc. ("Graves"), Tri-Valley Gas Co. and Innovative Solutions and Technologies, Inc. Enterprises also owned 73% of Meteor Holdings LLC and 61% of Rocky Mountain Propane LLC ("Propane"). In August 2001, the Company formed Capco Monument, LLC ("Monument"), and acquired the operation of convenience stores. In May 2002, the Company closed on the sale of its interest in properties in Kansas, realizing sales proceeds in the amount of $1.1 million. Approximately $0.7 million of the sales proceeds was used to repay long-term debt and the balance was used for working capital. The Company recorded a gain in the amount of $0.3 million on this transaction. 2 In June 2002, the Company closed on an acquisition of producing oil and gas properties located in Michigan and related accounts receivable at a total cost of $1.7 million. Approximately $0.4 million of the acquisition cost was allocated to accounts receivable and the remainder, $1.3 million, was allocated to producing oil and gas property. Funding for the acquisition consisted of cash payments in the total amount of $0.4 million and the assumption of seller-provided financing in the amount of $1.3 million payable to the operator of the properties. Effective December 31, 2002, the Company sold 100.0% of its equity ownership in Graves and Monument for $10,000 cash. The operations of Graves and Monument are reported as discontinued operations for the year ended December 31, 2002. In January 2003, Marketing closed on the sale of its preferred membership interests in Propane. Total consideration of $1.1 million consisted of (1) a cash payment in the amount of $0.8 million, (2) an 8% promissory note in the amount of $0.2 million due January 2006, and (3) a cash retention in the of $0.1 million to be paid upon the delivery of asset title transfer documents relating to Marketing's sale of Propane in April 2002. Effective January 1, 2003, the Company agreed to sell Enterprises to a private company owned by the Company's Chief Executive Officer. The transaction closed September 30, 2003. The operations of Enterprises for the nine-month period ended September 30, 2003, and for the year ended December 31, 2002, are reported as discontinued operations in the financial statements. Effective September 30, 2003, the Company restored assets and liabilities attributable to the business interests of Graves and Monument that had previously been reported as sold as of December 31, 2002. A gain resulting from the sale had been deferred by the Company at December 31, 2002, due to debt guarantees provided by the Company on a significant level of debt that was included in the sales transaction. In October 2003, the Company participated in the acquisition of producing properties and related gas processing and transmission facilities located in the state of Montana. The Company acquired an approximate 4.3% interest in the acquired properties. Funding for the acquisition consisted of a loan in the amount of $4.5 million provided by the operator of the acquired property, a cash payment in the amount of $250,000 and a credit in the amount of $500,000 extended to the Company's Chief Executive Officer for his participation in the acquisition process. The Company acquired the credit by issuing 8.7 million shares of Common Stock to the Chief Executive Officer. In addition, the seller deferred receipt of a portion of the sales amount which is to be repaid from future cash flow from the acquired properties. The Company's portion of this obligation is $229,000. The Company sold a portion of the total acquired property interest to other owners, realizing proceeds in the amount of $1.4 million that were credited against the Company's basis in the acquired property. The Company's cost of the acquisition was approximately $4.1 million. The loan from the operator is collateralized by the Company's interest in the acquired property and by the Company's interest in producing oil and gas property located in the state of Michigan. The Michigan and Montana properties were sold in December 2004 as described below. In October 2003, the Company acquired from a third party a 3% working interest in the Caplen Field in Galveston County, Texas at a recorded cost of $207,000. In November 2003, the Company closed on the acquisition of properties in the Brazos Field, offshore in Matagorda County, Texas. The Company owns a 65% working interest in the property and is the operator of the acquired property. The acquired properties consist of 22 wells, two of which are currently in 3 production. The Company's recorded cost of the acquisition, including a funding obligation to the seller of the property in the amount of $1.1 million, and net of fees earned from joint interest partners, was $1.2 million. In connection with the acquisition the Company and its joint interest partners were required to provide a surety bond in the amount of $1.3 million to the seller of the property. The surety company required a cash deposit in the amount of $700,000, of which the Company's portion was $278,000. A portion of monthly net cash flow from the acquired property will be used to fund the deposit account until the bond limit of $1.3 million is fully funded. Effective February 2005, this requirement was amended to provide for a series of twenty-four (24) monthly payments of $24,000 ($12,000 net to Capco's interest) to fully fund the deposit account. The surety company was given a security interest in the Company's working interests in the Brazos Field and the Caplen Field as collateral for this obligation. The Company's Chief Executive Officer also provided his personal guarantee to the surety company. An additional portion of the monthly net cash flow from the property will be used to fund another deposit account to the seller. When this account balance reaches $1.7 million the $1.3 million bond will be released. The Company's portion of this obligation, $1.1 million, is included in the Company's recorded cost of the acquisition. Effective December 31, 2003, the Company sold its equity ownerships in Resource and Limited to the Company's Chief Executive Officer for the assumption of certain liabilities. In February 2004, the Company closed on an acquisition of a production platform with nine additional wells in the Brazos Field, offshore in Matagorda County, Texas. The Company owns a 90% working interest in the wells and will be operator of the property. In conjunction with the acquisition, Capco plans to acquire leases for the mineral interests at an estimated cost of $144,000. Such expenditure is necessary before the Company can initiate production from any of the acquired wells. Under the terms of the agreement, the seller agreed to contribute as much as $1.0 million to apply toward payment of abandonment costs when, and if, such costs are incurred by the Company. As of December 31, 2004, the Company had not finalized its work program for this property, and had not expended any funds for lease acquisition. In February 2004, the Company entered into an agreement to drill and complete a coal bed methane well in Stephens County, Texas. The well was drilled to a depth of 1,100 feet at a cost of $0.1 million, and following a period of "dewatering" and evaluation, was determined to be non-productive. By drilling the well Capco earned the right to negotiate the purchase of a leasehold interest in approximately 4,000 acres, along with wells previously drilled on the property. Effective July 1, 2004, the Company exercised its option to acquire a 92.8% working interest in the property located in Stephens County, Texas. In addition to the acreage, the acquisition included one producing gas well drilled by the former owners, the coal bed methane well drilled by the Company during the year and seismic and geological studies. The Company issued 3.6 million shares of Common Stock as consideration for the acquisition cost of $0.4 million. The number of shares issued was negotiated between the parties based on analysis of the value of the underlying assets. The per share price of $0.16 approximated the market price of the Company's Common Stock at that time. Approximately 70% of the acquired working interest in the property was acquired as a result of Capco's exchange of shares for 100% equity ownership of Packard Gas Company with individuals, or entities controlled by individuals, who have either a direct, or beneficial, relationship to the Company, including the President of the Company. The negotiated acquisition price was determined in amounts prorata to all members of the selling group. Subsequent to the exercise of its option, the Company drilled and completed a gas well on the property 4 at a cost of $0.2 million. Following a period of evaluation of the two producing gas wells the decision was made to discontinue further drilling activities on the property, and as a result, the Company only earned acreage attributable to each well location actually drilled on the property. In July 2004, the Company participated with a 15% working interest in the acquisition of leases covering approximately 7,000 gross acres in a drilling prospect located in Fayette County, Alabama. Two wells were drilled on the property and both were determined to be incapable of commercial production. The Company plans to further evaluate the undeveloped acreage to determine if additional drilling is warranted. Capco incurred expenditures for lease acquisition and drilling costs in the total amount of $0.2 million for its 15% participation. In September 2004, the Company acquired, from a Director of the Company, an 80% equity interest in Bison Energy Company ("Bison"), an entity organized for the purpose of owning, and operating, oil and gas properties in the state of Wyoming. The 20% minority interest is held by the Director. In conjunction with the equity investment, the Director exercised options at a price of $0.0625 per share to acquire 800,000 shares of the Company's Common Stock. The option proceeds of $50,000 were advanced to Bison to provide funding for the acquisition cost of an oil property in the amount of $30,000; the balance was retained by Bison for working capital. The property consists of 720 gross acres and includes nine wells, four of which are currently in production. Rework operations are in progress in an effort to restore the remaining wells to production. Effective September 30, 2004, the Company sold its interests in non-operated producing properties located in Alabama and Louisiana to a company owned by the Company's Chief Executive Officer. Sales proceeds in the amount of $0.4 million were received by the Company in October 2004 and were used for working capital. The sales proceeds were credited against the Company's basis in oil and gas properties. No gain or loss was recognized from the sale as the disposition represented only 3% of the Company's proved reserves at the time of sale. If it is determined through due diligence by the Company that the properties could have been sold for an amount greater than $0.4 million, then the related party has the obligation to pay such excess to the Company, or the Company, at its option, may repurchase the properties at the original sales price. In October 2004, the Company acquired a 45% working interest in two properties located in Creek County, Oklahoma. The properties consisted of approximately 100 oil wells, the majority of which were not in production at the time of acquisition by the Company. Under the terms of the purchase agreement the Company is obligated to expend a total of $0.6 million over a specified period of time in an effort to bring injection and production wells back in to service to earn the entire 45% interest. As of December 31, 2004, the Company had incurred $48,000 of such costs. In December 2004, the Company sold a parcel of undeveloped land consisting of approximately 160 acres located in the province of Alberta, Canada. The Company had owned the land since 1999 with a recorded cost basis of $0.2 million. Consideration for the sale consisted of a cash payment of $0.1 million received in December 2004, assumption by the buyer of related indebtedness in the amount of $0.4 million and the issuance of a note receivable in the amount of $0.3 million. The Company realized a gain in the amount of $0.6 million from the sale. The note receivable was paid in full by the buyer in March 2005. In December 2004, the Company acquired a 100% working interest in an oil property consisting of approximately 80 wells located in Osage County, Oklahoma. The acquisition cost of $0.2 million is to be settled by the issuance of 1.0 million shares of the Company's Common Stock. The per share price of $0.20 approximated the market price of Capco's Common Stock at the time the agreement was negotiated with 5 the seller. The Common Stock was issued to the seller in March 2005. The seller of the property retained a net profits interest in the amount of $0.3 million that is to be paid from one-third of the net production from the property until paid in full. The net profit distributions will be included with the acquisition cost of the property as they are paid by Capco. In addition, the purchase agreement stipulates that Capco expend a minimum of $0.1 million of property development costs within one year from the date of acquisition. Effective December 31, 2004, the Company sold its interests in non-operated producing properties located in Michigan and Montana and other assets to the Company's Chief Executive Officer for the amount of $4.7 million. The Company received a fairness opinion for the sale in January 2005. The sales amount was settled by the payment of a cash deposit in the amount of $0.7 million, assumption of debt against the properties in the amount $3.3 million and the issuance of a note payable to the Company in the amount of $0.7 million. The note was paid in full in March 2005. The disposition resulted in a significant change to the depletion rate in the Company's full cost pool cost center, which required that gain or loss recognition be given to the sale. The Company recorded a gain in the amount of $0.4 million from the sale. NARRATIVE DESCRIPTION OF BUSINESS GENERAL Capco is an independent energy company engaged primarily in the acquisition, exploration, development, production for and sale of oil, gas and natural gas liquids. OIL AND GAS PRODUCTION Property Acquisitions and Sales In October 2003, the Company participated in the acquisition of producing properties and related gas processing and transmission facilities located in the state of Montana. The Company acquired an approximate 4.3% interest in the acquired properties. Funding for the acquisition consisted of a loan in the amount of $4.5 million provided by the operator of the acquired property, a cash payment in the amount of $250,000 and a credit in the amount of $500,000 extended to the Company's Chief Executive Officer for his participation in the acquisition process. The Company acquired the credit by issuing 8.7 million shares of Common Stock to the Chief Executive Officer. In addition, the seller deferred receipt of a portion of the sales amount which is to be repaid from future cash flow from the acquired properties. The Company's portion of this obligation is $229,000. The Company sold a portion of the total acquired property interest to other owners, realizing proceeds in the amount of $1.4 million that were credited against the Company's basis in the acquired property. The Company's cost of the acquisition was approximately $4.1 million. The loan from the operator is collateralized by the Company's interest in the acquired property and by the Company's interest in producing oil and gas property located in the state of Michigan. The Montana and Michigan properties were sold in December 2004 as described below. In October 2003, the Company acquired from a third party a 3% working interest in the Caplen Field in Galveston County, Texas at a recorded cost of $207,000. In November 2003, the Company closed on the acquisition of properties in the Brazos Field, offshore in Matagorda County, Texas. The Company owns a 65% working interest in the property and is the operator of the acquired property. The acquired properties consist of 22 wells, two of which are currently in production. The Company's recorded cost of the acquisition, including a funding obligation to the 6 seller of the property in the amount of $1.1 million, and net of fees earned from joint interest partners, was $1.2 million. In connection with the acquisition the Company and its joint interest partners were required to provide a surety bond in the amount of $1.3 million to the seller of the property. The surety company required a cash deposit in the amount of $700,000, of which the Company's portion was $278,000. A portion of monthly net cash flow from the acquired property will be used to fund the deposit account until the bond limit of $1.3 million is fully funded. Effective February 2005, this requirement was amended to provide for a series of twenty-four (24) monthly payments of $24,000 ($12,000 net to Capco's interest) to fully fund the deposit account. The surety company was given a security interest in the Company's working interests in the Brazos Field and the Caplen Field as collateral for this obligation. The Company's Chief Executive Officer also provided his personal guarantee to the surety company. An additional portion of the monthly net cash flow from the property will be used to fund another deposit account to the seller. When this account balance reaches $1.7 million the $1.3 million bond will be released. The Company's portion of this obligation, $1.1 million, is included in the Company's recorded cost of the acquisition. In February 2004, the Company closed on an acquisition of a production platform with nine additional wells in the Brazos Field, offshore in Matagorda County, Texas. The Company owns a 90% working interest in the wells and will be operator of the property. In conjunction with the acquisition, Capco plans to acquire leases for the mineral interests at an estimated cost of $144,000. Such expenditure is necessary before the Company can initiate production from any of the acquired wells. Under the terms of the agreement, the seller agreed to contribute as much as $1.0 million to apply toward payment of abandonment costs when, and if, such costs are incurred by the Company. In February 2004, the Company entered into an agreement to drill and complete a coal bed methane well in Stephens County, Texas. The well was drilled to a depth of 1,100 feet at a cost of $0.1 million, and following a period of "dewatering" and evaluation, was determined to be non-productive. By drilling the well Capco earned the right to negotiate the purchase of a leasehold interest in approximately 4,000 acres, along with wells previously drilled on the property. Effective July 1, 2004, the Company exercised its option to acquire a 92.8% working interest in the property located in Stephens County, Texas. In addition to the acreage, the acquisition included one producing gas well drilled by the former owners, the coal bed methane well drilled by the Company during the year and seismic and geological studies. The Company issued 3.6 million shares of Common Stock as consideration for the acquisition cost of $0.4 million. The number of shares issued was negotiated between the parties based on an analysis of the value of the underlying assets. The per share price of $0.16 approximated the market price of the Company's Common Stock at that time. Approximately 70% of the acquired working interest in the property was acquired as a result of Capco's exchange of shares for 100% equity ownership of Packard Gas Company with individuals, or entities controlled by individuals, who have either a direct, or beneficial, relationship to the Company, including the President of the Company. The negotiated acquisition price was determined in amounts prorata to all members of the selling group. Subsequent to the exercise of its option, the Company drilled and completed a gas well on the property at a cost of $0.2 million. Following a period of evaluation of the two producing gas wells the decision was made to discontinue further drilling activities on the property, and as a result, the Company only earned acreage attributable to each well location actually drilled on the property. 7 In July 2004, the Company participated with a 15% working interest in the acquisition of leases covering approximately 7,000 gross acres in a drilling prospect located in Fayette County, Alabama. Two wells were drilled on the property and both were determined to be incapable of commercial production. The Company plans to further evaluate the undeveloped acreage to determine if additional drilling is warranted. Capco incurred expenditures for lease acquisition and drilling costs in the total amount of $0.2 million for its 15% participation. In September 2004, the Company's 80%-owned subsidiary, Bison Energy Company, acquired a 33.33% working interest in an oil property located in Natrona County, Wyoming. The property consists of 720 gross acres and includes nine wells, four of which are currently in production. Rework operations are in progress in an effort to restore the remaining wells to production. Effective September 30, 2004, the Company sold its interests in non-operated producing properties located in Alabama and Louisiana to a company owned by the Company's Chief Executive Officer. Sales proceeds in the amount of $0.4 million were received by the Company in October 2004 and were used for working capital. The sales proceeds were credited against the Company's basis in oil and gas properties. No gain or loss was recognized from the sale as the disposition represented only 3% of the Company's proved reserves at the time of sale. If it is determined through due diligence by the Company that the properties could have been sold for an amount greater than $0.4 million, then the related party has the obligation to pay such excess to the Company, or the Company, at its option, may repurchase the properties at the original sales price. In October 2004, the Company acquired a 45% working interest in two properties located in Creek County, Oklahoma. The properties consisted of approximately 100 oil wells, the majority of which were not in production at the time of acquisition by the Company. Under the terms of the purchase agreement the Company is obligated to expend a total of $0.6 million over a specified period of time in an effort to bring injection and production wells back in to service to earn the entire 45% interest. As of December 31, 2004, the Company had incurred $48,000 of such costs. In December 2004, the Company sold a parcel of undeveloped land consisting of approximately 160 acres located in the province of Alberta, Canada. The Company had owned the land since 1999 with a recorded cost basis of $0.2 million. Consideration for the sale consisted of a cash payment of $0.1 million received in December 2004, assumption by the buyer of related indebtedness in the amount of $0.4 million and the issuance of a note receivable in the amount of $0.3 million. The Company realized a gain in the amount of $0.6 million from the sale. The note receivable was paid in full by the buyer in March 2005. In December 2004, the Company acquired a 100% working interest in an oil property consisting of approximately 80 wells located in Osage County, Oklahoma. The acquisition cost of $0.2 million is to be settled by the issuance of 1.0 million shares of the Company's Common Stock. The per share price of $0.20 approximated the market price of Capco's Common Stock at the time the agreement was negotiated with the seller. The Common Stock was issued in March 2005. The seller of the property retained a net profits interest in the amount of $0.3 million that is to be paid from one-third of the net production from the property until paid in full. The net profit distributions will be included with the acquisition cost of the property as they are paid by Capco. In addition, the purchase agreement stipulates that Capco expend a minimum of $0.1 million of property development costs within one year from the date of acquisition. Effective December 31, 2004, the Company sold its interests in non-operated producing properties located in Michigan and Montana and other assets to the Company's Chief Executive Officer for the amount of $4.7 million. The Company received a fairness 8 opinion for the sale in January 2005. The sales amount was settled by the payment of a cash deposit in the amount of $0.7 million, assumption of debt against the properties in the amount $3.3 million and the issuance of a note payable to the Company in the amount of $0.7 million. The note was paid in full in March 2005. The disposition resulted in a significant change to the depletion rate in the Company's full cost pool cost center, which required that gain or loss recognition be given to the sale. The Company recorded a gain in the amount of $0.4 million from the sale. Equipment, Products and Raw Materials Capco owns no drilling rigs, but it does own two pulling units which may be used for workover activities on Company-operated wells. In addition, Capco owns one crew vessel which is used to transport personnel and material to its properties located in the Texas Gulf Coast, and one lift boat