News Column

USA SYNTHETIC FUEL CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

February 21, 2014

The following information should be read in conjunction with the financial statements and notes appearing elsewhere in this Annual Report on Form 10-K. We are a development stage company and have had no revenues for the years ended December 31, 2013 and 2012. We anticipate that we may not receive any significant revenues from operations until we begin to receive revenues from operations at our Lima Facility, which we estimate will be at a minimum approximately twenty-four to thirty months from funding.

Certain information included in this report contains, and other reports or materials filed or to be filed by the Company with the Securities and Exchange Commission, or SEC, (as well as information included in oral statements or other written statements made or to be made by the Company or its management) contain or will contain, "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, Section 27A of the Securities Act of 1933, as amended, and pursuant to the Private Securities Litigation Reform Act of 1995. The forward-looking statements may relate to financial results and plans for future business activities, and are thus prospective. The forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results to differ materially from future results expressed or implied by the forward-looking statements. They can be identified by the use of terminology such as "may," "will," "expect," "believe," "intend," "plan," "estimate," "anticipate," "should" and other comparable terms or the negative of them. You are cautioned that, while forward-looking statements reflect management's good faith belief and best judgment based upon current information, they are not guarantees of future performance and are subject to known and unknown risks and uncertainties.

Any forward-looking statements are made pursuant to the Private Securities Litigation Reform Act of 1995, and are current only as of the date made.

As used in this Annual Report on Form 10-K, the terms "we," "our," "us," "the Company" and "USASF" mean USA Synthetic Fuel Corporation, a Delaware corporation and its consolidated subsidiaries, unless the context indicates otherwise.

Overview

We are a development stage environmental energy company focused on the development of low-cost clean energy solutions from the deployment and operation of commercial Ultra Clean Btu Converter facilities which we define as facilities utilizing a series of commercially proven and available processes to cost-effectively convert lower value solid hydrocarbons such as coal, renewables or petcoke into higher value, ultra clean energy products. Our Ultra Clean Btu Converter technology we plan to use will consist of commercially proven and technologically established gasification processes, gas purification processes and catalytic manufacturing processes to convert these solid hydrocarbon feed sources into higher value, environmentally cleaner UCSC for sale in transportation fuel markets.

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We believe that efficient and economical conversion of solid hydrocarbons using our Ultra Clean Btu Converter process can produce low cost, clean energy products at a lower cost than traditional methods. As of December 31, 2013, the spot price of a barrel of West Texas Intermediate crude was $98.17, and the spot price of a barrel of oil equivalent, or BOE, of natural gas was $24.99. We believe we can manufacture UCSC at a lower cost than traditional fuel products, and this cost advantage does not depend on government subsidies or tariffs.

The major activities in 2013 focused on financing and securing long term offtake customers related to the build out of its commercial Ultra Clean Btu Converter facilities. The Company signed a 10-year offtake agreement with Husky Energy to supply its Lima Refinery with Ultra Clean Synthetic Crude (UCSC). The contract is for production volume up to 80 million barrels which covers all of the output from Lima Energy Gas 1 and Gas 2 facilities. The current focus for Lima Energy Company has been site development work, preparing for the completion of construction. The Company has structured a rated bond transaction with a leading investment bank which we anticipate to be completed in 2014. Proceeds from the financing will be used to complete construction of Gas 1, to repay debt, and for working capital.

Manufacturing Plan

In order to introduce our high value, low cost UCSC product to market and support our business strategy, we plan to acquire or construct commercial-scale Ultra Clean Btu Converter facilities. We plan to fund our business strategy with proceeds from equity, debt, bonds, and internal cash flows. We intend to outsource the EPC and operations and maintenance of all of our Ultra Clean Btu Converter facilities to a third party, most likely GEC in all production locations.

Lima Facility

We are actively working towards the financing and development of the first phase of Lima Energy Gas 1. We currently expect to complete this financing in 2014. However, there can be no assurance that the financing will be completed in the targeted time frame or at all. In October 2012, we purchased property for the Lima Facility, consisting of approximately 63 acres, from the City of Lima, Ohio. Once the financing is complete, we will continue the construction of Gas 1, which is anticipated to take 24 months to 30 months to complete and cost approximately $388 million. Once commercial operations begin, Gas 1 is expected to have an average production of approximately 7,000 barrels per day of UCSC. We have entered into an UCSC Purchase and Sale Agreement with Husky Marketing and Supply Company, by which we will sell one hundred percent of our UCSC from Gas 1 during a 10-year term.

