Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations.
General
Discovery Energy Corp. (the “ Company ” ) was incorporated under the laws of the state of Nevada on May 24, 2006 under the name “Santos Resource Corp.” Its current business plan is to explore for and produce Hydrocarbons from a tract of land (the “ Prospect ”) covered by Petroleum Exploration License (PEL) 512 (the “ License ”) in the State of South Australia. The business plan was adopted near the end of fiscal 2012. In May 2012, the Company incorporated a wholly owned Australian subsidiary, Discovery Energy SA Ltd. ( “ Subsidiary ”), for the purpose of acquiring a 100% working interest in the License. In May 2016, the Subsidiary’s legal entity status changed from public to private and its name changed to Discovery Energy SA Pty Ltd. The Company is in the initial exploration phase of determining whether or not the Prospect contains economically recoverable volumes of crude oil, natural gas and/or natural gas liquid (collectively “ Hydrocarbons ”). For information about the milestones that the Company has achieved to date, see “Item 1. Business.” Although the Company’s current focus is primarily on the Prospect, management from time-to-time exchanges information with other industry participants regarding additional investment opportunities in Australia.
The Company has experienced losses and negative cash flows since inception, and it expects to incur such losses and negative cash flows for the foreseeable future. The Company has an accumulated deficit of $33,996,855 since inception through February 28, 2022. As of June 8, 2022, the Company had approximately $55,000 in cash available to meet its operating cash requirements. The Company’s losses (coupled with a limited amount of cash) cause substantial doubt about the Company’s ability to continue as a going concern for the 12 months following the issuance of our February 28, 2022 financial statements, and our independent registered public accountant has added an emphasis paragraph to its report on our financial statements for the year ended February 28, 2022 regarding our ability to continue as a going concern. The Company is maintaining an on-going effort to locate sources of additional funding, without which the Company will not be able to remain a viable entity. Information about the Company’s liquidity situation and its on-going capital raising activities is given in the section captioned “Liquidity and Capital Resources” below.
Critical Accounting Policies and Estimates
The Company’s discussion and analysis of its financial condition and results of operations as of February 28, 2022 are based upon its independently audited financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of these financial statements requires that management make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. The estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. These estimates and assumptions provide a basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions, and these differences may be material. The footnotes to the financial statements contain critical accounting policies that significantly impact the judgments and estimates used in the preparation of these financial statements. These policies should be reviewed to better understand the financial condition and results of operations of the Company.
Results of Operations
Results of operations for the fiscal years ended February 28, 2022 and February 28, 2021 are summarized in the table below:
Fiscal Year
Ended
February 28, 2022
Fiscal Year
Ended
February 28, 2021
Revenue
Operating expenses
Other expenses
Net loss
Operating expenses for the fiscal years ended February 28, 2022 and February 28, 2021 are summarized in the table below:
Fiscal Year
Ended
February 28, 2022
Fiscal Year
Ended
February 28, 2021
General and administrative
Warrant modification expense
Exploration costs
Total operating expenses
Comparison of Fiscal Year Ended February 28, 2022 to Fiscal Year Ended February 28, 2021
Revenues . The Company did not earn any revenues in either of the comparative fiscal years. Sales revenues are not anticipated until such time as the Prospect has commenced commercial production of Hydrocarbons. As the Company is presently in the exploration stage of its operations, no assurance can be provided that commercially exploitable levels of hydrocarbons on the Prospect will be discovered, or if such resources are discovered, that the Prospect will commence commercial production.
Operating Expenses . Total operating expenses incurred during the fiscal year ended February 28, 2022 decreased by $2,565,324 (68%), compared to those incurred during the fiscal year ended February 28, 2021. A warrant modification expense for the extension of the maturity date of outstanding warrants to December 31, 2023 for the fiscal year ended February 28, 2021 resulted in a warrant modification expense of approximately $2,710,000, compared to none for the fiscal year ended February 28, 2022. This is partially offset by a non-cash increase in general and administrative of approximately $177,000 for the fiscal year ended February 28, 2022. This primarily reflects the impact of accrual adjustments for prior years’ activities. Additionally, exploration costs decreased by approximately $32,000 for the fiscal year ended February 28, 2022.