which is used in connection with remediation activities at its production facilities in the Texas Gulf Coast. Capco's principal products are crude oil and natural gas. Crude oil and natural gas are sold to various purchasers including pipeline companies which service the areas in which Capco's producing wells are located. Capco's business is seasonal in nature, to the extent that weather conditions at certain times of the year may affect its access to oil and gas properties and the demand for natural gas. Principally all of Capco's oil and gas production is sold on a month-to-month basis with no firm sales contracts. The existence of commercial oil and gas reserves is essential to the ultimate realization of value from properties, and thus may be considered a raw material essential to Capco's business. The acquisition, exploration, development, production and sale of oil and gas are subject to many factors, which are outside Capco's control. These factors include national and international economic conditions, availability of drilling rigs, casing, pipe and other fuels, and the regulation of prices, production, transportation, and marketing by federal and state governmental authorities. Capco acquires oil and gas properties from landowners, other owners of interests in such properties, or governmental entities. For information on specific properties of Capco see Item 2. Capco currently is not experiencing any difficulty in acquiring necessary supplies or services as long as Capco can pay for the services and supplies nor is it experiencing any difficulty selling its products. Competition The oil and gas business is highly competitive. Capco's competitors include major companies, independents and individual producers and operators. Many of Capco's numerous competitors throughout the country are larger and have substantially greater financial resources than Capco. Oil and gas, as a source of energy, must compete with other sources of energy such as coal, nuclear power, synthetic fuels and other forms of alternate energy. Domestic oil and gas must also compete with foreign sources of oil and gas, the supply and availability of which have at times depressed domestic prices. Capco has an insignificant competitive position in the oil and gas industry. Governmental and Environmental Laws Capco's activities are subject to extensive federal, state and local laws and regulations controlling not only the exploration for oil and gas, but also the possible effect of such activities upon the environment. Existing as well as future legislation and regulations could cause additional expense, capital expenditures, restrictions and delays in the development of properties, the extent of which cannot 9 be predicted. Many states have been authorized by the Environmental Protection Agency to enforce regulations promulgated under various federal statutes. In addition, there are numerous other state as well as local authorities that regulate the environment, some of which impose more stringent environmental standards than Federal laws and regulations. The penalties for violations of state laws vary but typically include injunctive relief, recovery of damages for injury to air, water or property, and fines for non-compliance. Since inception, Capco has not made any material expenditures for environmental control facilities and does not expect to make any material expenditures during the current and following fiscal year. Insurance The Company has a commercial general liability policy, as well as other policies covering damage to its properties. These policies cover Company facilities in all states of operation. The exploration for, and production of, oil and gas can be hazardous, including unforeseen events such as blowouts, cratering of surface locations, fires and loss of well control. Events such as these can result in damage to wells and production facilities, injury to persons, loss of life and damage to the environment. While management believes the Company's insurance coverage is adequate for most foreseeable problems, and is comparable with the coverage of other companies in the same business and of similar size, its coverage does not protect the Company against all operational risks or for most third party liabilities relating to damage of the environment. Such environmental related coverage to third parties, is generally unavailable or available only at a prohibitive cost. Employees The Company employs approximately 27 people, none of whom are represented by any collective bargaining organizations. Management considers its employee relations to be satisfactory at the present time. ITEM 2. DESCRIPTION OF PROPERTIES. OIL AND GAS PROPERTIES. Capco's principal oil and gas properties during the year ended December 31, 2004, were located in the Texas Gulf Coast and the states of Michigan and Montana. In total, the properties located in these areas accounted for more than 93% of the Company's total annual revenue. Producing properties located in Alabama, Louisiana, Oklahoma, Texas and Wyoming provided less than 7% of Capco's annual revenue for year 2004. Michigan Capco owned working interests ranging from 2.8% to 22.5% in thirteen (13) oil and gas wells located primarily in Manistee and Oceana Counties, Michigan. Capco acquired the property interests in June 2002 at a cost of approximately $1.3 million. The Company derived gross revenue of $1.7 million and $2.2 million from the property during the years ended December 31, 2004 and 2003, respectively. Substantially all of the net operating cash flow from the property was utilized to reduce debt incurred with the original acquisition in 2002, and a subsequent refinancing in year 2003 in connection with the acquisition of a producing property located in the state of Montana. Effective December 31, 2004, the property was sold to Capco's Chief Executive Officer for the assumption of debt and cash (see Montana property). Montana Capco owned working interests ranging from less than 1% to 4.3% in approximately 1,100 oil and gas wells located in several counties in northern Montana. The properties were acquired by the Company in October 2003 at a cost of approximately $4.1 million. Capco derived gross revenue of $1.3 million and $0.2 million from the property during the years ended December 31, 2004 and 2003, respectively. All of the net operating cash flow from the property was utilized to 10 reduce debt incurred with the acquisition of the property. As of December 31, 2004, there remained approximately three years of debt amortization, based on current levels of net cash flow from the Michigan and Montana properties. Effective December 31, 2004, the two properties were sold to the Company's Chief Executive Officer for the assumption of $3.3 million of indebtedness against the properties and $1.2 million cash. Capco intends to use the cash proceeds to fund its drilling obligations in the first quarter of year 2005. Texas Gulf Coast Capco owns working interests ranging from 65% to 100% in thirty-six (36) wells located in offshore Matagorda County in the Texas Gulf Coast. The initial acquisition in this area was made in November 2003 at a cost of $1.2 million. Subsequent acquisitions in the area were made during the year 2004. Operations during the year 2004 included restoration of wells to production and expenditures to improve the production infrastructure and gas transmission capability to accommodate expected increases in production quantities as wells were returned to service. Capco derived gross revenue of $1.9 million and $0.1 million from the properties during the years ended December 31, 2004 and 2003, respectively. Activities planned for year 2005 include the restoration of additional wells to production, including one major recompletion attempt on an existing inactive wellbore. In addition, the Company plans to dispose of as many as thirteen (13) inactive well locations during the year 2005 either by designating wells for plugging and abandonment or by selling locations to other oil and gas operators. The Company anticipates that such actions will reduce the Company's bonding requirements. The previous owner of a property acquired by Capco during the year 2004 is expected to contribute as much as $1.0 million to certain abandonment costs to the extent such costs are incurred by the Company. Other Effective September 30, 2004, the Company sold its working interest ownership in non-operated properties located in the states of Alabama and Louisiana to a company owned by Capco's Chief Executive Officer. Sales proceeds in the amount $0.4 million were used for working capital. The properties provided net cash flow of $0.1 million during the nine-month period that Capco owned the interests in 2004. During the year 2004, Capco acquired working interests in additional oil and gas properties located in Creek and Osage Counties, Oklahoma, Stephens County, Texas and Natrona County, Wyoming at a combined acquisition cost of $0.7 million, plus development cost and net profits obligations. These properties, plus a property located in Galveston County, Texas that was previously acquired by Capco, accounted for total revenue of $0.1 million in 2004. For the year 2005, Capco plans to continue development activities on the properties located in Oklahoma to return inactive wells to service, and has also initiated workover operations on two wells in the Galveston County property in an attempt to increase production from the property. The Company will assess other shut-in wells on this property throughout the year 2005 in an effort to identify additional re-work locations. During the year 2004, the Company participated in the leasing of more than 7,000 gross acres and the drilling of two exploratory wells on a prospect in Fayette County, Alabama. Although both wells were determined to be non-productive, Capco does not consider the entire acreage block condemned at this time. The Company plans further evaluation of the remaining acreage under lease during the year 2005 to determine if additional drilling is warranted. 11 OIL AND GAS ACREAGE. Capco holds interests in oil and gas leaseholds as of December 31, 2004, as follows: Developed Undeveloped Expiration Properties Properties Date (1) ------------- --------------- ---------- Gross Net Gross Net State Acres Acres Acres Acres ----- ----- ----- ----- ----- Alabama -- -- 6,409 961 Nov '06-Mar `07 Mississippi 200 25 -- -- Oklahoma 4,140 2,655 -- -- Texas 14,958 9,671 -- -- Wyoming 720 240 -- -- Total 20,018 12,591 6,409 961 Net acres represent the gross acres in a lease or leases multiplied by Capco's working interest in such lease or leases. (1) Expiration date(s) of leases for undeveloped properties. Leasehold interests for developed properties are held by production. PROVED DEVELOPED AND PROVED UNDEVELOPED RESERVES. The following table sets forth the proved developed and proved undeveloped oil or gas reserves accumulated by Capco, for the years ended December 31, 2004, 2003 and 2002. The reserves are based on engineering reports prepared by Capco's independent engineers: Pressler Petroleum Consultants, Inc. in 2004; Burroughs Engineering Services and Netherland, Sewell & Associates, Inc. in 2003; and Gary E. Houghton Petroleum Engineer in 2002. All of such reserves are located in the United States of America. For the two-year period ended December 31, 2003, the Company also owned producing oil and gas property located in the province of Alberta, Canada, but the operations were minimal and estimates of proved reserves were not prepared at each year-end. In 2003, the Company sold the Canadian interests. As reported in the Company's Form 10-QSB/A for the quarterly period ended March 31, 2003 (filed on August 21, 2003), a review by the Securities and Exchange Commission of the Company's engineered proved reserves as previously reported resulted in the exclusion of certain proved undeveloped reserves. The excluded reserves consisted of the following at December 31, 2002: 10,005 mmcf of gas and 297,000 barrels of oil. The following information has been revised to include these changes. 2004 2003 2002 ----------------- ----------------- ----------------- Oil Gas Oil Gas Oil Gas (Bbls) (MCF) (Bbls) (MCF) (Bbls) (MCF) Proved Developed Reserves 307,818 1,458,287 351,194 15,507,081 326,873 2,535,627 Proved Undeveloped Reserves 78,862 1,657,984 210,021 2,107,182 210,919 326,116 ------- ---------- ------- --------- ------- --------- Proved Reserves 386,680 3,116,271 561,215 17,614,263 537,792 2,861,743 ======= ========== ======= ========= ======= ========= The Company had a significant decline in reserves in 2004 attributable to its producing properties located in onshore and offshore Texas. Downward revisions to the Caplen Field located in Galveston County, Texas totaled 151,427 barrels of oil and 240,085 mcf of gas. Production in the year 2004 was significantly curtailed due to field operational problems. Wells which were shut-in for an extended period during the year 2004, and remained shut-in at year end were reclassified to proved developed non-producing status. Proved developed gas reserves decreased from 317,506 mcf to 33,336 mcf. Approximately 55% of the decrease was due to the elimination of one well as it was determined during the year 2004 that the reservoir was depleted. Proved undeveloped oil reserves decreased from 210,020 barrels to 78,863 barrels due to the elimination of one location and per well reductions based on the incumbent engineer's evaluation of the locations. Proved reserves attributed to the Brazos Field located in offshore Matagorda County, Texas were revised downward in the amounts of 50,877 barrels of oil and 7,351,615 mcf of gas. Work-over activities were conducted on five wells during the year in an attempt to either increase production rates or restore wells to service. Such activities were successful on only one well. As a result the incumbent engineer significantly reduced the previously-reported proved reserves until such time that it can be demonstrated that the wells are capable of producing at economical levels. The changes reflect the engineers' subjective evaluation of the properties based on a number of factors including data that was available when 12 the evaluation was prepared, actual production during the current year and price changes. Properties sold by Capco during the year 2004 resulted in additional decreases of 190,400 barrels of oil and 6,262,000 mcf of gas. Properties acquired during the year 2004 resulted in an increase to proved reserves of 240,200 barrels of oil and 83,000 mcf of gas, while year 2004 production resulted in a decrease of proved reserves of 22,100 barrels of oil and 727,000 mcf of gas. Proved reserves are estimates of oil and gas to be produced in the future. There are numerous uncertainties inherent in the process of preparing such estimates, including future rates of production, timing and cost of development expenditures and the actual results realized as a result of such expenditures. The estimates presented in this Report are based on several assumptions including constant oil and gas prices, operating expenses and capital expenditures. Actual future production, cash flow and ultimate recoverable quantities of oil and gas may vary significantly from the estimated quantities, as variances from the assumptions could result in significant differences in quantities and value. No major discovery or other favorable or adverse event has occurred since December 31, 2004, which is believed to have caused a material change in the proved reserves of Capco. RESERVES REPORTED TO OTHER AGENCIES. There have been no reserve estimates filed with any other United States federal authority or agency. NET OIL AND GAS PRODUCTION. The following table sets forth the net quantities of oil (including condensate and natural gas liquids) and gas produced during the years ended December 31, 2004, 2003 and 2002: 2004 2003 2002 -------- -------- -------- Oil (Bbls): United States 22,087 38,613 31,372 Canada -- -- -- Gas (Mcf): United States 727,336 408,747 152,669 Canada -- 7,584 3,157 The following table sets forth the average sales price and production cost per units of production for the years ended December 31, 2004, 2003 and 2002: 2004 2003 2002 -------- -------- -------- Average Sales Price: United States: Bbl $37.13 $21.69 $22.93 Mcf $ 5.54 $ 4.92 $ 3.99 Canada-Mcf -- $ 1.78 $ 1.58 Average Production (Lifting) Costs: Per Equivalent Barrel of Oil: United States $17.87 $14.25 $12.76 Canada -- $ 7.01 $15.66 During the periods covered by the foregoing tables, Capco was not a party to any long-term supply or similar agreements with foreign governments or authorities in which Capco acted as a producer. 13 PRODUCTIVE WELLS (1). The following table sets forth Capco's total gross and net productive oil and gas wells as of December 31, 2004: OIL GAS --------------------- ------------------------ State Gross(2) Net(3) Gross(2) Net(3) ----- -------- ------ -------- ------ Oklahoma 91 60.7 -- -- Texas 4 2.4 27 19.0 Wyoming 9 3.0 -- -- --- ---- ----- ---- Total 104 66.1 27 19.0 --- ---- ----- ---- (1) Productive wells are producing wells and wells capable of production including wells that are shut in. (2) A gross well is a well in which a working interest is owned. The number of wells is the total number of wells in which a working interest is owned. (3) A net well is deemed to exist when the sum of fractional ownership working interests owned in gross wells equals one. The number of net wells is the sum of the fractional ownership working interests owned in gross wells expressed in whole numbers and fractions thereof. UNDEVELOPED PROPERTIES. During the year ended December 31, 2004, Capco acquired a 15% working interest in approximately 7,049 gross (1,057 net) acres of undeveloped property in Fayette County, Alabama. Two dry holes were drilled on the property, resulting in the condemnation of 640 gross acres. The remaining acreage (6,409 gross) is under evaluation by the Company to determine if additional drilling is warranted. Leases on the property expire at various times during the period November 2006 to March 2007. During the year ended December 31, 2003, the Company acquired working interests in undeveloped leases comprising approximately 855 gross acres (670 net acres) in Kern County, California. Following a period of evaluation, which included monitoring drilling activity by other operators in the area, the decision was made to abandon the prospect in the year 2004. Capco's oil and gas properties are in the form of mineral leases. As is customary in the oil and gas industry, a preliminary investigation of title is made at the time of acquisition of undeveloped properties. Title investigations are generally completed, however, before commencement of drilling operations. Capco believes that its methods of investigating are consistent with practices customary in the industry and that it has generally satisfactory title to the leases covering its proved reserves. 14 DRILLING ACTIVITY. The following table sets forth certain information for the year ended December 31, 2004, pertaining to Capco's participation in the drilling of exploratory and development wells: Gross(1) Net(2) ------- ----- Exploratory Oil -- -- Gas 1 0.9 Dry(3) 3 1.2 Development Oil -- -- Gas -- -- Dry(3) -- -- Total Oil -- -- Gas 1 0.9 Dry(3) 3 1.2 (1) A gross well is a well in which a working interest is owned. The number of wells is the total number of wells in which a working interest is owned. (2) A net well is deemed to exist when the sum of fractional ownership working interests owned in gross wells equals one. The number of net wells is the sum of the fractional ownership working interests owned in gross wells expressed in whole numbers and fractions thereof. (3) A dry hole is an exploratory or development well that is not a producing well. All of Capco's drilling activities were conducted in the United States of America. Capco did not conduct any drilling activities during the years ended December 31, 2003 and 2002. DELIVERY COMMITMENTS. Capco is not obligated to provide a fixed and determinable quantity of oil and gas in the future pursuant to existing contracts or agreements. OFFICE FACILITIES. Capco leases space for its executive offices at 5555 San Felipe, Suite 725, Houston, TX, and leases additional office space at locations in Tustin, CA and Tulsa, OK. Total leased space is approximately 5,500 square feet at the rate of $7,300 per month. ITEM 3. LEGAL PROCEEDINGS. The Company is a party to certain litigation that has arisen in the normal course of its business and that of its subsidiaries. A company engaged by Capco to provide well service in connection with workover operations on some of the Company's offshore wells has filed a claim for unpaid invoices in the amount of approximately $0.2 million. Capco has recorded less than $50,000 of such costs in its accounts, and has claims against the service company for damages and costs to its wells in an estimated amount in excess of $1.0 million. The Company expects to show that its damages far exceed the claim amount asserted by the service company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. During the fourth quarter of the fiscal year covered by this Annual Report, no matter was submitted to a vote of Capco's security holders through the solicitation of proxies or otherwise. 15 PART II ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. PRICE RANGE OF COMMON STOCK The Common Stock of Capco has been traded on the Bulletin Board since June 2000. In December 2003, the Company approved a 4 for 1 forward stock split on the Common Stock, and all references to shares of Common Stock made herein have been adjusted to give effect to the stock split. The following table sets forth the high and low bid prices of the Common Stock in the over-the-counter market for the periods indicated (after giving effect to the 4 for 1 forward split). The bid prices represent prices between dealers, and do not include retail markups, markdowns or commissions, and may not represent actual transactions. Public trading in the Common Stock of Capco is minimal. Quarter Ended Bid High Bid Low ------------- -------- ------- March 31, 2003 $ 0.12 $ 0.06 June 30, 2003 $ 0.09 $ 0.04 September 30, 2003 $ 0.16 $ 0.06 December 31, 2003 $ 0.20 $ 0.07 March 31, 2004 $ 0.37 $ 0.11 June 30, 2004 $ 0.26 $ 0.14 September 30, 2004 $ 0.21 $ 0.14 December 31, 2004 $ 0.23 $ 0.12 The number of record holders of Common Stock of Capco as of March 15, 2005, was approximately 677. Additional holders of Capco's Common Stock hold such stock in street name with various brokerage firms. Holders of Common Stock are entitled to receive dividends as may be declared by the Board of Directors out of funds legally available. No Common Stock dividends have been declared to date by Capco, nor does Capco anticipate declaring and paying Common Stock cash dividends in the foreseeable future. The following table presents information regarding the Company's equity compensation plans at December 31, 2004: Number of Number of securities securities to remaining available be issued upon Weighted-average for future issuance exercise of exercise price under equity outstanding of outstanding compensation Plan category options options plans ------------- -------------- ---------------- ------------------- Equity compensation plans approved by security holders 4,585,000 $0.12 5,390,577 Equity compensation plans not approved by security holders 12,000,000 $0.15 -- ---------- --------- Total 16,585,000 $0.14 5,390,577 ========== ==== ========= 16 ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION. This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that include, among others, statements concerning: the benefits expected to result from Capco's divestiture of petroleum marketing operations, including decreased expenses and expenditures that are expected to be realized by Capco as a result of the divestiture, and other statements of: expectations, anticipations, beliefs, estimations, projections, and other similar matters that are not historical facts, including such matters as: future capital requirements, development and exploration expenditures (including the amount and nature thereof), drilling of wells, reserve estimates (including estimates of future net revenues associated with such reserves and the present value of such future net revenues), future production of oil and gas, repayment of debt, realization of proceeds from disposition of real property, business strategies, and expansion and growth of business operations. These statements are based on certain assumptions and analyses made by the management of Capco in light of past experience and perception of: historical trends, current conditions, expected future developments, and other factors that the management of Capco believes are appropriate under the circumstances. Capco cautions the reader that these forward-looking statements are subject to risks and uncertainties, including those associated with the financial environment, the regulatory environment, and trend projections, that could cause actual events or results to differ materially from those expressed or implied by the statements. Such risks and uncertainties include those risks and uncertainties identified below. Significant factors that could prevent Capco from achieving its stated goals include: declines in the market prices for oil and gas, adverse changes in the regulatory environment affecting Capco, the inability to dispose of real property at prices sufficient enough to liquidate associated indebtedness, the inherent risks involved in the evaluation of properties targeted for acquisition, the Company's dependence on key personnel, the availability of capital resources at terms acceptable to the Company, the uncertainty of estimates of proved reserves and future net cash flows, the risk and related cost of replacing produced reserves, the high risk in exploratory drilling and competition. Capco or persons acting on its or their behalf should consider the cautionary statements contained or referred to in this report in connection with any subsequent written or oral forward-looking statements that may be issued. Capco undertakes no obligation to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. LIQUIDITY AND CAPITAL RESOURCES The following discussion is based on the continuing operations of the Company. Discontinued operations have been separately presented in the financial statements. At December 31, 2004, the Company had a working capital deficit of $0.1 million. However, current liabilities included certain accrued expenses in the amount of $0.3 million and a promissory note in the amount of $0.4 million that will not require the use of working capital to satisfy the obligations. Those accrued expenses include a $0.2 million obligation incurred in connection with the acquisition of an oil property in Oklahoma, and other liabilities in the amount of $0.1 million that will be settled during the year 2005 by the issuance of 1.0 million shares of Common Stock. The Company anticipates that the promissory note in the amount of $0.4 million will be assumed by a third party in connection with the acquisition of a producing oil and gas property that is expected to close in May 2005. 