Once we have begun construction on Gas 1, we plan to utilize Ohio Air Quality Development Authority bonds to finance the Gas 2 phase. Gas 2 will be located at the same site as Gas 1 and will cost an estimated $1.2 billion to construct. We estimate the construction period for Gas 2 to be approximately 30 months. Once commercial operations begin, Gas 2 will produce an average of over 15,000 barrels per day, or 5.5 million barrels annually, of UCSC, bringing our total production at the Lima Facility to over 22,000 barrels per day, or 8.3 million barrels annually and our total production capacity to over 10 million barrels per year. Husky has an option to purchase a portion or all of the volume of the UCSC produced by Gas 2.

Cleantech Energy Facility

The third project that we have identified is a synthetic fuel production facility in Johnson County, Wyoming using our Ultra Clean Btu Converter technology that we plan to build, own and operate. It is anticipated that the Cleantech Energy Facility will be designed to produce approximately 78,000 barrels per day, or 30.6 million barrels annually of synthetic fuel products, initially concentrating on UCSC. We plan to enter into an agreement for the sale of our UCSC product with a refinery, containing terms and conditions similar to the Lima Energy agreement with Husky. Financing for the Cleantech Energy Facility has not yet been secured and there can be no assurance that we will be able to secure financing at all. We plan to build the Cleantech Energy Facility adjacent to the Wyoming BOE Energy Asset, contingent upon our ability to secure the rights of the Wyoming BOE Energy Asset with the $70 million activation payment.

Performance Drivers

We expect the fundamental drivers of our financial results going forward will include the following:

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Commercialization of our UCSC product. We expect to commence recognizing revenues for UCSC sales when we complete construction of Lima Energy Gas 1 and it begins operations. We expect to grow our revenue base through the construction and commercial operation of Lima Energy Gas 2 to manufacture our UCSC. Our revenues for future periods will be impacted by our ability to construct and bring to commercial operations the Lima Facility phases in the timeframe we have planned. Our results will be impacted by the speed with which we execute our strategy and the capital cost and operating expenses of each of these facilities.

Feedstock and other manufacturing input prices. We plan to use solid hydrocarbons, such as coal, renewables and petcoke, as our feedstock for producing our UCSC product. We intend to locate our facilities near readily available sources in order to ensure reliable supply of cost-competitive feedstock. We currently intend to use petcoke as the initial feedstock for Gas 1 and Gas 2, and we believe we will be able to obtain a sufficient supply of petcoke for these facilities on acceptable terms. In addition, we own 200 million BOE of coal in Vigo County, Indiana, which we call our Indiana BOE Energy Asset. Although we do not currently intend to use the Indiana BOE asset to provide feedstock for Gas 1 and Gas 2, we believe we would be able to use it for this purpose if petcoke or other feedstocks are not available to us at acceptable prices. Contingent upon payment of a $70 million activation payment and certain other milestones, we will have an additional 1.02 billion BOE of coal available to us in our Wyoming BOE Energy Asset, which we currently intend to use to provide feedstock for our planned Cleantech Energy Facility.

Petroleum prices. We expect sales of our UCSC product to be impacted by the price of petroleum. In the event the petroleum prices increase, we may see increased demand for our product as refineries seek lower-cost alternatives to petroleum. Conversely, a long-term reduction in petroleum prices may result in our product being less competitive with other petroleum-derived alternatives. In addition, oil prices may also impact the cost of certain feedstocks we use in our process, such as petcoke, which may affect our margins.

Future Capital Requirements

The initial phase of our production strategy is the construction and operation of an Ultra Clean Btu Converter Facility in Lima, Ohio, which we expect to finance using the proceeds from our potential financing, described in detail below. We intend to produce UCSC at the planned Lima Energy Gas 1 and sell it to the adjacent refinery owned by Husky Energy Inc. ("Husky"). On September 27, 2013, Lima Energy Company, our wholly owned subsidiary, entered into an UCSC Purchase and Sale Agreement with Husky that provides for the purchase of all of the UCSC produced at this planned facility for a period of ten years.

Our cash requirements depend on many factors, including the pace of our project development activities and the employee team build-up to drive our future growth. Over the next four years, we expect to make significant expenditures to expand our projects currently under development and construction to bring them into commercial operation. We estimate that total project costs to bring each project into commercial operation will be approximately $388 million to complete the construction of Lima Energy Gas 1, approximately $1.2 billion for full construction of Gas 2, and approximately $4.1 billion for full construction of the Cleantech Energy Facility. Project costs include capital expenditures, engineering, procurement and construction and other owner costs incurred up to commencement of operations (such as interest during construction and development fees), but do not include annual fixed or variable facility operations and maintenance costs, including the cost of purchasing solid hydrocarbon feedstock which itself reflects the cost of extraction and delivery of the solid hydrocarbons.

Future Capital Sources

We have focused our efforts to date on obtaining large amounts of capital to fund our planned project development activity.