Other Income (Expense). Total other expenses incurred during fiscal year ended February 28, 2022 decreased by $1,183,272 (51%), compared to those incurred during the fiscal year ended February 28, 2021. This is primarily due to a decrease in amortization expense of $1,144,455 due to the extension of the maturity date of outstanding warrants to December 31, 2023
Net Income (Loss) . The Company had a net loss of $2,335,117 for the fiscal year ended February 28, 2022, compared to a net loss of $6,083,713 for the fiscal year ended February 28, 2021. Loss per common share was $0.02 for the fiscal year ended February 28, 2022, and $0.04 for the fiscal year ended February 29, 2021.
Cash Flows for the Fiscal Years Ended February 28, 2022 and February 28, 2021
Cash Used in Operating Activities: Operating activities for the fiscal year ended February 28, 2022 used cash of $208,596, compared to $202,674 for the fiscal year ended February 28, 2021.
Cash Used in Investing Activities : No cash was used for investing activities during fiscal years ended February 28, 2022 and February 28, 2021.
Cash Provided by Financing Activities: Proceeds from a Paycheck Protection Program loan in the amount of $120,000 was received during the fiscal year ended February 28, 2022. Additionally, the Company received gross proceeds of $75,000 for the issuance of a senior secured convertible debenture with a Maturity Date of December 31, 2023. Financing activities totaled $218,750 during the fiscal year ended February 28, 2021, resulting from the private placement of 500,000 common shares at $0.20 per common share for gross proceeds of $100,000, and proceeds from a Paycheck Protection Program loan in the amount of $118,750 .
Liquidity and Capital Resources
Financing History and Immediate, Short-Term Capital Needs
Early Financings . From January 2012 through May 27, 2016, business activities were financed primarily through private placements of common shares. During that period, several rounds of equity financing were conducted which raised total “seed” capital in the amount of $2,723,750 resulting in the issuance of 19,657,501 common shares. Moreover, from time to time, officers and directors of the Company provided short-term bridge funding or paid expenses on behalf of the Company. The amounts of these advances and expense payments (outstanding at the time of the Debentures financings described below) were repaid out of the initial proceeds from these financings. After these amounts were repaid, the Company has received (from time to time) one or more comparatively small advances from, and had a comparatively small amount of expenses paid by, officers and directors of the Company.
Debentures Financing . Beginning in May 2016 and continuing through August 2018, the Company relied on a series of placements of Debentures (debt instruments convertible into common shares). The Company undertook a subsequent isolated placement of Debentures, including one in November 2021 featuring an original principal amount of $75,000, and one Debenture in each of June and July 2022, both featuring an original principal amount of $50,000 . The 17 Debentures comprising this series and placement were issued pursuant to a Securities Purchase Agreement executed on May 27, 2016. Debentures having an aggregate original principal amount of $7,025,000 have been placed. In conjunction with certain Debentures and the extension of the maturity date of the Debentures, Warrants were issued that give the holder the right to purchase up to a maximum of 27,877,058 common shares at an initial per-share exercise price of $0.20.
Each of the Debentures includes the following features:
The Debentures bear interest at the rate of eight percent (8%) per annum, compounded quarterly. However, upon the occurrence and during the continuance of a stipulated event of default, the Debentures will bear interest at the rate of twelve percent (12%) per annum.
Interest need not be paid on the Debentures until the principal amount of the Debentures becomes due and payable. Instead, accrued interest is added to the outstanding principal amount of the Debentures quarterly. Nevertheless, the Company may elect to pay accrued interest in cash at the time that such interest would otherwise be added to the outstanding principal amount of the Debentures.
The principal amount of and accrued interest on the Debentures are due and payable in a single balloon payment on or before December 31, 2023.
We are not entitled to prepay the Debentures.
The Debentures are convertible, in whole or in part, into Common Shares at the option of holders, at any time and from time to time. The conversion price for Debentures having an aggregate original principal amount of $6,062,500 is $0.16, while the conversion price for a Debenture with an original principal amount of $962,500 is $0.20. All conversion prices are subject to certain adjustments that are believed to be customary in transactions of this nature, including so-called “down round” financing adjustments. The Company is subject to certain liabilities and liquidated damages for its failure to honor timely a conversion of the Debentures, and these liabilities and liquidated damages are believed to be customary in transactions of this nature.
The holders of the Debentures are entitled to have them redeemed completely or partially upon certain events (such as a change of control transaction involving the Company or the sale of a material portion of the Company’s assets) at a redemption price equal to 120% of the then outstanding principal amount of the Debenture and 100% of accrued and unpaid interest on the outstanding principal amount of this Debenture, plus all liquidated damages and other amounts due thereunder in respect of the Debenture.