17 Continuing Operations Net cash provided by operating activities totaled $3.1 million for the year ended December 31, 2004, compared to cash provided by operating activities of $8,000 for the year ended December 31, 2003. In 2004, net income, adjusted for reconciling items, provided a cash source of $1.7 million. Changes in assets and liabilities in 2003 resulted in a cash source of $1.4 million. In 2003, net loss, adjusted for reconciling items, resulted in a cash source of $0.7 million. Changes in assets and liabilities resulted in a cash outflow of $0.7 million. Net cash used in investing activities totaled $4.7 million for the year ended December 31, 2004, and net cash provided by investing activities totaled $1.1 million for the year ended December 30, 2003. A deposit in the amount of $0.4 million on a property acquisition, capital expenditures for oil and gas property in the amount of $4.0 million, purchases of other property and equipment in the amount of $0.7 million and the issuance of notes receivable in the amount of $1.0 million were the principal cash outflows in 2004. Proceeds in the amount of $1.7 million from the sale of oil and gas properties were the principal source of cash inflow in 2004. Net advances of $0.8 million received from related parties and proceeds of $0.8 million received from joint interest owners for their participation in property acquisitions were the principal sources of cash inflow in 2003. An equity contribution of $0.4 million to a subsidiary was the principal cash outflow in 2003. Net cash provided by financing activities totaled $3.4 million for the year ended December 31, 2004, and net cash used in financing activities totaled $1.1 million for the year ended December 31, 2003. Proceeds from borrowings and an increase in long-term liabilities provided cash inflows of $3.4 million and $1.4 million, respectively, in 2004. Payments on long-term debt resulted in a cash outflow of $1.4 million in 2004. Payments on long-term debt in 2003 totaled $1.1 million. The Company's total long-term debt decreased from a balance of $4.8 million at December 31, 2003, to a balance of $2.7 million at December 31, 2004. Proceeds in the amount of $1.6 million were received from the issuance of convertible promissory notes, convertible into the Company's Common Stock. An additional $1.0 million was borrowed in December 2004, to be repaid over a period of twenty months. In addition to the $1.5 million of debt reduction by cash payments, an additional $3.2 million of long-term debt was assumed by the buyers of land and oil and gas properties. The Company has various loans which require principal payments of $1.4 million in 2005. Of this amount, it is anticipated that $0.4 million will be assumed by a third party in connection with the acquisition of a producing oil and gas property that is expected to close in May 2005. The remainder of the payments are anticipated to be made from cash flow available from the operations of other producing property, and from proceeds from the sale of assets and equity and/or debt fundings. To the extent such cash flow is insufficient to make the debt payments and provide adequate working capital for the business of the Company, the Company may be required to reduce or curtail certain operations or seek other sources of capital. Capco has historically secured financing for its acquisition and development activities on a project-financing basis. Such financing has included the sale of portions of target acquisitions or drilling ventures to third parties, participation with co-venturers on financing arranged by the other party, private borrowings from individuals and private placements of the Company's Common Stock. Other than financing arrangements already consummated in the first quarter of 2005, the Company does not have any agreements or arrangements providing for such financing and it may not be available on terms acceptable to the Company. 18 In addition to debt service requirements, Capco has several other obligations that affect the Company's available cash flow. The Company is obligated to pay operating lease costs of approximately $0.1 million in 2005 for land and facilities and has an obligation to a surety company to make monthly cash collateral deposits of $12,000 over a period of twenty-four months, beginning February 2005. Acquisitions of producing oil and gas properties that closed during the year ended December 31, 2004, include obligations to make development expenditures of $0.6 million during the year 2005 to earn the entire working interests stipulated in the purchase agreements. Various purchase agreements require that funding obligations of $1.1 million and $0.3 million be paid from the net profits, if any, derived from the respective operations of the properties. Utilization of available cash flow to fund these requirements may affect Capco's ability to adequately fund other planned activities. Capco disposed of its equity ownership in Enterprise and subsidiaries during the year 2003, but remained as guarantor of certain indebtedness incurred by those business interests prior to the date of sale by Capco. As of December 31, 2004, Capco was the guarantor of $1.1 million of obligations for trade accounts, real estate and equipment purchases and leases owed by Enterprise. The obligations are being serviced by Enterprise, and Capco believes that there is sufficient underlying collateral value in the related assets to significantly reduce the exposure of loss to the Company. Capco is also the guarantor of indebtedness issued to one lender by Graves, a former subsidiary of Enterprise, in the amount of $3.9 million at December 31, 2004. Graves is owned by Capco's Chief Executive Officer. In December 2004, a Pay-Off Agreement ("Agreement") was negotiated with the lender, which provided for the following: the outstanding amount of debt owed was reduced from $3.9 million to $2.7 million by application of proceeds from properties sold and a discount given by the lender, scheduled monthly payments were to be made for the period February 15, 2005, to June 15, 2005, with the balance owing at June 30, 2005, $2.6 million, to be paid at that date ("Date of Closing"). Alternatively, by making a payment of $1.0 million on or before May 31, 2005, the Date of Closing would be extended for a period of ninety (90) days. As a further condition of the Agreement, the buyer deposited into an escrow account ten million shares of the Company's Common Stock. In the event that debt payments are not made in accordance with the terms of the Agreement, the lender has the right to proceed to collect the unpaid indebtedness based on the original amount owed and has the right to liquidate the Common Stock in escrow in addition to seeking other remedies available to it to collect the outstanding balance. At this time Capco believes that the indebtedness will be satisfied in accordance with the terms of the Agreement and that the Company will not incur any loss attributable to the guarantee. In the first quarter of year 2005, Capco closed on two financings to provide capital for its participation in the drilling of an exploratory well and for other planned activities. In January 2005, the Company received $1.5 million from the sale of portions of its working interests in producing oil and gas properties located in the Texas Gulf Coast, and an interest in an exploratory well on which drilling activities commenced in February 2005. On April 12, 2005, the Company announced that due to encountering excessive gas pressures at a depth of approximately 13,350 feet, the decision was made to sidetrack from the existing well bore and re-drill the well from a depth of approximately 8,500 feet to a depth in excess of 14,000 feet. As a result of the difficulties encountered in drilling this well, the cost has substantially exceeded the Company's planned expenditures in this regard and is increasing as the drilling continues. Significant capital resources of the Company have been and will continue to be utilized to pay the ongoing costs associated with the well. While the Company believes that it has sufficient capital resources to complete the drilling as currently planned, any further delays or complications may result in additional costs for which the Company will need to make financial arrangements. The Company anticipates that it will recover certain of the drilling costs from participants in 19 the well if and when the drilling reaches the targeted depth. Additionally, the Company intends to pursue a claim on the insurance covering the drilling of the well based upon the consequences of encountering the excessive gas pressures in the initial well bore, and any insurance proceeds would also assist in recovering a portion of the drilling costs. The Company cannot make any assurances concerning the potential completion of or production from this well. On March 10, 2005, the Company entered into a Securities Purchase Agreement with certain accredited investors with respect to a private placement under Regulation D of 10 million shares of the Company's Common Stock and common stock purchase warrants for 5 million shares of the Company's Common Stock, for a total purchase price of $3.0 million. The transaction closed on March 11, 2005. Capco intends to use the net proceeds from this issuance and sale of securities in the acquisition and development of oil and gas properties and for general corporate purposes. On March 15, 2005, the Company entered into an agreement for the acquisition of producing properties located in St. Bernard Parish, Louisiana, and Chandeleur Area, OCS Blocks 27, 29 and 30, and funded a $1.0 million cash deposit with the seller of the properties. Closing for the acquisition is scheduled for May 4, 2005. The closing cost is expected to approximate $12.0 million, after adjustment for net revenue credits from the effective date to the closing date and after credit for the $1.0 million cash deposit. Capco expects to fund the acquisition cost by selling the acquired property interests to third parties, while retaining an interest in the properties after the third parties receive payout on their investment amounts. The Company is responsible for any contamination of land it owns or leases. However, there may be limitations on any potential contamination liabilities as well as claims for reimbursement from third parties. The Company sells most of its oil production to certain major oil companies. However, in the event these purchasers discontinued oil purchases, Capco has made contact with other purchasers who would purchase the oil at terms standard in the industry. Discontinued Operations Discontinued operations reported for the year 2003 consist of operations for the nine-month period ended September 30, 2003. Net cash provided by operating activities totaled $2.5 million in 2003. Net loss, adjusted for reconciling items, resulted in a cash outflow of $0.5 million. Changes in assets and liabilities in 2003 provided a cash inflow of $3.0 million. Net cash provided by investing activities totaled $0.8 million in 2003. Proceeds of $0.8 million from the sale of an equity investment and $0.4 million from an equity contribution were the principal sources of cash inflow. Financing activities resulted in cash used of $3.3 million in 2003. Payments on a revolving credit facility and on long term debt resulted in cash outflows of $3.7 million. A decrease in restricted cash resulted in a cash inflow of $0.4 million. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company has no material exposure to interest rate changes. RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 2004, COMPARED TO YEAR ENDED DECEMBER 31, 2003 Capco's revenues from oil and gas sales were $4.8 million in 2004 compared to $3.1 million in 2003. This increase is due to increases in product prices paid at the 20 wellhead and production volumes. On a barrel of oil equivalent ("BOE") basis, the Company's price per BOE increased to $33.67 in 2004 from $28.90 in 2003, resulting in an increase in revenue of $0.5 million. Total production was 143,300 BOE in 2004, compared with 108,000 BOE in 2003, resulting in an increase in revenue of $1.2 million. The increase in revenue was due principally to production from two acquisitions that closed in the fourth quarter of 2003. The Montana properties acquired in November 2003 provided revenue of $1.0 million (37,000 BOE) in 2004, and the Brazos properties located in the Texas Gulf Coast that were acquired in November 2003 provided revenue of $1.7 million (48,000 BOE) in 2004. Capco's revenue from gas gathering, marketing, and processing, and oil field services increased to .4 million due to the Brazos property. Capco's gains on sales of land and oil and gas poperty increased to $1.0 million due to those sales in 2004. Capco's oil and gas production lifting costs including expensed workovers increased to $1.6 million in 2004 from $.7 million in 2003; production taxes increased to $.5 million in 2004 from $.4 million in 2003; gas gathering, marketing and processing increased to $.8 million in 2004 from $.4 million in 2003; all due principally to the increase in production volumes from 108,000 BOE in 2003 to 143,300 BOE in 2004. Capco's oil field services expenses increased to $.2 million due to the Brazos field. Net operating revenues from Capco's oil and gas production are very sensitive to changes in the price of oil, while Capco's expenses related to oil and gas production are not as sensitive to a change in price and Capco sold a significant portion of its producing properties in late 2004; thus it is difficult for management to predict whether or not the Company will be profitable in the future. General and administrative expenses were $1.3 million in 2004 and $0.9 million in 2003. The change is due to an increase in employment levels in Capco's Houston, Texas office necessitated by the properties operated by Capco in the Texas Gulf Coast. In 2003, Capco realized cost savings from relocation of the Company's administrative office from Orange, California to Denver, Colorado in February 2003. Depreciation, depletion and amortization was $0.8 million in 2004 and $0.6 million in 2003. This change is attributable to the increase in production volumes in 2004, cost additions to the Company's United States full cost pool in the second half of 2003 and during the year 2004, including acquisitions in Montana, Oklahoma and the Texas Gulf Coast. Interest income decreased to $19,000 in 2004 from $45,000 in 2003 as notes receivable taken by Capco in April 2003 were collected during that same year. Interest expense increased to $0.4 million in 2004 from $0.2 million in 2003, due principally to an increase in the average balance of interest-bearing indebtedness from $1.0 million in 2003 to $5.7 million in 2004. The increase was substantially related to debt incurred in the acquisition of oil and gas interests in Montana in late 2003 which was assumed by the buyer of those interests at December 31, 2004. Gain (loss) from sale of marketable securities, including unrealized holding gains (losses), decreased from a gain of $0.1 million in 2003 to a loss of $0.1 million in 2004, due principally to market value declines. In 2003, the Company recorded a loss of $0.2 million resulting from potential deficits that may result from the liquidation of debt issued by a former subsidiary for which the Company is a guarantor. YEAR ENDED DECEMBER 31, 2003, COMPARED TO YEAR ENDED DECEMBER 31, 2002 Capco's revenues from oil and gas activities were $3.1 million in 2003 compared to $1.3 million in 2002. This increase is due to increases in product prices paid at the wellhead and production volumes. On a barrel of oil equivalent ("BOE") basis, the Company's price per BOE increased to $28.90 in 2003 from $23.23 in 2002, resulting in an increase in revenue of $0.3 million. Total production was 108,000 BOE in 2003, compared with 57,300 BOE in 2002, resulting in an increase in revenue of $1.5 million. Production from the Michigan properties acquired in June 2002 totaled 78,000 21 BOE in 2003 (27,400 BOE in 2002); sale of the Buried Hills property in Kansas in May 2002 resulted in a comparative production decrease of 8,900 BOE in 2003. Two acquisitions that closed in the fourth quarter of 2003 produced 9,500 BOE in 2003. Capco's operating costs and expenses related to oil and gas activities increased to $1.5 million in 2003 from $0.7 million in 2002, due principally to the increase in production volumes from 57,300 BOE in 2002 to 108,000 BOE in 2003. Net operating revenues from Capco's oil and gas production are very sensitive to changes in the price of oil; thus it is difficult for management to predict whether or not the Company will be profitable in the future. General and administrative expenses were $0.9 million in 2003 and $1.5 million in 2002. The decrease is due to the closing of field offices in 2002, and the cost savings realized from relocation of the Company's administrative office from Orange, California to Denver, Colorado in February 2003. Depreciation, depletion and amortization was $0.6 million in 2003 and $0.4 million in 2002. This change is attributable to the increase in production volumes in 2003, cost additions to the Company's United States full cost pool in the second half of 2002, including acquisitions in Michigan and Louisiana, and cost additions in 2003, including acquisitions in Montana and the Texas Gulf Coast. Interest income increased to $45,000 in 2003 from $5,000 in 2002 as a result of interest accrued on notes receivable taken by the Company in April 2003. Interest expense decreased to $0.2 million in 2003 from $0.3 million in 2002, due principally to a reduction in the average balance of interest-bearing indebtedness from $2.4 million in 2002 to $1.0 million in 2003 (exclusive of the Montana acquisition debt that was placed in November 2003). Gain (loss) from sale of marketable securities, including unrealized holding gains (losses), increased from a loss of $0.1 million in 2002 to a gain of $0.1 million in 2003, due principally to market value appreciation. In 2003, the Company recorded a loss of $0.2 million resulting from potential deficits that may result from the liquidation of debt issued by a former subsidiary for which the Company is a guarantor. In 2002, the Company realized a gain of $0.3 million from the sale of the Kansas oil property, and recorded losses in the amount of $0.1 million from the acquisitions of minority interests in Limited. The Company did not have similar transactions in 2003. EFFECT OF CHANGES IN PRICES Changes in prices during the past few years have been a significant factor in the oil and gas industry. The price received for the oil produced by Capco fluctuated significantly during the last year. Changes in the price that Capco receives for its oil and gas is set by market forces beyond Capco's control as well as governmental intervention. The volatility and uncertainty in oil and gas prices have made it more difficult for a company like Capco to increase its oil and gas asset base and become a significant participant in the oil and gas industry. Capco sells most of its oil and gas production to certain major oil companies. However, in the event these purchasers discontinued oil and gas purchases, Capco has made contact with other purchasers who would purchase the oil and gas at terms standard in the industry. 22 CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management's Discussion and Analysis of Financial Condition and Results of Operations discusses the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to revenue recognition, recovery of oil and gas reserves, financing operations, and contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The most significant accounting estimates inherent in the preparation of the Company's financial statements include estimates as to the appropriate carrying value of certain assets and liabilities which are not readily apparent from other sources, primarily allowance for doubtful accounts, the discounted value of recoverable oil and gas reserves, the fair value of asset retirement obligations, the proceeds to be realized from the sale of real property, and the classification of net operating loss carryforwards between current and long-term assets. Accounts Receivable The Company has a diversified customer base and controls credit risk related to accounts receivable through credit approvals, credit limits and monitoring procedures. The Company routinely assesses the financial strength of its customers and, based upon factors surrounding the credit risk, establishes an allowance, if required, for un-collectible accounts. Investment in Equity securities For equity securities that the Company i) does not exercise control in the investee and ii) expects to divest within a short period of time, the Company accounts for the investment under the provisions of Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities". In accordance with FASB No. 115, equity securities that have readily determinable fair values are classified as either trading or available-for-sale securities. Securities that are bought and held principally for the purpose of selling in the near term (thus held for only a short period of time) are classified as trading securities and all other securities are classified as available-for-sale. Trading and available-for-sale securities are measured at fair value in the balance sheet. For trading securities any realized gains or losses and any unrealized holding gains and losses are reported in the statement of operations. For available-for-sale securities any realized gains and losses are reported in the statement of operations and any unrealized holding gains and losses are reported as a separate component of stockholders' equity until realized. Oil and Gas Properties The Company follows the "full-cost" method of accounting for oil and gas property and equipment costs. Under this method, all productive and nonproductive costs incurred in the acquisition, exploration, and development of oil and gas reserves are capitalized. Such costs include lease acquisitions, 23 geological and geophysical services, drilling, completion, equipment, and certain general and administrative costs directly associated with acquisition, exploration, and development activities. General and administrative costs related to production and general overhead are expensed as incurred. No gains or losses are recognized upon the sale or disposition of oil and gas properties, except in transactions that involve a significant amount of reserves. Proceeds from the sale of oil and gas properties are generally treated as a reduction of oil and gas property costs. Fees from associated oil and gas exploration and development partnerships, if any, will be credited to oil and gas property costs to the extent they do not represent reimbursement of general and administrative expenses currently charged to expense. In accordance with the full cost method of accounting, future development, site restoration and dismantlement and abandonment costs, net of salvage values, are estimated on a property-by-property basis based on current economic conditions and are amortized to expense as the Company's capitalized oil and gas property costs are amortized. The provision for depreciation and depletion of oil and gas properties is computed on the unit-of-production method. Under this method, the Company computes the provision by multiplying the total unamortized costs of oil and gas properties including future development, site restoration, and dismantlement abandonment costs, but excluding costs of unproved properties by an overall rate determined by dividing the physical units of oil and gas produced during the period by the total estimated units of proved oil and gas reserves. This calculation is done on a country-by-country basis. As of December 31, 2004, all of the Company's oil production operations are conducted in the United States of America. The cost of unevaluated properties not being amortized, to the extent there is such a cost, is assessed quarterly to determine whether the value has been impaired below the capitalized cost. The cost of any impaired property is transferred to the balance of oil and gas properties being depleted. The costs associated with unevaluated properties relate to projects which were undergoing exploration or development activities or in which the Company intends to commence such activities in the future. The Company will begin to amortize these costs when proved reserves are established or impairment is determined. Management believes no such impairment exists at December 31, 2004. In accordance with SFAS No. 143, "Accounting for Asset Retirement Obligations," the Company reports a liability for any legal retirement obligations on its oil and gas properties. The associated costs are capitalized as part of the full cost pool. Following is a reconciliation of the asset retirement obligation liability for the year ended December 31, 2004 (in thousands): Asset retirement obligation at January 1, 2004 $ 1,105 Liabilities incurred 1,088 Liabilities settled -- Accretion expense -- Revisions in estimated liabilities -- ----- Asset retirement obligation at December 31, 2004 $ 2,193 ===== At the end of each reporting period, the unamortized cost of oil and gas properties, net of related deferred income taxes, is limited to the sum of the estimated future net revenues from proved properties using current prices, discounted at 10%, and the lower of cost or fair value of unproved properties, adjusted for related income tax effects ("Ceiling Limitation"). 