General Development of Business

 

Hallador Petroleum Company (Hallador), a Colorado corporation, was organized by our predecessor in 1949.

 

About nine years ago, Yorktown Energy Partners II and affiliates (Yorktown) invested $5,025,000 in Hallador Petroleum, LLP, a newly formed limited liability limited partnership, (the "Partnership").  We are the general partner and received a 70% interest in the partnership in return for contributing our net assets and Yorktown representing the limited partners, received a 30% interest for its $5,025,000 cash contribution.  During the third quarter of 2005, we purchased the limited partners interest in the Partnership, and for accounting purposes the Partnership no longer exists and, as a result, there is no longer a minority interest caption on our balance sheet.  Prior to this transaction we, as general partner, consolidated the activity of the Partnership and presented the 30% limited partners’ interest as a minority interest.

 

On August 10, 2004, we entered into an agreement with E&B Natural Resources Management Corporation (a private company) to sell all of our interest in the South Cuyama field and adjacent exploration areas, all located in Santa Barbara County, California, for $23 million; consisting of $19.5 million in cash and an interest bearing (3.5%) note of $3.5 million due on September 30, 2005, which was paid.  Closing occurred on September 30, 2004 and we recorded a pre-tax gain of about $14 million.  Results from the South Cuyama field have been presented as discontinued operations in the accompanying Consolidated Statement of Operations.

 

Due to the sale, our board of directors and the Executive Committee of the Partnership, voted to discontinue new partnership operations effective October 1, 2004.  At that time,  the Partnership's assets consisted of cash, the $3.5 million note receivable, oil and gas properties in New Mexico and Texas, and other miscellaneous assets.  On October 1, 2004, our  board of directors and the Executive Committee of the Partnership, valued the oil and gas properties in New Mexico and Texas and the other miscellaneous assets at $4 million. On May 6, 2005 we made a cash distribution of about $5.2 million to the limited partners.  During the third quarter 2005, we purchased the limited partners' interest in the Partnership for about $1.2 million and made a final cash distribution to the limited partners of $1.6 million.  After these transactions, about $1.7 million remained in the minority interest account and was recorded as a reduction in our accumulated deficit account. 

 

In late March 2005, we invested $325,000 for a 29% interest in a newly formed entity called COALition Energy, LLC (CELLC) to pursue coal opportunities in the United States.  Some of our officers and directors also invested in CELLC.

 

We have concluded to deemphasize our oil and gas operations and concentrate our future efforts in the coal business.  With that in mind, the following events have occurred:

 

            1.         In early January 2006, we signed a Letter of Intent with Sunrise Coal, LLC (Sunrise) in order to effect a reorganization/merger between Hallador and Sunrise, a private company not affiliated with the Yorktown group of companies.  We are working on a formal agreement which we hope to execute sometime in the second quarter 2006. Upon closing, it is expected that our existing shareholders will own about 52% and the Sunrise shareholders will own about 48% of the new company. 

 

            CELLC brought us the Sunrise deal and, upon closing, they will receive a finders fee, stock and warrants in the new company.

 

            During the first quarter of 2006, we loaned Sunrise $7 million in order for Sunrise to begin development of their second coal mine (the "Carlisle mine").   Their Howesville mine began producing coal in November 2005.  Both mines are located in Indiana.   During the second quarter of 2006, Sunrise expects to enter into a $30 million line-of- credit with two Indiana banks, at which time our $7 million will be repaid.  We have agreed to guarantee this $30 million line-of-credit.

 

            2.         In late February 2006, we sold 3,181,816 shares for $2.20 per share (about $7 million) to our existing shareholders.  The proceeds will provide working capital for the Sunrise transaction.

 

With regards to our oil and gas business, the following events have occurred:

 

            1.         In August 2005, we began negotiations to purchase from Yorktown Energy Partners II, LP its 32% interest in Savoy Energy LLP, a private company engaged in the oil and gas business primarily in the State of Michigan.  A purchase price of $4.1 million was agreed upon and closing occurred on December 31, 2005.  On December 20, 2005 we sold about 1,893,000 shares of our common stock to Yorktown Energy Partners VI LP at $2.20 per share (about $4.1 million).  We will account for our interest in Savoy using the equity method of accounting.