The Debentures feature negative operating covenants, events of defaults and remedies upon such events of defaults that are believed to be customary in transactions of this nature. One of the remedies upon an event of default is the Debentures holders’ ability to accelerate the maturity of the Debentures such that all amounts owing under the Debentures would become immediately due and payable. The Debentures holders would then be able to resort to the collateral securing the Debentures, if the Company did not pay the amount outstanding, which is likely to be the case.
The Debentures are secured by virtually all of the Company’s assets owned directly or indirectly but for the License, which is held by the Company’s Australian subsidiary, Discovery Energy SA Pty Limited (the “ Subsidiary ”). Moreover, the Company has separately guaranteed the Debentures and has pledged all of its stock in the Subsidiary to secure such guarantee. The essential effect of these security arrangements is that, if the Company defaults on or experiences an event of default with respect to the Debentures, the holders of the Debentures could exercise the rights of a secured creditor, which could result in the partial or total loss of nearly all of the Company’s assets, in which case its business could cease and all or substantially all stockholders’ equity could be lost. For more information about this, see the Risk Factors captioned “THE EXERCISE OF SECURED CREDITOR RIGHTS COULD RESULT IN A SIGNIFICANT OR COMPLETE LOSS” herein.
Each of the Warrants includes the following features:
The initial per-share exercise price of the Warrants is $0.20 and is subject to certain adjustments that are generally believed to be customary in transactions of this nature. Subject to certain exceptions, the exercise price of the Warrants involves possible adjustments downward to the price of any common shares or their equivalents sold by the Company during the term of the Warrants for less than the then applicable exercise price of the Warrants. Upon the adjustment of the exercise price, the number of shares issuable upon exercise of the Warrants is proportionately adjusted so the aggregate exercise price of the Warrants remains unchanged.
All of the Warrants are currently exercisable and will remain so until their expiration date of December 31, 2023.
The Company is subject to certain liabilities and liquidated damages for failure to honor timely an exercise of the Warrants, and these liabilities and liquidated damages are believed to be customary in transactions of this nature.
The largest holder of the Debentures has the right to have elected to the Company’s Board of Directors one nominee. To date, the holder has not exercised this right.
Moreover, the holders of the Debentures have the right to require the Company to register with the SEC the resale of the common shares into which Debentures can be converted, the common shares that can be acquired upon the exercise of the Warrants and possibly other Common Shares. This preceding right is generally referred to as “demand” registration rights. The Company has the obligation to file a registration statement to effect the registration within certain periods of time, and the obligation to cause such registration statement to become effective within certain other periods of time. It will be liable for stipulated monetary damages if it fails in these obligations. The size of these damages is significant, although they are believed to be customary. Once a registration statement is declared effective, the Company must maintain it as effective and current until such time as the registered common shares are sold or become eligible to be sold pursuant to an exemption under certain circumstances, which it believes will never occur. In addition to the Debentures holders’ “demand” registration rights, the Debentures holders have “piggyback” registration rights whereby they can participate (without a demand) in most registrations that the Company might proposes.
The proceeds from the Debentures placements were generally used to fund the acquisition, processing and interpretation of the Nike Survey data and payment of the Company’s and the Debentures holders’ expenses associated with the placements. A portion of these proceeds were used to retire all of the then outstanding indebtedness (including the amounts owed to Liberty Petroleum for allowing us to be issued the License in its place, and loans made by management), and to acquire a 5.0% overriding royalty interest relating to the Prospect. Funds were also used for payment of general and administrative expenses. In addition to the preceding, a portion of the proceeds was used to pay Rincon Energy, LLC pursuant to a geophysical consulting agreement.
COVID-19 . The Company initially experienced no material impacts from the COVID-19 pandemic with respect to liquidity and capital. However, the negative reaction in financial markets was significant. Initially, the pandemic resulted in a severe decrease in demand for Hydrocarbons, in particular transportation fuels. This decrease resulted in a major drop in the price of crude oil and its resulting impact on financial markets in general and in particular, the energy industry. Demand has now largely recovered from pandemic declines. Exploration and production operations are recovering and funding is becoming more widely available. However, continuing threats of an increase in infection rates is concerning, though there has, to date, been no negative Hydrocarbon sector activity impact. For further risk discussion, see the risk factor captioned “PANDEMICS OR DISEASE OUTBREAKS (SUCH AS THE NOVEL CORONAVIRUS, ALSO KNOWN AS THE COVID-19 VIRUS) COULD MATERIALLY AND ADVERSELY AFFECT US IN A VAREITY OF WAYS.”