24 The calculations of the ceiling limitation and provision for depreciation, depletion, and amortization are based on estimates of proved reserves. There are numerous uncertainties inherent in estimating quantities of proven reserves and in projecting the future rates of production, timing, and plan of development. The accuracy of any reserves estimate is a function of the quality of available data and of engineering and geological interpretation and judgment. Results of drilling, testing, and production subsequent to the date of the estimate may justify revision of such estimate. Accordingly, reserve estimates are often different from the quantities of oil and gas that are ultimately recovered. Other Property and Equipment Non-oil and gas producing properties and equipment are stated at cost; major renewals and improvements are charged to the property and equipment accounts; while replacements, maintenance and repairs, which do not improve or extend the lives of the respective assets, are expensed currently. At the time property and equipment are retired or otherwise disposed of, the asset and related accumulated depreciation accounts are relieved of the applicable amounts. Gains or losses from retirements or sales are credited or charged to operations. Depreciation for non-oil and gas properties is recorded on the straight-line method at rates based on estimated useful lives ranging from three to fifteen years of the assets. Impairment of Long-Lived Assets In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." This statement supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of." Although retaining many of the fundamental recognition and measurement provisions of SFAS No. 121, the new rules significantly change the criteria that would have to be met to classify an asset as held-for-sale. The statement also supersedes certain provisions of Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," and will require expected future operating losses from discontinued operations to be displayed in discontinued operations in the period or periods in which the losses are incurred rather than as of the measurement date, as presently required. The Company adopted this new statement on January 1, 2002, and concluded that the effect of adopting this statement had no material impact on the Company's financial position, results of operations, or cash flows. Revenue Recognition The Company recognizes revenue upon transfer of ownership of the product to the customer which occurs when (i) the product is physically received by the customer, (ii) the Company issues an invoice to the customer which evidences an arrangement between the customer and the Company, (iii) a fixed sales price has been included in such invoice, and (iv) collection from such customer is probable. Stock Based Compensation The Company accounts for employee stock options in accordance with APB No. 25 "Accounting for Stock Issued to Employees". Under APB 25, the Company recognizes no compensation expense related to employee stock options, as no options are granted at a price below market price on the date of grant. 25 In 2002, the Company adopted SFAS No. 123 "Accounting for Stock-Based Compensation". SFAS No. 123, which prescribes the recognition of compensation expense based on the fair value of options on the grant date, allows companies to continue applying APB 25 if certain pro forma disclosures are made assuming hypothetical fair value method, for which the Company uses the Black-Scholes option-pricing model. For non-employee stock based compensation the Company recognizes an expense in accordance with SFAS No. 123 and values the equity securities based on the fair value of the security on the date of grant. For stock-based awards the value is based on the market value for the stock on the date of grant and if the stock has restrictions as to transferability a discount is provided for lack of tradability. Stock option awards are valued using the Black-Scholes option-pricing model. Income Taxes Provisions for income taxes are based on taxes payable or refundable for the current year and deferred taxes on temporary differences between the amount of taxable income and pretax financial income and between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are included in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled as prescribed in SFAS No. 109, "Accounting for Income Taxes". As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Comprehensive Income SFAS No. 130, "Reporting Comprehensive Income" establishes standards for the reporting and display of comprehensive income and its components in the financial statements. For the year ended December 31, 2004, the Company did not report any components of comprehensive income. For the year ended December 31, 2003, the Company had other comprehensive income relating to foreign currency translations. Earnings per Share The Company uses SFAS No. 128, "Earnings Per Share" for calculating the basic and diluted earnings (loss) per share. Basic earnings (loss) per share are computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding. Diluted earnings (loss) per share is computed similar to basic earnings (loss) per share except that the numerator is increased by the amount of interest expense attributable to the convertible promissory notes payable and the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. On a diluted basis, under the treasury method of calculating the additional shares outstanding, the Company's weighted average shares outstanding for the year ended December 31, 2004, have been increased for 5,192,941 shares of Common Stock as associated stock options have a dilutive effect on net income. Additionally, the number of shares outstanding for the year ended December 31, 2004, have been increased for 4,481,148 shares of Common Stock determined under the "if converted" method, due to the issuance of convertible notes payable during the year ended December 31, 2004. On a diluted basis, the Company's weighted average shares outstanding for the year ended December 31, 2003, have been increased for 1,212,992 26 shares of Common Stock as associated stock options have a dilutive effect on income from continuing operations, which is the benchmark number for determining whether potential common stock is included in determining earnings (loss) per share. In accordance with SFAS No. 128, the stock options are also considered to be potential common stock in determining loss per share on loss from discontinued operations and net loss, even though the stock options are antidilutive. New Accounting Pronouncements In March 2004, the Financial Accounting Standards Board (FASB) approved the consensus reached on the Emerging Issues Task Force (EITF) Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." The objective of this Issue is to provide guidance for identifying impaired investments. EITF 03-1 also provides new disclosure requirements for investments that are deemed to be temporarily impaired. The accounting provisions of EITF 03-1 are effective for all reporting periods beginning after June 15, 2004, while the disclosure requirements are effective only for annual periods ending after June 15, 2004. The Company has evaluated the impact of the adoption of EITF 03-1 and does not believe the impact will be significant to the Company's overall results of operations or financial position. In November 2004, the FASB issued SFAS No. 151, "Inventory Costs, an amendment of ARB No. 43, Chapter 4". The amendments made by Statement 151 clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The guidance is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 23, 2004. The Company has evaluated the impact of the adoption of SFAS 151, and does not believe the impact will be significant to the Company's overall results of operations or financial position. In December 2004, the FASB issued SFAS No.152, "Accounting for Real Estate Time-Sharing Transactions, an amendment of FASB Statements No. 66 and 67 (SFAS 152)". The amendments made by Statement 152 amend FASB Statement No. 66, Accounting for Sales of Real Estate, to reference the financial accounting and reporting guidance for real estate time-sharing transactions that is provided in AICPA Statement of Position (SOP) 04-2, Accounting for Real Estate Time-Sharing Transactions. This Statement also amends FASB Statement No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects, to state that the guidance for (a) incidental operations and (b) costs incurred to sell real estate projects does not apply to real estate time-sharing transactions. The accounting for those operations and costs is subject to the guidance in SOP 04-2. This Statement is effective for financial statements for fiscal years beginning after June 15, 2005, with earlier application encouraged. The Company has evaluated the impact of the adoption of SFAS 152, and does not believe the impact will be significant to the Company's overall results of operations or financial position. In December 2004, the FASB issued SFAS No.153, "Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions." The amendments made by Statement 153 are based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. Further, the amendments eliminate the narrow exception for nonmonetary exchanges of similar productive assets and replace it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance. Previously, 27 Opinion 29 required that the accounting for an exchange of a productive asset for a similar productive asset or an equivalent interest in the same or similar productive asset should be based on the recorded amount of the asset relinquished. Opinion 29 provided an exception to its basic measurement principle (fair value) for exchanges of similar productive assets. The Board believes that exception required that some nonmonetary exchanges, although commercially substantive, be recorded on a carryover basis. By focusing the exception on exchanges that lack commercial substance, the Board believes this Statement produces financial reporting that more faithfully represents the economics of the transactions. The Statement is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. Earlier application is permitted for nonmonetary asset exchanges occurring in fiscal periods beginning after the date of issuance. The provisions of this Statement shall be applied prospectively. The Company has evaluated the impact of the adoption of SFAS 152, and does not believe the impact will be significant to the Company's overall results of operations or financial position. In December 2004, the FASB issued SFAS No.123 (revised 2004), "Share-Based Payment". Statement 123(R) will provide investors and other users of financial statements with more complete and neutral financial information by requiring that the compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. Statement 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. Statement 123(R) replaces FASB Statement No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. Statement 123, as originally issued in 1995, established as preferable a fair-value-based method of accounting for share-based payment transactions with employees. However, that Statement permitted entities the option of continuing to apply the guidance in Opinion 25, as long as the footnotes to financial statements disclosed what net income would have been had the preferable fair-value-based method been used. Public entities (other than those filing as small business issuers) will be required to apply Statement 123(R) as of the first interim or annual reporting period that begins after December 15, 2005. The Company has evaluated the impact of the adoption of SFAS 123(R), and does not believe the impact will be significant to the Company's overall results of operations or financial position. In March 2005, the staff of the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 107 ("SAB 107"). The interpretations in SAB 107 express views of the staff regarding the interaction between Statement of Financial Accounting Standards Statement No. 123 (revised 2004), "Share-Based Payment" ("Statement 123(R)") and certain SEC rules and regulations and provide the staff's views regarding the valuation of share-based payment arrangements for public companies. In particular SAB 107 provides guidance related to share-based payment transactions with nonemployees, the transition from public entity status, valuation methods (including assumptions such as expected volatility and expected term), the accounting for certain redeemable financial instruments issued under share-based payment arrangements, the classification of compensation expense, non-GAAP financial measures, first-time adoption of Statement 123(R) in an interim period, capitalization of compensation cost related to share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements upon adoption of Statement 123(R), the modification of employee share options prior to adoption of Statement 123(R) and disclosures in Management's Discussion and Analysis subsequent to adoption of Statement 123(R). ITEM 7. FINANCIAL STATEMENTS. Included at Pages F-1 through F-42 hereof. 28 ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None ITEM 8A. CONTROLS AND PROCEDURES. (a) Evaluation of disclosure controls and procedures The Company's Chief Executive Officer and Chief Accounting Officer, after evaluating the effectiveness of the Company's "disclosure controls and procedures" (as defined in Sections 13a-14(c) of the Securities Exchange Act of 1934) as of the end of the period reported in this annual report (the "Evaluation Date"), concluded that the Company's disclosure controls and procedures were effective and designed to ensure that material information relating to the Company and its consolidated subsidiaries is accumulated and would be made know to them by others within those entities as appropriate to allow timely decisions regarding required disclosures. (b) Changes in internal controls The Company does not believe that there are significant deficiencies in the design or operation of its internal controls that could adversely affect its ability to record, process, summarize and report financial data. Although there were no significant changes in the Company's internal controls or in other factors that could significantly affect those controls subsequent to the Evaluation Date, the Company's senior management, in conjunction with its Board of Directors, continuously reviews overall Company policies and improves documentation of important financial reporting and internal control matters. The Company is committed to continuously improving the state of its internal controls, corporate governance and financial reporting. (c) Limitations on the effectiveness of controls The Company's management, including the Chief Executive Officer and the Chief Accounting Officer, does not expect that its disclosure or internal controls will prevent all errors or fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. PART III Items 9, 10, 11, 12 and 14 The information required by Items 9 through 12 and Item 14 is incorporated by reference to the Company's definitive proxy statement pursuant to Regulation 14A under the Securities Exchange Act of 1934, which the Company has filed with the U. S. Securities and Exchange Commission within 120 days after the close of the fiscal year ended December 31, 2004. 29 PART IV ITEM 13. EXHIBITS (a) Documents filed as part of this Report: (1) The following Financial Statements are filed as part of this Report: Page ---- Report of Independent Registered Public Accounting Firm, April 1, 2005 (July 19, 2006, as to the effects of the reclassification as disclosed in Note 1) F-1 Consolidated Balance Sheet, December 31, 2004 F-2 - F-3 Consolidated Statements of Operations and Comprehensive Income (Loss) for the years ended December 31, 2004 and 2003 F-4 - F-5 Consolidated Statements of Stockholders' Equity for the years ended December 31, 2004 and 2003 F-6 - F-7 Consolidated Statements of Cash Flows for the years ended December 31, 2004 and 2003 F-8 - F-12 Notes to Consolidated Financial Statements F-13 - F-38 Supplemental Information About Oil and Gas Producing Activities (unaudited) F-39 - F-42 (2) Exhibits Exhibit Number Description Location ------- -------------------------- ----------------------------------------- 2 Not applicable 3.1 Articles of Incorporation (incorporated by reference to and Bylaws Exhibits 4 and 5, respectively, to Registration Statement No. 2-73529) 3.2 Articles of Amendment (incorporated by reference to the company's Form 10-K filed May 31, 1984) 3.3 Articles of Amendment (incorporated by reference to the company's Form 10-K filed May 31, 1985) 3.4 Articles of Amendment (incorporated by reference to the Company's Form 10-QSB filed January 19, 2000) 4. Instruments Defining the (incorporated by reference to Rights of Security Holders, Exhibits 4 and 5, respectively, Including Indentures to Registration Statement No. 2-73529) 30 Exhibit Number Description Location ------- -------------------------- ------------------------------------ 10.1 1999 Incentive Equity Plan (incorporated by reference to the Company's definitive proxy statement filed December 2, 1999) 10.2 Stock Exchange Agreement (incorporated by reference to the between the Company and Company's Form 10-KSB for the year Sedco related to Capco ended December 31, 1999, filed Resource Corporation November 2, 2000 10.3 Stock Purchase Agreement, (incorporated by reference to dated January 30, 2001, Form 8-K of Meteor Industries, and between Capco Energy, Inc. dated February 13, 2001, Inc. and Meteor Industries, SEC File No. 0-27698) Inc. 10.4 First Amendment to Stock (incorporated by reference to the Purchase Agreement dated Company's Form 8-K filed May 7, 2001) April 27, 2001, by and between Capco Energy, Inc. and Meteor Industries, Inc. 10.5 Agreement by and among New (incorporated by reference to the Mexico Marketing, Inc., Company's Form 10-KSB for the year Meteor Marketing, Inc., ended December 31, 2002, filed Graves Oil & Butane Co., April 23, 2003) and the Sole Shareholder of Graves Oil & Butane Co., Inc. 10.6 Stock Purchase Agreement (incorporated by reference to the dated April 30, 2003, by Company's Form 8-K filed May 16, and between Capco Energy, 2003) Inc. and Sedco, Inc. 10.7 Amendment to Purchase (incorporated by reference to the Agreement by and between Company's Form 10-QSB for the Sedco, Inc. and Capco quarterly period ended September 30, Energy, Inc., September 2003, filed December 10, 2003) 30, 2003 10.8 Purchase Agreement by (incorporated by reference to the and between Sedco Energy, Company's Form 10-KSB for the year Inc. and Capco Energy, Inc., ended December 31, 2003, filed December 31, 2003 April 15, 2004) 10.9 Purchase Agreement by (incorporated by reference to the and between Sedco Energy, Company's Form 10-KSB for the year Inc. and Capco Energy, Inc., ended December 31, 2003, filed December 31, 2003 April 15, 2004) 10.10 Letter agreement dated (incorporated by reference to the July 25, 2003, by and Company's Form 10-KSB for the year between Omimex Canada, Ltd., ended December 31, 2003, filed Jovian Energy, Inc., and April 15, 2004) Capco Resource Corporation 31 Exhibit Number Description Location ------- -------------------------- ------------------------------------ 10.11 Letter agreement dated Filed herewith electronically September 29, 2004, by and between Packard Gas Company and Midwest EOR, Inc. 10.12 Agreement dated November 23, Filed herewith electronically 2004, by and among Capco Energy, Inc. and Ilyas Chaudhary 10.13 Letter of Intent dated Filed herewith electronically November 24, 2004, between Packard Gas Company and Midwest EOR, Inc. 10.14 Securities Purchase (incorporated by reference to the Agreement dated March 10, Company's Form 8-K filed March 16, 2005) 2005, by and among Capco Energy, Inc. and certain accredited investors 10.15 Asset Purchase Agreement Filed herewith electronically dated March 15, 2005, by and among Manti Resources, Inc., et al and Capco Offshore, Inc. 14. Code of Business Conduct (incorporated by reference to the and Ethics Company's Form 10-KSB for the year ended December 31, 2003, filed April 15, 2004) 21. List of Subsidiaries Filed herewith electronically 23.1 Consent of Stonefield Filed herewith electronically Josephson, Inc. 31.1 Certification of Chief Filed herewith electronically Executive Officer 31.2 Certification of Chief Filed herewith electronically Accounting Officer 32.1 Certification of Chief Filed herewith electronically Executive Officer pursuant to 18 U.S.C. section 1350 32.2 Certification of Chief Filed herewith electronically Accounting Officer pursuant to 18 U.S.C. section 1350 32 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized. CAPCO ENERGY, INC. /s/ Ilyas Chaudhary Dated: August 14, 2006 By --------------------------- Ilyas Chaudhary, CEO Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. /s/ Ilyas Chaudhary Dated: August 14, 2006 By --------------------------- Ilyas Chaudhary, CEO, Chief Financial Officer and Director /s/ Irwin Kaufman Dated: August 14, 2006 By --------------------------- Irwin Kaufman, Director /s/ William J. Hickey Dated: August 14, 2006 By -------------------------- William J. Hickey, Director /s/ Paul L. Hayes Dated: August 14, 2006 By -------------------------- Paul L. Hayes, Director 33 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders Capco Energy, Inc. and Subsidiaries We have audited the accompanying consolidated balance sheet of Capco Energy, Inc. and Subsidiaries, as of December 31, 2004, and the related consolidated statements of operations, comprehensive income (loss), stockholders' equity, and cash flows for the years ended December 31, 2004 and 2003. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. 