We have structured and are currently working to complete a private placement of secured limited recourse bonds in 2014, the proceeds of which we would use primarily to fund construction of Lima Energy Gas 1. However, there can be no assurance that this potential financing will be completed in the targeted time frame or at all. We expect that the proceeds of this financing will be held by a trustee, who will manage the drawdown schedule. Following completion of this transaction, we anticipate commercial operations at the Lima Facility to commence in approximately twenty-four to thirty months.

We have two reserve equity agreements, which we have not utilized. Pursuant to an agreement with AGS Capital Group, LLC, or AGS, a New York-based institutional investor, which was effective May 16, 2011 and will terminate on May 16, 2014, AGS committed to purchase up to $50 million of our common stock, subject to certain conditions, at our discretion. In order to activate the reserve equity with AGS, we must file a registration statement with the Securities and Exchange Commission covering the resale of any shares issued to AGS under the terms of the agreement. Once the registration statement is effective, of which there can be no assurance, AGS is obligated to purchase shares of our common stock capital in increments of up to $2 million from time to time at our discretion at a purchase price for our common stock of 90% of the Market Price as defined in the Agreement. We can terminate the agreement at any time prior to its expiration without cost or penalty.

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On April 6, 2011, we entered into an agreement with Kodiak Capital Group, LLC, or Kodiak, a New York based institutional investor, pursuant to which Kodiak committed to purchase up to $20 million of our common stock, subject to certain conditions, at our option. In order to activate the reserve equity with Kodiak, we are required to file a registration statement with the Securities and Exchange Commission covering the resale of any shares that may be issued to Kodiak under the agreement. Once the registration statement is effective, of which there can be no assurance, Kodiak will be obligated to purchase shares of our common stock in increments of up to $5 million over a six month period from time to time at our option at a purchase price per share of 70% of the volume weighted average price over five consecutive trading days as reported by Bloomberg. We can terminate the agreement at any time without cost or penalty. We can give no assurance that we will decide to utilize this vehicle and therefore, can give no assurance that this will occur soon or at all.

Recent Financing Transactions

Third Eye Investment

On November 18, 2013, we issued a 4% secured convertible note in the amount of $1,200,000 to Third Eye Capital Corporation of Toronto, Canada, or Third Eye, as administrative agent for the holders. This note was issued under the provisions of the Note Purchase Agreement discussed below. The principal amount and accrued interest are due November 18, 2014. We can repay the principal amount and accrued interest on the note in cash or common stock without penalty any time prior to the maturity date. The note bears interest at the rate of 4% per annum, and commences accruing on February 1, 2014. Interest will be payable in arrears, on the earlier of the stated maturity date, an equity raise in an aggregate sum of not less than $20 million or change of control. This note covers the fee to obtain a $60 million standby letter of commitment from Third Eye for future acquisitions.

On September 24, 2012, we completed a $35 million financing with Third Eye. The proceeds of the financing were used primarily to purchase the Indiana BOE Energy Asset from GEI. The acquisition of the Indiana BOE Energy Asset, which will serve as fuel equity, an asset-backed collateral, for Lima Energy Gas 1, was accounted for on the cost basis of $25.4 million, comprised of $25 million in cash and assumed liabilities and 2.5 million shares of our common stock, valued at $0.16 per share or $400,000, fair value of our stock at the date of acquisition. The remaining proceeds from the Third Eye transaction were used to fund the $3.0 million required secured cash account, to purchase the 63-acre project site from the City of Lima, advance the development and engineering work at the Lima site, and for working capital purposes. The transaction consisted of a note purchase agreement, a unit purchase agreement, and a royalty agreement, as described below:

Note Purchase Agreement. We entered into a Note Purchase Agreement, dated as of September 24, 2012, by and among us, Lima Energy Company, Third Eye as administrative agent for the holders, and each of the holders of notes from time to time party thereto, or the Note Purchase Agreement, under which we issued a 10% senior secured note in the aggregate principal amount of $30 million to Third Eye, as administrative agent for the holders. The principal amount of the note is due August 31, 2015. The note bears interest at the rate of 10% per annum, payable monthly. The first year's interest, or $3 million, was paid in advance on October 2, 2012. The Note Purchase Agreement also requires that we maintain a $3 million restricted cash balance. Any release from the restricted cash account is at the sole discretion of Third Eye. On December 31, 2013 we executed an amendment to the Note Purchase Agreement, which, among other things, changed the minimum restricted cash balance to $2 million.

In connection with the Note Purchase Agreement, we loaned $11 million to our subsidiary, Lima Energy Company, (the "Lima Loan") in return for an unsecured promissory note from Lima Energy Company in the aggregate principal amount of $11 million. The note accrues interest at a rate of 0.24% per annum and all interest and principal outstanding are payable on demand.