Equity Placements . Subsequent to the start of the Debentures placements, the Company continued certain private capital raising transactions involving its common shares. Beginning in November 2016 and continuing through the end of December 2020, the Company closed on a series of private placements in which an aggregate of 9,075,000 shares were issued for an aggregate purchase price of $1,886,250.
Paycheck Protection Program Loan . In connection with the Paycheck Protection Program established by the Coronavirus Aid, Relief, and Economic Security Act, the Company borrowed an initial loan during fiscal year 2021 in the amount of $118,750 and a second loan during fiscal year 2022 in the amount of $120,000. Over $100,000 in principal and interest on the initial loan was forgiven, and the unforgiven portion of this loan has been paid in its entirety. The Company applied for forgiveness of the second loan, but slightly less than $20,000 of the outstanding balance of the second loan was forgiven. The unforgiven portion (slightly over $100,000) will need to be repaid over a four-year period.
Available Cash . As of November 30, 2022, the Company had cash of approximately $19,000 and had negative working capital of approximately $6,780,000. Management believes that the cash on hand, as of the preceding date, will be sufficient to finance general and administrative expenses through January 31, 2023 although no assurance of this can be provided. However, this amount of cash will be insufficient to allow the Company to fulfill work commitment obligations in a timely manner. A plan for financing these obligations is discussed below. Management has been financing and intends to continue to try to finance all general and administrative expenses beyond available cash on hand by undertaking small raises of funds through private placements of common shares until such time as a larger raise is completed. No assurance can be provided of successfully raising any additional funds for this purpose.
Long-Term Capital Needs
The five-year work commitment relating to the License imposes certain obligations on the Company. The work requirements of the first two years, which included geotechnical studies and the Nike Survey, have been completed and reports and certain work materials have been submitted as required by the South Australian government. Going forward, additional funds will be required to meet the seismic and drilling obligations of License Years 3, 4 and 5. Working capital will also be needed to satisfy general and administrative expenses. Between May 2022 and October 2024 (the month in which the Company’s work commitments are currently required to be completed), the Company estimates that it will need to raise an additional $20 million to have sufficient capital to meet the remaining work commitments specified in the License and to fund operations. Net revenues produced from successful oil wells could provide some of the funds required to meet these capital needs. However, no assurance can be given that this or any other amount of financing will be obtained or that any oil revenue will be earned.
If successful with the early wells, work will continue with a full development plan, the scope of which is now uncertain but will be based on technical analysis of seismic data, field drilling and log reports, production history, costs estimates and sales prices. However, all of the preceding plans are subject to the availability of sufficient funding and the receipt of all governmental approvals. Without sufficient available funds to undertake these tasks, additional financings or a joint venture partner will be required.
Failure to procure a joint venture partner or raise additional funds will preclude the Company from pursuing its business plan, as well as exposing the Company to the loss of the License, as discussed below. Moreover, if the business plan proceeds as just described, but the initial wells do not prove to hold producible reserves, the Company could be forced to cease its initial exploration efforts on the Prospect.
Major Financing Efforts and Other Sources of Capital
The Company’s capital strategy has been, and continues to be, to attempt to engage in a single major capital raising transaction to provide sufficient funds to satisfy its capital needs for a number of years to come. While management has not completely abandoned this strategy, the Company did shift its emphasis in an effort to engage in one or more smaller capital raising transactions to provide sufficient funds to satisfy ongoing and future capital needs. During a two-year period beginning in May 2016, the Company completed a series of placements of its Debentures. The Company undertook subsequent isolated placements of Debentures, including one placement of a Debenture in November 2021 featuring an original principal amount of $75,000, and one Debenture in each of June and July 2022, both featuring an original principal amount of $50,000. All these Debentures have an aggregate original principal amount of $7,025,000. Regarding the future financing of the Company’s work commitments, the interpretation and analysis of the Nike Survey resulted in an inventory of more than 30 leads judged to be potential areas of crude oil accumulations. These initial prospective locations were prioritized and the results are being presented to prospective investors with a view to securing the capital to commence the Company’s initial drilling program. The Company needs to complete a major capital raise transaction to continue moving its business plan forward. In the interim, the Company is continuing efforts to raise comparably smaller amounts to cover general and administrative expenses. The Company has no assurance that it will be to raise any required funds. The Company is also pursuing efforts to secure one or more joint venture partners.