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 audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Capco Energy, Inc. and Subsidiaries as of December 31, 2004, and the results of its operations and its cash flows for the years ended December 31, 2004 and 2003, in conformity with accounting principles generally accepted in the United States of America. /s/ Stonefield Josephson, Inc. ------------------------------ CERTIFIED PUBLIC ACCOUNTANTS Irvine, California April 1, 2005 (July 19, 2006, as to the effects of the reclassification as disclosed in Note 1) F-1 CAPCO ENERGY, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET DECEMBER 31, 2004 ASSETS (Dollars in Thousands) Current Assets: Cash $ 1,805 Accounts receivable-trade, net of allowance of $45 482 Notes receivable, including a related party 981 Deferred tax asset 27 Other current assets 538 ------- Total Current Assets 3,833 Oil and gas properties, using full cost accounting, less accumulated depreciation and depletion of $1,727 9,197 Other Assets: Assets attributable to businesses under contract for sale (Note 7) 4,063 Other property and equipment, less accumulated depreciation of $70 649 Accounts receivable, related parties 14 Other assets 344 ------- Total Assets $ 18,100 ======= The accompanying notes are an integral part of the consolidated financial statements. F-2 CAPCO ENERGY, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (continued) DECEMBER 31, 2004 LIABILITIES AND STOCKHOLDERS' EQUITY (Dollars in Thousands) Current Liabilities: Accounts payable, trade $ 1,330 Current maturities, long-term debt, including a related party 637 Notes payable 762 Accrued expenses 1,174 ------- Total Current Liabilities 3,903 ------- Non-current Liabilities: Long term debt, less current maturities 515 Convertible promissory notes, net 1,516 Long-term liabilities 361 Asset retirement obligation 2,193 Deferred tax liability 27 ------- Total Non-current Liabilities 4,612 ------- Liabilities attributable to businesses under contract for sale (Note 7) 4,346 ------- Total Liabilities 12,861 ------- Commitments and Contingencies (Note 11) -- Stockholders' Equity: Common stock, $0.001 par value; authorized 150,000,000 shares; 101,023,476 shares issued 101 Additional paid in capital 3,074 Treasury stock, 1,267,708 shares, at cost (138) Retained earnings 2,202 ------- Total Stockholders' Equity 5,239 ------- Total Liabilities and Stockholders' Equity $ 18,100 ======= The accompanying notes are an integral part of the consolidated financial statements. F-3 CAPCO ENERGY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) For the Years ended December 31, 2004 and 2003 (Dollars in Thousands except per share) 2004 2003 ------ ------ Operating revenues: Oil and gas sales $ 4,825 $ 3,122 Gas gathering, marketing and processing 275 24 Oil field services 155 2 Gains on sales of land and oil and gas property 974 -- ------ ------ Total operating revenues 6,229 3,148 ------ ------ Operating costs and expenses: Oil and gas production lifting costs 1,569 719 Production taxes 478 385 Gas gathering, marketing and processing costs 768 426 Oil field services 172 -- Depreciation, depletion and amortization 809 615 General and administrative 1,266 872 ------ ------ Total operating costs and expenses 5,062 3,017 ------ ------ Operating profit 1,167 131 Other Income (Expenses): Interest income 19 45 Interest expense (399) (153) Gains (losses) on sales of investments- marketable securities (63) (7) Holding gains (losses)-marketable securities (2) 145 Loss attributable to guarantees of indebtedness of businesses sold under contract -- (151) Other 3 40 ------- ------- Income from continuing operations before taxes and minority interest 725 50 Provision for income taxes -- -- Minority interest in (income) of consolidated subsidiary -- (4) ------- ------- Income from continuing operations 725 46 Discontinued operations: (Note 6) Loss from operations of business transferred under contractual obligation to a related party during the year 2003 (net of applicable income tax benefit of $-0-) -- (1,264) Loss on disposal of discontinued operations to a related party -- (730) ------- ------- Net income (loss) 725 (1,948) ------- ------- Continued on Next Page The accompanying notes are an integral part of the consolidated financial statements. F-4 CAPCO ENERGY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) For the Years ended December 31, 2004 and 2003 (Dollars in Thousands except per share) (continued) 2004 2003 -------- -------- Other comprehensive income-net of tax Foreign currency translation adjustment -- 6 Less: minority interest in comprehensive income of consolidated subsidiary -- 1 ------- ------- Comprehensive income (loss) $ 725 $ (1,943) ======= ======= Earnings per share-basic: Income from continuing operations $ 0.01 $ -- Loss from discontinued operations, including business transferred under contractual obligation -- (0.02) Loss on disposal of discontinued operations -- (0.01) ------- ------- Net income (loss) $ 0.01 $ (0.03) ======= ======= Earnings per share-diluted: Income from continuing operations $ 0.01 $ -- Loss from discontinued operations, including business transferred under contractual obligation -- (0.02) Loss on disposal of discontinued operations -- (0.01) ------- ------- Net income (loss) $ 0.01 $ (0.03) ======= ======= Weighted average common share and common share equivalents: Basic 96,067,502 77,897,657 ========== ========== Diluted 105,741,590 79,110,649 =========== ========== The accompanying notes are an integral part of the consolidated financial statements. F-5
CAPCO ENERGY, INC. AND SUBSIDIARIES Consolidated Statements of Stockholders' Equity For the Years Ended December 31, 2004 and 2003 (Dollars in Thousands) Accumulated Preferred Stock Common Stock Additional Cumulative Deficit/ --------------- ------------------ Paid-In Translation Treasury Retained Shares Amount Shares Amount Capital Adjustment Stock Earnings Total ------- ------ ---------- ------ --------- ---------- --------- ----------- -------- Balance as restated at December 31, 2002 292,947 $ 293 78,298,216 $ 78 $ 1,231 $ (5) $ (124) $ 3,425 $ 4,898 Treasury stock -- -- -- -- -- -- (3) -- (3) (acquisitions) Shares issued in exchange for cash 120,000 -- 7 -- -- -- 7 Shares issued in exchange -- -- 200,000 -- 49 -- -- -- 49 for services Shares issued in settlement of related party liabilities -- -- 10,436,000 11 589 -- -- -- 600 Shares issued in exchange for -- -- 4,000,000 4 236 -- -- -- 240 investment Conversion of Preferred stock (292,947) (293) 2,929,500 3 317 -- -- -- 27 Cumulative translation -- -- -- -- -- 5 -- -- 5 adjustment Net loss -- -- -- -- -- -- -- (1,948) (1,948) ------- ------ ---------- ------ --------- ---------- --------- ----------- -------- Balance at December 31, 2003 -- $ -- 95,983,716 $ 96 $ 2,429 $ -- $ (127) $ 1,477 $ 3,875 Continued on Next Page The accompanying notes are an integral part of the consolidated financial statements.
F-6
CAPCO ENERGY, INC. AND SUBSIDIARIES Consolidated Statements of Stockholders' Equity For the Years Ended December 31, 2004 and 2003 (Dollars in Thousands) (continued) Accumulated Preferred Stock Common Stock Additional Cumulative Deficit/ --------------- ------------------ Paid-In Translation Treasury Retained Shares Amount Shares Amount Capital Adjustment Stock Earnings Total ------- ------ ---------- ------ --------- ---------- --------- ----------- -------- Balance at December 31, 2003 -- $ -- 95,983,716 $ 96 $ 2,429 $ -- $ (127) $ 1,477 $ 3,875 Treasury stock -- -- -- -- -- -- (11) -- (11) (acquisitions) Shares issued in exchange for cash 1,095,000 1 70 -- -- -- 71 Shares issued in settlement of liability -- -- 300,000 -- 30 -- -- -- 30 Shares issued for acquisition of property -- -- 3,644,760 4 433 -- -- -- 437 Discount on convertible notes -- -- -- -- 112 -- -- -- 112 Net income -- -- -- -- -- -- -- 725 725 ------- ------ ---------- ------ --------- ---------- --------- ----------- -------- Balance at December 31, 2004 -- $ -- 101,023,476 $ 101 $ 3,074 $ -- $ (138) $ 2,202 $ 5,239 The accompanying notes are an integral part of the consolidated financial statements.
F-7 CAPCO ENERGY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 2004 and 2003 (Dollars in Thousands) 2004 2003 ---------- ---------- Cash Flows From Continuing Operating Activities: Net income (loss) $ 725 $ (1,948) Adjustments to reconcile net income (loss) to net cash used in operating activities: Net loss from discontinued operations -- 1,264 Loss on disposal of discontinued operations -- 730 Depreciation, depletion and amortization 809 615 Loss attributable to guarantee of indebtedness of businesses sold under contract -- 151 Foreign currency translation adjustment 57 -- Loss on sales of investments - marketable securities 63 7 Holding losses (gains) - marketable securities 2 (145) Minority interest in income of consolidated subsidiary -- 4 Compensation cost of Common Stock/Treasury Stock issued -- 49 Increase in deferred tax asset (1,298) (379) Increase in deferred tax liability 1,298 379 Changes in assets and liabilities: (Increase) decrease in assets: Accounts receivable - trade (225) (177) Notes receivable (accrued interest) 2 (2) Other current assets (113) 38 Other assets (5) (192) Increase (decrease) in liabilities: Accounts payable 937 (203) Accrued expenses 812 (183) ------ ------ Net cash provided by continuing operating activities 3,064 8 ------ ------ Cash Flows From Discontinued Operating Activities: Net loss -- (1,264) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation, depletion and amortization -- 595 Loss on sale of property, plant and equipment -- 126 Decrease in deferred tax asset -- 219 Decrease in deferred tax liability -- (219) Continued on Next Page The accompanying notes are an integral part of the consolidated financial statements. F-8 CAPCO ENERGY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 2004 and 2003 (Dollars in Thousands) (continued) 2004 2003 ---------- --------- Changes in assets and liabilities: (Increase) decrease in assets: Accounts receivable - trade -- 2,741 Inventory -- 1,653 Other current assets -- (194) Other assets -- 5 Increase (decrease) in liabilities: Accounts payable -- (455) Accrued expenses -- (187) Taxes payable -- (448) Accrued environmental expenses-noncurrent -- (75) ------- ------- Net cash provided by discontinued operating activities -- 2,497 ------- ------- Net cash provided by all operating activities 3,064 2,505 ------- ------- Cash Flows From Continuing Investing Activities: Acquisition of subsidiary, net of cash 4 -- Deposit on property acquisition (400) -- Equity contribution to subsidiary -- (400) Net (advances) repayments with related parties (511) 768 Proceeds from sales of oil and gas property 1,736 816 Purchase of other assets (58) -- Capital expenditures for oil and gas property (3,960) (105) Purchase of property and equipment (652) (2) Proceeds from sale of marketable securities 128 563 Purchase of marketable securities -- (497) Increase in assets attributable to businesses under contract for sale (50) -- Issuance of notes receivable (981) -- ------- ------- Net cash (used in) provided by continuing investing activities (4,744) 1,143 ------- ------- Cash Flows From Discontinued Investing Activities: Cash applicable to assets held for sale -- 1 Net (advances) repayments with related parties -- (482) Cash proceeds from sale of equity investment -- 766 Cash proceeds from sale of property -- 87 Cash proceeds from equity contribution -- 400 Notes receivable payments -- 35 ------- ------- Net cash provided by discontinued investing activities -- 807 ------- ------- Net cash (used in) provided by all investing activities (4,744) 1,950 ------- ------- Continued on Next Page The accompanying notes are an integral part of the consolidated financial statements. F-9 CAPCO ENERGY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 2004 and 2003 (Dollars in Thousands) (continued) 2004 2003 ---------- ---------- Cash Flows From Continuing Financing Activities: Proceeds from notes payable 752 -- Proceeds from long-term debt 1,000 -- Proceeds from convertible promissory notes, net 1,628 -- Increase in long-term liabilities 361 -- Increase in asset retirement obligation 1,088 -- Payments on long term debt (1,438) (1,123) Sale of Common Stock and exercise of options 71 7 Purchase of Common Stock (12) (3) ------- ------- Net cash provided by (used in) continuing financing activities 3,450 (1,119) ------- ------- Cash Flows from Discontinued Financing Activities: Net (payments) advances on revolver -- (3,022) Decrease in book overdraft -- (83) Payments on long term debt -- (639) Decrease in restricted cash -- 441 ------- ------- Net cash used in discontinued financing activities -- (3,303) ------- ------- Net cash provided by (used in) all financing activities 3,450 (4,422) ------- ------- Net increase in cash 1,770 33 Cash, beginning of period 35 2 ------- ------- Cash, end of period $ 1,805 $ 35 ======= ======= Supplemental disclosure of cash flow information for continuing operations: Interest paid $ 333 $ 134 ======= ======= Taxes paid $ -- $ -- ======= ======= Supplemental disclosure of cash flow information for discontinued operations: Interest paid $ -- $ 383 ======= ======= Taxes paid $ -- $ -- ======= ======= Continued on Next Page The accompanying notes are an integral part of the consolidated financial statements. F-10 CAPCO ENERGY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 2004 and 2003 (Dollars in Thousands) (continued) 2004 2003 ---------- ---------- Supplemental disclosure of non-cash financing and investing activities for continuing operations: Common Stock issued in settlement of liability $ 30 $ -- ======= ======= Paid in capital provided as equity component of debt financing $ 112 $ -- ======= ======= Acquisition cost of oil and gas property settled with issuance of Common Stock $ 437 $ -- ======= ======= Accrual for acquisition cost of oil and gas property to be settled with issuance of Common Stock $ 200 $ -- ======= ======= Long-term debt and liabilities reduced for property sold $ 3,297 $ -- ======= ======= Note receivable issued as consideration for sale of property interest $ -- $ 208 ======= ======= Long-term liabilities assumed in connection with acquisitions of property $ -- $ 1,334 ======= ======= Long-term liability (released) assumed in connection with guaranty of indebtedness $ (432) $ 432 ======= ======= Common Stock issued for acquisitions of subsidiary and property $ -- $ 740 ======= ======= Common Stock issued for conversion of Preferred Stock $ -- $ 320 ======= ======= Long-term debt issued in connection with acquisition of accounts receivable and property $ -- $ 4,515 ======= ======= Continued on next page The accompanying notes are an integral part of the consolidated financial statements. F-11 CAPCO ENERGY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 2004 and 2003 (Dollars in Thousands) (continued) 2004 2003 ---------- ---------- Supplemental disclosure of non-cash financing and investing activities for discontinued operations: Note receivable and account receivable provided as proceeds in connection with sale of preferred membership interests $ -- $ 349 ======= ======= Long-term debt and accrued expenses reduced for property sold/exchanged $ -- $ 975 ======= ======= The accompanying notes are an integral part of the consolidated financial statements. F-12 CAPCO ENERGY, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES NATURE OF OPERATIONS Capco Energy, Inc. ("Capco" or the "Company") is an independent energy company engaged primarily in the acquisition, development, production of and the sale of oil, gas and natural gas liquids. The Company's production activities are located in the United States of America. The principal executive offices of the Company are located at 5555 San Felipe, Suite 725, Houston, TX 77056. The Company was incorporated as Alfa Resources, Inc., a Colorado corporation, on January 6, 1981. In November 1999, the Company amended its articles of incorporation to change its name from Alfa Resources, Inc. to Capco Energy, Inc. BASIS OF CONSOLIDATION The consolidated financial statements include the accounts of Capco and it's wholly and majority owned subsidiaries. Accordingly, all references herein to Capco or the Company include the consolidated results. All significant intercompany accounts and transactions have been eliminated in consolidation. The Company's significant subsidiaries in 2004 include Capco Offshore, Inc., and Packard Gas Company, and in 2003 included Capco Offshore, Inc. and Capco Resource Corporation. On September 30, 2003, the Company closed on the sale of Meteor Enterprises, Inc. ("Enterprises"), including all of that company's subsidiaries. The significant subsidiary of Enterprises at that time was Meteor Marketing, Inc. ("Marketing"). The results of operations of Enterprises are reported as discontinued operations in the year 2003 and include Marketing for the nine-month period ended September 30, 2003. Effective December 31, 2003, the Company sold Capco Resource Corporation. The Company currently holds an 80% equity interest in Bison Energy Company that was acquired from a Director of the Company during the year 2004. Bison's operations since date of acquisition resulted in a loss of $23,000. The entire amount of the loss has been reflected in the financial statements and no minority interest has been calculated. Until such time as operations recover the deficiency in minority interest of $4,600, 100% of results of operations will be reported by Capco with no reduction for minority interest. RISK FACTORS RELATED TO CONCENTRATION OF SALES AND PRODUCTS The Company's future financial condition and results of operations will depend upon prices received for its oil and natural gas and the costs of finding, acquiring, developing and producing reserves. Prices for oil and natural gas are subject to fluctuations in response to changes in supply, market uncertainty and a variety of other factors beyond the Company's control. These factors include worldwide political instability (especially in the Middle East), the foreign supply of oil and natural gas, the price of foreign imports, the level of consumer product demand and the price and availability of alternative fuels. F-13 USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management used significant estimates in determining the carrying value of its oil and gas producing assets and the associated depreciation and depletion expense related to sales' volumes. The significant estimates included the use of proved oil and gas reserve volumes and the related present value of estimated future net revenues therefrom (See Supplemental Information About Oil and Gas Producing Activities). CASH AND CASH EQUIVALENTS Cash and cash equivalents consist of short-term, highly liquid investments readily convertible into cash with an original maturity of three months or less. The Company maintains its cash in bank deposit accounts that, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts. The Company had $1.8 million cash balances in excess of federal insured limits as of December 31, 2004. FAIR VALUE OF FINANCIAL INSTRUMENTS The Company measures its financial assets and liabilities in accordance with accounting principles generally accepted in the United States of America. For certain of the Company's financial instruments, including accounts receivable (trade and related party), notes receivable and accounts payable (trade and related party), and accrued expenses, the carrying amounts approximate fair value due to their short maturities. The amounts owed for long-term debt also approximate fair value because interest rates and terms offered to the Company are at current market rates. CONCENTRATION OF CREDIT RISK Financial instruments that potentially subject the Company to concentrations of credit risk are cash and accounts receivable arising from its normal business activities. The Company places its cash in what it believes to be credit-worthy financial institutions. However, cash balances have exceeded the FDIC insured levels at various times during the year. The Company has a diversified customer base. The Company controls credit risk related to accounts receivable through credit approvals, credit limits and monitoring procedures. The Company routinely assesses the financial strength of its customers and, based upon factors surrounding the credit risk, establishes an allowance, if required, for un-collectible accounts and, as a consequence, believes that its accounts receivable credit risk exposure beyond such allowance is limited. The Company had an allowance of $45,000 as of December 31, 2004, that was based on its evaluation of specific customers' balances and the collectibility thereof. INVESTMENT IN EQUITY SECURITIES For equity securities that the Company i) does not exercise control in the investee and ii) expects to divest within a short period of time, the Company accounts for the investment under the provisions of Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities". In accordance with FASB No. 115, equity securities that have readily determinable F-14 INVESTMENT IN EQUITY SECURITIES, Continued fair values are classified as either trading or available-for-sale securities. Securities that are bought and held principally for the purpose of selling in the near term (thus held for only a short period of time) are classified as trading securities and all other securities are classified as available-for-sale. Trading and available-for-sale securities are measured at fair value in the balance sheet. For trading securities any realized gains or losses and any unrealized holding gains and losses are reported in the statement of operations. For available-for-sale securities any realized gains and losses are reported in the statement of operations and any unrealized holding gains and losses are reported as a separate component of stockholders' equity until realized. OIL AND GAS PROPERTIES The Company follows the "full-cost" method of accounting for oil and gas property and equipment costs. Under this method, all productive and nonproductive costs incurred in the acquisition, exploration, and development of oil and gas reserves are capitalized. Such costs include lease acquisitions, geological and geophysical services, drilling, completion, equipment, and certain general and administrative costs directly associated with acquisition, exploration, and development activities. General and administrative costs related to production and general overhead are expensed as incurred. No gains or losses are recognized upon the sale or disposition of oil and gas properties, except in transactions that involve a significant amount of reserves. Proceeds from the sale of oil and gas properties are generally treated as a reduction of oil and gas property costs. Fees from associated oil and gas exploration and development partnerships, if any, will be credited to oil and gas property costs to the extent they do not represent reimbursement of general and administrative expenses currently charged to expense. In accordance with the full cost method of accounting, future development, site restoration and dismantlement and abandonment costs, net of salvage values, are estimated on a property-by-property basis based on current economic conditions and are amortized to expense as the Company's capitalized oil and gas property costs are amortized. The provision for depreciation and depletion of oil and gas properties is computed on the unit-of-production method. Under this method, the Company computes the provision by multiplying the total unamortized costs of oil and gas properties including future development, site restoration, and dismantlement abandonment costs, but excluding costs of unproved properties by an overall rate determined by dividing the physical units of oil and gas produced during the period by the total estimated units of proved oil and gas reserves. This calculation is done on a country-by-country basis. As of December 31, 2004, all of the Company's oil production operations are conducted in the United States of America. The cost of unevaluated properties not being amortized, to the extent there is such a cost, is assessed quarterly to determine whether the value has been impaired below the capitalized cost. The cost of any impaired property is transferred to the balance of oil and gas properties being depleted. The costs associated with unevaluated properties relate to projects which were undergoing exploration or development activities or in which the Company intends to commence such activities in the future. The Company will begin to amortize these costs when proved reserves are established or impairment is determined. Management believes no such impairment exists at December 31, 2004. F-15 OIL AND GAS PROPERTIES, Continued In accordance with SFAS No. 143, "Accounting for Asset Retirement Obligations," the Company reports a liability for any legal retirement obligations on its oil and gas properties. The associated costs are capitalized as part of the full cost pool. Following is a reconciliation of the asset retirement obligation liability for the year ended December 31, 2004 (in thousands): Asset retirement obligation at January 1, 2004 $ 1,105 Liabilities incurred 1,088 Liabilities settled -- Accretion expense -- Revisions in estimated liabilities -- ----- Asset retirement obligation at December 31, 2004 $ 2,193 ===== At the end of each reporting period, the unamortized cost of oil and gas properties, net of related deferred income taxes, is limited to the sum of the estimated future net revenues from proved properties using current prices, discounted at 10%, and the lower of cost or fair value of unproved properties, adjusted for related income tax effects ("Ceiling Limitation"). The calculations of the ceiling limitation and provision for depreciation, depletion, and amortization are based on estimates of proved reserves. There are numerous uncertainties inherent in estimating quantities of proven reserves and in projecting the future rates of production, timing, and plan of development. The accuracy of any reserves estimate is a function of the quality of available data and of engineering and geological interpretation and judgment. Results of drilling, testing, and production subsequent to the date of the estimate may justify revision of such estimate. Accordingly, reserve estimates are often different from the quantities of oil and gas that are ultimately recovered. OTHER PROPERTY AND EQUIPMENT Non-oil and gas producing