Unit Purchase Agreement. We entered into a Unit Purchase Agreement, by and among us, Lima Energy Company, Third Eye as agent for the unit purchasers, and each of the unit purchasers from time to time party thereto. Pursuant to the Unit Purchase Agreement, we issued (i) a 4% subordinated secured convertible note to one of the unit purchasers in the amount of $5,000,000 due August 31, 2017 which is convertible into 10,312,500 shares of our common stock, (ii) a warrant granting one of the unit purchasers the right to purchase an aggregate of 10,312,500 shares of our common stock. The Unit Purchase Agreement provided, in total, $2,000,000 in proceeds.

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The initial conversion price of the convertible note is $0.48 per share, subject to adjustment in certain events. The convertible note will automatically convert into shares of our common stock (a) upon the sale of our common stock which values the shares of our outstanding common stock at an aggregate value of more than $500 million or (b) when the valuation of the shares of our outstanding common stock is more than $500 million for ten consecutive trading days, valued by reference to a closing price per share on a national stock exchange or other automated quotation system. The unit purchaser can require us to redeem the note or convert the note in whole or in part into shares of our common stock on or after September 24, 2017. The warrant has a term of 10 years. The warrant may be exercised in whole or in part and entitles the holder thereof to purchase 10,312,500 shares of Common Stock at an exercise price of $0.48 per share. The number of shares for which the warrant may be exercised and the exercise price are subject to adjustment in certain events.

We have the right, at any time prior to a unit purchaser exercising its right to convert the convertible note or exercise the warrant, as the case may be, upon 10 days prior notice to purchase the convertible Note and the warrant from the holder(s) thereof at a call price of $10 per share, subject to adjustment in certain events.

Royalty Agreement. In connection with the Unit Purchase Agreement, our subsidiary, Lima Energy Company, or Lima Energy, entered into the Royalty Agreement. Under the Royalty Agreement, Lima Energy will pay to certain royalty investors thereunder 5% of the annual aggregate gross sales of gas products relating to Lima Energy Gas 1 as additional consideration for the debt financing made available to Lima Energy under the Unit Purchase Agreement. The royalty payments begin on January 1, 2015 and continue for a period of 21 years, or until the aggregate royalties paid exceed $250 million. Should Lima Energy Company fail to complete Gas 1, we will owe liquidated damages of up to $250 million to the royalty investors.

In connection with the Third Eye financing, Lima Energy Company granted a first, second and third mortgage on Lima Energy's Company's rights and interests in the Indiana BOE Energy Asset to secure its obligations.

Lima Real Estate

On October 26, 2012, Lima Energy Company completed the acquisition of the project site for the Lima Facility, consisting of approximately 63 acres, from the City of Lima, pursuant to a Real Estate Acquisition and Development Agreement. The purchase price was $1.5 million. In connection with the acquisition, Lima Energy agreed that certain funds would be contributed to a non-profit entity over the term of the Agreement for the benefit of long term economic development within the City of Lima. At the signing of the Agreement, Lima Energy made an initial contribution of $100,000. It will contribute $100,000 per year for the next three years. We have not made the second annual $100,000 contribution as of the time of this filing. Also, commencing on the second calendar year immediately following commencement of commercial operations, it will contribute annually, for 20 years, the lesser of $5.0 million and 10% of net distributable cash flow of the Lima Facility, for the immediately preceding year, as those terms are defined in the Agreement. Pursuant to this agreement, the City had the right to repurchase the property for a purchase price of $1,500,000 on or after November 1, 2017, if the market value of the property at the time of exercise of the repurchase right as shown on the real property tax duplicate of County of Allen, Ohio is less than $2,500,000. On December 12, 2013 the City of Lima terminated its right to repurchase the property after it was satisfied that the Company had invested over $2.5 million in the property since the purchase.

Prior to our acquisition of Lima Energy in 2010, initial site development and construction work had been done at the site, resulting in 100,000 square feet of engineered concrete. On November 16, 2012, we entered into an agreement with a third party to prepare the site for continued construction work, which was completed in September 2013. The contract provided a price not to exceed $1,782,500. In addition, on December 1, 2012, we entered into a Design-Build Contract with a third party to provide design, construction and services for the Technology Innovation Center we are planning to construct at our site in Lima, Ohio. The estimated cost for this initial contract is $2,000,000. The parties may amend the contract at any time to include the additional phases of the Lima Facility. We may suspend, delay or interrupt the work in whole or in part for such period of time as we determine. The total cost of constructing the Technology Innovation Center is estimated at $9.5 million. We have not entered in to any agreements with any parties to complete the construction of the Technology Innovation Center. Since the purchase of the 63 acre site from the City of Lima in the fourth quarter of 2012 through December 31, 2013, we have invested over $2.5 million in the development of the facility. This included site preparation work totaling $1,782,500 and preliminary design work on our Technology Innovation Center of $575,661.