Sales from production as a result of successful exploration and drilling efforts would provide the Company with incoming cash flow. The proved reserves associated with production would most likely increase the value of the Company’s rights in the Prospect. This, in turn, should enable the Company to obtain bank financing (after the wells have produced for a period of time to satisfy the lenders requirements). Both of these results would enable the Company to continue with its development activities. Positive cash flow is a critical success factor for the Company’s plan of operation in the long run. Management believes that, if the Company’s plan of operation successfully progresses (and production is realized) as planned, sufficient cash flow and debt financing will be available for purposes of properly pursuing its plan of operation, although the Company can make no assurances in this regard.
Finally, to reduce its cash requirements, the Company might attempt to satisfy some of its obligations by issuing shares of its common shares, which would result in dilution in the percentage ownership interests of the Company’s existing stockholders and could result in dilution of the net asset value per share of the Company’s existing stockholders.
Consequences of a Financing Failure
If required financing is not available on acceptable terms, the Company could be prevented from satisfying its work commitment obligations or developing the Prospect to the point that the Company is able to repay the Debentures, which become due in December 2023. Failure to satisfy work commitment obligations could result in the eventual loss of the License and the total loss of the Company’s assets and properties. Failure to timely pay the Debentures could result in the eventual exercise of the rights of a secured creditor and the possible partial or total loss of the Company’s assets and properties. Failure to procure required financing on acceptable terms could prevent the Company from developing the Prospect. If any of the preceding events were to occur, the Company could be forced to cease its operations, which could result in a complete loss of stockholders’ equity. If additional financing is not obtained through an equity or debt offering, the Company could find it necessary to sell all or some portion of the Prospect under circumstances and at an price. However, no assurance can be provided that the Company will be to find interested buyers or that the funds received from any such partial sale would be adequate to fund additional activities. Future liquidity will depend upon numerous factors, including the of the Company’s exploration and development program, of License commitments and capital raising activities.
Known Trends
Management believes that it has discerned the following trends relevant to the Company:
Management is monitoring the on-going volatility in the prices of Hydrocarbons. The invasion of Ukraine is the primary cause of this volatility, and the overall tread of price increases. The Company’s base case scenario forecasts a Brent crude price averaging US$108 a barrel in 2022.
The average Brent price for 2021 was $US70 a barrel — up 67% from the 2020 average. A tight market supported the rally into early 2022 — with prices in January rising 15% month over month, to average US$86 a barrel. Prices grew by 12% month over month to average $US96 a barrel in February. Following Russia’s invasion, the risk of sustained energy supply shocks, and the imposition of sanctions, saw prices spike well over $US110 a barrel in May— the highest levels since July 2008.
While global oil output rose by 1.6% from 2020 levels to average 95 million barrels a day in 2021, inventories remain tight. The supply approach of OPEC+, combined with underperformance from some member nations, and a lagged recovery by some non-OPEC producers, led to falling global inventories, with OECD inventories reaching their lowest levels for seven years.
Global oil consumption in 2021 averaged 98 million barrels a day — this is 6.1% higher than in 2020, but 2.9% lower than in 2019. Consumption has been significantly impacted by the COVID-19 pandemic, with lockdowns and mobility restrictions affecting global industrial activity, commuting and leisure travel for significant periods.
As vaccination programs rolled out in 2021 and global economic growth rebounded, oil consumption began to recover. This recovery is set to continue in 2022, with consumption forecast to rise by 2.2% to reach 100 million barrels a day.
Australian oil consumption is forecast to recover to 2018–19 levels in 2021–22. For the rest of the outlook period, Australian oil consumption is projected to increase marginally, reaching 1.1 million barrels a day by 2025–26.
Australian crude oil and feedstock exports in 2021–22 are forecasted to increase by 1.7% to 281,000 barrels a day. Exports are projected to lift later in the outlook period, as a number of new oil projects come online.
Soaring oil prices are expected to lift Australian oil export earnings by 86% to $13.8 billion in 2021–22, with earnings then holding steady in 2022–23.
(Sources: BREE - Resources and Energy Quarterly – March, 2022)
Off-Balance Sheet Arrangements
During the year ended February 28, 2022, the Company had no off-balance sheet arrangements.