properties and equipment are stated at cost; major renewals and improvements are charged to the property and equipment accounts; while replacements, maintenance and repairs, which do not improve or extend the lives of the respective assets, are expensed currently. At the time property an equipment are retired or otherwise disposed of, the asset and related accumulated depreciation accounts are relieved of the applicable amounts. Gains or losses from retirements or sales are credited or charged to operations. Depreciation for non-oil and gas properties is recorded on the straight-line method at rates based on estimated useful lives ranging from three to fifteen years of the assets. IMPAIRMENT OF LONG-LIVED ASSETS In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." This statement supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of." Although retaining many of the fundamental recognition and measurement provisions of SFAS No. 121, the new rules significantly change the criteria that would have to be met to classify an asset as held-for-sale. The statement also supersedes certain provisions of Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of F-16 IMPAIRMENT OF LONG-LIVED ASSETS, Continued a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," and will require expected future operating losses from discontinued operations to be displayed in discontinued operations in the period or periods in which the losses are incurred rather than as of the measurement date, as presently required. The Company adopted this new statement on January 1, 2002, and concluded that the effect of adopting this statement had no material impact on the Company's financial position, results of operations, or cash flows. REVENUE RECOGNITION The Company recognizes revenue upon transfer of ownership of the product to the customer which occurs when (i) the product is physically received by the customer, (ii) the Company issues an invoice to the customer which evidences an arrangement between the customer and the Company, (iii) a fixed sales price has been included in such invoice, and (iv) collection from such customer is probable. STOCK BASED COMPENSATION The Company accounts for employee stock options in accordance with APB No. 25 "Accounting for Stock Issued to Employees". Under APB 25, the Company recognizes no compensation expense related to employee stock options, as no options are granted at a price below market price on the date of grant. In 2002, the Company adopted SFAS No. 123 "Accounting for Stock-Based Compensation". SFAS No. 123, which prescribes the recognition of compensation expense based on the fair value of options on the grant date, allows companies to continue applying APB 25 if certain pro forma disclosures are made assuming hypothetical fair value method, for which the Company uses the Black-Scholes option-pricing model. For non-employee stock based compensation the Company recognizes an expense in accordance with SFAS No. 123 and values the equity securities based on the fair value of the security on the date of grant. For stock-based awards the value is based on the market value for the stock on the date of grant and if the stock has restrictions as to transferability a discount is provided for lack of tradability. Stock option awards are valued using the Black-Scholes option-pricing model. Had compensation cost been determined based on the fair value at grant dates for stock option awards consistent with the SFAS No. 123, the Company's net income (loss) and earnings per share for the years ended December 31, 2004 and 2003, would have been adjusted to the pro-forma amounts indicated below: 2004 2003 -------- -------- Net income (loss) as reported (in thousands) $ 725 $ (1,948) Compensation recognized under APB 28 -- -- Compensation recognized under SFAS 123 (218) (1,110) Pro-forma net income (loss) $ 507 $ (3,058) Net income (loss) per share: Basic and diluted-as reported $ 0.01 $ (0.03) Basic and diluted-pro-forma $ 0.01 $ (0.04) F-17 STOCK BASED COMPENSATION, Continued The pro forma compensation expense based on the fair value of the options is estimated on the grant date using the Black-Scholes option-pricing model with the following assumptions used for grants: no dividends; expected lives ranging from 3 to 5 years for 2004 and 5 years for 2003; expected volatility ranging from 0.8% to 2.2% for 2004 and 2.9% for 2003; and risk free rates of return ranging from 3.29% to 3.74% for 2004 and from 2.27% to 3.27% for 2003. The weighted average fair value of those purchase rights granted in 2004 and 2003 was $0.13 and $0.07, respectively. INCOME TAXES Provisions for income taxes are based on taxes payable or refundable for the current year and deferred taxes on temporary differences between the amount of taxable income and pretax financial income and between the tax bases of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are included in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled as prescribed in SFAS No. 109, "Accounting for Income Taxes". As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be recognized. The Company has recorded a 100% valuation allowance as of December 31, 2004. COMPREHENSIVE INCOME SFAS No. 130, "Reporting Comprehensive Income" establishes standards for the reporting and display of comprehensive income and its components in the financial statements. For the year ended December 31, 2004, the Company did not report any components of comprehensive income. For the year ended December 31, 2003, the Company had other comprehensive income relating to foreign currency translations. EARNINGS PER SHARE The Company uses SFAS No. 128, "Earnings Per Share" for calculating the basic and diluted earnings (loss) per share. Basic earnings (loss) per share are computed by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding. Diluted earnings (loss) per share is computed similar to basic earnings (loss) per share except that the numerator is increased by the amount of interest expense attributable to the convertible promissory notes payable and the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. On a diluted basis, under the treasury method of calculating the additional shares outstanding, the Company's weighted average shares outstanding for the year ended December 31, 2004, have been increased for 5,192,941 shares of Common Stock as associated stock options have a dilutive effect on net income. Additionally, the number of shares outstanding for the year ended December 31, 2004, have been increased for 4,481,148 shares of Common Stock determined under the "if converted" method, due to the issuance of convertible notes payable during the year ended December 31, 2004. On a diluted basis, the Company's weighted average shares F-18 EARNINGS PER SHARE, Continued outstanding for the year ended December 31, 2003, have been increased for 1,212,992 shares of Common Stock as associated stock options have a dilutive effect on income from continuing operations, which is the benchmark number for determining whether potential common stock is included in determining earnings (loss) per share. In accordance with SFAS No. 128, the stock options are also considered to be potential common stock in determining loss per share on loss from discontinued operations and net loss, even though the stock options are antidilutive. NEW ACCOUNTING PRONOUNCEMENTS In March 2004, the Financial Accounting Standards Board (FASB) approved the consensus reached on the Emerging Issues Task Force (EITF) Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." The objective of this Issue is to provide guidance for identifying impaired investments. EITF 03-1 also provides new disclosure requirements for investments that are deemed to be temporarily impaired. The accounting provisions of EITF 03-1 are effective for all reporting periods beginning after June 15, 2004, while the disclosure requirements are effective only for annual periods ending after June 15, 2004. The Company has evaluated the impact of the adoption of EITF 03-1 and does not believe the impact will be significant to the Company's overall results of operations or financial position. In November 2004, the FASB issued SFAS No. 151, "Inventory Costs, an amendment of ARB No. 43, Chapter 4". The amendments made by Statement 151 clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The guidance is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 23, 2004. The Company has evaluated the impact of the adoption of SFAS 151, and does not believe the impact will be significant to the Company's overall results of operations or financial position. In December 2004, the FASB issued SFAS No.152, "Accounting for Real Estate Time-Sharing Transactions, an amendment of FASB Statements No. 66 and 67 (SFAS 152)". The amendments made by Statement 152 amend FASB Statement No. 66, Accounting for Sales of Real Estate, to reference the financial accounting and reporting guidance for real estate time-sharing transactions that is provided in AICPA Statement of Position (SOP) 04-2, Accounting for Real Estate Time-Sharing Transactions. This Statement also amends FASB Statement No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects, to state that the guidance for (a) incidental operations and (b) costs incurred to sell real estate projects does not apply to real estate time-sharing transactions. The accounting for those operations and costs is subject to the guidance in SOP 04-2. This Statement is effective for financial statements for fiscal years beginning after June 15, 2005, with earlier application encouraged. The Company has evaluated the impact of the adoption of SFAS 152, and does not believe the impact will be significant to the Company's overall results of operations or financial position. In December 2004, the FASB issued SFAS No.153, "Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions." The amendments made by Statement 153 are based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets F-19 NEW ACCOUNTING PRONOUNCEMENTS, Continued exchanged. Further, the amendments eliminate the narrow exception for nonmonetary exchanges of similar productive assets and replace it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance. Previously, Opinion 29 required that the accounting for an exchange of a productive asset for a similar productive asset or an equivalent interest in the same or similar productive asset should be based on the recorded amount of the asset relinquished. Opinion 29 provided an exception to its basic measurement principle (fair value) for exchanges of similar productive assets. The Board believes that exception required that some nonmonetary exchanges, although commercially substantive, be recorded on a carryover basis. By focusing the exception on exchanges that lack commercial substance, the Board believes this Statement produces financial reporting that more faithfully represents the economics of the transactions. The Statement is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. Earlier application is permitted for nonmonetary asset exchanges occurring in fiscal periods beginning after the date of issuance. The provisions of this Statement shall be applied prospectively. The Company has evaluated the impact of the adoption of SFAS 152, and does not believe the impact will be significant to the Company's overall results of operations or financial position. In December 2004, the FASB issued SFAS No.123 (revised 2004), "Share-Based Payment". Statement 123(R) will provide investors and other users of financial statements with more complete and neutral financial information by requiring that the compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. Statement 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. Statement 123(R) replaces FASB Statement No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. Statement 123, as originally issued in 1995, established as preferable a fair-value-based method of accounting for share-based payment transactions with employees. However, that Statement permitted entities the option of continuing to apply the guidance in Opinion 25, as long as the footnotes to financial statements disclosed what net income would have been had the preferable fair-value-based method been used. Public entities (other than those filing as small business issuers) will be required to apply Statement 123(R) as of the first interim or annual reporting period that begins after December 15, 2005. The Company has evaluated the impact of the adoption of SFAS 123(R), and does not believe the impact will be significant to the Company's overall results of operations or financial position. In March 2005, the staff of the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 107 ("SAB 107"). The interpretations in SAB 107 express views of the staff regarding the interaction between Statement of Financial Accounting Standards Statement No. 123 (revised 2004), "Share-Based Payment" ("Statement 123(R)") and certain SEC rules and regulations and provide the staff's views regarding the valuation of share-based payment arrangements for public companies. In particular SAB 107 provides guidance related to share-based payment transactions with nonemployees, the transition from public entity status, valuation methods (including assumptions such as expected volatility and expected term), the accounting for certain redeemable financial instruments issued under share-based payment arrangements, the classification of compensation expense, non-GAAP financial measures, first-time adoption of Statement 123(R) in an interim period, capitalization of compensation cost related to share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements upon adoption of Statement 123(R), the modification of employee share options prior to adoption of Statement 123(R) and disclosures in Management's Discussion and Analysis subsequent to adoption of Statement 123(R). F-20 FOUR-FOR-ONE FORWARD STOCK SPLIT Effective December 26, 2003, the Company's Board of Directors approved a four-for-one forward stock split on all outstanding shares of Common Stock. The Company's outstanding stock option awards and convertible notes were also adjusted accordingly. All share and per share amounts have been adjusted to give retroactive effect to this split for all periods presented. RECLASSIFICATION RESULTING IN AMENDING THE DECEMBER 31, 2004, FORM 10-KSB FILING The Company has revised the presentation of revenues, costs and expenses on the consolidated statements of operations pursuant to an SEC comment letter. The Company previously reported in 2004 and 2003 gross profit as a component of the Consolidated Statements of Operations for the years ended December 31, 2004 and 2003, in the amounts of $2.2 million and $1.6 million, respectively. Gross profit was determined by subtracting cost of sales, consisting of oil and gas production costs, production taxes, gas gathering expenses and oil field services expenses, from sales, consisting of oil and gas sales, gas gathering and oil field services revenue. Gross profit as previously reported did not include depreciation and cost depletion ("depreciation") applicable to these operations which, for the years ended December 31, 2004 and 2003, amounted to $0.8 million and $0.6 million, respectively. Gross profit for the years ended December 31, 2004 and 2003, would have been reported as $1.4 million and $1.0 million, respectively, if depreciation had been included as a component of cost of sales. Reclassification of depreciation would have had no effect on income from continuing operations as reported in each of the two years as the full amount of depreciation was reported separately in the Company's Consolidated Statements of Operations. Certain amounts have been reclassified in the prior year to be consistent with the classification as of December 31, 2004. 2. BUSINESS COMBINATION, ACQUISITION AND DIVESTITURES: The Company had the following acquisitions and divestments during the year ended December 31, 2004: ACQUISITIONS Effective July 1, 2004, the Company exercised its option to acquire a 92.8% working interest in a property located in Stephens County, Texas. In addition to the acreage, the acquisition included one producing gas well drilled by the former owners, the coal bed methane well drilled by the Company during the year and seismic and geological studies. The Company issued 3.6 million shares of Common Stock as consideration for the acquisition cost of $0.4 million. The number of shares issued was negotiated between the parties based on analysis of the value of the underlying assets. The per share price of $0.16 approximated the market price of the Company's Common Stock at that time. Approximately 70% of the acquired working interest in the property was acquired as a result of Capco's exchange of shares for 100% equity ownership of Packard Gas Company with individuals, or entities controlled by individuals, who have either a direct, or beneficial, relationship to the Company, including the President of the Company. The negotiated acquisition price was determined in amounts prorata to all members of the selling group. Subsequent to the exercise of its option, the Company drilled and completed a gas well on the property at a cost of $0.2 million. Following a period of evaluation of the two producing gas wells the decision was made to discontinue further drilling activities on the property, and as a result, the Company only earned acreage attributable to each well location actually drilled on the property. In September 2004, the Company acquired, from a Director of the Company, an 80% equity interest in Bison Energy Company ("Bison"), an entity organized for the purpose of owning, and operating, oil and gas properties in the state of Wyoming. The 20% minority interest is held by the Director. Bison's operations since date of acquisition resulted in a loss of $23,000. The entire amount of the loss has been reflected in the financial statements and no minority interest has been calculated. Until such time as operations recover the deficiency in minority interest of $4,600, 100% of results of operations will be reported by Capco with no reduction for minority interest. In conjunction with the equity investment, the Director exercised options at a price of $0.0625 per share to acquire 800,000 shares of the Company's Common Stock. The option proceeds of $50,000 were advanced to Bison to provide funding for the acquisition of a 33.33% working interest in an oil property in the amount of $30,000; the balance was retained by Bison for working capital. The property consists of 720 gross acres and includes nine wells, four of which are currently in production. Rework operations are in progress in an effort to restore the remaining wells to production. F-21 2. BUSINESS COMBINATION, ACQUISITION AND DIVESTITURES, Continued OIL AND GAS PROPERTIES In February 2004, the Company closed on an acquisition of a production platform with nine additional well in the Brazos Field, offshore in Matagorda County, Texas. The Company owns a 90% working interest in the wells and will be operator of the property. In conjunction with the acquisition, Capco plans to acquire leases for the mineral interests at an estimated cost of $0.1 million. Such expenditure is necessary before the Company can initiate production from any of the acquired wells. Under the terms of the agreement, the seller agreed to contribute as much as $1.0 million to apply toward payment of abandonment costs when, and if, such costs are incurred by the Company. In accordance with FAS 141, contingent consideration that is not recognized at the acquisition date is recognized and measured when the contingency is resolved and consideration is issued or becomes issuable. As of December 31, 2004, the Company has not finalized its work program for this property, and had not expended any funds for lease acquisition. In February 2004, the Company entered into an agreement to drill and complete a coal bed methane well in Stephens County, Texas. The well was drilled to a depth of 1,100 feet at a cost of $0.1 million, and following a period of "dewatering" and evaluation, was determined to be non-productive. By drilling the well Capco earned the right to negotiate the purchase of a leasehold interest in approximately 4,000 acres, along with wells previously drilled on the property. In July 2004, the Company participated with a 15% working interest in the acquisition of leases covering approximately 7,000 gross acres in a drilling prospect located in Fayette County, Alabama. Two wells were drilled on the property and both were determined to be incapable of commercial production. The Company plans to further evaluate the undeveloped acreage to determine if additional drilling is warranted. Capco incurred expenditures for lease acquisition and drilling costs in the total amount of $0.2 million for it 15% participation. Effective September 30, 2004, the Company sold its interests in non-operated producing properties located in Alabama and Louisiana to a company owned by the Company's Chief Executive Officer. Sales proceeds in the amount of $0.4 million were received by the Company in October 2004 and were used for working capital. The sales proceeds were credited against the Company's basis in oil and gas properties. No gain or loss was recognized from the sale as the disposition represented only 3% of the Company's proved reserves at the time of sale. If it is determined through due diligence by the Company that the properties could have been sold for an amount greater than $0.4 million, then the related party has the obligation to pay such excess to the Company, or the Company, at its option, may repurchase the properties at the original sales price. In October 2004, the Company acquired a 45% working interest in two properties located in Creek County, Oklahoma. The properties consisted of approximately 100 oil wells, the majority of which were not in production at the time of acquisition by the Company. Under the terms of the purchase agreement the Company is obligated to expend a total of $0.6 million over a specified period of time in an effort to bring injection and production wells back in to service to earn the entire 45% interest. As of December 31, 2004, the Company had incurred $48,000 of such costs. In December 2004, the Company acquired a 100% working interest in an oil property consisting of approximately 80 wells located in Osage County, Oklahoma. The acquisition cost of $0.2 million is to be settled by the issuance of 1.0 million F-22 OIL AND GAS PROPERTIES, Continued shares of the Company's Common Stock. The per share price of $0.20 approximated the market price of Capco's Common Stock at the time the agreement was negotiated with the seller. The Common Stock was issued to the seller in March 2005. The seller of the property retained a net profits interest in the amount of $0.3 million that is to be paid from one-third of the net production from the property until paid in full. The net profit distributions will be included with the cost of the property as they are paid by Capco. In addition, the purchase agreement stipulates that the Company expend a minimum of $0.1 million of property development costs within one year from the date of acquisition. The Company intends to monitor the operating results of the property during the year 2005, and will make a determination as to the expenditure for development costs at a later date. In accordance with FAS 141, the additional acquisition cost of $0.1 million will be recorded by the Company only if the decision is made to incur the expenditure. Effective December 31, 2004, the Company sold its interests in non-operated producing properties located in Michigan and Montana and other assets to the Company's Chief Executive Officer for the amount of $4.7 million. The Company received a fairness opinion for the sale in January 2005. The sales amount was settled by the payment of a cash deposit in the amount of $0.7 million, assumption of debt against the properties in the amount $3.3 million and the issuance of a note payable to the Company in the amount of $0.7 million. The note was paid in full in March 2005. The disposition resulted in a significant change to the depletion rate in Company's full cost pool cost center, which required that gain or loss recognition be given to the sale. The Company recorded a gain in the amount of $0.4 million from the sale. LAND In December 2004, the Company sold a parcel of undeveloped land consisting of approximately 160 acres located in the province of Alberta, Canada. The Company had owned the land since 1999 with a recorded cost basis of $0.2 million. Consideration for the sale consisted of a cash payment of $0.1 million received in December 2004, assumption by the buyer of related indebtedness in the amount of $0.4 million and the issuance of a note receivable in the amount of $0.3 million. The Company realized a gain in the amount of $0.6 million from the sale. The note receivable was paid in full by the buyer in March 2005. The Company had the following acquisitions and divestments during the year ended December 31, 2003: OIL AND GAS PROPERTIES In October 2003, the Company participated in the acquisition of producing properties and related gas processing and transmission facilities located in the state of Montana. The Company acquired an