Fundamentals of our Business

The Ultra Clean Btu Converter technology that we plan to utilize will consist of commercially proven and technologically established gasification processes, gas purification processes and catalytic manufacturing processes to convert the solid hydrocarbon feed sources such as coal, renewables or petcoke, into higher value, environmentally cleaner UCSC for transportation fuel markets.

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Although we have not generated any revenue to date, we expect to generate revenue from the sales of our UCSC product from our planned Btu Converter facilities. We may also generate revenues from the sale of electric power, CO2 and sulfur, all of which are produced during the gas-to-liquids Btu Converter process.

We expect our cost of goods sold will consist of facility-related fixed costs, feedstock and other variable costs.

Facility-related fixed costs. As an industrial process, our facilities will require a baseline level of staffing consisting of process engineering, monitoring staff, testing personnel, health safety and environmental personnel and maintenance personnel. Other fixed costs include maintenance materials and casualty and liability insurance, as well as property taxes. We plan to outsource the operations and maintenance functions to GEC, a related party. Feedstock. Our Ultra Clean Btu Converter facilities are being designed to convert a variety of solid hydrocarbons, such as coal, renewables or petcoke, into UCSC. The cost of procuring and preparing of the feedstock to be used in our Ultra Clean Btu Converter process will be a major component of cost of goods sold. Our actual feedstock costs may be higher or lower, depending on then-prevailing market conditions. Our flexible feedstock strategy will allow us to reduce our feedstock cost by taking advantage of current feedstock market conditions. Other variable costs. We expect to use water, natural gas and other variable cost items associated with our catalysts in our Ultra Clean Btu Converter process.



Our largest expenditures are the capital costs associated with the construction of our commercial-scale Ultra Clean Btu Converter facilities. These costs are comprised of land acquisition, site preparation, utilities, permitting, facility construction, start-up and contingency costs and related financing costs. We expect that the depreciation of these facilities costs will be included in cost of goods sold.

Our operating expenses currently consist primarily of general and administrative expenses.

Financial Operations Overview

Revenue and Cost of Goods Sold

To date, we have not generated any revenue or incurred any cost of goods sold, and we do not expect to do so until at least twenty-four to thirty months.

Operating Expenses

Operating expenses consist of general and administrative expenses. General and administrative expenses consist primarily of personnel-related expenses related to salaries and benefits, professional services, liability insurance and cost of compliance with securities, corporate governance and other regulations. Professional services consist principally of external legal, accounting, tax, audit and other consulting services. We expect to incur additional costs as we hire personnel and enhance our infrastructure to support the anticipated growth of our business.

Interest Income

Interest income consists primarily of interest income earned on our restricted cash balance. The restricted cash balance is required under the Third Eye Note Purchase Agreement. Release of restricted cash is at the sole discretion of Third Eye.

Derivative Gain/(Loss)

Our outstanding warrants to purchase 10,312,500 shares of our common stock are required to be classified as a liability and to be adjusted to their fair value at the end of each reporting period. Any changes in fair value of this warrant liability are required to be recorded as a gain or a loss, as applicable, in the period that the change in value occurs.

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Interest Expense

We incur interest expense in connection with our outstanding business loans. Interest expense is reflected as net interest expense, which also includes amounts related to amortization of debt discounts, amortization of debt related fees and accrued debt redemption costs. In the event the costs of our commercial facilities are funded with debt, we will capitalize interest related to the construction of those commercial facilities.

Income Taxes

We use the liability method in accounting for income taxes. Deferred income tax assets and liabilities are determined based upon differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.

The potential benefit of net operating loss carry forwards has not been recognized in the accompanying financial statements since we cannot be assured that it is more likely than not that such benefit will be utilized in future years.

The net operating loss carryforwards for income tax purposes are approximately $14,244,000 and will begin to expire in 2029. However, pursuant to Section 382 of the Internal Revenue Code, use of our net operating loss carryforwards may be limited if we experience a cumulative change in ownership of greater than 50% in a moving three year period. Ownership changes could impact our ability to utilize net operating losses and credit carryforwards remaining at the ownership change date. The limitation will be determined by the fair market value of common stock outstanding prior to the ownership change, multiplied by the applicable federal rate.

Basic and Diluted Net Loss per Share

Basic earnings per share is computed by dividing net loss available to common shareholders (numerator) by the weighted average number of shares outstanding (denominator) during the period. Diluted earnings per share gives effect to all potentially dilutive common shares outstanding during the period. Diluted earnings per share excludes all potentially dilutive shares if their effect is anti-dilutive.

Results of Operations

For the Years Ended December 31, 2013 and December 31, 2012

Revenues

We had no revenues for the years ended December 31, 2013 and 2012.