 

            2.         In December 2005, we sold substantially all of our interest in our North Dakota properties for about $1.6 million, which was our original investment; accordingly, no gain or loss was recognized.

 

            3.         In late March 2006, we signed a letter-of-intent with Approach Resources Inc., to sell them all our interests in our Albany Shale prospect located in Kentucky.  If we close this transaction, we expect to recognize a gain of about $600,000 and our cash proceeds will be about $3.3 million. Approach Resources Inc., based in Fort Worth, Texas, has an affiliation with the Yorktown group of companies.

 

Our office is located at 1660 Lincoln Street, Suite 2700, Denver, Colorado 80264, phone 303.839.5504, fax 303.832.3013.  We have no website.

 

Until we close the Sunrise deal, there is no need to discuss the coal business and the rest of this discussion will be about our oil and gas operations.

 

We operate oil and natural gas properties for our own account and for the account of others.  We also review and evaluate producing oil and natural gas properties, companies, or other entities, which meet certain guidelines for acquisition purposes.  Occasionally, we engage in the trading and acquisition of non-producing oil and gas mineral leases and fee-simple minerals.

 

Markets

 

Our products are sold to various purchasers in the geographic area of the properties.  Natural gas, after processing, is distributed through pipelines.  Oil and natural gas liquids (NGLs) are distributed through pipelines or hauled by trucks.  The principal uses for oil and natural gas are heating, manufacturing, power, and transportation.

 

Competition

 

The oil and gas industry is highly competitive.  We encounter competition from major and independent oil companies in acquiring economically desirable producing properties, drilling prospects, and even the equipment and labor needed to drill, operate and maintain our properties.  Competition is intense with respect to the acquisition of producing and partially developed properties.  We compete with companies having financial resources and technical staffs significantly larger than our own. We do not own any refining or retail outlets and have minimal control over the prices of our products.  Generally, higher costs, fees and taxes assessed at the producer level cannot be passed on to our customers.

 

We also face competition from imported products as well as alternative sources of energy such as coal, nuclear, hydro-electric power, and a growing trend toward solar. We could incur delays or curtailments of the purchase of our available production.  We may also encounter increasing costs of production and transportation while sale prices remain stable or decline.  Any of these competitive factors could have an adverse effect on our operating results.

 

Environmental and Other Regulations

 

Our operations are affected in varying degrees by federal, state, regional and local laws and regulations, including, but not limited to, laws governing allowable rates of production, well spacing, air emissions, water discharges, endangered species, marketing, prices and taxes.  We are further affected by changes in such laws and by constantly changing administrative regulations.

 

Most natural gas pricing is presently deregulated and the remaining regulation has no material impact on our prices.  We cannot predict the long-term impact of future natural gas price regulation or deregulation.

 

We are subject to various federal, state, regional 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 or the lessee for the cost of pollution clean-up resulting from operations, subject the owner or lessee to liability for pollution damages, require suspension or cessation of operations in affected areas or impose restrictions on injection into subsurface aquifers that may contaminate groundwater.  Such regulation has increased the resources required in, and costs associated with, planning, designing, drilling, installing, operating and abandoning our oil and natural gas wells and other facilities.

We have and will continue to make expenditures to comply with these requirements, which we believe are necessary business costs.  Although environmental requirements do have a substantial impact upon the energy industry, generally these requirements do not appear to affect us any differently or to any greater or lesser extent than other companies.

 

Although we are not fully insured against all environmental and other risks, we maintain insurance coverage, which we believe, is customary in the industry.

 

During 2005, the cost to comply with these recurring environmental regulations were not significant to our continuing operations and are not expected to be in the foreseeable future.

 

To the extent these environmental expenditures reduce funds available for increasing our reserves of oil and natural gas, future operations could be adversely impacted.  Despite the fact that all of our competitors have to comply with similar regulations, many are much larger and have greater resources with which to deal with these regulations.

 

Other

 

We have no significant patents, trademarks, licenses, franchises or concessions.

 

The oil business is not generally seasonal in nature; although unusual weather extremes for extended periods may increase or decrease demand.  Natural gas prices tend to increase in the fall and winter months and to decrease in the spring and summer.

 

We have four full-time employees and two part-time employees.  When needed we also engage consulting petroleum engineers, environmental professionals, geologists, geophysicists, landmen, accountants and attorneys on a fee basis.