approximate 4.3% interest in the acquired properties. Funding for the acquisition consisted of a loan in the amount of $4.5 million provided by the operator of the acquired property, a cash payment in the amount of $250,000 and a credit in the amount of $500,000 extended to the Company's Chief Executive Officer for his participation in the acquisition process. The Company acquired the credit by issuing 8.7 million shares of Common Stock to the Chief Executive Officer. In addition, the seller deferred receipt of a portion of the sales amount which is to be repaid from future cash flow from the acquired properties. The Company's portion of this in the acquired property and by the Company's interest in producing oil and gas property located in the state of Michigan. F-23 OIL AND GAS PROPERTIES, Continued obligation is $229,000. The Company sold a portion of the total acquired property interest to other owners. Proceeds in the amount of $1.4 million received from the other owners were credited against the Company's basis in the acquired property. The Company's cost of the acquisition was approximately $4.1 million. The loan from the operator is collateralized by the Company's interest In October 2003, the Company acquired from a third party a 3% working interest in the Caplen Field in Galveston County, Texas at a recorded cost of $207,000. In November 2003, the Company closed on the acquisition of properties in the Brazos Field, offshore in Matagorda County, Texas. The Company owns a 65% working interest in the property and is the operator of the acquired property. The acquired properties consist of 22 wells, two of which are currently in production. The Company's recorded cost of the acquisition, including a funding obligation to the seller of the property in the amount of $1.1 million, and net of fees earned from joint interest partners, was $1.2 million. In connection with the acquisition the Company and its joint interest partners were required to provide a surety bond in the amount of $1.3 million to the seller of the property. The surety company required a cash deposit in the amount of $700,000, of which the Company's portion was $278,000. A portion of monthly net cash flow from the acquired property will be used to fund the deposit account until the bond limit of $1.3 million is fully funded. Effective February 2005, this requirement was amended to provide for a series of twenty-four (24) monthly payments of $24,000 ($12,000 net to Capco's interest) to fully fund the deposit account. The surety company was given a security interest in the Company's working interests in the Brazos Field and the Caplen Field as collateral for this obligation. The Company's Chief Executive Officer also provided his personal guarantee to the surety company. An additional portion of the monthly net cash flow from the property will be used to fund another deposit account to the seller. When this account balance reaches $1.7 million the $1.3 million bond will be released. The Company's portion of this obligation, $1.1 million, in included in the Company's recorded cost of the acquisition. OTHER In January 2003, Marketing closed on the sale of its preferred membership interests ("interests") in Propane. Total consideration of $1.1 million consisted of (1) a cash payment in the amount of $766,000, (2) an 8% promissory note in the amount of $199,000 due January 2006, and (3) a cash retention in the amount of $150,000 to be paid upon the delivery of asset title transfer documents resulting from Marketing's sale of Propane in April 2002. The carrying value of the interests at December 31, 2002, had been adjusted to equal the anticipated proceeds. Effective September 30, 2003, the Company recorded the sale of Enterprises to Sedco, Inc., a private company owned by Ilyas Chaudhary, the Company's Chief Executive Officer. The operations of Enterprises for the nine month period ended September 30, 2003, are reported as discontinued operations in the financial statements. The Company reported a loss of $730,000 for the disposal of the discontinued business interests (see Note 6). Effective September 30, 2003, the Company restored assets and liabilities attributable to business interests that had previously been reported as sold as of December 31, 2002. A gain resulting from the sale had been deferred by the Company due to debt guarantees provided by the Company on a significant level of debt that was included in the sales transaction (see Note 7). Effective December 31, 2003, the Company sold its equity ownership in Resource and Limited to the Company's Chief Executive Officer for the assumption of certain liabilities. F-24 3. INVESTMENTS IN EQUITY SECURITIES-MARKETABLE SECURITIES As of December 31, 2004, the Company had disposed of its portfolio of marketable securities in common stock, realizing total losses in the amount of $65,000. In January and February 2003, the Company sold the remaining shares of its equity interests in Chaparral Resources, Inc., realizing a loss of $10,000 from the sales. During the year 2003, the Company reported unrealized holding gains in the amount of $145,000 due to increases in the carrying value of marketable securities. 4. NOTES RECEIVABLE Notes receivable consisted of the following as of December 31, 2004 (in thousands): Note receivable, interest at 6% per annum, due May 1, 2005, collateralized by land $ 295 Note receivable, interest at 6% per annum, due March 31, 2005, from a related party, collateralized by Common Stock of the Company 686 ----- Total $ 981 ===== The notes were paid in full in March 2005. 5. OIL AND GAS PROPERTIES Oil and gas properties consisted of the following as of December 31, 2004 (in thousands): Properties being amortized $ 10,713 Properties not subject to amortization 211 Accumulated depreciation and depletion (1,727) ------ Oil and gas properties, net $ 9,197 ====== At December 31, 2004, certain of these assets collateralized a portion of the Company's long-term debt (see Note 9). Certain other oil and gas producing properties collateralized the Company's obligation to a surety company (see Note 2). Depreciation and depletion expense totaled $0.8 million and $0.6 million for the years ended December 31, 2004 and 2003, respectively. 6. DISCONTINUED OPERATIONS In October 2002, the Company's Board of Directors directed management to sell all assets and liabilities of the petroleum marketing operations, including the convenience stores operations. In December 2002, the Company closed on the sale of assets located in the state of New Mexico (see Note 7). In March 2003, the Company received a proposal from Sedco, Inc. ("Sedco"), a private company owned by Ilyas Chaudhary, the Company's Chief Executive Officer, to acquire Enterprises, except for 4.0 million shares of Enterprises' equity ownership in Network Fueling Corp., at a cash price of $2.5 million, effective F-25 6. DISCONTINUED OPERATIONS, Continued January 1, 2003. The Company's Board of Directors accepted the proposal, subject to the receipt of a fairness opinion that was received in August 2003. At that time the Company had received a nonrefundable deposit in the amount of $300,000, a 7% promissory note in the amount of $1.0 million due October 31, 2003, and a second 7% promissory note in the amount of $1.2 million due April 30, 2004. In addition, Sedco provided 12,000,000 shares of the Company's Common Stock as security for payment of the two promissory notes. In September 2003, the transaction was amended for the following: the cash purchase price was reduced to $1.75 million and the 4,000,000 shares of NFC common stock were returned to Enterprises. In addition, Sedco assumed an obligation in the amount of $1.45 million that the Company owed to Enterprises. This amount, combined with the nonrefundable deposit in the amount of $300,000, constituted full payment of the amended purchase price of $1.75 million. The Company recorded the sale of the business interests, effective September 30, 2003, recording a loss of $730,000 for the disposal of the discontinued business interests. The historical operations of the business interests subject to the disposition have been presented in the statements of operations and statements of cash flows as discontinued operations. Year 2003 includes the historical operations for the nine-month period ended September 30, 2003, that preceded the recorded sale. The Company is guarantor of certain obligations of Enterprises and its subsidiaries in the aggregate amount of $1.1 million at December 31, 2004. The obligations consist of vendor trade accounts, and real estate and equipment purchases and leases. Management believes that there is sufficient underlying collateral value in the related assets to significantly reduce the potential loss, if any, to the Company. Summarized below are the results of discontinued operations for 2003, consisting of the nine-month period from January 1 to September 30, 2003, the date of sale by Capco (in thousands): Sales $ 49,082 Gross profit $ 8,860 Loss from operations $ (841) Net loss from operations $ (1,264) 7. BUSINESSES UNDER CONTRACT FOR SALE Effective December 31, 2002, the Company entered into an agreement to sell Graves and Monument, subsidiaries whose assets, consisting principally of land, buildings and equipment, were primarily located in the state of New Mexico, at a sales price of $10,000 cash. The assets of Graves were utilized in the distribution of refined petroleum products. The convenience store business consisted of two store locations that were in operation in Albuquerque and Farmington, New Mexico. The Company agreed to continue to operate the businesses for a period of time subsequent to the date of sale to allow the buyer time to make separate credit arrangements with lenders and suppliers, and to negotiate for the removal of the Company as the guarantor of a significant portion of the indebtedness assumed by the buyer. The sales transaction resulted in a gain to the Company in the amount of $0.2 million; however, due to the significant risk still assumed by the Company in the form of the loan guarantees, the gain is deferred until such time that the risk had either been significantly reduced or eliminated. F-26 7. BUSINESSES UNDER CONTRACT FOR SALE, Continued At December 31, 2003, approximately $3.8 million of indebtedness, including accrued interest, was owed to one lender, and Graves was in default on the indebtedness. Remedies available to the lender include declaring the entire note balances, including accrued and unpaid interest, immediately due and payable, foreclosing on the pledged security, which includes land, buildings, and equipment, and collecting on any guarantees. Discussions have been held with the lender, but no settlement has been reached at this time. During the year 2003, the buyer marketed the real estate for sale, and certain properties were contracted for sale. The sale of one property closed in September 2003, resulting in a reduction in the amount of $0.6 million to the total debt assumed by the buyer. Effective September 30, 2003, the Company re-evaluated the exposure relating to the debt guarantees. While management believed that there was sufficient value in the underlying assets such that the Company would not incur a loss from this disposal, the Company believed that the disposal no longer met the criteria to be recorded as a divestiture of a subsidiary for accounting purposes. Accordingly, the decision was made at September 30, 2003, to restore the assets and liabilities attributable to the businesses that were sold to the Balance Sheet to be reported as "Assets attributable to businesses under contract for sale" and "Liabilities attributable to businesses under contract for sale". The Company further evaluated the exposure relating to the debt guarantees as of December 31, 2003, and determined that there was not sufficient value in the underlying assets such that the Company would, in all likelihood, incur a loss from this disposal. It was estimated that the liabilities which are guaranteed by the Company exceeded the underlying net assets by approximately $0.3 million. The Company accounted for this deficit by eliminating the deferred gain of $0.2 million that was recorded at the end of year 2002, and by recording a charge to year 2003 operations in the amount of $0.2 million. Discussions between the parties continued throughout year 2004, and in December 2004, the parties entered into a Pay-Off Agreement ("Agreement"), which provided for the following: the outstanding amount of debt owed was reduced from $3.9 million to $2.7 million by application of proceeds from properties sold and a discount given by the lender, scheduled monthly payments were to be made for the period February 15, 2005, to June 15, 2005, with the balance owing at June 30, 2005, $2.6 million, to be paid at that date ("Date of Closing"). Alternatively, by making a payment of $1.0 million on or before May 31, 2005, the Date of Closing would be extended for a period of ninety (90) days. As a further condition of the Agreement, the buyer deposited into an escrow account ten million shares of the Company's $0.001 par value Common Stock. In the event that debt payments are not made in accordance with the terms of the Agreement, the lender has the right to proceed to collect the unpaid indebtedness based on the original amount owed and has the right to liquidate the Common Stock in escrow in addition to seeking other remedies available to it to collect the outstanding balance. 8. NOTES PAYABLE Notes payable consisted of the following at December 31, 2004 (in thousands): Note payable, interest at 20% per annum, due upon closing of the acquisition of a certain producing oil and gas property, collateralized by substantially all of the Company's assets $ 400 F-27 8. NOTES PAYABLE, Continued Note payable, interest at 6% per annum, payable in monthly installments of $19, which includes principal and interest, due November 2005, collateralized by equipment 198 Note payable, interest at 8% per annum, payable in one installment of $80 and ten monthly installments of $10, which includes principal and interest, to November 2005, collateralized by oil and gas leases 164 ------ Total $ 762 ====== 9. LONG TERM DEBT Long-term debt consisted of the following as of December 31, 2004 (in thousands): Note payable to an individual, interest at 9% per annum, plus an incremental interest rate of 1% for every $1 that West Texas Intermediate Crude exceeds $21 per barrel payable quarterly, convertible into Common Stock of the Company at the option of the holder at a conversion rate of $0.38, with the unpaid principal due in May 2003 $ 25 Note payable to a related party, interest at 7%, payable in monthly installments of $4, due on June 30, 2006 127 Note payable to an individual, interest at 12.0% per annum, payable in monthly installments of $60, which includes principal and interest, due in August 2006, collateralized by producing oil and gas properties and by the guarantee of the Company's Chief Executive Officer 1,000 ------ Total debt 1,152 Less current maturities 637 ------ Long term debt $ 515 ====== The following is a summary of the principal amounts payable over the next two years (in thousands): Year ending December 31, 2005 $ 637 2006 515 ----- $ 1,152 ===== Interest expense for all corporate borrowings totaled $399,000 and $153,000 for the years ended December 31, 2004 and 2003, respectively. F-28 10. CONVERTIBLE PROMISSORY NOTES Convertible promissory notes consisted of the following as of December 31, 2004 (in thousands): Notes payable to individuals, interest at 12% per annum, payable quarterly, convertible into Common Stock at the option of the holders at a conversion rate of $0.20, with the unpaid principal due at various times during the period February to June 2007 (net of unamortized discounts of $22) $ 998 Note payable to an individual, interest at 9% per annum, payable quarterly, convertible into Common Stock at the option of the holder at a conversion rate of $0.16, with the unpaid principal due in September 2007 (net of unamortized discount of $75) 585 ------ $1,583 ====== At the option of the holders, the notes can be converted into as many as 9.2 million shares of the Company's Common Stock. Notes not converted during the three-year period from date of sale are to be redeemed for their face amount on the third anniversary from the subscription date. Pursuant to EITF 98-5, "Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios", discounts of approximately $0.1 million attributable to the beneficial conversion feature were recorded as additional paid in capital. The discounts are being amortized using the effective interest rate method over the terms of the indebtedness. 11. COMMITMENTS AND CONTINGENCIES ENVIRONMENT Capco, as owner and operator of oil and gas properties, is subject to various federal, state, and local laws and regulations relating to discharge of materials into, and protection of, the environment. These laws and regulations may, among other things, impose liability on the owner of real property and the lessee under oil and gas leases for the cost of pollution clean-up resulting from operations, subject the owner/lessee to liability for pollution damages and impose restrictions on the injection of liquids into subsurface strata. Although Company environmental policies and practices are designed to ensure compliance with these laws and regulations, future developments and increasing stringent regulations could require the Company to make additional unforeseen environmental expenditures The Company maintains insurance coverage that it believes is customary in the industry, although it is not fully insured against all environmental risks. The Company is not aware of any environmental claims existing as of December 31, 2004, that would have a material impact on its consolidated financial position or results of operations. There can be no assurance, however, that current regulatory requirements will not change, or past non-compliance with environmental laws will not be discovered on the Company's properties. F-29 11. COMMITMENTS AND CONTINGENCIES, Continued LAND RENTALS AND OPERATING LEASES The Company leases office facilities and equipment under operating leases expiring through October 31, 2007, and is obligated to pay land rentals on oil and gas properties through December 31, 2012. As of December 31, 2004, future minimum rental payments required under operating leases are as follows (in thousands): Year ending December 31, 2005 $ 114 2006 92 2007 78 2008 24 2009 24 Thereafter 71 ---- $ 403 ==== Rental expense charged to continuing operations totaled $64,000 and $70,000 for the years ended December 31, 2004 and 2003, respectively. Rental expense included in discontinued operations totaled $554,000 for the year ended December 31, 2003. LEGAL PROCEEDINGS The Company is a party to certain litigation that has arisen in the normal course of its business and that of its subsidiaries. A company engaged by Capco to provide well service in connection with workover operations on some of the Company's offshore wells has filed a claim for unpaid invoices in the amount of approximately $0.2 million. Capco has recorded less than $50,000 of such costs in its accounts, and has claims against the service company for damages and costs to its wells in an estimated amount in excess of $1.0 million. The Company expects to show that its damages far exceed the claim amount asserted by the service company. OTHER In connection with the acquisitions of producing oil and gas properties that closed during the year ended December 31, 2004, Capco is committed to make development expenditures of $0.6 million during the year 2005 to earn the entire working interests stipulated in the purchase agreements. Capco is obligated to a surety company to make monthly cash collateral deposits of $12,000 over a period of twenty-four months, beginning February 2005. Various purchase agreements require that funding obligations of $1.1 million and $0.3 million be paid from the net profits, if any, derived from the respective operations of the properties. 12. EQUITY COMMON STOCK For the year ended December 31, 2004, the Company had the following significant equity transactions: The Company issued 300,000 shares of Common Stock in settlement of a liability with a recorded cost of $30,000, which represented the fair market value of the Common Stock when the settlement was agreed to by both parties. F-30 12. EQUITY, Continued COMMON STOCK, continued The Company issued 1,095,000 shares of Common Stock upon the exercise of options, realizing proceeds of $70,500. The Company issued 3,644,760 shares of Common Stock for the acquisition of an oil and gas property at a cost of $437,000, which represented the fair market value of the Common Stock when the acquisition closed. For the year ended December 31, 2003, the Company had the following significant equity transactions: The Company issued 120,000 shares upon the exercise of a stock option by a Director, realizing proceeds of $7,000. The Company issued 200,000 shares as compensation to the employees of a former subsidiary at a cost of $11,000. The Company issued 4,000,000 shares to acquire the equity ownership of Capco Offshore, Inc. at a cost of $240,000. The Company issued 10,436,000 shares in settlement of amounts due to the Chief Executive Officer at a cost of $600,000. The Company issued 2,929,500 shares in exchange for the issued and outstanding Preferred Stock at a cost of $320,000. TREASURY STOCK In 2004, the Company acquired 60,600 shares of Common Stock at a cost of $11,000 to be held as Treasury Stock. In 2003, the Company acquired 40,000 shares of Common Stock at a cost of $5,000 to be held as Treasury Stock, and sold 28,600 shares of Common Stock from treasury, realizing proceeds of $2,000. STOCK OPTIONS The Company has a Stock Option Plan providing for the issuance of incentive stock options and non-qualified stock options to the Company's key employees. Incentive stock options may be granted at prices not less than 100% of the fair market value at the date of the grant. Non-qualified stock options may be granted at prices not less than 75% of the fair market value at the date of the grant. The Company's common stock options were granted at exercise prices equal to, or in excess of, market prices on the grant dates, and therefore no compensation cost was recognized. The options were granted with maximum terms between one and five years. F-31 12. EQUITY Continued STOCK OPTIONS, Continued A summary of the status of the Company's stock option plan as of December 31, 2004 and 2003 is presented below: 2004 2003 ------------------ ------------------- Weighted Weighted average average exercise exercise Shares price Shares price --------- ---------- --------- --------- Outstanding at beginning of year 15,880,000 $ 0.13 11,141,604 $ 0.23 Granted at market -- -- -- -- Granted exceeding market 1,700,000 $ 0.18 16,000,000 $ 0.13 Exercised (1,080,000) $ 0.06 (120,000) $ 0.06 Canceled (500,000) $ 0.20 (10,861,604) $ 0.24 Forfeited -- -- (280,000) $ 0.23 --------- ----- --------- ----- Outstanding at end of year 16,000,000 $ 0.14 15,880,000 $ 0.13 ========== ===== ========== ===== Options exercisable at end of year 16,000,000 $ 0.14 15,880,000 $ 0.13 ========== ===== ========== ===== Options Outstanding Options Exercisable -------------------------------------------------------- --------------------- Weighted average Weighted Weighted Year Range of Number remaining average average options exercise outstand- contractual exercise Number exercise granted prices ing life price exercisable price ------- -------- --------- ----------- -------- ----------- -------- 2003 $0.06 to $0.25 14,800,000 3.75 years $0.13 14,800,000 $0.13 2004 $0.17 1,200,000 4.75 years $0.17 1,200,000 $0.17 ---------- ---------- $0.06 to $0.25 16,000,000 3.82 years $0.14 16,000,000 $0.14 Non-employee options The Company did not issue options to acquire the Company's Common Stock to any non-employee during the year ended December 31, 2004. In January 2003, the Company issued an option to an individual to acquire 600,000 shares of the Company's Common Stock at an exercise price of $0.20, exercisable for a period of three years. The option was issued in exchange for market consulting services. Using the Black-Scholes option-pricing model, the Company recorded an increase to paid-in capital, and a charge to operations, in the amount of $38,000 for the value of the option grant. Options to acquire 15,000 shares of the Company's Common Stock were exercised during the year ended December 31, 2004, leaving a balance of unexercised options of 585,000 at December 31, 2004. F-32 13. INCOME TAXES Components of the provision for income taxes for the years ended December 31, 2004 and 2003, are as follows: 2004 2003 ---- ---- Current $ -- $ -- Deferred -- -- ---- ---- Total provision $ -- $ -- ==== ==== Following is a reconciliation of the Federal statutory rate to the effective income tax rate for the years ended December 31, 2004 and 2003: 2004 2003 ---- ---- Federal income tax rate 34.0% (34.0)% State income taxes, net of federal benefit 6.0% (6.0)% Utilization of NOL carry forward -- -- Effect of valuation allowance (40.0)% 40.0% ---- ---- Effective income tax rate 0.0% 0.0% ==== ==== At December 31, 2004, the