Operating Expenses

Our operating expenses increased $5,156,848 to $7,165,660 for the year ended December 31, 2013 compared to $2,008,812 for the year ended December 31, 2012. The increase is primarily attributable to higher general and administrative expenses related to personnel growth, increased professional services, independent director fees and property taxes, totaling $1,629,813, debt administration fees of $600,000 related to our financing with Third Eye and $2,988,800 in accrued legal exposure and other costs associated with the summary judgment issued on December 17, 2013 denying us the ability to be dismissed from the case of Dorsey & Whitney LLP vs. Global Energy Inc. and USA Synthetic Fuel Corporation.

Other Income

Other income decreased $66,331 to $4,481 for the year ended December 31, 2013. The decrease in other income is related to a change in estimate for liabilities of $69,125 recognized as other income in 2012. Other income also includes interest income, which increased $2,794 to $4,481 for the year ended December 31, 2013. The increase in interest income is related to the year over year total interest income earned on the restricted cash balance. This restricted cash account is required under the Note Purchase Agreement with Third Eye. Any release from the restricted cash account is at the sole discretion of Third Eye.

Interest Expense

Interest expense increased $4,321,211 to $6,402,430 for the year ended December 31, 2013 compared to $2,081,219 for the year ended December 31, 2012. The increase in interest expense is primarily attributable to the year over year change of $3,775,448 in interest expense related to the $35 million financing from Third Eye, which we entered into in September 2012. Interest expense includes year over year increases in debt discount amortization and note fee amortization related to the Third Eye transaction of $642,301 and $801,482, respectively. We also incurred a fee of $1,200,000 in November 2013 related to a $60,000,000 standby letter of commitment issued by Third Eye. In December 2013 we accrued $11,200 in interest expense related to the summary judgment previously discussed in this filing. In September 2012, we recognized $610,612 of nonrecurring interest expense related to delays in finalizing the $35 million debt financing transaction with Third Eye.

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Derivative Gain/Loss

We recognized $13,217,000 in derivative losses for the year ended December 31, 2013 compared to $1,766,500 for the year ended December 31, 2012. The derivative losses recognized during the years ended December 31, 2013 related to the stock warrants issued in connection with our financing transaction with Third Eye. In 2012, we recognized $1,452,000 in derivative losses related to the stock warrants issued in connection with our financing transaction with Third Eye. In addition, in 2012, we recognized $314,500 in derivative losses related to convertible loans totaling $158,250 from a third party. The loans were convertible into the Company's common stock after one hundred and eighty (180) days at discounts ranging from 55% to 65% to the market value of the Company's common stock, of which, $23,000 of this debt was converted to stock.

Income Taxes

For the years ended December 31, 2013 and 2012, there were no provisions for income taxes recorded.

Net Loss

We experienced a net loss of $26,780,609, or $0.33 per share, for the year ended December 31, 2013 compared to a net loss of $5,785,719, or $0.07 per share, for the year ended December 31, 2012, an increase of $20,994,890. The increase in net loss is primarily attributable to $13,217,000 in derivative losses related to recording the fair value of the stock warrants associated with the 4% subordinated secured convertible debt for this reporting period under the mark to market approach, higher debt related costs associated with the financing from Third Eye and $3,000,000 in accrued legal exposure cost, interest and other costs associated with the Dorsey complaint against us and GEI.

Basic and Diluted Net Loss per Share

Our net loss for the year ended December 31, 2013 was $0.33 per share, and $0.07 per share for the year ended December 31, 2012. The increase in net loss per share was driven primarily by higher derivative losses, interest expense related to the Third Eye Capital transactions and accrued legal exposure cost associated with the Dorsey complaint against us and GEI.

Liquidity and Capital Resources

As of December 31, 2013, we had $564,591 of cash, which we plan to utilize for working capital purposes. In addition we had $2,001,241 in restricted cash on our balance sheet. This restricted cash account is required under the Note Purchase Agreement with Third Eye. Any release from the restricted cash account is at the sole discretion of Third Eye.

We anticipate further losses during the development stage and it is reasonably possible that we will not be able to fund our operations or comply with certain financial covenants over the next 12 months without taking certain actions. Such actions include, but are not limited to modifying current debt agreements, entering into new debt agreements, issuing capital stock, reducing operating expenses and liquidating assets.

We expect construction of Lima Energy Gas 1 will require approximately $388 million to complete. We have structured, and are currently working to complete, a private placement of secured limited recourse bonds that we expect will provide sufficient proceeds to complete construction of Gas 1, to repay our Third Eye Notes and to give us additional working capital.

Cash Flows Years Ended December 31, 2013 2012



Cash used in operating activities $ (4,367,089 )$ (5,682,120 ) Cash used in investing activities (2,065,000 ) (27,503,569 ) Cash provided by financing activities 4,000,368 36,180,884

Increase/(Decrease) in cash $ (2,431,721 )$ 2,995,195

Net Cash Used In Operating Activities

For the year ended December 31, 2013, cash used in operating activities decreased to $4,367,089 compared to $5,682,120 for year ended December 31, 2012. Major items affecting operating cash included $20,994,890 increase in net loss, which included an increase of $13,559,378 in non-cash expenses related primarily to recording the fair value of the stock warrants associated with the 4% subordinated secured convertible debt for this reporting period under the mark to market approach and other debt related amortization costs. Our primary uses of funds in 2013 were related to salary expenses, professional fees related to the financing of our Lima Energy project and SEC reporting and compliance costs for the current fiscal year. This increase in net loss was offset by increases in our current liabilities of $5,747,423 and a decrease of $2,185,923 in the interest prepaid to Third Eye. In 2012, our primary uses of operating cash related to prepaid interest and professional fees associated with the Third Eye debt transaction, salary expenses, other professional fees related to normal operations and SEC reporting and compliance costs.

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Net Cash Used in Investing Activities

For the year ended December 31, 2013, cash used in investing activities decreased by $25,438,569 to $2,065,000 compared to $27,503,569 for the year ended December 31, 2012. The decrease is primarily attributable to $25,168,863 in cash used to purchase the Indiana BOE Energy Asset during 2012, which is discussed elsewhere in this filing. During the years ended December 31, 2013 and 2012, we invested $2,052,721 and $2,329,583, respectively, in site work for the Lima Facility and further construction activities of our Technology Innovation Center.

Net Cash Provided by Financing Activities

For the year ended December 31, 2013, cash provided by financing activities decreased by $32,180,516 to $4,000,368, compared to $36,180,884 for the year ended December 31, 2012. In 2012, we received the net proceeds from the Third Eye financing and $11,000,000 of proceeds from the issuance of 1,100,000 shares of our common stock to GEI. During the year ended December 31, 2013, we received $1,750,000 in remaining proceeds of the 4% subordinated secured convertible note. During 2013, we also received $1,000,000 in proceeds from the issuance of 100,000 shares of our common stock to a private investor and $1,000,000 released from the restricted cash account by TEC to us to use in operations. This restricted cash account is required under the Note Purchase Agreement with Third Eye and any further release from the restricted cash account is at the sole discretion of Third Eye.

Cash Position and Outstanding Indebtedness

Our total indebtedness at December 31, 2013 increased by $8,597,422 to $44,152,659 from $35,555,237 as of December 31, 2012. Our indebtedness is comprised of debt from financing transactions with Third Eye, as well as to accounts payable, accrued liabilities, and advances from related parties. This increase was primarily attributable to the $1,750,000 in remaining proceeds from the 4% subordinated secured convertible note issued to Third Eye Capital which were received during 2013 as we reached certain milestones, $1,200,000 from the issuance of a short term convertible note to Third Eye for fees associated with a $60 million standby letter of commitment, $3,000,000 in accrued legal exposure costs, interest and other costs associated with the Dorsey complaint against us and GEI, and a $1,447,423 increase in accounts payable and accrued liabilities. The amount reflected in Long Term Liabilities in our Consolidated Balance Sheets is net of $4,868,769 and $5,367,601 in debt discounts and unamortized fees expense at December 31, 2013 and December 31, 2012, respectively.

At December 31, 2013, we had current assets of $584,558 compared to current assets of $5,189,735 at December 31, 2012. We had long term assets of $32,264,935 at December 31, 2013 and long term assets of $31,455,179 at December 31, 2012.

Off-Balance Sheet Arrangements

During the periods presented, we did not have, and we do not currently have any off-balance sheet arrangements.

Inflation

Due to our limited operating history with respect to the production of energy and energy producing fuels, our production offerings and supplies have not been subject to significant price fluctuations as a result of inflationary or other market conditions; however, certain of our product offerings and supplies may be subject to future price fluctuations due to inflationary and other market conditions. We believe that we will largely be able to pass such increased costs on to our customers through price increases, although we may not be able to adjust our prices immediately due to fixed price contracts for specific terms. In general, we do not believe that inflation has had a material effect on our results of operations in recent years. The effect of technological advances on costs has not been determined, and in some cases has not caused prices on certain products to decrease, which could have a negative impact on margins.

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Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, expenses and related disclosures. We base our estimates and assumptions on historical experience and on various other factors that we believe to be reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. The results of our analysis form the basis for making assumptions about values of assets and liabilities that are not readily apparent from other sources. Our actual results may differ from these estimates under different assumptions and conditions.