Company had net operating loss carry forwards of approximately $10.0 million. The Company anticipates that it will be able to utilize only a portion of the net operating loss carry forwards during the year 2004. Therefore, the Company has established a valuation allowance for the remaining net operating loss carry forwards. The Company realized as a tax benefit in the year 2004 only that amount applicable to the net operating loss carry forwards that were utilized in the year 2004. The valuation allowance for the year ended December 31, 2004, decreased by approximately $62,000. The net operating loss carry forwards expire at various dates through the year 2021. Deferred tax assets and liabilities reflect the net tax effect of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. Significant components of the Company's deferred tax assets and liabilities are as follows at December 31 (in thousands): 2004 2003 ---- ---- Deferred tax asset: Marketable securities, receivables and liabilities $ 27 $ -- Loss carry forward 3,973 2,631 Less: valuation allowance (2,149) (2,078) ----- ----- $ 1,851 $ 553 ===== ===== Deferred tax liability: Property and equipment and investments $ 1,851 $ 553 ===== ===== F-33 14. RELATED PARTY TRANSACTIONS Year Ended December 31, 2004 The Company had several transactions with its Chief Executive Officer, Ilyas Chaudhary, and Sedco, Inc. and Meteor Enterprises, Inc., private companies controlled by Mr. Chaudhary ("affiliates"). The Company received cash advances in the total amount of $350,000 from affiliates. The Company paid expenses in the amount of $93,000 in behalf of affiliates, and was charged a total of $67,000 for expenditures made by affiliates in behalf of the Company. The Company accrued, and paid, compensation expense in the amount of $175,000 due to affiliates in accordance with the Chief Executive Officer's employment. The Company made cash advances in the total amount of $766,000 to affiliates that included repayment of balances owed to affiliates at the beginning of the year, repayment of cash advances received during the year and settlement of expenditures made by the respective parties during the year in behalf of each other. Of such advances, $108,000 was considered to be advance payments of Mr. Chaudhary's compensation for the year 2005, and has been reclassified as a prepaid expense in the accompanying financial statements as of December 31, 2004. No amount was due to, or due from, affiliates at December 31, 2004, except as discussed below. Effective September 30, 2004, the Company sold its interests in non-operated producing properties located in Alabama and Louisiana to a company owned by the Company's Chief Executive Officer. Sales proceeds in the amount of $0.4 million were received by the Company in October 2004 and were used for working capital. If it is determined through due diligence by the Company that the properties could have been sold for an amount greater than $0.4 million, then the related party has the obligation to pay such excess to the Company, or the Company, at its option, may repurchase the properties at the original sales price. In September 2004, the Company acquired from a Director of the Company an 80% equity interest in a start-up company formed for the purpose of acquiring producing oil and gas properties. Subsequent to the incorporation of the company, Capco advanced $50,000 to the company to provide funding for the cost of an acquisition and for working capital. In October 2004, the Company issued 3.6 million shares of Common Stock as consideration for the acquisition cost of an oil and gas property. The number of shares issued was negotiated between the parties based on analysis of the value of the underlying assets. The per share price of $0.16 approximated the market price of the Company's Common Stock at that time. Approximately 70% of the acquired working interest in the property was acquired as a result of Capco's exchange of shares for 100% equity ownership of Packard Gas Company with individuals, or entities controlled by individuals, who have either a direct, or beneficial, relationship to the Company, including the President of the Company. The negotiated acquisition price was determined in amounts prorata to all members of the selling group. Effective December 31, 2004, the Company sold its interests in non-operated producing properties located in Michigan and Montana and other assets to the Company's Chief Executive Officer for the amount of $4.7 million. The Company received a fairness opinion for the sale in January 2005. The sales amount was settled by the payment of a cash deposit in the amount of $0.7 million, assumption of debt against the properties in the amount of $3.3 million and the issuance of a note payable to the Company in the amount of $0.7 million. The note was paid in full in March 2005. The Company incurred interest expense in the amount of $11,000 on a note payable to a Director of the Company that was outstanding during the year ended December 31, 2004. F-34 14. RELATED PARTY TRANSACTIONS, Continued Year Ended December 31, 2003 The Company had several transactions with its Chief Executive Officer, Ilyas Chaudhary, and Sedco, Inc., a private company controlled by Mr. Chaudhary ("affiliates"). The Company received cash advances in the total amount of $298,000 from affiliates. The Company paid expenses in the amount of $27,000 in behalf of affiliates, and was charged a total of $114,000 for expenditures made by affiliates in behalf of the Company. The Company accrued, and paid, compensation expense in the amount of $175,000 due to affiliates in accordance with the Chief Executive Officer's employment. The Company made cash advances in the total amount of $291,000 to affiliates that included repayment of cash advances received during the year and settlement of expenditures made by the respective parties during the year in behalf of each other. The Company charged affiliates $43,000 for interest due on the notes receivable issued in connection with the acquisition of Enterprises by Sedco. The Company issued 8,696,000 shares of Common Stock to affiliates at a cost of $500,000 to acquire an additional interest in a producing oil and gas property, and 1,740,000 shares of Common Stock to affiliates at a cost of $100,000 in settlement of amounts due affiliates. Effective December 31, 2003, the Company sold its equity interests in Resource and Limited to Sedco for consideration consisting of the assumption of certain liabilities in the amount of $238,000 and the minority interest of Limited in the amount of $364,000. At December 31, 2003, the Company owed $530,000 to affiliates. In addition, the Company had several transactions with Enterprises, a former subsidiary of the Company that was acquired by Sedco effective January 1, 2003. Although the operations of Enterprises for the nine-month period ended September 30, 2003, are reported by the Company as discontinued operations, the following discussion includes transactions for the entire year 2003. At January 1, 2003, the Company owed $978,000 to Enterprises. During the year 2003, the Company was charged a total of $264,000 for expenditures made by Enterprises in behalf of the Company. The Company received cash advances in the total amount of $373,000 from Enterprises, and remitted cash advances to Enterprises in the total amount of $175,000. Effective September 30, 2003, Sedco assumed $1.45 million of the account balance owed to Enterprises by the Company in payment of the balance owed to the Company in connection with the sale of Enterprises to Sedco. At December 31, 2003, the Company was owed $10,000 by Enterprises. The Company received a cash advance from the President of the Company in the amount of $11,000, and paid $5,000 for expenses in behalf of a company owned by the President. At December 31, 2003, the Company owed $6,000 to this individual. 15. PROFIT SHARING PLAN The Company maintains a defined contribution profit sharing plan ("401 (k) Plan") covering all eligible employees. Profit sharing contributions are made (i) at the discretion of the Board of Directors; and (ii) on the employee's behalf from salary deferrals. Eligible employees may contribute on a pre-tax basis up to 100% of their qualifying annual compensation, to a maximum of $40,000. Employer discretionary contributions are not to exceed 50% of the first six percent of each employee's compensation. The Company did not incur any expense for employer matching contributions for either of the years ended December 31, 2004 and 2003. F-35 16. BUSINESS SEGMENTS For the years ended December 31, 2004 and 2003, the Company operated in one industry segment: acquisition, exploration, development, and production of oil and gas reserves, including investments in the equity securities of other public companies involved in similar activities. The Company's headquarters and all of its operations are located in the United States of America. Effective December 31, 2003, the Company disposed of its oil and gas property interests in Canada. A summary of the Company's revenues and long-lived assets by geographic area is as follows (in thousands): Canada United States Total -------- ------------- ------- Operating revenues: Year ended December 31, 2004 $ -- $ 6,229 $ 6,229 ====== ====== ====== Year ended December 31, 2003 $ 13 $ 3,135 $ 3,148 ====== ====== ====== At December 31, 2004: Oil and gas properties (net) $ -- $ 9,197 $ 9,197 ====== ====== ====== Other property and equipment (net) $ -- $ 649 $ 649 ====== ====== ====== 17. MAJOR CUSTOMERS For the year ended December 31, 2004, the Company had oil and gas sales to two customers that accounted for approximately 52.3% and 33.0%, respectively, of total oil and gas sales. One customer accounted for 49.6% of accounts receivable as of December 31, 2004. For the year ended December 31, 2003, the Company had oil and gas sales to two customers that accounted for approximately 75.7% and 10.7%, respectively, of total oil and gas sales. 18. SUBSEQUENT EVENTS On February 3, 2005, the Company announced that drilling had commenced on an exploratory well at Outer Continental Shelf ("OCS") Galveston Block 297. Capco is the operator of the well which is targeted for a total drilled depth of 13,500 feet. The Company's initial working interest ownership in the property was 60%; however, portions of that interest were subsequently sold to private investors. On April 12, 2005, the Company announced that due to encountering excessive gas pressures at a depth of approximately 13,350 feet, the decision was made to sidetrack from the existing well bore and re-drill the well from a depth of approximately 8,500 feet to a depth in excess of 14,000 feet. As a result of the difficulties encountered in drilling this well, the cost has substantially exceeded the Company's planned expenditures in this regard and is increasing as the drilling continues. Significant capital resources of the Company have been and will continue to be utilized to pay the ongoing costs associated with the well. While the Company believes that it has sufficient capital resources to complete the drilling as currently planned, any further delays or complications may result in additional costs for which the Company will need to make financial arrangements. The Company anticipates that it will recover certain of the drilling costs from participants in the well if and when the drilling reaches the targeted depth. Additionally, the Company intends to pursue a F-36 18. SUBSEQUENT EVENTS, Continued claim on the insurance covering the drilling of the well based upon the consequences of encountering the excessive gas pressures in the initial well bore, and any insurance proceeds would also assist in recovering a portion of the drilling costs. The Company cannot make any assurances concerning the potential completion of or production from this well. On February 7, 2005, the Company executed an Amended Memorandum of Terms with an unrelated private investor (the "Investor") that provided the terms whereby the Investor would invest up to $7.5 million in oil and gas property interests owned by the Company. The properties effected by the transaction included three wells in the Company-operated Brazos Field in the Texas Gulf Coast, the exploratory well at OCS Galveston Block 297 and a pending acquisition of producing properties in OCS High Island Block 196. In addition, the Investor holds an option to participate in a planned workover on a well in the Brazos Field, and agreed to fund future capital requirements for the applicable properties in amounts and at times determined by mutual agreement of Capco and the Investor. Closing of the transaction is scheduled to occur at the time that the Investor receives approval to own offshore leases from the Minerals Management Service ("MMS"). In addition to the acquired property interests, the Investor is to receive warrants to purchase shares of Capco's Common Stock. The number of warrants will be determined based on the trading price of the Common Stock at the date of closing. The Investor paid $1.5 million to the Company for a portion of Capco's interests in the wells in the Brazos Field and the exploratory well being drilled at OCS Galveston Block 297. On February 10, 2005, Capco announced the purchase of producing properties in OCS High Island Block 196 at a cost of $2.5 million. Additionally, bonds in the total amount of $3.5 million were posted with the MMS. Funding for the acquisition, including bond deposits, was provided by the Investor, who will initially own the entire acquired interest. Capco will operate the property. In addition to the fundings described above the Investor had previously advanced $0.4 million to Capco in December 2004 for a deposit that was made in connection with the acquisition of the OCS High Island Block 196 property. In total the fundings amounted to $6.4 million. This amount is documented as a bridge loan that is to remain in effect until the Investor receives owner approval from the MMS and the property interests are assigned by Capco to the Investor. In addition to the Investor's acquired interests in several of Capco's properties, the Company has provided the Investor with additional security interests in a majority of the Company's unencumbered assets. The security will be released when the assignments become effective. All of the operating cash flow attributable to the acquired property interests will accrue to the Investor, until such time that the Investor has received reimbursement of all invested funds, plus a stated return on the invested funds ("Payout"). At Payout, Capco will earn a two-thirds interest in the future net operating cash flow to be derived from the property interests. On March 10, 2005, the Company entered into a Securities Purchase Agreement (the "Purchase Agreement") with certain accredited investors with respect to a private placement under Regulation D of 10 million shares of the Company's Common Stock and common stock purchase warrants for 5 million shares of the Company's Common Stock (the "Warrants"), for a total purchase price of $3.0 million. The transaction closed on March 11, 2005. No underwriter discounts or commissions were paid in connection with this transaction. Capco intends to use the net proceeds from this issuance and sale of securities in the acquisition and development of oil and gas properties and for general corporate purposes. F-37 18. SUBSEQUENT EVENTS, Continued The Warrants are exercisable into a total of 5,000,000 shares of the Company's Common Stock at an initial exercise price of $0.45 per share, subject to adjustment pursuant to the anti-dilution provisions set forth in the Warrants, and expire five (5) years from the date of issuance. On March 11, 2005, Capco issued 1 million shares of the Company's Common Stock to an individual, realizing proceeds of $0.2 million. Capco intends to use the proceeds for working capital. On March 15, 2005, the Company entered into an agreement for the acquisition of producing properties located in St. Bernard Parish, Louisiana, and Chandeleur Area, OCS Blocks 27, 29 and 30, and funded a $1.0 million cash deposit with the seller of the properties. Closing for the acquisition is scheduled for May 4, 2005. The closing cost is expected to approximate $12.0 million, after adjustment for net revenue credits from the effective date to the closing date and after credit for the $1.0 million cash deposit. Capco expects to fund the acquisition cost by selling the acquired property interests to third parties, while retaining an interest in the properties after the third parties receive payout on their investment amounts. F-38 SUPPLEMENTAL INFORMATION ABOUT OIL AND GAS PRODUCING ACTIVITIES (UNAUDITED) Capco's independent engineer, Pressler Petroleum Consultants, Inc. prepared reserve estimates for the year end report for 2004. Capco's independent engineers, Burroughs Engineering Services and Netherland, Sewell & Asociates, Inc., prepared reserve estimates for the year end report for 2003.. Management cautions that there are many inherent uncertainties in estimating proved reserve quantities and related revenues and expenses, and in projecting future production rates and the timing and amount of development expenditures. Accordingly, these estimates will change, as future information becomes available. Proved oil and gas reserves are the estimated quantities of crude oil, condensate, natural gas and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved developed reserves are those reserves expected to be recovered through existing wells with existing equipment and operating methods. As reported in the Company's Form 10-QSB/A for the quarterly period ended March 31, 2003, a review by the Securities and Exchange Commission of the Company's engineered proved reserves as previously reported resulted in the exclusion of certain proved undeveloped reserves. The excluded reserves consisted of 10,005 mmcf of gas and 297,000 barrels or oil at December 31, 2002. The following information has been revised to include these changes. The Company had a significant decline in reserves in 2004 attributable to its producing properties located in onshore and offshore Texas. Downward revisions to the Caplen Field located in Galveston County, Texas totaled 151,427 barrels of oil and 240,085 mcf of gas. Production in the year 2004 was significantly curtailed due to field operational problems. Wells which were shut-in for an extended period during the year 2004, and remained shut-in at year end were reclassified to proved developed non-producing status. Proved developed gas reserves decreased from 317,506 mcf to 33,336 mcf. Approximately 55% of the decrease was due to the elimination of one well as it was determined during the year 2004 that the reservoir was depleted. Proved undeveloped oil reserves decreased from 210,020 barrels to 78,863 barrels due to the elimination of one location and per well reductions based on the incumbent engineer's evaluation of the locations. Proved reserves attributed to the Brazos Field located in offshore Matagorda County, Texas were revised downward in the amounts of 50,877 barrels of oil and 7,351,615 mcf of gas. Work-over activities were conducted on five wells during the year in an attempt to either increase production rates or restore wells to service. Such activities were successful on only one well. As a result the incumbent engineer significantly reduced the previously-reported proved reserves until such time that it can be demonstrated that the wells are capable of producing at economical levels. ANALYSIS OF CHANGES IN PROVED RESERVES Estimated quantities of proved reserves and proved developed reserves of crude oil and natural gas, the majority of which are located within the United States, as well as changes in proved reserves during the past two years are indicated below: Oil (Bbls) Natural Gas (MCF) --------- ---------------- United States ------------- Proved reserves at December 31, 2002 537,792 2,861,743 Purchases of minerals in place 95,573 15,453,989 Extensions and discoveries -- -- Sales of minerals in place (68,325) (184,611) Production (38,613) (408,747) Revisions of previous estimates 34,788 (108,111) -------- ---------- Proved reserves at December 31, 2003 561,215 17,614,263 Purchases of minerals in place 240,212 83,231 Extensions and discoveries -- -- Sales of minerals in place (190,355) (6,262,191) Production (22,087) (727,336) Revisions of previous estimates (202,305) (7,591,696) -------- ---------- Proved reserves at December 31, 2004 386,680 3,116,271 ======== ========== Proved developed reserves, December 31, 2004 307,818 1,458,287 ======== ========== F-39 ANALYSIS OF CHANGES IN PROVED RESERVES, Continued Oil (Bbls) Natural Gas (MCF) --------- ---------------- Canada ------ Proved reserves at December 31, 2002 -- -- Production -- (7,584) Revisions of previous estimates -- 7,584 ------ ------ Proved reserves at December 31, 2003 -- -- ====== ====== Proved developed reserves, December 31, 2003 -- -- ====== ====== Effective December 31, 2003, the Company disposed of its interest in producing properties in Canada. There are no reserves attributable to partnership or minority interests at December 31, 2004. The Company incurred the following capitalized costs related to oil and gas activities during the year ended December 31, 2004 (in thousands): Properties being amortized $ 4,029 Properties not subject to amortization 211 ----- $ 4,240 ===== OIL AND GAS OPERATIONS Depletion, depreciation and amortization per equivalent unit of production for the years ended December 31, 2004 and 2003, was $5.55 and $5.72, respectively. Costs incurred by the Company during the year 2004 for acquisition, exploration and development activities are as follows (in thousands): Acquisition of producing properties $ 681 Exploration and development 3,559 ----- $ 4,240 ===== STANDARDIZED MEASURE OF DISCOUNTED NET CASH FLOWS AND CHANGES THEREIN The following information at December 31, 2004, and for the years ended December 31, 2003 and 2004, sets forth standardized measures of the discounted future net cash flows attributable to the Company's proved oil and gas reserves. Future cash inflows were computed by applying year-end prices of oil and gas (with consideration of price changes only to the extent provided by contractual arrangements) and using the estimated future expenditures to be incurred in developing and producing the proved reserves, assuming continuation of existing economic conditions. Future income tax expenses were computed by applying statutory income tax rates to the difference between pretax net cash flows relating to the Company's proven oil and gas reserves and the tax basis of proved oil and gas properties and F-40 STANDARDIZED MEASURE OF DISCOUNTED NET CASH FLOWS AND CHANGES THEREIN, Continued available operating loss and excess statutory depletion carryovers reduced by investment tax credits. Discounting the annual net cash flows at 10% illustrates the impact of timing on these future cash flows. The following table presents the standardized measure of discounted net cash flows at December 31, 2004 (in thousands): United States ------------- Future cash inflows $ 34,039 Future cash outflows: Production costs (10,418) Development costs (1) (5,787) ------- Future net cash flows before future income taxes 17,834 Future income taxes (4,586) ------ Future net cash flows 13,248 Adjustment to discount future annual net cash flows at 10% (3,683) ------ Standardized measure of discounted future net cash flows $ 9,565 ====== (1) Includes estimated expenditures in each of the next three years to develop proved undeveloped reserves as follows (in thousands): $1,919 (2005), $894 (2006), and $-0- (2007). The following tables summarize the principal factors comprising the changes in the standardized measures of discounted net cash flows during the years 2004 and 2003 (in thousands): United States Canada Year 2004 ------------- ---------- --------- Standardized measure, beginning of period $ 32,442 $ -- Sales of oil and gas, net of production costs (2,264) -- Net change in sales prices, net of production costs 9,279 -- Changes in estimated future development costs (1,658) -- Purchases of minerals in place 2,956 -- Sales of minerals in place (11,841) -- Revisions of quantity estimates (30,488) -- Accretion of discount 3,244 -- Other, including changes in production rates (timing) (2,845) -- Change in income taxes 10,740 -- ------ ------ Standardized measure, end of period $ 9,565 $ -- ====== ====== F-41 STANDARDIZED MEASURE OF DISCOUNTED NET CASH FLOWS AND CHANGES THEREIN, Continued United States Canada Year 2003 ------------- ---------- --------- Standardized measure, beginning of period $ 8,101 $ -- Sales of oil and gas, net of production costs (1,587) (5) Net change in sales prices, net of production costs 1,906 -- Changes in estimated future development costs (149) -- Purchases of minerals in place 35,386 -- Sales of minerals in place (705) -- Revisions of quantity estimates 202 5 Accretion of discount 810 -- Other, including changes in production rates (timing) 472 -- Change in income taxes (11,994) -- ------ ------ Standardized measure, end of period $ 32,442 $ -- ====== ====== Effective December 31, 2003, the Company disposed of its interest in producing properties in Canada. F-42