While we have provided a detailed review of our significant accounting policies in Note 2 to our consolidated financial statements included elsewhere in this filing. We believe the following critical accounting policies involve significant areas of management's judgments and estimates in the preparation of our consolidated financial statements.

Impairment of Long-Lived Assets

We assess impairment of long-lived assets and test long-lived assets for recoverability when events or changes in circumstances indicate that their carrying amount may not be recoverable. Examples of such events or changes in circumstances that could trigger a review include, but not limited to, a decrease in market price of the assets, adverse change in business climate, legal or regulatory factors, obsolescence or significant damage to the assets. In such cases we determine the fair value based upon forecasted, undiscounted cash flows which the assets are expected to generate and the net proceeds expected from their expected sale. If the carrying amount exceeds the fair value of the asset, it is decreased by the difference between the two being the amount of the impairment. As of December 31, 2013 and December 31, 2012, we have not identified evidence of the impairment of our long-lived assets.

Accounting for Derivative Instruments

Convertible Debt. In 2011 and the first quarter of 2012 we borrowed $158,250 from an unrelated party which is convertible into shares of our common stock after 180 days at discounts to the price of shares of our common stock ranging from 55% to 65%. As of the transaction date, the value of the embedded derivative was immaterial. Subsequently, during 2012, using the mark to market approach, we computed the embedded derivative value to be $314,500 using the Black-Sholes pricing model. The convertible debt was paid off in July 2012.

Warrants. On September 24, 2012, we entered into a Unit Purchase Agreement, dated as of September 24, 2012, and amended on October 2, 2012 with Third Eye as agent for the unit purchasers. In connection with the Unit Purchase Agreement, we issued a warrant to the unit purchasers granting the right to purchase an aggregate of 10,312,500 shares of our common stock. The warrant included certain anti-dilution protection that requires the fair value of the warrant to be recorded as a liability. As a liability, we are required to record the fair value of the stock warrant liability each reporting period. We recognized a derivative loss of $13,217,000 and $1,452,000 for the fiscal year ended December 31, 2013 and 2012, respectively. The fair value of this warrant is computed using the Monte Carlo simulation model with the following input:

Years Ended December 31, 2013 2012 Risk free interest rate 2.79 % 1.73 % Volatility (Rounded) 80.00 % 80.00 % Probability of non-dilution event 95 % 95 % Probability of dilution event 5 % 5 % Going Concern Assumption



We are a development stage environmental energy company focused on low cost clean energy solutions from the deployment of proven Ultra Clean Btu Converter technology. The accompanying consolidated financial statements have been prepared on a going concern basis of accounting, which contemplates that the company will continue in operation for the foreseeable future and will be able to realize its assets and discharge its liabilities and commitments in the normal course of business.

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As of December 31, 2013, since inception, we have incurred $42,838,402 in net losses of which $25,472,022 were non-cash expenses. We have $564,591 of cash on hand and have an additional $2,001,241 currently in restricted funds which we anticipate being able to use all or part of for working capital purposes. We anticipate further losses during the development stage and it is reasonably possible that we will not be able to fund our operations or comply with certain financial covenants over the next 12 months without taking certain actions. Such actions include, but are not limited to modifying current debt agreements, entering into new debt agreements, issuing capital stock, reducing operating expenses and liquidating assets.

We currently intend to complete significant capital transactions in 2014 and we have access to reserve equity lines if we meet certain requirements. These transactions are discussed in more detail in the "Future Capital Requirements" section of this filing. In addition, we have major assets valued in excess of $100 million that may be utilized to increase liquidity. There can be no assurance that these capital transactions will be completed or asset liquidations would get completed in the targeted timeframe, which could impact our ability to have sufficient resources to meet our objectives raising doubt as the Company's ability to continue as a going concern.

Stock-Based Compensation

We account for employee stock-based compensation in accordance with Financial Account Standards Board, or FASB, Accounting Standards Codification, ASC, 718, Compensation - Stock Compensation. Under the fair value recognition provisions of this statement, share-based compensation is measured at grant date based on the fair value of the award and is recognized as an expense over the applicable vesting period of the stock award (generally two years) using the straight line method. During the year ended December 31, 2013, the Company issued a stock award of 50,000 shares to our Chief Financial Officer and no stock options or warrants. The stock award in 2013 had a fair value of $81,000. We record expense on a straight-line basis for awards with installment vesting. We recognized equity compensation expense of $6,231 for the year ended December 31, 2013. At December 31, 2013, we have unrecognized costs related to unvested shares totaling $74,769. During the year ended December 31, 2012, the Company issued no stock awards and issued no stock options or warrants in connection with employee compensation.

Recent Accounting Pronouncements from Financial Statement Disclosures

There are no recent accounting pronouncements that have an effect on our financial statement disclosures.


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